UK supermarkets: The rise of PE ownership, but at what cost?

UK retail has been in the eye of a storm over the past decade – first from online retail, then from the pandemic and now the cost-of-living crisis. This has led to significant distress and corporate activity in the sector.

Retailers are an attractive prospect to private equity firms due to reliable cashflows, which can be used to service the associated high debt levels and meet interest payments until sale.

Asda and Morrisons were both sold to private equity firms in 2021. This marked a turning point as supermarkets are notoriously low-margin businesses, with none of the characteristics that private equity firms usually target, such as high returns.

Rising interest rates heighten the risk to private equity-owned operators, due to high debt burdens (Morrisons’ net debt obligations were reportedly £3.2bn before the CD&R takeover vs. £7.5bn now, when other obligations are included.) This could lead to asset-stripping and cost-cutting measures to achieve overly-optimistic target returns – there are signs that this is already starting to emerge, particularly in relation to Morrisons.

The debt burden is an unwanted additional pressure that bond investors are now starting to price in – yields on the debt of Morrisons and Asda are more than double those of Tesco. This differential extends to real estate – the pricing expectations of purchasers looking to acquire Asda or Morrisons stores are lower than on competitors’ locations, mainly owing to the private equity ownership of Asda and Morrisons.

As the below chart shows, the pricing differential has widened since Q1 2022, with Asda and Morrisons now trading at 100 bps+ discount to their main competitors. Also noteworthy is the pricing premium paid for smaller lot sizes, due to attractiveness of local, convenience assets, and strong interest from private investors. This is particularly prevalent for Aldi and Lidl assets, where pricing has returned to the 4%’s in recent months, despite the wider economic backdrop.

JLL's Frankie Carl-Maddox suggests that "Liquidity for Asda and Morrisons is heavily predicated on how the asset trades – investors are able to get comfortable at circa 6.5% if store performance is strong. Preferably buyers also want the security of an underpin as well, whether this be from another operator or from alternative uses."

Looking forward, grocery assets have a track record of resilience even in economic downturns and we expect that the sector (which benefits from essential spend and offers defensive, long-term income) will remain a preferred choice for many investors. The year has certainly started positively, with Q1 2023 investment volumes at c.£800m, well above the 10-year average of c.£270m.

However, despite overall buoyancy in the grocery investment market, a two-tier market has clearly emerged as private equity owned stores continue to trade at a significant discount. It remains to be seen whether this gap has now stabilised or will continue to widen as the year progresses.