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The internet isn't the only thing killing U.S. retailers

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Department stores are getting the blues 01:26

Traditional U.S. retailers are experiencing a tough year, with more than a dozen already having declared bankruptcy in 2017. 

The growth of ecommerce, as well as competition from European rivals such as H&M and Zara, are often blamed for brick-and-mortar chains' troubles. Yet there is another, less recognized, factor weighing on a number of retailers -- the role of private equity investors, which operate by loading up companies with debt. 

Take Rue21, a teen-focused retailer that some analysts think is in imminent danger of bankruptcy. The chain was bought by private equity firm Apax Partners in 2013 for $1.1 billion. Loaded up with debt of almost $1 billion, Rue21 has struggled to make its debt payments amid waning demand for its clothing. 

Private equity funds operate by raising money from investors and using the funds to acquire companies that, while distressed, still have value. PE executives then direct management to make strategic and operational changes in order to boost a business' performance. The goal, buyout firms say, is to turn companies around and eventually sell them for a profit. PE firms make money by collecting fees for managing funds and in taking about 20 percent of the earnings when a business is sold. 

But PE firms also tend to fund their acquisitions partly with debt raised by the target company. That can leave already struggling businesses swimming in red ink, hindering their recovery -- or pushing them into insolvency.  

"When you are in public relations for private equity, you say leveraging up the company imposes discipline, because they have to generate a certain amount of cash to pay the debt," said Jude Gorman, general counsel at Reorg Research. "It sounds great until you say, 'But what happens when some sort of secular trend hits and the company doesn't have the cash to make the loan payment?'"

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The result, he noted, are companies like Rue21, which are struggling to juggle their loan repayments while figuring out how to get consumers back in their stores. With so much cash servicing debt, that means less money available to invest in improvements that could help keep the retailer in business. 

Some retailers end up shuttering stores to save money, but companies are often in a bind because they need to keep their shelves stocked with inventory to attract consumers, as well as retain enough staff to deal with customers and ensure a pleasant shopping experience.  

"When you combine the costs with the debt -- then a thing comes along called Amazon and you don't have the customers anymore, all your 13-year-old girl customers are shopping at H&M -- what are you going to do?" he said. "There's no real solution."

Many of the worst-performing retail bonds are backed by private-equity companies, according to Bloomberg News. 

Neiman Marcus, owned by Ares Management and the Canada Pension Plan Investment Board, has almost $5 billion in debt. Other troubled retailers backed by private equity firms include Payless, the discount shoe store, which filed for bankruptcy in April; Eastern Outfitters; and Gordmans Stores. 

"What a private equity companies does is they put in a small equity check, then have the company borrow a bunch of money, secured by the assets of the company," Gorman said. "Rue21 is emblematic of everything that's going on with retail, especially the private equity overlay."

In a statement, Apax Partners said it has "supported Rue21 in its growth initiatives, including an increase in capex for new stores, investments in its omni-channel capabilities, launch of a new store format in ruePlus and several initiatives aimed at transforming the customer experience. Unfortunately, the environment has been a challenge for many retailers, and Rue21 is no exception. We are supportive of the company's efforts as it continues to serve its customers."

The 10 retailers most likely to fail in 2017
The 10 retailers most likely to fail in 2017

Private equity investment in the retail sector picked up before the financial crisis, reaching a peak of $32 billion in retail investments in 2006, according to data from Dealogic. After a slump during the financial crisis and the recession, private equity investors ramped up their investments, reaching a post-recession peak of $11.7 billion in 2013.

Given the struggles of retailers since 2016, it's no surprise that private equity firms are backing away from the sector. This year, only $452 million of private equity has been invested in retailing businesses, Dealogic noted. 

The problems aren't limited to retail. Marsh Supermarkets, an Indiana-based grocery chain that dates to the 1930s, filed for Chapter 11 bankruptcy protection on Thursday. Marsh was owned by PE firm Sun Capital, which bought the chain in 2006 for $325 million.   

More broadly, the role of private equity in corporate America has come under greater scrutiny, with critics questioning whether their investments lead to negative outcomes for workers, such as lower wages and benefits. The recent book "Glass House" by Brian Alexander, for example, examined the history of Lancaster, Ohio, the home base of glass company Anchor-Hocking. 

Two PE firms owned the glass factory at different times. Buyout firms have a goal of delivering returns to their investors, which means issues such as job security and living wages may factor as strongly into their operating plans. In Lancaster, a system that rewarded financial engineering was substituted for a more old-fashioned capitalism, where corporate leaders had deeper ties to the community.

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