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Private equity funds have hoarded companies in just about every industry in a frenzied leveraged buyout spree that started early this decade and has yet to subside. Now private capital's increasing focus on retailers is forcing shopping center owners to adopt new strategies to evaluate potential and existing tenants.

“[Retailer] privatization is becoming more of an issue,” says Josh Poag, CFO of Memphis, Tenn.-based lifestyle center developer Poag & McEwen. “All of a sudden, the retailer we were dealing with before may not be the same retailer we're dealing with in the future.”

With a seemingly limitless supply of acquisition capital, private equity pools have snapped up some 134 U.S.-based retailers for $68.2 billion since 2002, according to Dealogic, an international capital markets data research firm. Some $60 billion of those deals occurred within the last three years.

On March 12, for example, private equity behemoth Kohlberg Kravis Roberts & Co. (KKR) agreed to buy struggling discounter Dollar General for $7.3 billion in the third biggest leveraged buyout (LBO) since 2002, according to Dealogic. Just a few days later, Apollo Management announced it would buy Claire's Stores for $3.1 billion.

Last year, private equity funds acquired more than 30 retailers: Among the top deals of 2006, Bain Capital Partners and Blackstone Group bought Michaels Stores in a transaction valued at roughly $6 billion.

Retail analysts expect the trend to continue. Why? Private capital pools like retailers' cash flow, and in many cases their low debt levels. Those elements are particularly important given the amount of debt private equity buyers frequently load onto targets to finance the acquisitions. According to a report by Citigroup, the typical LBO structure includes 51% of bank debt and 18% of high-yield debt.

Saturated with stores, the retailing landscape is ripe for consolidation. “In today's world just about everybody's fair game,” says Billy Busko, a managing director with New York-based Financo, an investment bank focused on retail and consumer industries.

Blurring transparency

But the retailer LBO craze presents potential headaches for shopping center landlords. Publicly traded retailers disclose financial information that measures the health of the companies. Private equity buyouts threaten that transparency, which ultimately could challenge retail property investors looking to lease, buy, sell, develop or refinance projects.

Case in point: In 2005, private equity fund Sun Capital Partners led a $1.2 billion acquisition of general merchandiser ShopKo, and subsequently executed sale-leaseback transactions with the properties.

Last year, KeyBank provided an unidentified owner with short-term mezzanine debt to finance four ShopKos in the West, says Dan Walsh, managing director for the private equity group at Cleveland-based KeyBank Real Estate Capital.

But ShopKo's new owner was hardly enthusiastic about sharing financial information, he adds. “I would say there's some unsettled territory in terms of the disclosure that landlords want and what tenants will give,” Walsh says. “There's a decent amount of negotiation that has to occur to see where that settles.”

That's not to say that private retailers in all cases refuse to provide financial information during lease negotiations or even during the lease term, says Ron Wheeler, chief operating officer of the Sembler Co., a St. Petersburg, Fla.-based developer of shopping and mixed-use centers. But many retailers fight financial data requests, which has convinced Wheeler and other shopping center landlords to eliminate potential resistance going forward.

“[Private equity buyouts] add the unknown and risk to deals,” explains Wheeler, whose firm owns and manages some 7 million sq. ft. and is currently developing 10 million sq. ft.

“I've told our leasing people that if we're dealing with a public company, make sure our leases require that [the retailer] has an obligation to provide financial information if it is bought by private equity.”

Protecting interests

Michael Carroll, executive vice president of real estate operations with New York-based New Plan Excel Realty Trust, talks about taking similar precautions. The real estate investment trust (REIT) owns and manages some 465 community and neighborhood shopping centers in the U.S. Currently, Australia-based Centro Properties Group is buying New Plan for $6.2 billion in a deal that's expected to close in the second quarter.

Carroll, like others, anticipates a loss of transparency as retailers go private, but New Plan will continue to press for sales information during lease negotiations, he says. He also suggests that large property owners who lease several locations to the same retailers typically have good relationships with the operators and are in a better position to negotiate for financials than smaller property owners.

“It's an issue that everybody in our space has to take into consideration,” Carroll says. “It's an ever-changing situation, and you do the best you can to keep tabs on a retailer's progress to protect yourself.”

In some cases, however, obtaining access to sales may not provide retailers any protection. While private equity funds may inject struggling retailers with badly needed capital, they frequently saddle acquisitions with debt and then slash costs by closing stores, firing personnel and cutting capital expenditures.

Those changes could result in diminished customer service at stores or empty storefronts. In either case, they threaten a shopping center's reputation.

“If private equity's buying a company for a financial play and is going to suck it dry and get its money out as fast as possible, that worries us,” Poag says. “If private equity's buying it because of the operating business and sees a growth plan, that's something that really doesn't scare us as much.”

Drawing on experience

Shopping center landlords are hardly unprepared for tight-lipped merchants who have recently moved to the private world from the public market. Retailing's private ranks include sizable regional and local operators such as H-E-B and Publix who are shy about sharing information, experts say.

One way to mitigate risk, Poag and others state, is to focus on signing retailers who are among the top three in sales within their respective sector — soft goods, general merchandise or electronics, for example.

Shopping center owners also can combat reduced transparency with the same kind of due diligence they should be practicing already, says Michael LaRue, president of LaRue Associates in Highland Park, Ill. After all, he points out, now-defunct drug store chain Phar-Mor reported glowing financials — until auditors discovered they were fantasy.

“When you go into a store, do you feel instinctively that it's going to be thriving and successful three years from now unless somebody does something really stupid?” asks LaRue, who provides development, brokerage and consulting for retail real estate clients. “With that as the first test, we all probably make better decisions.”

Property owners also can often access financial and credit information about private retailers through resources such as Standard & Poor's, Moody's and the International Council of Shopping Centers, other experts say. If those pursuits fail to instill landlords with confidence about the retailer, they add, it's probably best to end negotiations and walk away.

Jacksonville, Fla.-based Regency Centers, a REIT that owns and manages some 400 shopping centers in 37 metro areas, for example, checks retailers' credit backgrounds before signing any tenants, says Mary Lou Fiala, president and COO of Regency Centers.

“We're on top of our retailers so that we have a good sense as to what's going on in their business,” she says. “At this point, we haven't seen any difference whether they're private or public.”

Plus, just because a tenant trades publicly doesn't guarantee disclosure, particularly when a diversified holding company owns a retailer, adds Kristin Olson, a managing director with Buchanan Street Partners in Newport Beach, Calif.

Indeed, publicly traded Live Nation has an equity interest in 160 concert venues, including House of Blues and the Fillmore in San Francisco. But it also promotes concerts, plays and specialized motor sports events. House of Blues is a tenant in Buchanan Street's Houston Pavilions project, a 60,000 sq. ft. entertainment center underneath a 200,000 sq. ft. office component.

Thus, even though Live Nation is publicly traded, it's a challenge to get financial information about its individual business units, says Olson, whose firm provides equity for local operators and is looking to increase its roughly $110 million retail portfolio.

Strong appeal

Shopping center owners have little choice but to prepare for more retailer privatization. Absent tightening capital markets or a spectacular post-buyout bankruptcy, retail analysts expect more retailer LBOs.

In fact, the $68.2 billion in retailer acquisitions since 2002 marks the most activity in the space since the LBO wave in the 1980s swept up R.H. Macy & Co., Federated Department Stores and other operators.

In an early February research report, Kate McShane and four other Citigroup retail analysts predicted that retail buyouts this year would rival 2006's robust activity. In their estimation, Liz Claiborne, Timberland, Finish Line, Build-a-Bear Workshop and Circuit City are among the names ripe for a takeover.

“Retail remains attractive to sponsors because of compelling balance sheet and cash flow characteristics,” stated the analysts' report, which also correctly identified Dollar General as a likely target a month before KKR's offer. “Private equity is looking for the potential for incremental growth in revenues or margins in order to justify their investments.”

Private equity has launched its aggressive retailer hunt at an opportune moment, suggests KeyBank's Walsh. Strong consumer spending is driving retailers to repackage their brands to more effectively compete. The Gap and even Wal-Mart Stores, for instance, are undertaking remerchandising efforts.

“There's a lot of innovation going on in retail right now,” says Walsh. “Dominant players keep emerging, and the struggling ones need to be refreshed.”

Hope for stragglers

For struggling retailers, going private also means escaping shareholder demands for short-term profitability and quick turnarounds.

Case in point: Last fall, Dollar General announced it would close 400 stores and offered big markdowns on out-of-season apparel in a push to transform its operations and eventually become more profitable. Under previous practices, the chain had packed such inventory away until the next season.

The measures weren't enough. The company, which has relatively high debt levels, reported that earnings per share fell to 44 cents in 2006 from $1.08 in 2005. Even though Dollar General also reported same store sales increases early this year, efforts to reformat stores, improve the merchandising mix and create a better shopping experience were only getting underway, noted Credit Suisse retail analyst, Michael Exstein, in a March research report.

That opened the door for KKR, which offered $22 a share for Dollar General, a 14% premium at the time the deal was announced. The company's shares generally traded between $21 and $21.40 through much of April.

“With KKR recently announcing a $22 LBO takeout offer,” Exstein reported, “the road to recovery will occur as a private company, which is likely in the best interest of all parties involved as there are no quick fixes.”

Unlocking real estate value

Private equity funds have also pursued retailers with attractive real estate holdings, tapping into underlying property value. Following a well-tested strategy, the buyers have sold off properties to pursue sale-leaseback strategies or to simply dispose of weak performers. In either case, the funds have typically beefed up the balance sheet of the core business.

For example, a consortium of investors acquired and split up Albertson's Inc. last June in a $17.3 billion LBO — the largest retailer buyout since 2002. Rival grocer Supervalu and drug store chain CVS landed more than 1,700 Albertson's, Sav-On and Osco stores.

Meanwhile, private equity firm Cerberus Capital Management, REIT Kimco Realty Corp., and other investors acquired some 660 Albertson's stores as well as distribution centers, offices and other assets.

The Cerberus and Kimco group closed on $1.7 billion in financing secured by the properties and announced the closing of roughly 125 stores. The strategy is paying off: In February, Kimco announced it had received a cash distribution of $121.3 million resulting from disposition of Albertson's assets and a refinancing of the remaining assets.

The company invested some $50 million in the deal, according to comments made by executives during quarterly conference calls in 2006. Kimco sees more opportunities on the horizon, according to comments made by David Henry, Kimco's vice-chairman and CIO, at the Deutsche Bank 2007 Real Estate Outlook Conference early this year.

But the strategy is exciting real estate investors who also pursue value-add plays. Hartford, Conn.-based Hutensky Group, for example, acquires shopping centers fraught with vacant space, bankrupt tenants and lender problems with the aim of turning them around.

Brad Hutensky, president of the company, predicts that private equity pools will continue to swiftly close stores and sell off real estate as they seek to strengthen balance sheets. The firms will then pay down the debt financing their acquisitions.

“We think private equity buyouts are a tremendous opportunity because there's going to be a lot of dislocation of real estate — store closings, stores relocating and store openings,” he says. “Those things already happen in retail — they're just a fact of the business. But this may accelerate that for certain retailers and impact shopping centers.”

Joe Gose is a Kansas City-based writer.

Buyout Announced Private Equity Sponsor Buyout Target Core Business Status
Jan. 18, 2006 Bain Capital Partners LLC Burlington Coat Factory Discount apparel Completed
Jan. 23, 2006 Cerberus Partners LP Albertson's Food-drug Completed
June 30, 2006 Bain Capital Partners LLC
Blackstone Group LP
Michaels Stores Arts and crafts Completed
Feb. 9, 2007 Apollo Advisors LP
Ares Management LLC
Teachers Private Capital
GNC Nutrition foods Completed
March 12, 2007 Kohlberg Kravis Roberts & Co. Dollar General Soft and hard goods Pending
March 20, 2007 Apollo Advisors LP Claire's Stores Women's accessories Pending
Source: Dealogic

Private equity gives retail REITs the cold shoulder

Private equity funds have snatched up an increasing number of real estate investment trusts (REITs) over the last several years, removing them from the glare of the public markets. But the privatization wave to date has all but ignored retail REITs.

Since 2000, some 39 REITs have gone private in buyout deals valued at $114.2 billion, according to Charlottesville, Va.-based SNL Financial. That roster includes only nine retail REITs — seven shopping center trusts, one regional mall company and one outlet center owner.

Even in most of those cases, however, overseas property companies traded on foreign exchanges led the buyouts rather than private equity, and SNL Financial considers those transactions privatizations because the REITs are no longer listed on a U.S. exchange.

Affiliates with publicly traded Australian property trust Centro Properties Group, for example, acquired two U.S. REITs in 2005 and 2006 for $4.5 billion. Centro Properties also is buying New Plan Excel Realty Trust in New York for $6.2 billion.

Why are private equity funds giving retail REITs the cold shoulder? Quite simply, private fund managers are buying what they believe are undervalued real estate assets in the public market for an arbitrage play, says Keven Lindemann, director of SNL Financial's real estate group. Retail REITs are largely considered fully valued.

Office properties in major metropolitan markets have been the most attractive properties to fill the arbitrage strategy, thanks to impressive rent growth and projections for even more. Indeed, private equity funds have acquired 10 office REITs for $53 billion since late 2004.

“Retail just doesn't have that same rent growth dynamic,” says Michael Carroll, executive vice president of real estate operations for New Plan.

Office rents grew an average of 3.38% in the fourth quarter of 2006 in the top 10 office markets ranked by rent growth, according to Reis, a New-York-based commercial real estate data cruncher. Rents in the top 10 retail markets grew an average of only 1.9%.

Still, the lack of private equity interest in retail REITs has hardly slowed merger activity in the sector, particularly as the trusts push for savings and efficiency. Since 2000, U.S.-listed retail REITs have made 11 acquisitions valued at some $29 billion, according to SNL Financial. Most recently, Cleveland-based Developers Diversified Realty Corp. bought Inland Retail REIT for $6.3 billion.

“There's a perception that economies of scale do mean something in the retail property type — you can be bigger and better,” Lindemann says. “That idea has not been proven in other property types.”
Joe Gose

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