Leverage Can Hamper PE-Backed Retailers’ Ability to Innovate

Heading into 2019, the biggest concern for commercial real estate landlords isn’t simply the threat e-commerce poses to retail tenants. A more poignant question about e-commerce disruption might be this: Does the retailer have the financial freedom to respond?

In recent years, we’ve seen a flood of private equity capital rush into the retail sector, acquiring retailers and subsequently levering up their balance sheets. Heavy debt burdens are hampering these retailers’ ability to react to shifts in consumer trends, including pressure from e-commerce, and leading to many business’ demise. Sears, Toys “R” Us and Winn-Dixie serve as recent, well-known casualties of the leveraged buyout model. They are not alone. The correlation between bankruptcy and private equity financing in the retail sector is high.

In an era of strong e-commerce growth, developing a successful omni-channel strategy is imperative to the survival of companies in nearly every retail segment. Whether that means building a better Internet delivery system, enhancing the in-store experience or modernizing distribution centers, the investments to improve the omnichannel experience are costly. When a company suffers from heavy debt loads, it can’t try creative ideas that will help it navigate e-commerce disruption and the retailer risks becoming less competitive. Rising interest rates will only exacerbate the problem. As debt becomes more expensive, pressure builds on highly-levered companies and management must prioritize paying down debt over investing in stores.

Many retailers are navigating the e-commerce transition successfully. As I’ve noted before, the grocery industry serves as a prime example where incumbents are making big investments and leveraging their strong brands to meet the Amazon challenge head on. Kroger, for example, has taken a minority stake in Ocado, an online grocer in the UK. As part of the partnership, Kroger will build 20 high-tech warehouses using the latest in robotics and artificial intelligence to innovate in-home grocery delivery. Walmart has also acquired or invested in grocery delivery companies both in the U.S. and internationally to improve its delivery model.

We find success stories among other tenants in our grocery anchored properties as well. PetSmart has completely revamped its in-store experience, providing services such as grooming and pet training to bring consumers into the store. In these examples, the investments were costly, but position the companies for a new age of retail.

Some retailers will inevitably get left behind, but plenty of examples, including many among Phillips Edison’s own tenants have evolved in a shopping environment that requires bold innovation. Companies can only navigate change if they invest to do so. It’s why our biggest concern in evaluating retailers as potential tenants isn’t about e-commerce, but how they are funded.