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Retail and venture capital

Retail can present important opportunities for private equity firms, says Sarah Whitney of PwC. The increasing fragmentation of the sector will lead to more and more M&A activity in the future. Large UK retailers, like other large corporations, have been divesting themselves of non-core operations in recent months, and private equity firms can benefit from this.

The increasing importance of private equity houses has been a key feature of the M&A market in recent times, and this has applied to retailing as much as any other sector, particularly in the last couple of years.
One of the reasons driving this is that the trend towards “low calorie retailing” - all of the goodness (in theory at least), but none of the excess fat - has created opportunities for investors. The bloated retail conglomerate is now a thing of the past and over the last few years we have seen entities such as Sears and Storehouse consigned to the history books, while many of the UK's largest retailers have been divesting non-core operations. This provided the private equity investor with a much wider choice of businesses to consider, including some with considerable turnaround potential. The bloated retail conglomerate is now a thing of the past.
Set against this, the fear of how e-commerce and the arrival of Wal-Mart would affect the retail sector had been enough to deter many investors in the past. However, B2C retailing is still only a minor part of the industry as a whole and Wal-Mart's arrival, though clearly significant, has not engendered the seismic shift that many had predicted.

Uncertainty returns
In the aftermath of 11th September, though, the world has become a much more uncertain place, and this applies to financial markets and investor sentiment as much as to the political landscape. This may act as a brake on investments by venture capitalists, primarily through tougher negotiations with providers of debt finance. The debt market has, without a doubt, become noticeably more difficult in recent months.
However, the tougher climate may also throw up some interesting opportunities for the shrewd investor, especially as the price expectations of vendors adjust to reflect the new economic reality. Investments made by VCs during tough economic times are often among the strongest performers in a particular portfolio. Given this, and the fact that many of the larger private equity firms have raised substantial funds recently, they will still be casting their eyes over a large number of potential opportunities in the coming months.

So what is a venture capitalist looking for in a retailer?
First and foremost, not surprisingly, are the hard numbers - an ability to generate profits and cash, coupled with the predictability of future earnings streams to enable the VC to structure the deal and value the business appropriately. Equally important, what are the chances of achieving a successful and rewarding exit in 3-5 years? The exit potential is crucial, especially given that flotation is not currently regarded as a viable option in most cases and, depending on the particular area of retailing, trade buyers may be relatively thin on the ground. How can the VC make a turn and still leave something for a trade buyer to develop? Exit potential is crucial.
Behind this are the more subjective elements of the equation: quality of management team; strength of the brand and the potential to extend it into new areas; level of differentiation from competition. Is it a focused operation? What are the barriers to entry? Is it an “exciting” concept? The flip side, though, is that investors still worry about lease costs, retailers' abilities to adapt to recession, the high level of competition both within the retail trade and also with other sectors looking to attract discretionary spending; and a common feeling that retailers have an inexhaustible list of “leaves on the line” excuses for poor trading. Allied to this is the fear of a high profile failure - retail failures tend to attract rather more attention than the average widget manufacturer.

The Changing Structure of UK Consumer Spending
While the overall level of consumer expenditure is mainly dependent on the prevailing economic climate, there are a whole host of other factors which can cause consumers to shift their spending priorities away from one type of product and towards another. These often reflect cultural changes: for example, expenditure on home maintenance & repair rose by 46% between 1995 and 2000, partly influenced by the increase in home and garden makeover programmes on television. Similarly, at the start of the 1990s, the typical weekly outgoings for a British household did not include Internet access charges, National Lottery tickets, or mobile phones bills, yet these are all now significant categories of expenditure.
A much greater emphasis is also being placed on health and beauty, which means more spending being diverted towards gym memberships, vitamin supplements and the like. Total expenditure on equipment for sports and outdoor pursuits rose by 76% in the five years to 2000, while hairdressers and beauty salons enjoyed a gain of 46%.
The table opposite shows the best performing categories of consumer spending between 1995 and 2000. For reference, total consumer expenditure grew by 32.8% over this period. At the top of the list comes motorcycles, which were buoyed by the huge increase in demand for scooters in the latter part of the 1990s. Another category to note is financial services, partly reflecting the significant increase in share dealing by individuals in recent years, although the final 2001 figure (which has not yet been published) is likely to show a sharp fall as the stock market has become more volatile.
The importance of new technologies also comes through clearly. Within photographic/optical goods, spending has been boosted by the introduction of digital technology, while toys & electronic games have benefited from the growing popularity of Playstations and other consoles. In spite of substantial falls in unit prices, total expenditure on PCs and similar equipment also exhibited a significant increase.
Looking at the broader categories of spending, we can see that consumers diverted an increasing proportion of income towards communication and recreation in the five years to 2000, whereas spending on food and clothing has diminished in importance. We would expect expenditure on food to increase less quickly than other sectors during a period of economic prosperity, but the relatively slow growth in spending on clothing and footwear is rather more alarming. Although 2001 did see a strong rebound in the clothingmarket, fashion retailers are having to face up to the fact that they are competing with mobile phones, eating out and health clubs, as well as other clothing shops, for their customers' precious pounds. 
 

PricewaterhouseCoopers (www.pwcglobal.com) is the world's largest professional services organization. Drawing on the knowledge and skills of more than 150,000 people in 150 countries, we help our clients solve complex business problems and measurably enhance their ability to build value, manage risk and improve performance in an Internet-enabled world.