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Not Quite a Fever, But Industry's LBO Tempo Could Pick Up

Fashion stocks could be back in fashion, as several private equity investment firms specializing in LBOs are taking a closer look at this sector.

NEW YORK — Fashion just might be coming back into fashion again.

With plenty of cash to invest and few "good," sexy tech and telecom firms to buy, several private equity investment firms specializing in leveraged buyouts are starting to take a closer look at the sometimes stodgy world of fashion and retail.

Of course, there’s really nothing stodgy about fashion and retail, which frequently conjure up images of glamour and celebrity. However, the so-called old economy business model utilized by firms in the sector used to pale in comparison with the once-touted new economy models of the dot-coms.

Not anymore. Gone with the dot-bombs is the idea of unproven business concepts generating quickie sales and profits. Back in vogue for the first time since the early Nineties are old-fashioned business models with proven track records, consistent earnings and products that can be touched and felt.

Of course, given the ongoing war in Iraq, many firms are likely to stay on the sidelines until there is some certainty over its duration and outcome.

According to Andrew Jassin, co-founder of consulting firm The Jassin-O’Rourke Group, there are many fashion-related firms looking for financing to grow. In addition, there are owners who are looking to cash out on all or part of their ownership interests. While not all negotiations will result in agreements, Jassin said that he’s getting approached more and more frequently by private equity firms for ideas on possible deals.

That’s also good news for retail and apparel companies looking for dollars with which to grow their businesses.

Why now?

Gilbert Harrison, chairman of investment bank Financo Inc., observed, "There is a tremendous amount of money committed to buyout firms by large institutions, pension funds and corporations. Most of that money has not been put to work. The nature and quality of some of the [proposed] deals, and also pricing, have been such that prudent managers don’t want to proceed because the deals are perceived as not good enough for investment."

According to research by Morgan Stanley, buyout firms have more than $100 billion in cash on hand for investments. Blackstone Group, for example, in 2002 raised $6.5 billion for its buyout fund. There’s still excess cash out there flowing into the funds. In January, Boca Raton’s Sun Capital Partners, which specializes in turnarounds and special situations, raised $500 million — $100 million more than originally planned — for its LBO fund, Sun Capital Partners III.
In a classic LBO, such as the 1999 transaction involving St. John Knits International, capital is borrowed to take the firm private. Buyers, because they use debt to fund their purchases, expect the company’s operating cash flow to service that debt. Typically, the debt consists of the assets of the targeted firm, which generally is pledged as collateral for the borrowed funds.

Private companies can also enter similarly structured deals. Whether the targeted firm is private or public, the exit strategy of the buyer, after fine-tuning the target’s operations, is to cash out either by selling the company or by taking it public through an initial public offering.

Howard Bader, an attorney at Ballon Stoll Bader & Nadler, observed, "There is so much pent-up money out there ready to do deals, and many companies out there treading water. We see both apparel firms looking for investors and boutique investment firms looking to do deals."

Most of the queries don’t pan out, Bader said. Smaller boutique investment firms face competition from the larger, better-known players. In addition, many of the firms seeking sources of new capital may not provide the "pop" in the investment that typically attracts buyout firms.

"One of the problems is that you have to be really careful about where the money is invested. There are mature businesses out there looking for financing, but then there’s really no or little possibility for expansion. The deals that get done tend to have an upside to the story," Bader said.

Just how many retail and apparel firms will eventually cuddle up with an investment partner before the year is over is still unclear. One roadblock to the completion of an LBO these days involves the financing component of the deal. Banks are getting stingier about how much they’re willing to provide in loans. That means that buyout firms have to put in more equity, as much as 50 percent in some cases, compared with the mid-to-late Eighties, the Golden Age of the LBO, when as little as 10 percent could get a deal done.

Another change is that buyout firms are more cautious now, a remnant of the days not too long ago when many got burnt. Investments soured either because the targeted firms failed or the weak market conditions meant that a hoped-for IPO or sale suddenly became impossible to do.
Brad Cost, who heads up the corporate law practice at Torys, worked on between 25 to 30 deals during the Nineties when he represented Merrill Lynch in LBOs including Donnkenny and Chorus Line. One widely successful LBO he worked on for Merrill was a company then known as Norton McNaughton, which was renamed McNaughton Apparel Group after it bought the Jeri-Jo and Miss Erica labels. Cost was on McNaughton’s board from when it went public in 1994 until it was acquired by Jones Apparel Group in 2001. Former McNaughton ceo Peter Boneparth now heads Jones in the same role.

According to Cost: "When LBOs were the rage, apparel firms had almost no debt on their balance sheets. Because they didn’t borrow money, the balance sheets could support a lot of borrowing to get the LBO done, and the owner would get his payout with borrowed money.

"What I’m seeing now is that firms in general have a fair amount of debt. The banks are not lending as much even though many are flush with cash. The more debt firms have on their balance sheets, the harder it is to refinance. That chills the LBO possibility, and is one of the reasons why many deals now don’t get done."

Jim Abbott, an attorney at Carter Ledyard & Milburn specializing in corporate and private equity transactions, pointed out that the conservatism of banks about how much they are willing to lend has left many buyout firms sitting on substantial pools of cash. "They would like to invest that money, but just can’t put together the deals and have them financed in the way that would promise the [requisite return] to their investors."

Abbott expects to see an increased interest by buyout firms in the retail and apparel industry. "Now they are looking at solid businesses that can make a profit and generate revenue with some measure of consistency."

Wilbur Ross — whose private equity firm WL Ross & Co. manages funds that are owed millions of dollars in the Burlington Industries bankruptcy — said that textile firms can be ideal candidates for LBOs because the receivables and inventories are often the easiest to finance. Recent LBOs in the sector have included WestPoint Stevens and Spring Mills.
Those deals, too, are getting tougher to do. During the height of the LBO craze in the mid-Eighties, many deals were done in which senior lenders — typically banks — were willing to lend up to 4 or 5 times multiples. Not anymore. Those multiples of EBITDA — earnings before interest, taxes, depreciation and amortization — have dropped considerably.

"Even a few years ago, senior lenders were willing to lend 3 to 3.5 times multiples. In general, they’ve now gotten even more conservative, in part because they were hurt by many bankruptcies. Now they’re lending in the range of 2 to 2.5 times multiples," Ross said.

To get at least some deals done, firms are looking to midtier or mezzanine financing. Kelly Engel, director of finance at investment bank Peter J. Solomon, observed that there’s a "tremendous amount" of it in the market right now.

Mezzanine financing involves debt instruments that are subordinated to senior paper — considered most safe — and therefore riskier, but not as risky as equity. Amounts under $150 million are considered bridge loans and in the mezzanine category. Amounts over $150 million are still referred to as junk bonds for their high-risk, high-yield nature.

Elizabeth Eveillard, an investment banking consultant who also serves as an outside director on several retail boards, observed that the more successful deals in retail and apparel are those in which the buyout firms have previous experience in the sector.

"The experience can prove critical because it can be a very tricky market to invest in. Investors need to understand both the price-value equation and the strategic competitive issues such as concept, positioning and life cycle of the business," she explained.

John Howard, senior managing director of the merchant banking group at Bear, Stearns & Co., told WWD, "Our criteria, when looking for opportunities, include whether the company has potential for significant growth and strong management. We [favor] firms that are underappreciated by current ownership, whether private or public."

Howard explained that part of his group’s due diligence includes "looking deep inside the companies to understand what makes them tick. We want to find the reasons for the nature of the franchise and for its future growth."
So far, retail firms seem to be the more-favored opportunity than apparel firms.

The Stamford, Conn.-based firm Saunders Karp & Megrue hit a home run with its investment in Charlotte Russe, a 1996 LBO. The teen retail chain eventually went public. Another retail home run for Saunders Karp was The Children’s Place.

More recently, Bear, Stearns in December completed its LBO of Vitamin Shoppe Industries. A month earlier, as reported, Limited Brands completed its sale of Lerner New York/New York & Co. to Bear, Stearns. Aeropostale, a much earlier LBO in 1998, was successfully taken public in May 2002.

The Vitamin Shoppe was previously recapitalized in 1997 via an LBO by FdG Associates and J.P. Morgan Partners. The December 2002 deal with Bear, Stearns, was reported to be valued at over $300 million, and includes Jeff Horowitz staying on as chairman.

According to Howard, "The Vitamin Shoppe is a fast-growing business and is in the process of an aggressive expansion through new stores. That makes it an appropriate candidate for an IPO at the right moment, which could be anywhere from 18 months to two or three years."

A key ingredient to what attracted Bear, Stearns to the retail chain, Howard emphasized, was the fact that it is an "unbelievably well-managed company. It was a very successful LBO for its previous owners." Bear, Stearns snapped up the investment when the previous investors decided it was "time to cash in." The merchant banking group "paid a high price for the company because we felt it was well positioned to grow in the future."

Howard declined to talk about numbers, but investment banking sources said that Bear, Stearns and its partner, BNP Paribas, hold $120 million in senior debt. In addition, Bear, Stearns put in another $120 million in equity. The balance, about $65 million, was provided by Blackstone Mezzanine Partners.

As reported, November’s deal with Limited Brands was led by Lerner ceo Richard Crystal. Lerner was bought by Limited in 1985. According to Limited, the sale fetched $78.5 million in cash. Limited also took back some paper to complete the financing, similar to Blackstone’s mezzanine financing of Vitamin Shoppe. For the privilege, Limited received $75 million in subordinated notes and warrants for 15 percent of the common equity of the new company. The sale of Lerner was part of Limited’s refocusing of its portfolio that included divesting itself of some overlapping brands.
For Bear, Stearns, Lerner represented a different type of retail growth story.

Howard explained: "Historically, Lerner’s was not a growth company. Lerner’s was a stepchild of the Limited, but it was also one of the good performing businesses in Limited’s portfolio. We think Lerner is a pearl. It is definitely not Vitamin Shoppe. While you can’t expect 15 percent growth, there’s a lot that we think we can do."

For Howard’s group, the plan includes refocusing Lerner’s real estate portfolio. "Lerner’s shouldn’t have been in as many of the A and B malls that it is in. We think the opportunities are in street locations and strip centers. There is a lot of good real estate in Brooklyn and Staten Island. Lerner’s should be in local neighborhoods where people are in sync with the [chain’s] product and where we can be more productive with the lower rents. About 15 percent of the Lerner’s stores are not productive on a four-wall basis."

Also in progress is a name change to New York & Co. from Lerner’s. One possibility that Bear, Stearns is exploring is the opening of a shop-within-a-shop under the Lerner’s nameplate focusing just on the plus-size customer

The chain Aeropostale was acquired by Federated Department Stores when it merged with R.H. Macy’s. After earlier unsuccessful attempts to sell the chain, it was finally bought by Bear, Stearns in 1998. The merchant banking arm paid $6.2 million as part of the total $14 million buyout package. Bear, Stearns and Merrill Lynch took the company public in May 2002. On the first day of the public offering, 12.5 million shares were sold, raising $225 million. Priced at $18 a share, the stock opened at $24.90 and closed at $27.75. Its price has since declined, closing at $13.99 on the New York stock Exchange Friday.

"With Aeropostale, we found that the return on the investment in a new store was between 40 percent and 60 percent. With those numbers, you should open as many stores as you can. Obviously, this has to be done in the context of responsible growth. In Aeropostale, we built a new culture, have great people to run it and great product. We still have a very great opportunity for growth with the chain," Howard noted, adding that Bear, Stearns retained a significant stake in the company.
While Howard favors retail, he noted that apparel firms can sometimes be good investments. Wall Street, he said, has a tendency to be uneasy about investing in apparel firms because of the fashion risk, even though that risk is often "overblown."

To be sure, history has not been kind to investors in apparel firms. One often-discussed firm in investment banking circles is Donna Karan. The company went public so that its owners could cash in on their hard work.

It wasn’t until much later, said one investment banker who requested anonymity, that investors realized that the real money-making nerve of the business was through its licenses and trademarks, owned by privately held Gabrielle Studios and not a part of the public firm.

When LVMH Moët Hennessy Louis Vuitton bought Donna Karan International, it paid Karan $400 million for Gabrielle Studios alone. The public company was acquired in November 2001 for $243 million in cash and assumed debt in the range of $4 million to $5 million.

Another example that proved to be a headache was the Pegasus fiasco, which reinforced the impression in the financial world that apparel firms may not be the best investment risk in town.

While other apparel firms that have gone public — Tommy Hilfiger Inc. and Polo Ralph Lauren Corp., to name a few — are surviving changing fashion cycles, none had an uphill ride when the stock market was soaring, a fact bemoaned by Polo ceo Ralph Lauren at an annual meeting several years ago. Because few hot fashion companies were able to take advantage of a bull market before late 2000, the investment bankers and attorneys who structure the deals say that investors perceive that there probably are better opportunities elsewhere.

Jeffrey Hornstein, managing director at Peter J. Solomon, added, "One of the problems with apparel firms, in part because of the fashion risk, is that there is often an uncertainty over the cash flow of the business. Cash flow is important because you have to have a certain level that is consistent in order to be able to service the debt that’s involved in the deal."

One well-known apparel firm that was able to get a deal done was St. John Knits, which went public in 1993. Tired of living life in a fishbowl and pressured to drive its top line, Bob Gray, founder and then chairman, decided in December 1998 to take the high-end apparel firm private.
While consumers loved the St. John label that was the core of the firm’s business, they weren’t so hot about its extension brand, SJK. Faced with difficulty in meeting Wall Street’s growth expectations, the company began looking at other options for growth beyond its core knit line.

The company in 1998 found a partner in Vestar Capital Partner, which took it private in a stock buyout that gave 77 percent ownership to Vestar, and 16 percent to the Gray family. The remaining 7 percent is publicly traded over the counter.

LBOs are not without their risks. There have been several firms that have followed the LBO route since its heyday in the Eighties, and at least three — all done in 1986 — have left their investors awash in red ink.

Edward Finkelstein, chairman of R.H. Macy & Co., the fifth-largest department store chain at the time, took the company private through an LBO valued at $3.6 billion. Ronald Perelman completed a $1.8 billion acquisition of Revlon via an LBO. Linda Wachner, former chairman of Warnaco Group, completed her hostile LBO of that firm.

Since then, those firms have had their share of troubles. R.H. Macy eventually filed for bankruptcy, and was subsequently acquired by Federated Department Stores, itself a victim of a bungled LBO by Canadian real estate mogul Robert Campeau.

Revlon went public in March 1996, after one failed attempt in 1992. Since the LBO, the company has been plagued by losses even back in 1992. Proceeds from the 1996 IPO — $180 million was raised through the sale of 7.5 million shares at $24 a share — were used to pay down debt. Revlon was saddled at the time by about $1.5 billion in debt from the LBO. Earlier this month, the company reported its 17th straight quarterly loss.

In the case of Warnaco, the company went public in 1991, but then, after a series of acquisitions, ran into cash-flow problems that eventually led it to file for bankruptcy. It exited bankruptcy proceedings in January, and is now known as Warnaco Inc.