Thursday 5 March 2020

How private equity ruined a beloved grocery chain

An investment firm was supposed to help Fairway survive. So why is the company now filing for bankruptcy?

The news of Fairway Market’s second foray into bankruptcy, this time with the threat that stores could be liquidated to pay off the unsustainable debt hanging over the grocery chain, dismayed its legions of loyal Manhattan customers. Fairway’s New York City stores draw an eclectic crowd of shoppers: local residents, professors and students at schools from the City University of New York to Columbia University, and others seeking its fresh-baked breads, unusual cheeses, and wide range of international foods. Upscale and idiosyncratic, with its humble roots still evident, Fairway is emblematic of the city in which it has become a storied institution. But, fatefully, it is also emblematic of the way private-equity investors—including Fairway’s former owner Sterling Investment Partners—have hastened the fall of brick-and-mortar stores caught in the so-called retail apocalypse.

The story is a familiar one, even for shoppers hundreds of miles from the nearest Fairway. Most consumers have seen some of their favorite chains—Toys “R” Us, Shopko, Claire’s, Payless ShoeSource, Nine West, Gymboree, Staples, and A&P, among many others—face financial distress and shutter some or all of their stores. Like Fairway, these businesses were owned by private equity, a form of finance in which investors buy, overhaul, and then sell companies. Also like Fairway, the other retail chains were profitable at the time they were taken over. Before those buyouts, these businesses had low debt levels and owned their real estate—a necessary precaution for companies suddenly facing more competition or industries seeing widespread changes.

Most companies mean to stay in business for the long term, and those in the industries most exposed to the business cycle know that low debt and no rent are the keys to surviving hard times and then prospering when the good times return. The motivation is very different for private-equity owners, who operate under a shorter time frame, often just three to five years, before moving on. For them, low levels of debt and high levels of real-estate ownership present a get-rich-quick opportunity.

The low debt means that private-equity firms can acquire retail chains by putting up very little of their own money and can take on high levels of debt that the company, not the investors who own it, must ultimately repay. The real estate gives investors an opportunity to sell off some of it and pocket the proceeds, leaving the stores to pay rent on properties they once owned. Especially attractive to private-equity owners is the high cash flow in retail operations. Private-equity owners have not been shy about putting their hands in the till to pay themselves exorbitant dividends.

Unfortunately, private-equity owners are far more accustomed to taking money out of retailers than to putting money into them, and the hollowed-out chains they own are ill-equipped to meet today’s competitive challenges. Brick-and-mortar stores need to invest in e-commerce, same-day delivery, and the technologies and logistics that success in retail now requires. While all traditional retail faces these challenges, chains owned by private equity make up a disproportionate share of businesses that have failed. This record is not just a product of markets; it’s a matter of morality as well. Private-equity firms profit as the companies they own tumble into bankruptcy.

Fairway’s problems began in 2007, when one of the market’s founders decided to retire and sell his interest. The company caught the eye of Sterling Investment Partners, which acquired a majority stake in the grocer for $137 million. Sterling agreed to put up $50 million in equity for the purchase while turning to CapitalSource—a lender co-founded by John Delaney, who later went on to mount an abortive bid for the 2020 Democratic presidential nomination—for $87 million in debt financing. While large, well-known private-equity firms such as the Blackstone Group, KKR, and the Carlyle Group generally focus on relatively large acquisition targets, Sterling is one of hundreds of lesser-known private-equity firms that buy smaller or family-owned companies. In addition to the initial debt, the company may take on additional debt to expand the company. As described in Fairway’s 2016 bankruptcy filing, Sterling kept borrowing money on the grocery chain’s behalf from 2009 to 2012.  

After purchasing a company, private-equity investors often scoop up other businesses and add them to the initial acquisition. Sterling made aggressive use of this strategy. One complex transaction financed the purchase of more grocery stores. Fairway, which previously had only a handful, grew to 15 locations in the New York City area before being forced in 2016 to shutter a Lake Grove, New York, store that had been open for only two years.
Spread thin and loaded with debt, Fairway was not well equipped to respond to the challenge of steeper competition from the online grocer FreshDirect (founded by a former Fairway executive) and a Trader Joe’s that opened not far from Fairway’s flagship Upper West Side location.

Yet even as Trader Joe’s started to encroach on Fairway’s territory with its own set of specialty foods, Fairway continued to attract customers who were very much drawn to a store that still operated like a family business, brought a personal touch to decisions about which items to stock on its shelves, and offered customers a high level of service. This was due in no small measure to the company’s staff. “There were always six people in the store capable of doing every job in there,” United Food and Commercial Workers Local 1500 President Robert Newell told us. About 83 percent of Fairway’s 3,000 workers are unionized, as Fairway’s CEO, Abel Porter, declared in the market’s most recent bankruptcy filing. The union advantage for both the grocery chain and the workers was summed up succinctly by Newell. New employees faced a tough six-month probationary period after which those who proved their mettle found themselves “part of the family.” The grocer was assured that new employees could do the job, while workers who made the cut got full health-care benefits and a pension—largely unheard of in the retail industry.

Fairway’s debt took a toll on the company. It last made a profit in 2010, when it squeezed out a narrow $5 million gain on $400 million in sales as it paid out almost $14 million in interest payments on its debt, according to public documents filed in 2013. By 2011, Fairway’s grocery business was in trouble. Even as its revenues grew to $486 million, its costs to open new stores and run old ones increased, while its interest payments grew to $19 million

Workers at Fairway began to find themselves at odds with Sterling, whose decision making, they believed, had become too narrowly focused on the bottom line and was jeopardizing the business’s relationship with customers. Sterling’s approach also brought it into conflict with Fairway’s founding family. Employees were aghast when Sterling fired Randi Glickberg, the vice president of customer and community relations and the granddaughter of one of Fairway’s creators. Meanwhile, losses continued to grow.

In 2013, when Sterling filed the paperwork for an initial public offering, it was still making the case that Fairway could one day grow to as many as 300 locations nationwide. Stock-market investors weren’t fazed by the beloved grocer’s deteriorating financial situation. Fairway went public at $13 a share, bringing in about $177 million ostensibly to the benefit of the grocery chain.

Tucked away in the IPO filing, though, was a paragraph detailing how Sterling would be able to use the proceeds to pay itself a dividend of nearly $80 million. PitchBook, a highly regarded source of data on private equity, reports that Sterling investors also paid themselves and their management team an additional $17 million from Fairway’s funds.

Practices like these are pure financial engineering—a way for owners to squeeze more money out of a business without proportionately improving its ability to generate new revenue. While a private-equity firm certainly has the power to make the decision to pay itself and its limited partners a dividend, the companies paying this dividend are left with more debt to repay and are deprived of resources to invest in themselves to remain competitive.

At Fairway, the growing weight of its debt load—almost $280 million by 2016—limited the grocery chain’s ability to compete not only against Whole Foods and Trader Joe’s, but also against the seemingly unlimited resources that Amazon and other large corporations have poured into their online grocery businesses. (Fairway’s former private-equity owners, perhaps not surprisingly, attribute the chain’s woes to a changing market rather than their own financial interventions. A spokesperson for Sterling maintained that competition from Whole Foods and Trader Joe's as well as online grocers was primarily responsible for increased price pressures  and reduced foot traffic at Fairway’s stores.)

Regardless, the financial machinations continued. In June 2016, Fairway underwent Chapter 11 bankruptcy reorganization, during which the company’s senior lenders exchanged some of the debt for equity, reducing Fairway’s debt to $140 million and its annual debt service by $8 million a year. The Blackstone Group’s debt-investing arm, GSO Capital Partners, part of the group that provided the initial funds to allow Fairway to operate while in bankruptcy, ended up taking a 45 percent stake in the chain. Two years later, in August 2018, GSO Capital completely disposed of its stake by selling it to Goldman Sachs, a spokesperson for Blackstone confirmed.

Despite ridding itself of $140 million of its loans in the bankruptcy process, Fairway soon found itself again loaded with debt and struggling to stay afloat. By 2019, its sales had grown to $643 million, but the burden of the leases on its stores and the interest payments on its debt led the grocer to lose a whopping $68.8 million. Late last month, with $227 million in debt and another $67 million in unfunded pension liabilities, Fairway again filed for bankruptcy.

Village Super Market, the owner of ShopRite and Gourmet Garage, has put in a $70 million offer for five of Fairway’s Manhattan stores, including the flagship Upper West Side location, and its distribution center. Village Super Market’s CEO, Robert Sumas, has indicated that those stores would continue to operate under the fabled Fairway name. Workers may not fare as well. Village Super Market has indicated that it is not interested in taking on the pension liabilities as part of its offer. The fate of the remaining nine stores and the many workers they employ is unclear. The shuttering of these grocery stores remains a possibility.

Fairway, like Gymboree, Toys “R” Us, and so many other retailers before it, failed because it was saddled with debt and could not adapt to meet new competitive pressures. And, as in the case of Fairway, the private-equity firms that owned these other failing companies still managed to recoup their investments and make a profit. They extracted value by collecting advisory fees, paying themselves dividends, or stripping away a company’s assets. While the private-equity firms profited, the bankrupt company’s workers paid the price. When Toys “R” Us closed in 2018, 31,000 workers lost their job. When A&P went out of business in 2016, 21,000 workers lost their job and pension benefits.

A lack of transparency disguises private equity’s role in the retail apocalypse. When General Motors in November 2018 decided to halt production at five North American plants and cut up to 15,000 jobs, Congress summoned the company’s CEO, Mary Barra, to answer for its decision. In contrast, few people outside finance know what Sterling or KKR or Blackstone is. Even after companies owned by private-equity firms go bankrupt, the investors suffer no public approbation or damage to their professional reputation. They can still raise money from pension funds and other institutional investors to buy out other companies under the guise of saving them

Newell, the head of UFCW Local 1500, is concerned that Fairway workers will pay the price for the self-serving decisions of Sterling and the chain’s other Wall Street owners. Newell said that union workers already lost nearly $80 million in pension benefits during the A&P bankruptcy, and he sees a parallel with the Fairway bankruptcy.

If private-equity firms cannot be socially responsible stewards of capital, then Congress will need to act. One possible reform would involve fully taxing the advisory and other fees that private-equity investors extract from the companies they own. Another potential reform would impose restrictions on dividends paid out in the two years following a buyout. Since the current system allows private-equity firms to reap much of the positive gains from successful acquisitions, they could also be required to bear some of the liability for a company’s debt when the buyout ends in bankruptcy.

Private-equity firms claim that they make their money turning troubled companies around, and some do. But all too often, these investors buy healthy companies and use their superior access to borrowed money as a method of harvesting profits on their investments from the companies they acquire. Having made their money, they then move on, and the fate of employees in hollowed-out companies is no concern of theirs.

(Source: The Atlantic)

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