Apollo’s Grocery Thesis
This past week, I read about the Federal Trade Commission’s ongoing attempt to block Kroger’s $25bn deal to acquire Albertsons (NYSE: ACI) and was interested to see the role that private equity has played in ACI and this merger so far. Now, I had always believed that leveraged buyouts and grocery stores were like oil and water; I could see little reason why private equity would ever be interested in acquiring a grocery chain. Almost immediately, I can point to the low-margin nature of the business as a key reason why the industry as a whole is unattractive. Barriers to entry are low, competition has historically been fierce in large markets and shifting consumer preferences suggest that players that operate in the medium/high-end of the market — like many of Albertson’s subsidiaries like Safeway — may have a more volatile top line as well. Finally, moderate capital intensity associated with new store builds and inventory buildup costs may further threaten the predictability of future cash flows.
I can speculate and assume that the reasons above have contributed to low historical interest in the field. However, there are notable pros associated with the nature of this industry. Low sponsor interest can keep valuations low, especially important given rising valuations across many sectors today. PE dry powder has also given funds a large amount of capital to freely deploy so many funds may be willing to overpay for attractive assets. In contrast, the limited sponsor interest in the grocery industry indirectly caps valuations and can allow a sponsor to enter at an attractive valuation. That’s exactly what Apollo Global Management (“Apollo”) did. The firm espouses the importance of the “buy” phase in any investment. In a recent podcast, Co-Head of Private Equity David Sambur emphasized that most investment performance is shaped by the “buy” and I believe that for the grocery sector, the “buy” is particularly “worry-free”, offering an attractive entry point. However, the inherent risks associated with the business are a greater cause for concern; if managed appropriately and with a clear thesis for value creation, even a grocery store can be a promising investment.
This was apparent in Apollo’s investment in Albertson’s. The firm’s hybrid value business invested in Albertsons in June of 2020 through a $1.75bn convertible preferred stock investment which, at the time, was one of the largest preferred stock investments in recent years. Now, this was just one of many investments the firm has made in the grocery space over the last 5 years; most other notable investments were made by the firm’s private equity business and include The Fresh Market, Smart & Final, Cardenas Markets and Tony’s Fresh Market among others. However, the unique nature of this investment — a convertible preferred stock minority investment as opposed to a traditional buyout / controlling stake acquisition — was particularly interesting.
A Brief History of Albertsons
Cerberus Capital Management (“Cerberus”) acquired the company back in 2006 and has poured money into the business over the last two decades, including funding add-on acquisitions such as Safeway. Although Cerberus has managed to trim its stake in the company since then, the firm just unable to get a liquidity event. An IPO attempt failed in 2015 and a merger with Rite Aid was scrapped three years later.
The success of the company’s second attempt to IPO in June of 2020 was questionable. Unlike the first attempt, the IPO went through but did not raise nearly enough. The number of shares offered fell from 65 million to 50 million and shares were priced at $16, slightly below the $18 — $20 per share target that the investment banks were aiming for.
Therefore, in hindsight, the company’s decision to issue $1.75bn of preferred stock just weeks before the IPO was nothing short of a great idea.
Apollo’s Investment
The structure of the convertible preferred investment was also very interesting. With a need for cash, the company was eager to receive an investment from Apollo and one aspect of the transaction that stood out to me was the voting rights that were afforded to Apollo and its affiliates. Despite making a preferred stock investment, Apollo incorporated a governance structure that allowed it to receive the same voting rights as a common shareholder, with the added liquidation preference and a 6.75% annual dividend.
The volatility of the common stock and underperformance post-IPO proved that the preferred stock was the right investment to make. It offered a consistent income stream which, given the razor-thin margins and moderate industry-wide volatility, was absolutely necessary for a grocery investment. When Apollo ultimately converted its preferred shares into common stock ~1.5 years later in December 2021, it had collected its dividend payments and the shares had appreciated by over 100% to over $35. This was perfect for Apollo; the convertible preferreds had a conversion price of $35.68. By the end of the month, ACI shares fell by over 15% as the convertible preferred stock, when converted, gave Apollo a 17.5% ownership stake. Now, some other affiliates such as HPS Investment Partners chose not to convert their stock so the dilution was slightly less than it perhaps could have been. Regardless, this move identifies a few key points. Apollo benefitted from the price appreciation of the stock and also received dividend payments. Since Cerberus owned ~30% of the outstanding stock post-dilution, paired with the 17.5% Apollo ownership stake, Apollo could work with other institutional investors to control a majority stake and operate the company as if it were a private company.
More Financial Engineering
Armed with a controlling stake and in need of a liquidity event to exit their investment, Cerberus and Apollo led ACI to announce a $4bn special dividend payment in late 2022. The dividend would largely be funded with cash on hand but also a new $1.5bn loan that would saddle the company with more debt. This was partly justified by the announcement of a merger with Kroger, which was estimated to bring about over $500mm of synergies. Kroger had also approved the payment of the dividend and had agreed to acquire the company after the payout of the dividend. For a second, it seemed as if Apollo and Cerberus had found their liquidity event without any impediment.
Regulatory action followed swiftly. Numerous states attempted to block the payment of the dividend and raised anti-trust concerns as Kroger and Albertsons were the second and fourth largest grocery chains in the country. However, courts ultimately decided that the payment of the dividend was a private business matter and states did not have the ability to block such a transaction. As a result, the dividend was approved in January 2023.
Albertsons Today
The fate of the Kroger-Albertsons merger is currently in regulators’ hands and a decision is not expected until August at the very earliest. However, the transaction does highlight a few interesting points.
- Problems at Scale
ACI is in a tough situation that many large companies often find themselves in. With larger companies, the buyer universe is already very small. There are notable anti-trust concerns if the company is a market leader and so a transaction with a strategic buyer will always have some element of regulatory and execution risk associated with it. In such cases, a sponsor is likely the best buyer and sometimes, the only viable option. This was evident in the case of Simon & Schuster and KKR last year as well, with KKR stepping in after the transaction with Penguin Random House faced regulatory blowback.
2. Financial Engineering
Sometimes businesses that may be unattractive for traditional large-cap private equity firms can make for good investments. Low investor interest keeps valuations low and with sufficient financial engineering, an attractive rate of return is still achievable. Personally, I generally view transactions where a new sponsor invests in companies that are already sponsor-backed as difficult investments. The low-hanging fruit is typically gone and if ACI had been owned by Cerberus for over 15 years, I initially believed that the opportunities for value creation were limited. But this was a very different situation where Cerberus was desperate to exit and was willing to dilute itself with a minority investment from Apollo to ultimately get a liquidity event sooner. The ability to force a dividend recap transaction in a public company due to high institutional ownership also stood out to me and given Apollo’s ability to control nearly 20% of equity post-conversion, it was evident that the firm, along with Cerberus, had anticipated such a transaction back in 2020.
3. Preferred vs Common Stock
Why did Apollo invest in the preferred stock instead of the common? I will have to speculate here as the firm has not publicly justified its decision. However, I believe that they had seen how Cerberus had been stuck holding the business for nearly 20 years and had repeatedly struggled to exit. Acquiring a control equity position would have trapped the company from a liquidity standpoint and Apollo would have just repeated Cerberus’ mistake.
Acquiring a minority stake in the common equity was also risky because timing the exit had been very difficult in the past. The IPO resulted in a terrible valuation for the business and it was clear that public markets had mixed opinions about the company’s future performance. With the exact date and time of the exit up in the air, it was — in my opinion — better not to gamble on share price appreciation and instead opt for the reliability of the preferred dividend, especially if the firm was willing to grant voting rights to Apollo as well. If the share price skyrocketed, the conversion option still allowed Apollo to participate in the upside. ACI was still cash flow generative but some cyclicality and volatility in cash flows, and unreliable share price performance justified the move higher up in the capital structure
Final Note: I have included an approximation of Apollo’s returns from this investment below (although I had to make significant assumptions due to the lack of information available). The firm’s hybrid value fund targets a 15% IRR and this investment should clear that threshold.
