Hey Honey, we bought Needless Markup!

Dateline: Washington

News Report: Ares and CPPIB acquire Neiman Marcus for $6bn

When my parents lived in the U.S. for a period thanks to a work posting, my Mother became a bit of an expert in the U.S. department store business, as only customers can be. She didn’t have bottomless resources, but she was enthralled with how retailers had perfected their trade in a way she’d never experienced in Canada. In her view, only Harrods in London held a candle to Neiman’s, Nordstroms and Bloomies. I wonder how she’d have reacted to wake up one morning earlier this week to find out that she, along with the rest of Canada, now owned “Needless Markup” thanks to our money managers at CPP Investment Board.

Although Neimans was about to be taken public for a profit by its former PE owners, Warburg Pincus and TPG, I hadn’t planned on buying any shares. In fact, I don’t think I’ve ever bought a retailing stock in my life. But, thanks to our all-for-one-and-one-for-all pension structure, it seems I’m buying Neimans off Warburg and TPG just the same — likely at a premium to whatever Neimans’ IPO valuation was. An IPO poised to happen just as the Dow Jones is hanging around its all-time highs. It’s no that I don’t love the store or its discount outlet, as I do. But since I am more than likely to buy something there at 20% off the previously reduced 50% discount, rather than full price, I feel I’m always getting the better end of the bargain in our relationship. Who wants to own the shares of a company you think you are perennially fleecing as a customer?

As private equity deals go, our strategy with this transaction isn’t entirely clear. There are only four ways you can make money as a private equity investor: 1) eventually take the company public and sell your shares over time into the public market; 2) retain the investment and take out meaty dividends over an extended period; 3) eventually sell the asset to a strategic buyer who needs your company now that you’ve vastly improved its performance and critical mass; 4) flip it to another private equity player after you’ve done the core of #3. There are minor variances on these four clear avenues, such as dividend recaps in conjunction with these four categories, but for illustrative purposes, I think this is the list.

For CPPIB, which claims to be a “long term” investor — except when its not (Skype) — Neimans can definitely fit the bill. They have the luxury of owning it forever, actually, since I am confident that brick and mortar stores will always have a place in our lives. Our firm is one of the backers of fast-growing Beyond The Rack, Canada’s third largest online retailer (behind Amazon and EBay). People have definitely gotten comfortable with regularly doing retail online, but there’s something about “going shopping” that will always appeal to many.

Owning the Neiman asset is one thing. How are we going to make money at it?

I suppose we could always take it public down the road. Ares told the Financial Times that the plan is to invest “meaningful capital into the business to ensure Neiman’s long-term position as the unparalleled leader in luxury retail”. Perhaps they mean a move to Canada, to follow the five stores that Nordstrom has announced for Calgary, Ottawa, Vancouver and Toronto. Whatever the plan, reinvesting your free cash flow in the business means we CPPIB beneficiaries won’t be getting any dividends to speak of for the foreseeable future. I can’t see a trade sale as our exit, since there’s no clear buyer. And for PE guys to flip a deal they bought from some other PE guys to a third set of PE guys seven or 10 years from now seems to be the most unlikely outcome of all. Which leaves us with another IPO filing in five or seven years. Ares isn’t in this deal forever, since that is not the nature of their limited partnership vehicles; so unless CPPIB wants to buy out their partner down the road, and harvest the cashflow, a liquidity event may well be forced upon us. God willing.

Globe and Mail Columnist David Parkinson called the move a “splurge”, which was the first critical word written about CPPIB’s investment activities at Canada’s National Newspaper in memory (see prior post “Why so uninquisitive about the CPP Investment Board, ROBers?” Mar 3-13):

The guardian of Canada’s massive $183.3-billion taxpayers’ pension fund has developed an taste for luxury retail. It may find this isn’t the easiest sector to swallow.

In doing so, it’s making its first significant investment into a segment of the retail sector that is considerably riskier than is often assumed, at a time when assets look distinctly overvalued. Analysts at Merrill Lynch recently identified the consumer discretionary sector as the most overpriced sector in the S&P 500, with an implied price downside of a whopping 39 per cent based on price-to-book-value valuations. Within that, the luxury-goods segment is showing 44-per-cent price downside. The sector is near a record-high value relative to the rest of the S&P 500; typically, that’s an indicator of a sector at the peak of its cycle.

And Neiman Marcus’s current owners, private-equity firms Warburg Pincus and TPG Capital, haven’t exactly had a great time as owners of this luxury gem themselves. The selling price of $6-billion represents an 18-per-cent premium over what Warburg and TPG paid when they bought Neiman Marcus in 2005 – an average of just 2.2 per cent a year on their initial $5.1-billion investment.

The official logic for buying seems to be that luxury retail is a high-margin business that is resilient to economic downturns, since the rich can still afford to be rich even when the economy goes sour. But there’s not a lot of evidence to support that notion. The S&P Global Luxury Index, which tracks the biggest luxury-related companies in the world, lost two-thirds of its value during the Great Recession – suffering even deeper losses than the broader stock indexes such as the S&P 500 and the MSCI World Index.

Now that you’re frightened for your pension dollars, the good news is that Ares Fund management have had decent success as private equity investors over the most recent funds. CPPIB has been a limited partner in all four of the Ares Corporate Opportunities Funds (I-IV) since 2003, with a US$450 million allocation to Ares IV in 2012. Although CPPIB won’t disclose the data in a useful way (see representative post “CPPIB’s new website fails to improve opaque disclosure” Aug 8-13), CalPERS reports the following return figures for Ares I: 13.9% IRR with a 1.7x return on capital and for Ares II: 13.9% IRR and a 1.8x return on capital.

But not every PE deal works out, as we painfully know from CPPIB’s investment disasters on other recent “double down” deals, such as EMI, Freescale and TXU, for example (see prior post “12 questions CPP Investment Board won’t be answering on BNN today” Jan 17-13).

Retail is particularly susceptible to performance swings, which isn’t the kind of volatility you want for a pension plan. In 2009, sales at Neiman fell 21 per cent to US$3.6 billion. It lost US$668 million that year, and its PE backers were forced to write down goodwill associated with the Neiman brand name. Profit rose to US$140 million in 2012 as sales grew 7% to US$4.5 billion. That’s what $6 billion buys us these days, I guess.

Pension plans with long term liabilities spend a great deal of time advocating to their stakeholders about the need to match their investment strategy with their fiduciary responsibilities. I’m sure the CPPIB Neimans investment memo laid out all of the ways we are going to make money on this deal, but the retail sector is no toll road, power plant, airport or AAA office development. The kind of stable asset you put a big chunk of your nest egg into.

Perhaps the CPPIB investing “algorithm” told our managers they were horribly underweight North American retail, so they had no choice but to find a suitable asset and back up the truck to skate back onside their asset allocation model. But I doubt it.

Neimans was about to go public and one has to assume that CPPIB was pitched by Ares to buy the whole thing, instead of letting the deal hit the public market. It’s not as though domain research led someone at CPPIB to call Ares out of the blue and say: “let’s buy Neimans”. Which is compounded by the fact that there’s no hedge CPPIB can put on this deal to protect against the sheer certainty of these three things over the next decade: i) another recession or two will knock down sales and profits for a spell, giving back much of what we earn otherwise, ii) the existing stores are in a never-ending need of updating, given the expectations of shoppers for fresh, new enviroments, and iii) the growing gap between rich and poor in the United States isn’t going to be solved quickly, so there will be no incremental shift of consumers with a newfound capacity to enjoy high end retail (unlike China and India, for example) — if anything, demographics are against the sector as young men and women learn to buy luxury goods, housewares, shoes and clothing online.

Public market investors can play these types of companies throughout the cycles, and exit their positions when they think the time is right. But when you’re a private equity owner, you own it. There is no liquid market to sell in to. CPPIB obviously thought it would make us more money keeping Neiman private for now, rather than investing on the proposed IPO. For sure, they can put far more of our capital out the door via this deal structure than whatever allocation might have been available from Neiman’s lead underwriters.

But that can’t be the rationale, right? Even if it looks to be just about that simple. “Great Blue Whale” indeed.

MRM
(disclosure — I own part of Neimans, whether I like it or not)