Will Retail Debt and Financial Distress Continue to Grow?
Source: Analyses of bankruptcy data by Analysis Group.
The increasing amount of leverage on brick-and-mortar retailers’ balance sheets underscores the need for a sophisticated understanding of debt management options.
The number of financially distressed retail companies has been climbing, reaching levels rivaling the recession years. Indeed, data from S&P Capital IQ shows that in 2017 the number of large-scale retailers filing for bankruptcy grew to 11, compared to only 2 in 2014. News reports of shuttered big box stores and dark malls abound, and 2018 has already seen announcements of plans to close stores by such retail giants as Toys“R”Us and mall-staple Claire’s. Even Manhattan is not immune, with news articles about empty storefronts in upscale sections of SoHo and on stretches of Broadway.
Research from S&P Global Ratings indicates that, in 2017, fully 20% of retail companies were classified as “distressed,” doubling the rate from 2016. With a rating of CCC or lower, distressed companies are well below investment grade and characterized as investments with “substantial risks” – just shy of being “extremely speculative.”
This so-called “retail apocalypse” has coincided with massive changes in the industry, such as the rise of e-retailers and the growing number of retail acquisitions by private equity (PE) firms. Both trends highlight the challenges brick-and-mortar retailers can have with managing large debt loads.
Retail struggles with debt
Highly leveraged companies may face the most difficulty remaining viable in this environment of decreasing brick-and-mortar traffic and revenue. For example, in one of the largest retail bankruptcies of all time, the September 2017 Chapter 11 filing by Toys“R”Us reflected years of declining sales and nearly $5 billion in debt, pushing the company into liquidating its inventory and stores. Retail operations depend heavily on large capital investments and on operating leases, requiring companies to apply more resources toward servicing debt and less toward investing in the new technologies and new business models needed to compete with e-retailers.
Although leveraged buyouts by PE companies increase debt loads, which can be difficult to manage in times of financial distress, academic research suggests that PE-backed firms that encounter financial distress may actually fare better than non-PE-backed firms. A 2014 article indicates that PE firms have been making acquisitions in industries that already have lower rates of recovery from default – such as retail – rather than being the force driving them into default. The researchers conclude that “[w]hen private equity-backed firms do become financially distressed, they are more likely to restructure out of court, take less time to complete a restructuring, and are more likely to survive as an independent going concern, compared to financially distressed peers that are not backed by a private equity investor.” 1
PE firms are also important buyers of financially distressed companies out of bankruptcy. A 2016 article found that 10% of companies that emerge from bankruptcy do so through a going-concern sale of substantially all assets to a financial buyer such as a PE firm. The researchers found that recovery rates, survival rates, and other indicators suggest that bankruptcy sales are “consistent with the efficient redeployment of assets via sales in bankruptcy. 2
Down but not necessarily out
Increasingly, however, retail companies are considering options outside of Chapter 11 to restructure debt and remain in business. In particular, the industry has seen a rise in distressed exchanges (DEs), such as the one Sears offered in January 2018 to extend loan maturities and replace interest payments with payments in kind.
DEs have largely been an understudied solution, but that may be changing. Some evidence exists showing that DEs produce higher recovery rates, as they can be used to bolster a company’s balance sheet without incurring the time and cost of a Chapter 11 filing. Our analysis of data from Moody’s shows that DEs have risen from 10% of non-financial defaults from 1990–2007 to more than 40% in 2010–2016. As an added incentive, the 2009 American Reinvestment and Recovery Act and later changes to tax law have allowed gains from DEs to be excluded from taxation. Distressed exchanges may also be especially attractive to PE investors, who typically have little interest in court-monitored restructuring.
A cautionary look ahead
Retailers are facing increasing pressure to take remedial action while their balance sheets still allow it. According to Moody’s, the next few months are likely to bring more defaults and ratings downgrades in the retail sector, and a significant amount of debt is expected to come due within the next few years. In addition, several developments on the regulatory front have the potential to add pressure on struggling retailers. (See sidebar.) The question remains whether the “retail apocalypse” will continue unabated, or if new approaches to debt management can temper it. ■
Caveats in the Regulatory Landscape
If a business is already struggling with its debt structure, recent changes in the regulatory landscape could add pressure.
- Some have blamed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) for increased retailer liquidations. This reform shortened the time retailers had to assume or reject store leases following a bankruptcy filing to just a few months.
- In 2015, the Financial Accounting Standards Board (FASB) changed its standard for reporting debt issuance costs (by issuing ASU 2015-03). Previously, a company could present these costs as either a prepaid asset or a deduction to debt. Now, it must present debt issuance costs as a direct deduction to the amount of related debt liability presented on its balance sheet. For some borrowers, the change could mean the difference between compliance with a debt covenant ratio and an apparent breach.
- Similarly, a 2016 change in FASB guidance on lease accounting (ASU 2016-02) requires companies to recognize certain operating lease assets and liabilities on the balance sheet, when previously such leases were off-balance sheet. These additional assets and liabilities could affect financial metrics and debt covenants, especially in industries such as retail that rely heavily on leasing.
- Hotchkiss, E., Smith, D.C., Stromberg, P., Private Equity and the Resolution of Financial Distress, Working Paper, SSRN (2014)
- Gilson, S., Hotchkiss, E., Osborn, M., Cashing Out: The Rise of M&A in Bankruptcy, Working Paper, SSRN (2016)
Drum, J., Stangle, B., Starfield, R., "Keeping Covenants: Getting Debt Ratios Right," Journal of Accountancy (June 1, 2018)
Grgeta, E., Danilov, K., Colorado, C., "Sears, SRG, and the Economics of Fraudulent Conveyance" Journal of Corporate Renewal (November/December 2017)
Michael Holland, Managing Principal
Nick Vigil, Associate