Recent Private Equity Courtship Of British Supermarket Chains Is Bewildering

Low-growth, capital-intensive, low margin and scarred by an embarrassing record of expansion failures, British supermarket chains have long been bullied by financial analysts. Britain’s supermarkets were the ugly duckling that nobody had eyes for. In 2014, Morrisons was touted around potential buyers to no avail. Yet suitors are filing in now. Just this year, US private equity firm CD&R acquired Morrisons; Compatriot private equity firm Fortress, having lost out on its bid for Morrisons, bulked up its shareholding in Tescos while Czech billionaire Daniel Kretinsky’s Vesa Capital doubled its stake in Sainsbury's to 9.9% in May. The ugly duckling has matured into a beautiful swan. Why did this fairy tale come?

Firstly, low-interest rates facilitated borrowing, an essential component of a private equity firm’s modus operandi. Private equity firms acquire companies, grow them (usually by installing better management), and sell them for a profit. The acquisition is funded through leveraged finance, which refers to raising a large amount of debt secured against the purchased company’s assets. With record-low interest rates, as central banks rush to encourage spending to revive a covid-stricken economy, leveraged finance has become very easy for private equity firms as the cost of debt falls. Low-interest rates have also directed the attention of yield-hungry investors to private equity firms, offering an abundance of spending power.

Secondly, the shifting consumption dynamics during lockdowns have given supermarkets a glow-up. As restaurants closed and people were compelled to spend more time at home, the panic-buys and inevitable increase in kitchen endeavors have spiked spending at supermarkets. Within weeks of the coronavirus outbreak in 2020, Tescos had already seen a 30% hike in sales. The pandemic has ushered in an age of steady-cash flows for supermarkets, making them attractive targets to private equity firms.

Thirdly, the sizable freehold estates that acquire supermarkets provide business advantages. The estates can be sold off to organisations like real estate investment trusts as a convenient arrangement to pay off debts: the cash generated from the sale provides repayment, while the private equity-owned supermarket rents the property from the trust using its income. This can even trigger a dividend recapitalisation, the issuing of new debt by private equity firms to offer investors dividends–thus keeping them onboard and keen to invest.

Opinion

The flurry of private equity activity is at first blush welcoming. Private equity investments increase the finance available for investments, support companies through periods of financial distress and increase the operating performance of portfolio companies by contributing to the growth and strategy of the company. At least in the short term, private equity activity increases productivity in the economy.

However, there are catches. Leveraged financing, owing to the large amount of debt involved, pressures the private equity firm to consolidate (i.e. streamline its operation) and cut expenses to maximise profits. One collateral damage is supermarket employees, whose livelihoods may be sacrificed to pursue profit.

Some private equity firms may neglect the long-term development of portfolio companies as well as the interest of employees, businesses and society. These private equity firms would be primarily concerned with the growth and profitability of portfolio companies before their exits, which typically occur only 5-7 years after the acquisition.

The demise of Debenhams and electrical goods chain Comet offers a helpful case study (and a portent of doom): denuded their most valuable assets (i.e. stores) to cut expenses and burdened with millions of debt, both companies met horrible ends. Comet, in particular, collapsed only within months of private equity ownership, resulting in the loss of 7000 jobs. The loss of jobs, in turn, cost taxpayers an estimated £50 million in lost tax revenues and redundancy payments.

The fates of both companies highlight the potential problem relating to the aim of private equity owners to cash out quickly (so they can move on to acquire another business). Part of ‘quickly’ is to omit the time-consuming work that nurtures businesses, like understanding consumer demand and redesigning products. Expediency also necessitates profit maximisation, leading to aggressive cost-cutting and reducing investments without regard to consequences that would befall employees and society. Profits may look great on paper in the short term, because the equity-light nature of leveraged financing means that immediate profits generated from cutting costs need not be carved out as dividends for shareholders. Nevertheless, in the long run (often after the private equity firm exits), for companies run by irresponsible and short-sighted private equity owners, the development would be stunted due to a lack of investments or loss of assets in the process of cost-cutting. The staggering level of debt inevitably incurred from leveraged financing also renders the company vulnerable to economic downturns or even simply bad patches in business. Private equity ownership can be a recipe for disaster.

Perhaps only time will tell if private equity ownership is really the happy-ever-after for supermarkets in Britain.

If there is no guarantee of a happy ending, Supermarkets should grow ‘big’ enough to fend off the raid of private equity. And if there is something attractive about acquiring supermarkets, why shouldn’t supermarkets themselves grow by taking over other supermarket chains?

Europe’s supermarket chains are cheap. French retail corporation Carrefour trades on a p/e ratio of about 13. Dutch food retailer and Europe’s largest supermarket group Ahold Delhaize is on about 23, the same as Sainsbury’s. A giant like Tescos should have the firepower–which would only foreseeably grow as rivals’ private equity backing dampen interests to repeat the mutually destructive price wars that was waged 10 years ago. British supermarkets should swoop in quickly, before private investors snap up their European counterparts– Just last month, American hedge fund Elliott Advisors purchased a 3% stake in Ahold Delhaize.

For supermarket chains, Expansion is almost synonymous with returns. The larger the chain is, the larger its customer base. In turn, the size of the customer base gives supermarkets ‘muscle’ to secure supplies at the best prices and exploit economies of scale more quickly. With lessons learnt from M&S’ failed expansion in France and Tesco’s over-ambitious global expansions, British supermarkets should know what to do.

There would of course be obstacles. Having lost Unilever, RELX and more recently Shell, the Dutch would not be pleased to let Ahold fall into British hands. The same mix of national sentiment and economic concern would also hold President Macron back from allowing a smooth takeover of Carrefour. More importantly, antitrust concerns loom. Earlier this year, Sainsburys’ move to acquire Asda was blocked by the Competition and Markets Authority, which waved off claims that the acquisition would lead to lower consumer prices. But the logic for poaching supermarkets in Europe is compelling. Expansion, not least to fend off private equity interests, benefits everyone in the country–supermarkets, employees, and society.

The view from law firms

Law firms benefit whether British supermarkets venture into Europe or not. If supermarkets decide to expand, more (big-ticket) transactional work will be done. Other practice areas such as competition and real estate would also get paid. If nothing changes, law firms would still be kept busy in advising supermarkets on ESG-related issues, which has become a genuine concern for stakeholders and private equity owners alike.

By Oscar Wong