Private Equity Money and Grocery Retailers: What Does it Mean?

Private equity money has long nibbled around the edges of the grocery retailing market. But it generally has not attracted the investors and big deals that seem to proliferate in high-margin growth industries like technology and e-commerce businesses.

But that has changed. Private equity has flooded the retail grocery market in the past decade, resulting in deals involving Albertsons, Safeway, Winn-Dixie, Bi-Lo, Jewel and many other well known grocery banners.

Why the interest? Experts say it's because the retail grocery business generates stable cash flow and often holds good real estate. And new competition from untraditional venues–such as convenience stores, big box retailers, and the like–has created a bit of turmoil, which favors roll-ups.

"The fact that private equity is interested in the grocery business is not really new, but lately there have been some big transactions," notes Mickey Chadha, a vice president and senior analyst at Moody's Investors Service who follows the retail grocery business. "The primary reasons are that grocery stores and supermarket chains throw off healthy cash flow, so private equity firms have the opportunity to extract cash dividends and boost returns. And the industry has experienced a lot of changes in the last few years that have created opportunities in terms of consolidation."

Recession, Competition Fuel the Trend

Keys to the trend are the general financial struggles in the grocery business and the growing competition in the field. As traditional grocery retailers struggle against convenience stores, big box stores and other new entries to the marketplace, sometimes the best thing to do is sell out.

"Big box retailers like Walmart and Target adding groceries to their superstore concepts have put significant competitive pressure on traditional grocers who cannot compete on price," explains Ken Morris, principal at Boston Retail Partners. "They have to find other ways to retain customers, like offering better service. In some cases, even with improved service, independent grocers can't maintain a profit with their razor-thin margins that are severely impacted by decreases in volume."

The non-traditional grocery retailers seek food sales to increase traffic for their other lines, Chadha says, and that encroachment is creating an over-saturated market. Just because there are many more places to buy groceries these days, customers are not necessarily buying more.

"That has created a shift because you cannot have that many food retailers and that many stores, because the market is only growing as much as inflation or population growth," he says. "This is not a very high-growth business, so ultimately you will see more store closures, consolidations, mergers and acquisitions to create what would be an optimal store base."

Distressed Retailers Tempting

Traditional grocery retailers that brought on too much debt during the recession are now being squeezed out by new market players. These traditional grocers are particularly attractive to some kinds of investors, because they can buy them at a good price and squeeze out value. These companies still have excellent brand reputation and steady cash flow, even if it's declining.

A major player in the distressed grocery area is Cerberus Capital Management, which bought Albertsons in 2006, Supervalu in 2013 and Safeway in 2014.

"Cerberus has a history of seeking out underperforming companies as takeover targets," wrote Mike Paglia, director of retail insights at Kantar, in a report about the acquisitions.

Paglia evaluated the results of the Albertsons and Supervalu acquisitions in a report for Kantar US Insights. He noted that after the investments, the retailers sought to boost bottom-line results rather than focus on long-term growth.

"This orientation towards boosting profitability at the corporate level manifested itself in the stores–particularly in a lack of strategic investment, ongoing cost-cutting initiatives and the closing or selling of underproductive assets," Paglia wrote in his report.

For its part, Cerberus claims that it does plan to grow the Safeway business, not just squeeze out value. A press release after the merger was announced read, in part: "Albertsons has successfully transformed underperforming retail grocery stores into strong performers by focusing on enhancing the local customer experience," said Lenard Tessler, co-head of global private equity and senior managing director at Cerberus. "Similarly, Safeway has consistently provided outstanding value and customer service throughout the communities it serves. Combining these strong management teams will strengthen the ability of Safeway and Albertsons to deliver on a shared commitment to offering customers higher quality products at lower prices, which will undoubtedly yield positive results for all stakeholders in the business."

Real Estate Also Attractive

A shift in the market is only part of the equation. Another important issue is that many grocery retailers sit atop a perennially valuable asset: real estate. Traditional grocery stores need a lot of room, and in many cases the retailers have long owned the ground and buildings they occupy.

"Many retailers are really real estate focused businesses," Morris notes. "In fact, we have developed strategies for retailers that clearly indicated that their most important system is their lease management system – even more important than their enterprise system. Often times, the real estate is the most important and valuable aspect of a grocery retailer's business, and smart retailers own their real estate as well as a portfolio of valuable leased holdings. When investment firms look at a grocery deal, the value of the real estate is often one of the most important factors in the analysis."

The Cerberus acquisition of Safeway clearly involved a large valuation of the real estate under the stores, as evidenced by the fact that three of the major investors behind the deal–Kimco Realty Corporation, Klaff Realty LP, Lubert-Adler Partners LP–are real estate-related firms. A Cerberus spokesperson declined to comment about the value of the real estate in the transaction. Safeway Realty Holdings, which disposes of surplus Safeway real estate, has 80 properties currently listed for sale or lease on its website, ranging from a shopping mall property in Hawaii to 19.6 acres of vacant land in Arizona.

"A lot of opportunities exist in selling the real estate," Chadha says. "A lot of private equity firms have been involved because they feel the real estate value of these stores is much better than what is available from the operations of the stores."

Show Me the Money

Real estate is an important asset, but cash flow is still king when it comes to private equity investment in grocery retailers. Investors want to see solid cash flow and the potential to increase that cash flow through streamlining operations, cutting costs, consolidating certain operations and other maneuvers.

"From a private equity standpoint, they make decisions to invest in retail grocery businesses the same as in any business," Chadha says. "Number one, can they improve operations to enhance their profitability? Is it underperforming? Are there are lot of opportunities to cut costs? Number two, what are the prospects for them to exit three or four years down the road?"

As far as cutting costs, Chadha notes that the list of potential slashes is long. Labor costs are often high on the list, including the renegotiation of union contracts, if possible. Capital costs are another target area, as are leases and other property costs.

"There are a lot of ways to streamline those costs," Chadha says. "They can cut shrinkage, improve inventory management and streamline distribution. Grocery retailing is not a high-growth business, not a sexy business. But it does throw off a lot of cash and offer a lot of opportunities to improve the return on capital."

The exit strategy is also important. Private equity companies are not essentially in the grocery retailing business–they're in the money-making business. Thus they need to be able to envision a good, rapid return on their investment.

"Investment firms are usually motivated to make a phenomenal quick return for their investors," Morris says. "They look at ways to quickly increase the value of the investment and flip it for a profit– similar to a house flip. Sometimes it involves consolidating operations by eliminating the acquired company's administrative staff and absorbing the duties with its existing corporate staff. In other cases, investors may acquire the retailer for the real estate value and quickly sell it for a profit and consolidate the store portfolio by closing less profitable venues and convert the remaining leaner entity to leased locations going forward."

The Future

Will this trend continue? As long as there are good values to be had and people keep preparing meals at home, yes, private equity will be interested in grocery retailers.

"Private equity just by its nature comes down to access to capital on the markets," Chadha says. "If access dries up, transactions downshift. All things being equal, if access to capital continues, you'll see private equity firms look at firms they think are undervalued and they can improve and then exit. In food retail it's not that the multiples are going to increase dramatically, because it's not a high growth business. But the investors are tempted by the stability."