Private Equity Pillage:

Debt Sucks the Life Out of PE-Owned Companies

The bankruptcy of Southeastern Grocers, owned by PE firm Lone Star Funds, provides a classic example of how private equity drives companies into bankruptcy while extracting millions of dollars for themselves and their investors. Southeastern is the owner of well-known brands BI-LO, Fresco y Más, Harveys, and Winn-Dixie, located in seven southeastern states. While all supermarket chains face intense competition and thin profit margins, Southeastern’s regional competitors, such as Publix Super Markets, have survived and flourished.

Lone Star first bought out Southeastern’s predecessor, BI-LO, in 2005 in a leveraged buyout, and took the company private. It ran the company into bankruptcy by 2009 and emerged from Chapter 11 in 2010. It tried to sell the chain to publicly traded Kroger and employee-owned Publix Super Markets, but they were not interested. After six years of ownership, Lone Star was overdue in paying promised outsized returns to its investors. So it executed a “dividend recapitalization” — meaning that it loaded the company with even more debt to pay dividends to itself and its investors. Between 2011 and 2013, it paid itself and its investors $839 million in dividends — money that could have been used to make stores more competitive. The struggling company became saddled with interest payments. One loan of $475 million, used to pay dividends of $458 million to Lone Star, required Southeastern’s BI-LO to pay $205 million in interest between 2014 and 2018. Lone Star’s owner, John Grayken, is a billionaire who famously renounced his US citizenship to avoid paying taxes.

As if this weren’t enough debt, Lone Star sent Southeastern on a buying spree rather than invest in existing stores. In 2012, it bought out Winn-Dixie for $561 million, creating a chain of 690 stores and 63,000 employees. In 2013, it added another 165 stores (Harveys, Sweetbay, and Reid’s) in an LBO worth $265 million, as well as 22 Piggly Wiggly stores in an LBO worth $35 million. Lone Star renamed the company Southeastern Grocers.

To offset the growing debt due to dividends and LBOs, the company sold the real estate of a distribution center for $100 million and several stores for $45 million, and then required the affected entities to pay rent on the buildings they used to own — further undermining their financial stability — referred to in financial parlance as a “sale/leaseback.” In need of more cash, Lone Star secured a series of revolving credit loans and debt financings between 2014 and 2017. In the meantime, between 2011 and 2018, Lone Star took out a total of $980 million in dividends from Southeastern Grocers, according to Moody’s Investors Service.

By March 2018, Southeastern filed a “pre-packaged” Chapter 11 bankruptcy. Once used for unique situations, PE firms now treat them as a staple in their bankruptcy proceedings, allowing the PE owners to fast-track the process by working out a deal with senior creditors before the bankruptcy filing. Unsecured creditors — mainly vendors, suppliers, and workers who are owed back wages, vacation pay, health insurance, and other payments — have little time to respond and are often left out in the cold. When the company exited bankruptcy in June 2018, about 2,000 workers had already lost their jobs. The deal reduced debt from about $1.1 billion to $600 million, with creditors swapping debt for equity and the company agreeing to close 94 stores, affecting thousands more workers’ jobs.

This all too familiar story is not about “disruptive” new competitors or price wars — it is about private equity extracting wealth and driving companies into bankruptcy. The same playbook drove Tops Markets into bankruptcy only a month before Southeastern Grocers. The northeastern chain of 170 grocery stores was bought out by Morgan Stanley Private Equity and Graycliff Partners in an LBO worth $310 million in 2007. Morgan Stanley pursued a number of LBO add-ons between 2007 and 2012, and then financed the buyout of the company, including all of its debt, by Tops management in December 2013. By that time, Morgan Stanley had loaded the company with $724 million in debt — more than twice the original purchase price. That included some $377 million in dividends that Morgan Stanley paid to itself and its investors — equal to 55 percent of the total debt that had accrued. This does not include advisory fees charged by Morgan Stanley nor the future interest payments that Tops had to shoulder.

As in the case of Southeastern Grocers, the debt overhang left Tops with little wiggle room to reduce prices or resources to invest in store upgrades, new products, and online services needed to be competitive, as it reported itself in its bankruptcy filing. At the time of the bankruptcy, it had 14,800 employees, with 12,000 represented by UFCW and 700 by the Teamsters. The company used the bankruptcy process to substantially reduce the pension benefits for members of both unions by withdrawing from the unions’ defined-benefit pension plans and replacing them with 401(k) plans. In January 2018, the S&P Global Ratings agency downgraded Tops’s credit rating from CCC+ to CCC, eight levels below investment grade. In August, one day before it announced its plans for emerging from bankruptcy, the company closed ten stores. The bankruptcy plan will reduce Tops’s debt from $700 million to $435 million, and its interest payments from $80 million a year to about $36 million.

The future remains uncertain, however, as Tops’s financials are still fragile. Despite the reduction in debt, Tops expects its interest expenses will wipe out nearly all its operating profits for the next three years. It projects a loss of $13 million in 2019 and expects to just about break even in the following two years.

Fairway Market, a small chain of upscale specialty grocery stores mostly in Manhattan, faced a similar struggle for survival. Acquired by PE firm Sterling Investment Partners for $150 million in an LBO in January 2007, the grocery chain found itself with $100 million in debt — a very high debt load for a small company in the cyclical grocery industry. But its PE owners weren’t done loading Fairway with debt. Five further rounds of debt financing occurred between December 2009 and December 2012, including a leveraged recapitalization in January 2010 to pay down some of the chain’s existing debt and to finance the purchase of additional stores. Industry observers characterized the expansion as “aggressive and miscalculated.” The chain grew to 15 locations in the New York City area.

In April 2013, Sterling returned Fairway to the public markets via an initial public offering (stock sale), but retained a large portion of the stock, giving it control of about 80 percent of the voting power in the chain. Fairway’s shares sold at $13 a share, above its expected range of $10 to $12. The IPO raised $177.5 million, most of which ostensibly went to the chain; only $3.2 million went directly to its PE owners. However, the chain used the proceeds from the IPO to pay affiliates of Sterling Investment Partners $76.8 million in accrued dividends on their preferred stock, $9.2 million in connection with the termination of the monitoring fee agreement, and $8.1 million in bonuses to certain members of the management team. So Sterling and its investors extracted even more money from the actual grocery operation.

Things did not go well for Fairway following its IPO. Burdened by significant debt obligations and recurring interest and principal payments, Fairway was far less able than other specialty shops to respond to the increased availability of organics in mainstream supermarkets or to the entry of Whole Foods in the neighborhoods it served. By July 2015, its share price had plummeted to $3 a share from its IPO value of $13, and by December it was down to 70 cents. As with Southeastern Grocers, efforts to sell the highly indebted chain failed, and in May 2016 Fairway initiated a pre-packaged Chapter 11 bankruptcy reorganization. In the prepackaged bankruptcy, the company’s senior lenders exchanged some of the debt for equity, reducing Fairway’s debt from nearly $280 million to $140 million and its annual debt service by $8 million a year. Suppliers and vendors who were owed $21 million to $27 million would be kept whole and not suffer losses.

In sharp contrast to bankruptcies in other PE-owned businesses, Fairway pledged to respect collective-bargaining agreements with its 3,400 unionized workers — 85 percent of its employees — who were primarily represented by UFCW. Fairway’s legacy of positive labor–management relations and investment in human resources management practices predates its acquisition by Sterling Investment Partners. It had traditionally hired a full-time workforce and provided workers with employer-sponsored health insurance and a defined-benefit pension plan. Management attributed the chain’s ability to cater to its high-end clientele to the quality of its customer service. Remarkably, the PE owners left this in place even as the company sank into bankruptcy — but the creditors absorbed the losses.

In July 2016, a couple of months after seeking Chapter 11 protection, Fairway was bought out of bankruptcy by GSO Capital Partners (a unit of PE giant Blackstone Group) and a consortium of Wall Street investors through yet another LBO for an undisclosed amount of money and debt. As the cycle of added debt and bankruptcy continues, worker pay could well be next.

What's Next for Sustainable Jobs in the Grocery Sector?

Grocery chains employ 2.8 million workers, distributed in small towns and cities across the country. They still account for the majority of food-at-home purchases and are an important source of jobs in local communities. Their continued presence is important to the local economy and to a sense of community in the neighborhoods they serve. PE firms have acquired at least 50 grocery chains in the last few years — attracted to them for their real-estate assets, low debt, and high cash flow. Their strategy of buying, selling, and flipping stores undermines the economic security of workers and the stability of local communities.

With heightened demand for one-stop shopping, organics, a wide variety of healthy products and services, online ordering and delivery, and more, grocery chains find they must race to emulate the most innovative products and services while containing prices. This takes deep financial pockets.

Private equity can assemble the resources needed to invest in facility upgrades, technology, worker skills, and product and service innovations to help supermarkets remain competitive. But their core business model requires these funds to be extracted rather than reinvested. Kroger and Albertsons — the numbers one and two supermarket chains in the country — provide a useful comparison.

Kroger is conventionally owned. Albertsons is held by private equity. Kroger is about twice the size of Albertsons — with $105 billion in sales in 2017 compared to Albertsons’ $60 billion. But both are huge, successful corporations with locations in 35 states each. Kroger operates under 26 banners (including Dillons, Food 4 Less, Fred Meyer, King Soopers, Ralphs, City Market, QFC, Owen’s, Pay-Less, and Smith’s) in 2,782 supermarkets and 2,268 in-store pharmacies, plus 1,489 fuel centers and 42 distribution centers, according to its 2017 Fact Book.

Albertsons operates under 20 well-known brands — including Albertsons, Safeway, Shaw’s, Acme, Vons, Jewel-Osco, United Supermarkets, Market Street, Star Market, and Haggen. Its 2,318 supermarkets include 1,777 pharmacies, 1,275 in-store coffee shops, and 397 adjacent fuel centers, according to its website. Both report that they have robust sales of their own private-label brands, with Kroger owning 37 manufacturing plants and Albertsons 20. Both have developed organic and healthy food lines and both have acquired a “meal kit” services company (Home Chef for Kroger and Plated for Albertsons). Moreover, both are majority-unionized — Kroger with 449,000 full- and part-time workers, and Albertsons with 280,000 —with workers in each chain represented by the same unions, primarily UFCW and the Teamsters.

The big difference is Albertsons’s PE ownership and history of leveraged buyouts that has burdened the supermarket chain with a debt overhang of $12 billion since its buyout of Safeway in January 2015. This constrains its ability to lower prices or innovate to compete against Amazon’s Whole Foods, Walmart, or Kroger. Compared with other grocery chains, Albertsons has more than twice the net debt-to-earnings ratio — 4.74, compared with Kroger’s 2.13, Sprouts Farmers Market’s 1.44, and Publix’s 0.35.

Following the PE playbook, Cerberus Capital Management bought Albertsons in an LBO in 2013 after having held a minority stake in the company since 2006. Under this ownership, Albertsons grew through a series of LBO-financed acquisitions from 2006 to 2013, culminating in the mega-buyout of Safeway for $9.2 billion (using 82.5 percent debt) in January 2015. This pushed Albertsons’s debt level to $12.5 billion, a factor in Cerberus’s failed attempt to launch an IPO in mid-2015. One industry analyst noted that the failed IPO would “definitely put them at a disadvantage, because if they can’t improve their stores, improve their customer experience, it’s hard for them to stand out among the competitive grocery market.”

After Albertsons’s failed IPO in the fall of 2015, its financial performance declined: operating income fell substantially between 2016 and 2018, and bond investors assigned higher levels of risk for the company’s bonds during 2017, and the S&P Global Ratings revised its outlook on Albertsons to negative in November 2017.

Despite poor financial performance, however, Albertsons paid out a $250 million dividend to Cerberus and the firm’s investors in June 2017. It financed the dividend in part from the proceeds of a sale-leaseback arrangement for some of its stores. Moreover, during this same period, Cerberus was charging “advisory” and “transactions” fees to Albertsons, which will cost the company at least $70 million for the period of 2014 to 2018.

Cerberus attempted another IPO in April 2018 for $2 billion, but canceled it in favor of a reverse merger in which Rite-Aid ostensibly bought Albertsons, even though it was Albertsons that initiated the $24 billion merger. The deal would have created a combined company of 4,900 stores, including 4,300 pharmacy counters and 320 clinics, but would not provide much-needed new equity capital. It would, however, have positioned the Cerberus-led investor group to exit its investment in Albertsons. The reverse merger with publicly traded Rite-Aid would have transformed Albertsons into a publicly traded company, with Cerberus and its investors holding a huge number of shares in the newly merged business. The supermarket’s owners hoped to sell off their shares in the now-public grocery and pharmacy chain after a long 12 years as investors and owners.

Critics pointed to the downside risks of the merger, which they viewed as one of desperation — two weak companies becoming one larger weak company. Rite-Aid and Albertsons called off their planned merger on the eve of the vote because of growing opposition from Rite-Aid shareholders. Some of the largest had announced plans to vote against it, jeopardizing its success. Cerberus’s next move and Albertsons’ future are uncertain. Albertsons’ debt-weakened state has undermined its PE owners’ attempts at a speedy and profitable exit. Will they now turn to asset sales to pull cash out and reward themselves, without regard to the poor prospects this will create for Albertsons, its 280,000 workers, and the hundreds of communities the stores serve? Or will they postpone plans to exit their ownership of Albertsons and increase their equity investment in the supermarket chain? Such an infusion of cash would enable Albertsons, after years of underinvestment in its stores, to make meaningful improvements in its operations.

The answer may hinge on what public pension funds do. These funds have increasingly invested in private equity, despite its unsavory and anti-worker practices, lured by the promise — if often not the reality — of higher returns. The question of whether the big pension funds should avoid private equity or use their investment to reform its practices has been hotly debated. (Pension funds cling to the hope of high yields despite the reality that half the PE funds launched since 2006 have not beaten the stock market and many more have failed to provide returns high enough to compensate for the added risk of these illiquid investments.) The California Public Employees’ Retirement System (CalPERS) has a large stake in Albertsons via its investment in the Cerberus fund that owns the supermarket chain. Will CalPERS, which has responsibility for managing the retirement savings of California public-sector workers, many of whom live in communities served by supermarkets Albertsons owns, insist that Cerberus abandon attempts at a quick exit, extend the time they are willing to hold the grocery chain, and commit to making investments that will improve store operations and increase profits?

In the meantime, Albertsons’ competitor, Kroger, is in a far different competitive position. The June 2018 Moody’s credit opinion of Kroger noted its large scale and strong balance sheet as key credit drivers. According to its 2017 Fact Book, Kroger’s debt strategy is to maintain a low net total debt-to-earnings ratio of between 2.3 and 2.5. Between 2015 and 2017, it invested roughly $3 billion each year in existing stores and operations, and it plans similar levels of capital investment in existing facilities for the 2018–2020 period. This is part of its “Restock Kroger” program, announced in October 2017, that includes the substantial renovation of its 2,800 supermarkets, expansion of partnerships to provide additional services, and investment in workforce development. It will use free cash flow to invest $9 billion in these projects to enhance the use of customer data, to optimize space allocation, and to upgrade technology and infrastructure for faster checkout, digital displays, video analytics, machine learning, and online shopping. Investments will include funds for employee training and development as well as $500 million to incrementally raise wages of associates over the three-year period. It has already launched its own new apparel line, is piloting a driverless vehicle for home delivery, and has formed a new partnership with the leading online supermarket service, Ocado, to build 20 new automated distribution centers at an estimated cost of $400 million to build in the next three to five years.

Leading Wall Street analysts cite these strengths, plus Kroger’s unexpectedly strong earnings report for the first quarter of 2018, as evidence that the company can survive Amazon’s threat. Kroger’s digital sales grew by 66 percent in the first quarter of 2018. The Wall Street Journal cited Kroger’s “aggressive” strategies on many fronts as evidence it will remain an industry leader. It also noted that Kroger is increasing wages and benefits for its workers and is investing a billion dollars to shore up pension liabilities. The pension contribution is unusual for the grocery industry and contrasts sharply with Albertsons’ behavior. Kroger may see this pension contribution as a key investment in its workforce and in its efforts to respond to new competition. According to the Journal, the company’s “strategy is paying off.” For Kroger’s workers, the future looks bright.

This tale of two supermarkets tells us much about the future of regional grocery chains. The rapid shifts in the competitive environment these chains face is a force to be reckoned with, but it need not be a death knell for them. Supermarket chains, like most retail establishments, are frequently buffeted by economic conditions and changes in consumer preferences. Traditionally, they have carried a low debt burden and owned their own real estate to serve as a buffer against hostile headwinds and to provide breathing room and resources to respond to new challenges.

PE owners have turned this model on its head — loading the supermarket chains they own with huge debt burdens intended to boost returns to themselves and their investors and, frequently, selling off real-estate assets in sale-leaseback arrangements to lower debt and line the PE firm’s pockets. In stable market conditions, this is a winning strategy for PE owners. But in today’s turbulent times, with supermarkets facing a series of disruptions, the outcome for the stores, their workers, their vendors, and their customers is increasingly uncertain — and the specter of bankruptcy omnipresent.