Menu
RSS

With Both VC And PE Firms, Retailers Must Balance Investment Risks And Rewards Featured

  • Written by  Glenn Taylor
With Both VC And PE Firms, Retailers Must Balance Investment Risks And Rewards

Attendees at any retail conference in 2019 are likely to see numerous panels and keynotes that include venture capitalists, private equity investors or both, with speakers detailing their experiences investing in brands, assisting with growth strategies and the various challenges that can arise.

While each deal has its own individual contours, there’s a basic divide between the strategies of VC and PE investors. VCs often take on companies in their nascent states, as the retailer (and the investors) seek the elusive goal of creating a unicorn — a company with a billion-dollar valuation. In contrast, private equity firms often quietly back some of the larger, established brands in the hopes of maintaining stable growth.

ADVERTISEMENT
Both types of investments carry risks for the retailers and the funders. VC money can pump up the hype that overvalues early-stage companies that have not yet mastered business fundamentals, leading to failed IPOs and steep declines in stock prices. PE funding can help retailers monetize undervalued assets, but if it’s not accompanied by solid growth plans, the added debt load can prevent companies from investing in critical technologies that would allow them to take advantage of new opportunities.

In 2020 and beyond, retailers of all sizes that are considering outside investments will need to understand both the benefits and drawbacks of dealing with these different types of firms.

Early-Stage VCs Make Serious Investments In Emerging Brands

Venture capitalists typically invest in a business from the ground up, with many “early-stage” companies attracting funds in their efforts to scale up. In fact, e-Commerce startups raised $5.9 billion in early-stage capital from investors in 2018, according to a report by Ernst & Young.

Sanket Parekh, Founder and Managing Partner of Secocha Ventures, an early-stage venture capital firm, noted that his firm bases its decision-making processes largely on continuing changes in consumer preferences, in combination with the company’s ability to sell directly to consumers.

One such example is the company’s investment in Clare, a DTC e-Commerce paint seller: “We find opportunities where companies are disrupting that supply chain and offering an ability to cut costs — lowering basic operating expenses because you’re not stocking paints at a few thousand locations and instead stocking in five locations across the country,” Parekh said in an interview with Retail TouchPoints. “We’ve learned that from the Caspers of the world that have changed the way we buy mattresses. A lot of people don’t realize how impactful working capital could be on a company. You stock goods over a few hundred locations, you’re carrying more inventory and spending more money. The minute you change that equation, it’s quite dramatic in learning how little money you need to build a large company.”

Beyond offering a solid product and a differentiated service, venture capitalists taking a chance on these types of early-stage companies also rely heavily on key metrics such as the customer lifetime value (LTV) to cost per acquisition (CAC) ratio, which translates to, How many marketing dollars have you spent on a customer and how much have you earned from that?

“If that ratio is healthy, you know the company is healthy,” Parekh said. “We see WeWork and Uber in the news and we’re seeing all these companies where the LTV to CAC was not a healthy number.”

VC Partner To Brands: Show Profitability, Build Network Before Going To Venture

Seth Beers, Managing Partner at Harbinger Ventures, a venture capital firm for early-stage, female-led businesses, noted that his company is focused entirely on ensuring that investments are made in companies with profitable fundamentals already in place. Typically, most companies Harbinger invests in start off within the $5 million to $10 million revenue range before scaling up.

“In our world, even with omnichannel disruption, we’re seeing brands in the CPG space that can get to sustainable break-even between $20 million and $30 million in sales,” Beers said in an interview with Retail TouchPoints. “What drives that are strong gross margins, efficient customer acquisition, strong retention metrics. In all our businesses, the brand has the ability to continue to invest in growth, whether they want to take on more equity capital, grow opportunistically and sell a larger portion of the business, or be more thoughtful about how they grow.”

For early-stage retailers, Beers recommends incorporating fundraising before even getting to the venture stage, both to build a network and to give the company a perspective on the type of people they want supporting them.

“So often, we’re generally seeing companies wait too long,” Beers said. “But in our business, a relationship is so critical for being able to build in over time. This not only increases the interest of the investor, but it also allows the founders to know who they want alongside their journey.”

Late-Stage Investments Create Unicorns, But They’re Not Without Risk

Although a good portion of younger venture capital firms are looking to get in early, the “age of disruption” in retail has made later-stage growth more attractive. Case in point: in 2019 alone, popular digital natives such as Casper, Glossier, Rent The Runway and most recently online marketplace Faire all entered the $1 billion-valuation club with the help of massive funding rounds led by VC firms. And Instacart has generated $1.9 billion, largely from venture funding, with the company now valued at $7.8 billion. But it’s important to remember that provable growth numbers indicate a less risky investment, valuations at this state in a company’s lifecycle can easily be overinflated.

The initial hype behind companies such as Uber, Peloton and WeWork that have resulted in both major stock dips and a pulled IPO should be object lessons for retailers and investors alike. Avoiding the effects of hype is doubly important in an industry that turns on a dime due to fast-changing consumer habits. Any retailer with plans to go public with a bunch of venture capital money behind it must still prove that its business model is profitable and sustainable — even if the retailer identifies itself as a growth company.

Private Equity Ownership Remains Controversial, But It Still Offers Value

While the retail-venture capital relationship has continued without much public scrutiny, private equity has come in for its share of criticism in recent years — particularly since high-profile bankruptcies such as Toys ‘R’ Us, Payless ShoeSource and Sports Authority all occurred under the ownership of private equity firms. Additionally, with as many as 1.3 million U.S. retail jobs potentially lost due to these bankruptcies and store closures, more people are asking whether private equity benefits retailers at all.

Under the private equity model, a firm usually finances the acquisition with “60% to 70% debt, and the expectation is that the retailer over time uses free cash flow and EBITDA growth toward debt reduction at some point in its future,” according to David Silverman, Senior Director, Corporates at Fitch Ratings. “That simply hasn’t worked out that way.”

This model makes sense in theory for retailers that need an immediate cash infusion and are on a growth path. It actually can even put struggling retailers on the right path to monetizing their undervalued assets effectively.

“You have to look at why private equity firms buy these companies to begin with,” said Mickey Chadha, VP and Senior Credit Officer at Moody’s Investors Service in an interview with Retail TouchPoints. “Number one, the firm feels the company has an execution problem and feels management hasn’t taken advantage of some strategic ideas. The firm also feels that there is a hidden asset value in the company such as real estate that is not being valued by the market properly. They can monetize those assets at a profit. In a consolidating industry, the firm also may want to make multiple acquisitions so that the company is bigger and then [can] compete, before selling it to a strategic buyer.”

Changes In Overall Consumer Spending Habits Exacerbate PE Problems

But many times, when sales plunge and the overall market shifts its spending, these retailers are essentially strong-armed into prioritizing their debt payments rather than reinvesting the money into the business.

For example, Silverman noted that at the time of their private equity acquisitions, businesses such as Toys ‘R’ Us, Payless, Neiman Marcus, Gymboree and J.Crew appeared to have much stronger pathways toward EBITDA growth, where the debt structure would be easier to manage. But given each company’s inability to generate sales growth amid declining store traffic, additional online competition and changing customer habits, these retailers ended up at a natural disadvantage — even as they opened new stores and increased their online product assortments.

“We see in many cases that these weaker companies don’t have the ability or the bandwidth to invest in stabilizing market share, and a combination of weak cash flow and upcoming maturities (deadlines for debt payments) is what drives a company into a default inclusive of a distressed debt exchange or a bankruptcy,” said Silverman in an interview with Retail TouchPoints.

Distressed Retailers Must Mull Debt Payment Options, Assets Before Ownership Decisions

With that said, retailers going forward with ownership changes will need to think about the implications of putting debt on their balance sheet and how that may impact future cash flow, as well as seek out numerous options for maturity schedules. Additionally, retailers must consider what they would be likely to lose if they enter this “distressed” mode down the line — a situation that often ends with the sale of assets that the company still considers highly valuable but can no longer afford.

“Those assets could be distribution centers,” Silverman said. “They could be secondary businesses, or in some cases they could be franchise or branding rights in new markets or new territories. The unfortunate aspect is that the vast majority of retailers don’t have a lot of hard assets that they can sell. Most retailers rent their stores and don’t own a lot of manufacturing facilities. That’s been a challenge, particularly in the mall-based specialty apparel space.”

It’s clear that the “distressed” retailers of today certainly haven’t been helped by this overload of debt, but that does not automatically mean that private equity is inherently bad for retail.

“A moderate amount of leveraged debt on a company, or the right amount depending on what your growth assumptions are is not a bad thing,” Chadha said. “You can balance that, but too much debt and very little growth and opportunity for profitability is a recipe for ultimate disaster. It depends on the company, but an overarching theme is that if you are highly leveraged and you don’t have the scale today to compete with the larger players with a much stronger balance sheet and much stronger cash flows, you are going to be in trouble.”

back to top