When Kohlberg Kravis Roberts (KKR), the legendary New York City-based private equity player, purchased the discount retailer Dollar General for $7.3 billion in July of 2007, the deal hardly made waves. Although it was one of the largest private equity buyouts in the retail sector, it came at the tail end of a four-year stretch in which deals with billion-dollar price tags were the norm. During that time, retailers of all types, including Albertsons, Neiman Marcus, Michaels Stores, Burlington Coat Factory, PETCO and Toys 'R' Us, fell into the arms of private equity buyers. In 2006 and 2007, there were 91 leveraged buyouts of retailers in the U.S., totaling more than $48 billion. By contrast, in 2008, there were 24 buyouts totaling less than $1.2 billion.

Yet two years later, the Dollar General deal stands out as one of the few true success stories from that buying binge. With its focus on budget shoppers, the retailer has withstood the recession better than most. Moreover, from the start, the deal was a retail play—not a real estate bet in disguise, as many other buyouts have proven to be.

"Dollar General has been a real home run," says Craig Johnson, president of Customer Growth Partners, a New Canaan, Conn.–based consulting firm. "That's where the retail market and the wholesale migration toward value players have very much worked in favor of the company."

For its fourth quarter ended January 30, Dollar General reported net income of $81.9 million, 47.8 percent higher than the $55.4 million reported in the fourth quarter the year prior. Total sales during the period rose 11.2 percent compared to 2007, to $2.85 billion. Same-store sales increased 9.4 percent. In April, as thousands of companies around the country continued to lay off workers in order to stay afloat, Dollar General announced a plan to create 4,000 new jobs in 2009 to support an additional 450 stores. Last year, the retailer opened a net of 168 new stores.

To KKR's credit, the firm says it bought Dollar General because it thought a downturn was coming before the credit crisis hit in September, although it did not think the damage would be of this magnitude. "I think it's fair to say that the downturn in consumer spending was greater than anybody anticipated," says Mike Calbert, KKR's partner in charge of Dollar General. "Clearly we didn't think that the level of consumption [we had] was sustainable, just given the lack of savings, the leverage level the consumer was getting to. We thought there was going to be a pullback, but the reality of the ... worst fourth quarter in 40 years of retail history wasn't something that we anticipated."

Still, the deal was a bet that discount chains would become more popular during a downturn—a bet that has paid off in spades. In addition, the fact that Dollar General leases all of its stores, rather than owning them, might have made KKR less focused on getting value out of its real estate holdings and more focused on improving profit margins for the core operating business.

Overall, though, the Dollar General story is an exception to how things have played out for private equity buyouts. The combination of a tightened credit market, a fall in real estate values and a pullback in the retail sector has dealt crippling blows to many buyout targets. Back in September of 2006, private equity players were preaching the message that they'd learned their lessons from the wave of disastrous leveraged buyouts of the 1980s. This time they would saddle buyout targets with less debt and pour more resources into what they thought were undervalued retail companies. And even if things didn't turn out well, they saw a potential safety net in the value of real estate many firms held. In fact, analysis of some companies during the height of the boom showed the value of underlying real estate to be greater than market capitalization of the entire firm. That made the buyouts no-brainers.

But the reality has turned out much different. The recession and the accompanying credit crisis have proved too much to handle for a number of buyout targets. The precipitous decline in consumer spending has made it difficult to make money on core operating businesses, especially given that many of the bought-out chains were secondary or tertiary players in their respective sectors, according to Todd Hooper, principal with Kurt Salmon Associates, a global management consulting firm. Debt has also been an issue. Many of the deals were financed with short-term acquisition loans, which were meant to be eventually replaced with permanent financing. But private equity firms have had trouble getting permanent loans since late 2007. Meanwhile, the precipitous drop in real estate values and spiking vacancies in the retail sector took away the new owners' supposed safety net.

As a result, many of the chains that were viewed as undervalued steals in 2005, 2006 and 2007—Linens 'n Things, Fortunoff, Mervyns—are now defunct following a series of painful liquidations. And we're likely to see more privately held retailers join their ranks, says Johnson.

"We believe the economy is near the bottom now, but don't see a big turn till next year," he notes. "And the [leveraged buyouts (LBOs)] tend to be over-leveraged and not have a strong capital base. We think it's more likely than not that we will see additional Chapter 11 [filings] and some direct liquidations. We haven't seen the last of it by any means."

Continue: "Winners and Losers"...

Winners and losers

Back when credit was readily available, underperforming retail chains were an attractive target for private equity players because they offered a high potential for profit at little cost. Private equity firms usually amass vast portfolios of firms in different sectors because their whole business model is based on risk, notes Hooper. In order to win multibillion-dollar bids for national retailers like Linens 'n Things or Dollar General, they secure short-term acquisition loans that can account for anywhere from 40 percent to 90 percent of the acquisition price. The higher the leverage level, the more acquisition power the firm has. KKR, for example, owns a stake in Toys 'R' Us, bedding manufacturer Sealy Corp., real estate finance firm Capmark Financial Group and many others, in addition to its ownership of Dollar General.

The financing is usually secured by the assets of the firm to be acquired and is meant to be replaced by permanent loans a few months down the road. The new owners then attempt to capitalize on their holding companies by either cutting operating costs, or improving profit margins for the underlying business; in some cases, both. Once the turnaround is completed, in two or three years' time, the company is returned to the public market through an IPO, generating additional profits for the private equity players.

The risk attached to this sort of play has to do with the financing model, which backs acquisition loans with low investment grade bonds and features high-interest payments that can destroy the acquired firm if the turnaround strategy is not successful. Moreover, with sky-high debt-to-equity ratios leveraged buyouts can turn disastrous if private equity players can't refinance their loans. That problem has materialized in August of 2007, when the credit crisis first hit the U.S. and it continues to be a pressing concern. According to Standard & Poor's, between 2010 and 2014, more than $476 billion in LBO loans will reach maturity. But even without accounting for the current credit shortage, in recent years, the annual leveraged loan issuance has averaged only $104 billion.

The breakdown of which retailers are headed for extinction and which will ultimately survive the carnage will depend in large part on how strong the core retail business was at the time of the buyout, says Hooper. "If you think about the guys that are struggling now, most of it is fundamental problems with their model that were accelerated by the debt they've taken. There wasn't enough time to turn them around" before the downturn hit.

The good news is that there appear to be some outperformers among the bought-out retailers, including Dollar General, J. Crew and Toys 'R' Us. For example, for the first quarter ended May 1, J. Crew Group, Inc. reported that total sales rose 5 percent, to $240 million and revenues increased 2 percent, to approximately $346 million, though same-store sales declined 2 percent compared to the first quarter of last year. The performance is impressive given J. Crew's position on the more expensive side of the specialty apparel sector, one of the more challenged sectors in this economy, notes James C. Bieri, president and CEO of Detroit-based consulting firm the Bieri Co. J. Crew, which is headquartered in New York City, is partially owned by Texas Pacific Group.

Meanwhile, toy seller Toys 'R' Us, Inc., which is owned by KKR, Bain Capital and Vornado Realty Trust, has been slowly getting ahead by cutting operating expenses and gaining market share by eating up its competitors. In May, for example, it signed a contract to buy upscale rival FAO Schwarz for an undisclosed sum. Other purchases have included eToys.com, Toys.com, babyuniverse.com and ePregnancy.com.

For the first quarter ended May 2, Toys 'R' Us reported a 5.4 percent drop in same-store sales compared to the first quarter of last year. The retailer's gross margin, however, remained the same, at 35.9 percent.

On the flip side, consider Linens 'n Things, which was picked up by Apollo Management Ltd. and National Realty & Development Corp. (NRDC) for $1.2 billion in 2006. The chain always trailed rival Bed, Bath & Beyond in the big box home furnishings sector, notes Johnson. In recent years, discounters Target and Wal-Mart have also crowded the home furnishings field. So when the housing crisis drove down Americans' furniture and housewares purchases in late 2007 and early 2008, the Clifton, N.J.–based retailer found it couldn't compete. In May 2008, Linens 'n Things was forced to file for Chapter 11 bankruptcy, with initial hopes of restructuring as a leaner, more profitable operation. As of year-end 2007, the company faced $1.42 billion of debt, against assets worth $1.74 billion. In June 2008, the bankruptcy court approved Linens 'n Things for $700 million in debtor-in-possession (DIP) financing from the GE Capital Corp. Given the market environment, the firm was lucky to secure a DIP loan—with many financial firms on the verge of ruin, DIP financing has been scarce in this recession.

By October, however, the company's owners were forced to begin liquidation proceedings as sales continued to plummet and the chain faced mounting pressure from bondholders to pay back debt. In the aftermath of the liquidation, the retail real estate market was flooded with hundreds of vacant big boxes. (As of October 2008, Linens 'n Things operated 371 stores.)

The fallout in retail has hit all sectors. Sales of electronics, furniture, apparel, books and accessories have plummeted as the world faces the worst recession in 80 years. In November of 2008, the Deloitte Consumer Spending Index turned negative for the first time since 1980. Since October of last year, U.S. chain stores have had 10 consecutive months of same-store sales declines, according to ICSC. From January through April, same-store sales have fallen by an average of 0.5 percent, compared to a gain of 0.9 percent in 2008 and 2.1 percent in 2007.

As a result, even chains that were previously considered well managed and recession proof have suffered. For example, luxury department store operator Neiman Marcus, Inc., which was bought by Texas Pacific Group and Warburg Pincus for $5.1 billion in May of 2005, has often been lauded for the management savvy of its president and CEO Burton M. Tansky and executive vice president Karen W. Katz. Since the buyout, the chain attempted an expansion campaign, opening new Neiman Marcus stores, launching the boutique clothing concept Cusp and planning to gradually enter smaller markets. In addition, until the stock market meltdown of 2008, luxury sellers were thought to be one of the safest sectors in the industry, since recessions tend to have less of an impact on the shopping habits of the very wealthy than on those of the middle class. But for the second quarter of 2009, ended Jan. 31, Neiman Marcus reported that its total sales declined 21 percent, to $1.08 billion from $1.37 billion a year ago, and its same-store sales fell 22.8 percent. The retailer ended the quarter with an operating loss of $529.7 million.

"I don't think you will see Neiman Marcus go belly up, but they might close stores," says Hooper.

The Dallas-based company currently operates 40 Neiman Marcus stores and two Bergdorf Goodman locations. At the time of the buyout, the retailer operated 35 Neiman Marcus stores and two Bergdorf Goodmans.

Another retailer that might find itself on the verge is PETCO, which was bought by Texas Pacific Group and Leonard Green & Partners for $1.8 billion in 2006. The two firms already had plenty of experience with the retailer after having bought it in the fall of 2000 and sold it back into the public market two years later. By 2006, however, the San Diego, Calif.–based pet food and supplies seller was less popular with consumers than sector rival PetSmart, according to Johnson. Adding to the pressure now is the fact that as Americans continue to lose jobs and watch their life savings disappear, many are less inclined to pamper their pets with premium products. Instead of shopping at a specialty pet store, they are going to discount stores like Wal-Mart and Dollar General, says Johnson.

The fates of accessories seller Claire's and department store chain Sears also remain doubtful. For the fourth quarter ended Jan. 31, the most recent period for which financial information is available, Claire's Stores, Inc. reported a net sales decline of 12.2 percent, to $393 million, and a same-store sales decline of 7.2 percent. For the first quarter ended May 2, Sears Holdings Corp. reported a 7.4 percent decline in domestic same-store sales compared to the same period last year and a gross margin of $2.9 billion, down 3 percent from $3.0 billion in the first quarter of 2008. Claire's and Sears are owned by Apollo Management, L.P. and hedge fund ESL Investments, respectively.

Continue: "Real Estate Pipe Dream" and "Too Much Risky Business"...

Real estate pipe dream

Back in the heyday of the buyout era, many private equity players felt they could justify paying billions of dollars for retail chains because there was always the possibility of a real estate play if the retail operation went under, says Johnson. At the time, retail landlords clamored to get back spaces from struggling tenants so they could finally turn a profit on their below-market rents. What private equity raiders hadn't foreseen was that a pullback in consumer spending would coincide with a severe downturn in the commercial real estate sector. With retail property values falling 25 percent since they reached their peak in 2007, according to research from New York City–based Real Capital Analytics, empty stores are no longer worth a fortune. Expectations are that values may drop another 15 percent before bottoming out.

When the consortium of Sun Capital Partners, Cerberus Capital Management and Lubert-Adler and Klaff Partners bought mid-market department store chain Mervyns from Target Corp. for $1.2 billion in July of 2004, Mervyns' real estate was among its main attractions. At the time of the buyout, Mervyns was struggling—it was just another mid-market chain in a moribund department store sector, according to Johnson. But it had a fleet of more than 250 stores, including 155 that were company-owned. The stores averaged approximately 80,000 square feet in size and represented quite an attractive chunk of space as real estate values continued to climb up.

But in spite of some modest efforts to turn around the struggling chain—for example, broadening product selection and bringing in more private label products,—Mervyns' retail operation never prospered. The fact that Lubert-Adler, whose focus is on real estate rather than retail, spun off Mervyns' real estate division and sold many of the chain's leases to third parties, bringing up Mervyns' rents, made the situation much worse. Meanwhile, by the end of 2008, as the chain was liquidating, its property holdings had lost most of their value. When department store operator Kohl's and apparel seller Forever 21 teamed up to buy 43 leases belonging to Mervyns in December of last year, they paid from 20 cents to 25 cents on the dollar for the assets, according to sources involved in the transaction.

"The problem was that there were too many big boxes coming online," says Hooper. "I think it was just a strange safety net if people expected real estate to provide any kind of a fallback—even [during the boom years] people realized there were too many big boxes. That was never destined to be a really strong out."

Too much risky business

The big question right now is whether the aftermath of the recent LBO run will leave the retail landscape as battered as the private equity attack of the 1980s. When the acquisitions were taking place, industry experts pointed to the fact that private equity players were being more careful about taking on debt than during the gung-ho days of the 1980s LBO era. They generally employed leverage levels of 40 percent or 50 percent rather than 90 percent. That was supposed to safeguard against credit-related bankruptcies and liquidations. In many cases, they also made good-faith efforts to improve the retailers' operations, instead of focusing only on the bottom line.

But then the global credit crisis hit and the current recession turned out to be the worst one since the 1930s, in addition to the fact that there were now a lot more retail concepts chasing limited demand for discretionary goods than there were 20 years ago, says Johnson.

"Wal-Mart and other value retailer are sucking up any available excess demand," he notes. "And it's leaving marginal players beached—when the tide goes out, you see which swimmers don't have trunks on."

Still, that's the nature of the private equity business, adds Hooper—the whole leveraged buyout model carries with it a high level of risk, especially for those firms that target high-profile acquisitions.

"It's just a cycle that the markets go through," he notes. "If you are comfortable making a ton of money in good years and losing a lot of money in bad years, that's fine."