The recent flurry of activity surrounding the love affair between private equity and retail and the latest results from the John Lewis Partnership have dominated retail news over the past two weeks.
These topics together sum up much about the state of play in todayäs high street. First, private equity. The attractions of retail to this segment of the investment community is not new, but the current courtships of Sainsburyäs and Boots show that their appetites have yet to be sated.
The basis of the attraction is quite simple: cash. In these days of progressively extending payment periods, a growing number of retail businesses are able to sell their stock before they pay for it. Most of these deals depend one way or another on borrowing large sums to do the deal and then using cash from the leaner, fitter acquired business to pay back the debt. The acquired company in effect pays for itself to be taken over. Retailers are better placed than most to facilitate this because they are so cash rich.
So, against the background of mega bids and deals concerning two of Britain’s top-drawer retail brands comes the John Lewis Partnership (JLP). Its stunning results are the last under the outstanding stewardship of the outgoing chairman Sir Stuart Hampson. A number of elements in the results were noteworthy, but for me a few items really stood out in the context of where retail today finds itself and how private equity fits into it all.
First, there is the £400m JLP spent on capital investment. This is not just on developing and opening new stores, but also on maintaining the fabric of its existing ones in order to defend its market shares. The second comes in the £300m it invested in benefits for partners, not just the bonus itself but also other financial and social benefits. Verdict has been conducting a customer satisfaction survey for eight years across all of UK retailing, and the latest results, just published, show Waitrose top, followed closely by its sister chain of John Lewis Department Stores. It is this investment that allows the partnership to deliver the best customer service in retail.
So, what has all this to do with private equity? I am certainly not advocating that the owners of retail businesses follow the JLP model: it is far from being the only retail business model that works. However, these results underline a number of key universal truths. UK retail has reached a level of physical maturity, which means that just opening more space is no longer a viable route to sustainable growth. More and more, it is the proposition that will count: having an offer that is defined by demand and truly adding value in satisfying that demand.
This requires investment. Investment in understanding customers, in serving them with relevant product at the right price, in an appropriate environment. The financial fortunes of retailers will be defined by their top line performance. There is an implicit challenge here for private equity.
This new retail climate which is sales/demand-driven cannot be ignored. While the means of market entry may remain the same, this new reality will impact on exits. The traditional exit of private equity investors is built around physical growth: this will become increasingly difficult on its own. In the same way that the focus of retail managements is moving to increasing sales, the same focus must move to the top of the private equity agenda too.
The foundation of a retail business’ profitability is its revenue stream, and how sustainable it is. This is all about the brand, what it promises and, critically, what it delivers. Retail brands need constant investment and nurturing, with a clear vision in mind.
Achieving this while streamlining the retailer’s cash flows will become a more sensitive issue. It may take some spectacular failures to drive this point home, but in time, the whole approach to financial engineering in retail will change.
So, am I predicting the boys in dark suits will be leaving the retail industry on the shelf? Emphatically not. The attractions of retail remain huge, as do the opportunities for investors. Many retail businesses have models that were built for a very different competitive climate. Some need radical surgery undertaken by experts outside the glare of public ownership. There are lots more deals to be done, even if everyone has to run faster to make them work.
Richard Hyman is managing director of Verdict Consulting