<em><strong>PE firms can maximize returns by focusing on the customer experience of retail chains</strong></em>
By Todd Maute

Some observers apparently think that brick-and-mortar retail businesses are a bad bet for private equity.

But by paying close attention to the customer-facing side of the chains they invest in, private equity firms stand a much greater chance of maximizing returns - even in the face of the admittedly daunting challenges arising from e-commerce. After all, high-definition broadcasts haven't killed live sporting events, and TV evangelists haven't stopped people from going to church.

When retailers emphasize the point of differentiation their brand offers, and enhance the customer experience and relationship, they give people a reason to come to their stores in precisely the same way. Brand loyalty is a huge factor in the value of any retailer, and Forrester Research has found that the customer experience is the driving factor in determining brand loyalty. "This means companies can't expect to outperform competition on price while ignoring their customers' experience," wrote senior analyst Maxie Schmidt-Subramanian in a May 2013 report.

A report from earlier this year highlighted the particular struggles of specialty retail "category killers" like Toys "R" Us, Sports Authority, Petco, Burlington Coat Factory and Guitar Center, arguing that the private equity heavy hitters that had invested in these chains had, to date, come up short. With the likes of Amazon on a veritable tear, it is certainly valid to question investments in certain specialty retail formats. But because the $10 trillion U.S. economy is consumer-driven to a remarkable extent, retail is too huge a sector for private equity firms to ignore altogether.

Clearly, these firms will continue to sink billions of dollars into retail investments of various kinds. So asking whether retail amounts to a bad bet might be the wrong question. It is more productive to ask if private equity firms are playing their hand correctly in this arena, and if they are doing all they can to maximize retail returns. Many private equity firms have yet to focus on the creative, customer-facing side of retail. Are some brick-and-mortar chains too vulnerable to Amazon and its ilk? Certainly. But this hardly means all of retail amounts to a bad bet. Risk can never be eliminated, but by taking a holistic approach that includes the brand and its customers, private equity firms can boost their odds of walking away from the table as big winners.

Consider another, very different, analysis: "Vindicated," runs the headline of Mergers &amp; Acquisitions magazine's March 2011 cover story. "Oak Hill Capital's sale of Duane Reade - the 2010 'Deal of the Year'- highlights the perseverance of the PE model." Here the reporter focuses on Walgreen Co.'s 2010 acquisition of New York's largest drugstore chain, which gave Oak Hill a return of about 1.5 times its approximately $400 million investment in Duane Reade. In the context of the challenges Duane Reade had faced prior to Oak Hill's stewardship, this was an impressive result. CBX worked with Duane Reade on its private label, store design and other branding initiatives.

It was a move that took some courage. Oak Hill had initially invested $239.5 million in Duane Reade, followed by an additional $39.5 million. But it was in the late summer of 2009 when, heartened by a new strategy, Oak Hill risked another $125 million.

What was so different about this new approach? It was customer-facing.

To back up for a moment, when most private equity firms invest in retailers, they typically focus on ramping up efficiencies and reaping the benefits of scale. These back-end changes, which are mostly invisible to the customer, hinge on taking a hard look at headcount, systems, real estate, warehouses, the supply chain - just about any process improvements that could make the company more profitable. This is part of the standard playbook because it mostly works.

But, as mentioned, the customer does not usually see or feel these changes directly. Realizing this, Oak Hill decided to go further. A critical part of its approach was to invest in the customer-facing side of the business to drive top-line growth. The chain's New York City stores were located on some fantastic corners, but the experience inside them was anything but inspiring, with excessively high gondolas, inaccessible pharmacy counters and dirty floors. Oak Hill's 2009 investment was geared toward reinvigorating the stores, as well as the Duane Reade brand.

In the company's press release announcing the acquisition, Walgreens CEO Greg Wasson lauded Duane Reade's recent initiatives in urban retailing, customer loyalty and private brand products. He noted that, in the prior fiscal year, Duane Reade had posted "the highest sales per square foot in the retail drugstore industry nationwide."

Oak Hill had used consumer and market insights to make dramatic, customer-facing improvements at Duane Reade. As Walgreens noted in the announcement, these included new store designs with wide aisles and contemporary décor, a much improved pharmacy featuring lower service counters for more personalized patient interaction, introduction of "Doctor on Premises" walk-in health care and a store-within-a-store prestige beauty concept called "Look Boutique." Walgreens also lauded the launch of a family of exciting new private brands, including food and beverage brand DR Delish and a much expanded customer loyalty program called FlexRewards.

The Duane Reade nameplate had been transformed into an asset, and so had its private label line - a novel change for a retailer. Now, Walgreens is leveraging many of these brighter, more relevant brands across its portfolio.

Dollar General is another example of a private equity firm using customer-facing changes with a powerful effect. When Kohlberg Kravis Roberts &amp; Co. (NYSE: KKR) acquired Dollar General in 2007 for $7.3 billion, the chain was hardly a dog. But KKR was not content to focus on back-end efficiencies alone.

Instead, the firm took an aggressive approach to the customer-facing side of Dollar General's business. It elevated the look and feel of the stores, seeking to make them fresh, bright and clean, and launched a rebranding initiative with shiny yellow carts and baskets. It updated signage with messaging trumpeting "the new Dollar General," and launched customer-centric store formats with smarter merchandise adjacencies, wider aisles and more convenient checkout.

Dollar General also expanded its consumables presentation, ramping up its emphasis on packaged foods, snacks, beverages, beauty aids and more. In its 2009 annual report, the chain noted that its new crop of private-label brands in particular had gone a long way toward boosting gross profits.

Buoyed by these changes, Dollar General went public in November 2009 - the largest retail IPO in nearly 14 years. Today, Dollar General continues to build sales per square foot and generate solid same-store sales on top of one prior-year gain after another. And of course, the chain continues to show enviable earnings growth and profit margins: In fiscal 2012, net income climbed 24.3 percent to $973.1 million on an 8.2 percent increase in sales to $16.02 billion. With that, net margin expanded to 6 percent of sales from 5.2 percent in fiscal 2011 and 4.8 percent in 2010. This attests to Dollar General's ability to engage customers with the right product mix and pricing.

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