PJ SOLOMON's Head of Financing Advisory Joe Stein speaks with David Shiffman and Jeff Derman of the firm's Consumer Retail Group about the keys to financing retailers amidst challenges facing the sector including a global pandemic.
PJ SOLOMON's Head of Financing Advisory Joe Stein speaks with David Shiffman and Jeff Derman of the firm's Consumer Retail Group about the keys to financing retailers amidst challenges facing the sector including a global pandemic.
There was no playbook. And we saw many of our clients work quickly to figure out what to do to conserve capital, to protect their people and to position their businesses for when better days would come. Welcome to this episode of the PJ SOLOMON Presents podcast, where we'll be diving into retail financings in the context of a very unique 2020. I'm Jeff Derman, a partner in our Consumer Retail Group. With me today are my colleagues David Shiffman, who co-heads the Consumer Retail Group and has been my colleague for the last 15 years, and Joe Stein, who is the centerpiece of this discussion and our longstanding head of the Financing Advisory practice. To start, we probably should step back to more predictable times at the beginning of this year when we published our outlook for retailers in 2020. At that time, one key theme we had was the separation of the haves and have nots. We'd already seen an acceleration in bankruptcies in 2019, and that contributed to well over 9,000 store locations closed last year. So the sector already came into the year with many retailers hobbling before COVID hit and effectively shut the sector down. Our Consumer Retail practice, as many listeners know, is traditionally driven by strategic M&A activity. However, for many clients, COVID meant putting aside strategically sound M&A projects and focusing inward. So we rapidly had to pivot to helping clients deal with the disruption by having the liquidity to make it through to the return to normalcy, whenever that happens and in whatever form it takes. And this is where David and my work with Joe comes in. I know we both had a lot of questions for Joe today. David, why don't you get us rolling with you first.
David Shiffman:Joe, if I'm a sitting CFO and I have to solve for my liquidity, when do I call our friends at PJ SOLOMON versus calling my existing lender or look for an underwriting solution, as opposed to a private solution, which feels like a path we often walk down with our clients?
Joe Stein:Sure, David, well first of all, we're unbiased. We want to bring the right solution to our clients. So we're not lenders, we're not advocating for a certain solution. We're not trying to protect our capital or our exposure as banks often do. The key is to identify situations early. And I think that's one of the big lessons that we learned coming into COVID is many retailers were really caught by surprise. They didn't have the right financial flexibility coming into the situation and they felt distress immediately when stores closed. There's really two markets, the private market, which is populated by banks and direct lenders and certain credit funds. There's been a big proliferation of those funds over the last 10 or 12 years, since the last downturn where banks are more heavily regulated today. And these credit funds have just popped up all over the place and they're providing tailored solutions to clients on a di screte b asis. So th ey're b uy and hold type lenders who will do term loans, who will do certain as set-based o r heavily collateralized loans. And they are filling a very important void for retailers in particular. Certainly the public markets, which are broadly syndicated loans that are distributed by banks to institutional investors, or the high yield market, for example, ar e c ertainly open to bigger companies that have EBITDA of$50 million or more, for example, and have a financing need of at least$250 million for af termarket l iquidity purposes. So that's sort of a benchmark and that's a rated market, but in the private market, really anything goes big and small, very storied. And even in the healthy co ntext w here you're doing an acquisition and potentially there's synergies, or there's a story around a merger, it can be important to do that di screetly a nd bring a financing partner into th e s ituation and have them do diligence alongside you and understand the story and then fund the transaction either solely or in a small group of lenders. So what we try to do is figure out based on the client need what the best outcome and the best market is for our clients.
David Shiffman:The number one issue that most CEOs and CFOs start with when they contact us is they tell us how valuable their existing lending relationship is. And they ask us how we go about preserving that relationship while driving the best outcome for the client.
Joe Stein:We really respect existing relationships. That's first and foremost, we recognize the importance that banks have in our clients's lives and the capital that they're providing. Any situation of course is unique. And we know many of these lenders because we are very active in the retail and consumer market. They're well familiar with how we operate and we have a good idea as to how they behave as well. We like these incumbent relationships, but our presence as an advisor suggests that competitive tension is going to be necessary. So we talk to other lenders as appropriate, and we make sure that the solutions that they're providing are appropriate and are on market and and competitive. And I think our presence signals that situation to the lenders. And I think from a client standpoint, it's nice to have that voice behind the scenes, coaching them up on market conditions and protocols and giving advice on capital markets type issues, just like you guys do in an M&A or a strategic context.
Jeff Derman:Joe, you and I worked on a situation that was relatively complex at the beginning of COVID and carried through for several months. And through that process, we saw both public and private market opportunities come our way, which we had to sort through. What would you take away as some of the biggest learnings about how the public markets versus the private markets are thinking about retail today and what might it mean for our clients going forward?
Joe Stein:Certainly all of the capital markets as it relates to retail are very selective. So they're going to be gravitating to the sector leaders, the sub sector leaders, because they know that it's a survival of the fittest environment. And to your point at the top of the show the haves and have nots. So that's always critical. The private market is more tailored and more flexible in many regards because it really is designed for a particular capital source to meet the needs of a business plan or a situation. The public markets by contrast are more cookie cutter. There's certain protocols, there's certain norms that are expected in terms of size of financing documents. And of course the whims of the technical factors of those markets, whether it's leveraged loan market, the equity markets, the bond markets, where inflows of capital are important, there are certain headline risks. So they're more fickle in terms of how they behave day to day. So there's windows of opportunities. Those opportunities can can close. The private market is more straightforward and it's more even keel, but in fairness, the private market, there's a premium price to it because it's a buy and hold type market and there's more work to it. There's more analysis that goes to it. The transactions are often more storied, so there's a premium price for it. And the documents and the structures are typically more limited or more restrictive, I should say, in terms of covenants and flexibility afforded throughout the document.
Jeff Derman:Hey, Joe, as our clients start to look past COVID to hopefully more normal times where M&A is going to once again become part of the playbook, if you will, how do you think the lending universe is going to think about acquisition financing in retail and what are going to be some of the things that those lenders are looking for to stand behind clients who are looking to access capital to affect strategic combinations?
Joe Stein:Well, first and foremost is their competitive positioning. We talked about that, but it's very important. Lenders are very attracted to performing companies and companies that have a reason for being, and have an ability to fight the headwinds that we're all facing in the consumer retail world. So that's sort of a fundamental basis and frankly many don't meet that criteria and have a hard time accessing capital. Then they'll look for collateral, but that doesn't mean that there needs to be a hundred percent coverage with collateral, but collateral provides a certain measure of comfort that lenders look for. So whether it's inventory, real estate, IP, or other assets that's important. And then the e-commerce capabilities that clients have, and that also gets to pereceived brand value. So when you put all those things together, if the company is generating cashflow and has a strong position in the market and has collateral, lenders will gravitate to those opportunities, and it's our job to find the right structure that works in that environment. But lenders are open for business and they are going to be willing to support clients in these strategic transactions.
David Shiffman:Let's say five years forward, we're in 2025. Is it a winner take all in there are 20 dominant retailers with likely Amazon in Walmart battling for supremacy, but there are 20 top retailers taking 80 plus percent of all the revenue dollars out of the market?
Jeff Derman:Well, David, you know, we talked about in our annual letter, the big keep getting bigger. The capital availability, and let's be honest through COVID no one questioned whether Walmart or Target or anyone of that scale was at risk of being able to secure capital, right? So they did not have the issues that many of our other clients were facing. So they will continue to be able to build their empires. There's no question about that. And they will continue to be able to take risks that others won't. Some of those will pay off much like we've seen with Target and their well-timed investments in things like Shipt, which allowed them to very quickly pivot to a direct to consumer slash local delivery scenario in the early days of COVID and immediately seize upon that. They'll continue to be able to take those risks, but I think there's still very much a place for the more distinctive retailers out there too, the category killers who resonate with consumers, who are enthusiastic about certain categories, who want the authenticity and the connection to maybe to brands and or the retailers representing those brands, that will be separate and distinct from those big behemoths who no question will continue to be important and dominating parties in the category, but they won't be the only parties.
David Shiffman:So if I approach Joe and I am a subscale size retailer with a growing web business, but also a store based business, how do I get the attention of the capital markets to make sure that I have enough liquidity to drive my business so I can compete in the future before I get drowned out of existence, as a result of those large cap players?
Joe Stein:Well, many of the issues are interrelated, as you can appreciate. I mean, they have to have a certain presence and they have to have a certain operating performance that gives them some level of financial flexibility. And I think that's the big lesson learned in this COVID environment is many were unprepared for it because they didn't have the liquidity. They didn't have the ability to absorb the pain of closing stores and furloughing employees and just the massive dislocation that happened. So this has been a major lesson, and I think, I think boards and senior management teams are now taking a step back and are making sure that they have a conservative financial policy and they are trying to improve their balance sheets. And they are looking out and trying to stockpile liquidity to the best of their ability, whether that's improving their financing structures and borrowing proactively to make sure that they have capital. This is the forefront of the conversations that are going on with clients. And we're seeing real time the ability to absorb a shock like this, or continuing to battle and compete when there's just ongoing headwinds is critical and you can't do it without liquidity and you can't do it without some measure of financial flexibility. And it's best to improve that position before trouble hits.
David Shiffman:The advice we gave to our clients universally in February and March, when this hitand people didn't know what they were up against. And we said, raise capital as soon as possible, capital may be more expensive. So your cost of capital may rise in periods of duress, but all things being equal, that's a small price to pay for those who sit with capital is opposed to those who are unable to get capital. And we've seen that in spades throughout the year.
Jeff Derman:The craziness that occured over the course of 2020 and continues to occur, have you seen clients start to change their businesses,should something like this repeat itself two, three, four years from now to be better positioned to withstand those things. And if so, how?
David Shiffman:We have and those sitting with significant excess capital now will do one of two things. One they will use it to reinvest in their business over time when they come out the other side of this or two, many who are acquisitive view it as pre-funding a war chest when the right time approaches in that the right opportunities present themselves, they will have pre-funded those acquisitions. So thats on the capital markets front. As it relates to operationally and the revenue model, clients have learned a couple of things. I think clients are selling a lot more at full price than they ever imagined. They pulled back dramatically on their receipts. They canceled orders. Most of the more disciplined clients are running much more balance sheets with significantly less inventory. And they've gotten comfortable selling fewer goods, but at much higher prices. And I think coming in towards the end of year end, we're seeing that in the space, you know, soft lines, footwear, accessories get a lot of attention, but I've heard repeatedly, for instance, in the automotive space scarcity of inventory yet never making as much money as they have before solely on selling as much as they can at full price. So we have many clients that are actually making a lot more money than they have in the past. The other thing is they took out significant expense throughout their P&L and that's not new. We saw that playbook, remember Jeff and Joe, coming out of the great recession. And I think most CEOs and senior executives, I know Steve Sadove who is our advisory director was the CEO of Saks at the time, talking to us about how much cost he was able to take out of his business. Yet he was highly competitive, able to operate and therefore coming out of the great recession, he was making more in margins than he ever had before. And I could see that playbook returning in many of our clients seeing that. The last thing I would say is since the great recession it's been a terrific expansion period economically for companies individually. And I think a number of companies were under invested in technology over invested in people in right now they're learning how to navigate that. And many of our clients will embrace more technology in the future and probably run businesses that have less SG&A and ultimately less headcount.
Jeff Derman:Well, I think the other thing David to your list of areas that retailers are going to take learnings from, it'd be very interesting to see how people, how our clients start to think about signing that next retail lease and what is in that lease and how they're going to manage their portfolios of stores going forward. As things come up for renewal or opportunities present themselves for store expansion. I'm not sure what that looks like going forward, but it feels like it's going to be very different than your standard landlord-retailer relationship circa 2019 or 2018. What Is going to be different about the lender retail borrower relationship in 2021 versus where we were in 2019, based on what's happened this year?
Joe Stein:They're going to come out of this more conservative. And I think one of the ways we're already seeing it is inventory appraisals have been hit pretty hard given the fact that stores have been closed and the market has been so stressed. So the net orderly liquidation values of inventory, which is a key measure for asset based lenders, those have been reduced and they'll remain reduced in a trough type way for a number of months, if not the balance of 2021. So we're going to have to see some consistency back to the market before lenders push the envelope on structures as they were doing coming into COVID and this really was a chance for them to regroup and step back. And I think the inventory issue is going to reverberate throughout the market for some time. And everybody's adjusting to that and that's working out. Lenders are more conservative. Clients see it. They're forecasting that in and what it results in is less liquidity, less borrowing capacity. So it speaks to having some measure of financial flexibility, because these are the kinds of things that you have to work through when you get in these stress situations,
David Shiffman:That's a fantastic wrap up to our conversation around retail financing. If you had to leave people with a final piece of advice, what would it be?
Joe Stein:It would be to call us and talk to us. We value the dialogue and I enjoy working with you both. And we work closely and comprehensively together. So we're a cohesive group and it's natural for us to gang tackleclient matters. And it starts with a conversation. We work discreetly, we work informally. Not everything is a formal engagement. It's often getting advice and getting some perspective on a market or a potential decision. And we value that as you both know, Peter Solomon has always preached to us that we play for the long term. It's not about the transaction, or it's not about the near term. It's building that trust over time and in the financing world, that happens day to day. And I love being part of those discussions. And I look forward to continuing the dialogue.
David Shiffman:This has been incredibly helpful and thoughtful in terms of your perspective on the financing marketplace. And I know Jeff Derman and I have spent years working with you and trying to solve these issues for clients. So we look forward to our next conversation and thank you everyone.
Jeff Derman:And one final note for our listeners as well. We've been talking about the Consumer Retail space today of course. Joe Stein is our partner across all the industries that PJ SOLOMON covers. So if anybody has questions, whether about Consumer Retail or other areas, by all means, please visit our website, pjsolomon.com. We look forward to hearing from you.