Debenhams: Private Equity Deal

Debenhams private equity deal serves as great ammunition for the critics of private equity, providing them with enough reasons to oppose this concept, especially now after Debenhams has announced its third profits warning. Debenhams has really not benefited at all from its time out of the public spotlight and after two and a half years, its stored fail to match up to the revitalized Marks and Spencer outlets and its fashion ranges simply do not compare to those of rivals Primark and John Lewis, which appear to be enjoying their days of prime.

Sales declined and shares have performed poorly after returning to the stock market in 2006. As Evans (2007) put it, "The pain for those investors who took a punt on the stock is heightened by the riches secured by the company's former owners and management team. " Analysis: In 2003, Texas Pacific Group, CVC and Merrill Lynch Private Equity bought Debenhams and invested ? 600 million. In three years they tripled their investment after they engaged in cost cutting exercises and sold off freehold property. As a consequence, Debenhams now was left with ?

1 billion in debt, and when trading conditions tightened a bit, the company had little room to improve profitability. Regardless, when the stock was floated, analysts still gave buy ratings to Debenhams. However, it has now become a case in point for opponents of private equity ownership because of the downward trend in shares since that point on, so much so that when Sports World was about to be floated, the 'Debenhams Effect' was one of the reasons why expectations dampened prior to the floatation, even though Sports World was debt-free, and was owned by one individual (Rigby, 2007).

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Rob Templeman, Chief Executive at Debenhams has gotten tired of how his group has become the "whipping boys for private equity. " He defended the cost-cutting measures undertaken when the enterprise was privately owned saying it had created efficiencies, and it should be remembered that very few retailers have substantial property portfolios. He further believed that the problems the retail giant is going through are not structural, and an accelerated investment programme can definitely help improve bottom-line performance.

This will include refitting of existing stores and establishing presence in new locations such as Liverpool and Bath (Barriaux, 2007). The trading strategy adopted by Debenhams, with a lot of emphasis on discounting and one-off sales, has also affected the chain negatively as investors have learnt how to shop "off-prime". Richard Ratner, from Seymour Price, agrees: "We have argued for some time that the number of megadays and sales has been in danger of trashing the brand. We believe that this could have taken its toll."

As far as a return to private equity ownership is concerned, Philip Dorgan of Panmure Gordon opined, "Given the shares have underperformed expectations and the stock is well known by private equity, we would not rule out a return to the private arena" (Rigby, 2007). But the question remains: Was Debenhams move into the private arena a positive move in the first place? Debenhams is one of Britain's oldest department store chains and when it was floated in 2003, there was no reason to believe that the takeover would not be a successful one.

John Lovering, chairman and a key figure in this private equity deal believed that Debenhams was a better run and more efficient enterprise than the other companies in the private equity deals he had masterminded. Also it had the potential to expand and grow. And its market share and profit margins were increasing year after year. Three years after Debenhams went private, it had already earned more than three times the investment made into it (Rigby, 2007).

But even though Lovering and the other deal makers behind this private equity ownership arrangement promoted this as a successful one, there were indications that things were not quite so rosy. Already Debenhams was either struggling to, or failing to attain its forecasted levels of sales and profits. Still, Mr. Lovering, who when the Debenhams shares floated in May 2006, sold about ? 5 million of his own shares, did not point to any troubles Debenhams may have faced as a result of its private equity deal (Rigby, 2007). Still, there is only a limit to which trouble can stay unnoticed.

As Debenhams issues its third profits warning, shares declined by a whopping 15% in just one session in mid-April. Investors who did not sell off their shares are the best witnesses of how their stock's value has fallen: from 195p at float in May to 120. 75p at July-end. This has caused many to wonder about how right Debenhams decision to venture into private equity was, and in general, does the private equity actually fulfill its promise of enhancing the value of businesses which are not performing to their potential, by buying, restructuring and selling them back to the public?

Advocates of private equity maintain that businesses which are underperforming or are badly run can be transformed and placed on the fast-track to growth as compared to similar public companies. But Debenhams has become a case study of the negatives private equity has to offer. Now, private equity is accused of not adding or creating value, but instead de-valuing companies for the sake of posting short-term gains, as was the case with Debenhams.

This controversy has gained massive public popularity as trade unions in the UK as well as politicians have strongly stated their stand about how the private equity industry generates wealth for themselves by loading acquisitions with debt, laying off employees and stripping assets (Disappointment at Debenhams). In this scenario, Rob Templeman maintains that performance had been badly affected by bad weather, changing fashion trends and rising interest rates, and was not the result of actions taken after going private.

But one private equity expert disagrees, "They tried to present it in the best possible light, that there was sustainability to what was being done (to Debenhams) . . . But that is what the market got wrong" (Rigby, 2007). The fact that Debenhams private equity deal caused it to run into such immense amounts of trouble could hardly have been surmised in 2003 when Templeman and his supporters attained victory after an extended battle to take control of this 103-store chain.

Templeman was nothing less than a success story in the private equity industry himself because he had engineered two lucrative deals or Homebase and Halfords, turning them around in just a matter of time, selling them in 20 months or less. Debenhams then, looked to be a similar success as well. There was property which could be sold to strengthen cash flows, and margin to squeeze suppliers in order to add value through better channel management and trading tactics (Rigby, 2007). When Templeman officially acquired control over Debenham in December 2003, the changes were frequent.

He had a simple agenda: he wanted to cut costs, improve the cash management, and increase the sales of the company. One of the initial things he did was reorganize retailer's debt. As soon as Debenhams was acquired, the balance sheets showed that Debenhams' net debt was ? 1. 4 bn, which included the ? 1. 1 bn put up by the private equity backers to raise funds for the acquisition. The total net debt was a whopping nine times the annual trading profit so in order to get rid of the costly short term loans, Debenhams re-mortgaged some stores, in this way getting access to cheaper financing, and raised ?

325 m through bonds and securities. These two actions resulted in dividends for new owners, worth ? 130m just a few months after the acquisition. Not just this, Templeman also made operations more efficient and tripled cash flows between 2002 (? 87. 7m) and 2004 (? 286. 4m). Net debt was also paid off and decreased by ? 537m (Rigby, 2007). During Debenhams' Private Days: However, the tactics adopted by Debenhams during this time were what got it into trouble eventually. Not only did it cut costs, it reduced prices of slow-moving goods which harmed the equity of the brand.

In the very first few months, Debenhams held sales and offered discounts on ? 30m worth of inventory which was not selling well prior to this. According to Templeman this was justified because, "In our view, if stock is not selling at full price it is better for margins to reduce it during that season. If you are not selling it in June, mark it down in June. If you are selling it in January for 70-80 per cent off, you are financing that stock for six months" (Rigby, 2007). The store's image was adversely affected by the frequent sales and discounts offered to customers.

According to Bridgewell, an investment bank, "Debenhams has moved to a 'clear as you go' trading strategy" which has "given the stores a more promotional feel. " Now, Debenhams has more of a bazaar feel about it, rather than the shopping emporium it used to be. When the holding of sales was compared across competitors, it was found that in the 2006-07 period, where Debenhams held sales 16 weeks in one year, Marks and Spencer ranked next with eight weeks (half of Debenhams time period), John Lewis which was the closest competitor next at six weeks, and Next last at five to six weeks (Rigby, 2007).

Supplier contracts also started to be renegotiated as payment dates which stood at an average of 27 days after delivery were changed to 60. Templeman also asked some suppliers for additional discounts and these measures helped improve cash flows by ? 100m, in the first year after acquisition. As suppliers were now waiting for longer periods of time to be paid for goods, the amount Debenhams owed to them increased from ? 30. 3m (2001) to ? 196m after five years. A business analysis tool known as the Collins Stewart's Quest model said that Debenhams had the "best- in-class performance" in terms of retaining money it owed to its suppliers.

Supplier contracts were not only renegotiated, suppliers were also cut, which also increased operating margins (Rigby, 2007). Another method to cut costs was to lay off employees: in the first year, staff at the head office was reduced by 125, and when Debenhams' stock was floated in 2006, even though 17 new stores had been added, the total number of employees was lower by about a thousand, which is a reflection of the massive layoffs which took place during the three years it was private (Rigby, 2007). The cost savings which Templeman was striving to achieve, and succeeding at, was not without its downside.

Senior management did not want to stick around. As one ex-Debenhams senior executive put it, it was like the atmosphere was no longer how it had been: "Their attitude was like 'you lot at Debs, it wasn't like the incumbents were part of the team'. " A fair share of talented executives, valuable members of the team, left for competitors such as BHS and New Look (Rigby, 2007). Cash flows were managed also by cutting capital expenditure, which decreased by 39% and store refurbishment expenses were reduced by 77%. This, especially in the face of Marks and Spencer's ?

80-90 per square foot programme for refurbishment, was reflected in the horrible condition of about 60 outlets in particular, and it consequently hampered performance (Rigby, 2007). Regardless of the above, Debenhams under Templeman managed to become one of Europe's most profitable buy-outs when in the summer of 2005, the investment of its private equity backers had tripled. But its problems were far from over. As Moore (2007) noted, "In the two years since its private equity owners re-floated Debenhams, the retailer has lost more than half its value."

While top management blames misreading fashion trends and other factors, the decisions Templeman and others took during Debenhams' private days are the reasons for the current state of affairs (Rigby, 2007). The business was loaded up with excessive amounts of debt, and as the freehold property was sold off to generate cash flows, the fixed costs increased. Stores were not invested in as they should have been according to market demands, and common public opinion was that their stores were old-fashioned, dark and there were visibility problems.

Cost-cutting was taken to the extreme level where it even resulted in loss of profitability. The near-perpetual sales annoyed customers, leading to lower sales volume (Cranage, 2007). At this point, Debenhams represents an example of the failure of private equity, and to become a success once again, the stores will need to be spruced up, products and fashion trends will have to be-aligned and a better price architecture will have to be developed so that customers return to Debenhams and sales volume and share price stop plummeting.

The private equity deal should not be considered the culprit, since there have been successful deals as well, what led this particular deal to become a flop was the actions management took in an attempt to make the venture a success in the short-term, sacrificing its longer-term sustainability while doing so.

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