Frank Newman: How a private equity investor made $500m

The receivers have been called in to Dick Smith Electronics (DSE), which operates 331 stores in Australia and 62 in New Zealand.

Another retailer getting into trouble is not earth shattering news, but the history behind the company is an interesting one; in particular how  a private equity firm was able to extract half a billion dollars from their short-term investment in the company.

The business was started by Dick Smith in 1968, initially to install car and service radios. It soon branched out into wholesaling electronic products, which was one of the most popular hobbies of the time. By 1980 the company had grown to 20 stores and Dick Smith sold 60% of the company to Woolworths, and the remaining 40% two years later. As the electronics hobby boom faded in the late 80 and 90s the company changed its emphasis to retailing electronic consumer products and cell phones. 

By 2012 the company was struggling in a tough retail environment.  In November 2012 Woolworths restructured and sold the business for $115m to Anchorage Capital partners, an Australian based private equity company. On its website Anchorage says it paid $20m for the company, which was the initial cash payment made to Woolworths. The balance of the purchase price is likely to have come out of DSE from cash on hand and the sale of assets sitting within the company.

Anchorage put in place what it called a "turnaround program" and a year later sold the business in an Initial Public Offering (IPO) on the Australian Stock Exchange for $520m. Anchorage retained 20% but sold that stake in September 2014. It was in and fully out within two years, and clipped $500m in the process.

This is how Anchorage describes the turnaround program.

"Following the acquisition Anchorage introduced a new CEO...and further strengthened the existing management team...In partnership with Anchorage, this management team immediately began implementing a highly successful program of operational, strategic, customer and cultural initiatives across all areas of the value chain."

Those major initiatives included:

• Introducing sales incentives for staff and staff training (presumably sales training).
• Renegotiating supply agreements (presumably negotiating better discounts), and opening up an office in Hong Kong to source unbranded products (to lower purchasing costs).
• New marketing program in collaboration with suppliers (presumably offering deals on consignment stock).
• "Significant clearance of old and obsolete stock; improved stock management and ordering practices; optimised freight movement including closure of two distribution centres." Indeed the sale of stock was massive, reducing from $312m in November 2012 to $171m by June 2013, just before the IPO.
• Adding 10-15 stores using a couple of new store formats.
• Entering into an agreement with David Jones to take over the consumer electronics counters within their department stores.

They then go on to say as a result of these initiatives earnings before interest and tax increased from $23.4m in 2013 to $71.8m in 2014.

This is a very good case study of how private equity companies operate. They essentially go into deals with two broad objectives.

The first is to extract as much cash out of the business as possible. In this case they achieved that by substantially reducing stock levels.  Their net investment was therefore not $155m but $20m (if that).

The second objective which is to make the next years earnings look as attractive as possible and selling those future earnings to the public for a multiple of 7.4x earnings. It's that that made them $500m.

Things appeared to be going well for the listed company until October last year, when they reported a dramatic turnaround in sales and problems turning inventory into cash.

Despite heavy discounting up through to Christmas, the inventory position worsened, and last week the company was placed into receivership after failing to secure short-term bank funding to buy inventory.

Essentially the problem appears to be a build up of inventory levels financed by debt, and an inability to turn that inventory at a profit.

Of course out of pocket investors have their daggers out, with Anchorage being a target, and some questioning the "flick-it-on" approach by private equity investors generally. The question being asked is whether the turnaround program which produced short term book profits, was sustainable in the long-term , or is it simply a case of the current management not having the skills too manage the business.

In any case, Anchorage has $500m in its pocket, while current investors have nothing. For some the lesson is simple - don't buy an IPO when the seller is a private equity investor.