CPPIB paid $6-billion for luxury retailer Neiman Marcus. The bet backfired.

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At the height of the holiday shopping season in 2013, the head of private investments for Canada Pension Plan Investment Board flew to Dallas to promote his latest retail conquest.

A few months earlier, CPPIB and its private equity partner, Ares Management, revealed they were the new owners of Neiman Marcus, the largest luxury retailer in the United States. The company sells couture apparel, designer accessories and fine jewels to affluent customers online and in department stores. A strengthening American economy, coupled with visions of international expansion, made CPPIB see nothing but growth.

The $6-billion (U.S.) price tag ranked among the richest buyouts the pension fund had ever participated in, but André Bourbonnais, its private-investment head, told a crowd at the historic Adolphus Hotel in downtown Dallas that the deal would pay off because this was an exclusive asset. "These iconic brands don't come to market often." he said.

When people called to say congratulations, he would reply: "We're really happy about the deal, but call me in five years when we've tripled our investment," according to a report on the breakfast event.

But it's looking increasingly unlikely that the phone will ring. Neiman Marcus is saddled with nearly $5-billion (U.S.) in debt, and in early January, the retailer announced that it's turning to a new chief executive to revive it in a difficult market for shopping malls. This came after the company cancelled plans to go public and abandoned efforts to sell itself. Rating agencies have suggested a balance-sheet restructuring is inevitable. Depending on the severity, it could ultimately wipe out CPPIB's $690-million equity investment. (Much of the total purchase price was paid for with debt.)

How did Neiman Marcus – and CPPIB – get here? Some problems, such as the energy-sector crash that squeezed core Texan consumers and the natural disasters that have disrupted tourist shopping, were beyond their control. Other woes, such as the surge in online shopping and the sudden emergence of new, niche brands in high-end fashion and cosmetics have forced the retailer to play catch-up – and it has struggled.

The experience illustrates just how risky private investments can be. But Canadians will have to get comfortable with them, because the Toronto-based fund is pouring more and more money into alternative investment strategies – such as developing real estate, buying infrastructure assets and directly investing in businesses – all to eke out better returns for pensioners than can be found in public securities. (At the end of its last fiscal year, nearly half of CPPIB's $317-billion portfolio was in private assets, with 28 investments specifically in direct private equity that were valued at $17.6-billion.)

As the Neiman Marcus case shows, picking winners isn't easy – and it's arguably getting harder, because asset values are scorching almost across the board. At the same time, a record $1-trillion in cash has been raised by global private equity funds and they're all out competing for deals, making it harder to discern value.

A "risky" investment

When CPPIB bought Neiman Marcus, which operates 42 of its brand name stores across the U.S., as well as two Bergdorf Goodman department stores in New York City and an off-price chain named Last Call, the retail sector was reconfiguring to adapt to monumental structural shifts, such as the rise in online shopping. The company bought a luxury Germane-commerce company Mytheresa.com in 2014 as part of an effort to keep pace.

The expectation, though, was that high-end brands would be more stable because their rich clientele would be loyal and less price sensitive in market downturns – and who better to benefit than Neiman Marcus, which had been around for more than a century after opening its first store in downtown Dallas in 1907?

CPPIB also envisioned international expansion, with the Asian market looking particularly lucrative.

To some, it was wishful thinking. "When CPPIB bought into [Neiman Marcus], I shook my head. I just didn't understand it," said Maureen Atkinson, senior partner of research insights at consulting firm J.C. Williams Group. "High-end fashion is very risky. It comes and goes. And I know they've been around for a long time, but they also haven't done well for long time."

The skepticism proved to be justified.

Neiman Marcus primarily caters to women, with more than 60 per cent of its revenue coming from women's clothing, shoes, handbags and accessories. Although the company has kept its designer base diverse, with only two designers representing more than 5 per cent of total revenue last year, its business has been disrupted by the emergence of new brands. On top of that, designers continue to open their own independent stores to cut out the middleman.

Consumers are also more impatient than ever before; they want to buy new fashion trends much more quickly. Fashion shows, for one, are splashed all over social media and customers tend to want what they see on digital platforms almost immediately – a trend sometimes referred to as "see it now, wear it now." And despite Neiman Marcus's scale benefits as the largest luxury goods department store in the United States, as judged by sales, mall traffic has been falling.

Internally, the retailer has wrestled with operational issues, including data breaches and major setbacks tied to the bungled launch of its new NMG inventory system that caused major problems when trying to view inventory as well as when handling accounts payable.

As for any expansion, the vision of taking the brand name to new markets has yet to materialize. "What was hot, and may have been part of the logic for buying this business, was the emergence of the Asia market," Ms. Atkinson said. "That all sounds very easy, but [Asia's] a different world. And there are department stores in Asia that carry these brands."

As all of these woes compounded, revenue fell for two fiscal years straight and operating losses climbed to $531.8-million in its 2017 year. In early January, the retailer announced a chief executive change, with departing CEO Karen Katz replaced by Geoffroy van Raemdonck, who last worked for Ralph Lauren Corp.

A turnaround may be possible, but the retailer's debt burden makes it much more difficult. Neiman Marcus continues to churn out sizable cash flow, but much of it is eaten up by interest payments. As of March, 2017, right before the leverage woes took centre stage, its total debt burden amounted to 9.7 times its earnings before interest, taxes, depreciation and amortization, according to rating agency Moody's Investors Service – an extremely high ratio.

As of Friday, the largest tranche of Neiman Marcus's senior unsecured debt was yielding more than 24 per cent, an indication of the market's view that the risk is high. (The bonds, due in 2021, trade at around 61 cents on the dollar, according to Bloomberg data.) The company's overall debt, which includes a term loan, starts to mature in 2020.

When downgrading Neiman Marcus's $1.6-billion in unsecured debt to CC from CCC-minus last June, rating agency Standard & Poor's said a restructuring is likely, noting that the retailer's operating performance "will not rebound sufficiently to support its very highly leveraged capital structure" and that it sees "heightened risks of a distressed exchange."

The terms of these exchanges differ each time, but debt investors are typically forced to writedown a portion of their holdings in return for a higher interest rate on the remaining position, a situation that just transpired at J. Crew, another troubled retailer owned by private equity firms. It is possible a full-blown restructuring could materialize, and in that scenario, there is the potential for all of the company's equity to be wiped out.

CPPIB and Mr. Bourbonnais declined to comment for the story. Neiman Marcus did not respond to requests for comment.

A long-term outlook

Even if CPPIB writes off its entire equity position, the massive fund can absorb the loss. CPPIB has also had large private equity wins in the past few years that help offset any writedown.

However, the pension fund's executives often speak about their long-term outlook, and this longevity is supposed to be tied to compensation. This scenario suggests even the best-designed pay systems can't account for every variable, as staff changes have complicated matters.

Mr. Bourbonnais left CPPIB in 2015 to run PSP Investments, a pension fund for Canada's public-sector employees. Mark Wiseman, the head of CPPIB at the time of the Neiman deal, has also moved on to become Global Head of Active Equities at BlackRock in New York.

With such turnover, it is hard to know if strategies get executed as planned, and it is difficult to pin executives to the performance of their assets – in outcomes both good and bad.

Any writeoff would also hurt one of the key metrics CPPIB relies on most to measure its success: dollar value add. The fund measures its annual returns relative to an internal benchmark to judge whether its riskier active management strategy is worth it. In years when the DVA is positive, the fund outperforms its equivalent passive management strategy; when it is negative, CPPIB would have been better off investing in vanilla stocks and bonds.

CPPIB has delivered $8.9-billion of "net dollar value add" – meaning it has made $8.9-billion more than it would have under its old passive strategy, after accounting for the active strategy's costs. Yet, last year it underperformed the benchmark by $8.2-billion. If the fund does so again by a similar amount when the current fiscal year ends – which is possible because public markets have been extremely hot of late, boosting the passive strategy – it will have erased practically all of the active gains since implementing this riskier strategy about 10 years ago. In that scenario, a Neiman Marcus writeoff certainly won't look good.