How Private Equity Buried Payless
Finance-driven capitalism was supposed to make the economy more dynamic. A failed shoe chain shows why it hasn’t happened.
By Neil Irwin NY Times
TOPEKA, Kan. — The financiers who had taken over Payless Shoe Source didn’t have much experience selling low-priced footwear, but they had big ideas about how things ought to be done. One was capitalizing on enthusiasm for the 2018 World Cup in the Latin American countries where the company had hundreds of stores.
When they saw an opportunity to buy a million pairs of World Cup-branded flip-flops, the money men turned shoe sellers overruled the midlevel supply managers at corporate headquarters in Topeka, who had pointed out a couple of problems.
First, the sandals mostly wouldn’t arrive on store shelves until after the World Cup was over.
Second, they were branded with the flags of countries like Mexico and Argentina — countries where Payless didn’t have any stores.
Ultimately, the flip-flops had to be unloaded at steep markdowns, one of many missteps at a company that by early 2019 would liquidate its stores in the United States and enter its second bankruptcy in rapid succession, putting 16,000 people out of work. (It emerged from bankruptcy last month, with its third ownership group in four years.)
As in any corporate failure, there is no one cause. Over seven years, Payless went through a wringer of private equity and hedge fund stewardship that left it with inadequate technology, run-down stores and no financial cushion to survive an era of upheaval in retail.
But the collapse of Payless is more than a story of one discount shoe company that couldn’t hack it in a changing business environment. It provides disquieting clues about one of the great mysteries of the modern economy.
Why hasn’t the finance-driven capitalism of the last few decades created faster growth? What if the masters of financial efficiency are making choices that don’t actually create the more dynamic, productive economy they promise?
In extreme cases, what if they don’t really know what they’re doing at all?
The rise of the buyout kings
The difference between economies that thrive and those that falter boils down to two related factors: how effectively capital is deployed, and how well corporations are governed.
When a nation’s savings are channeled toward worthwhile projects, and effective managers are put in charge of large companies, good things tend to result. When resources are devoted to boondoggles, and companies are run by incompetent cronies, everyone ends up poorer. Think of how much richer West Germany became compared with East Germany over the four decades the country was divided.
But there is no single answer to the question of what form of capital allocation and corporate governance works best. The United States has typically relied on stock and bond markets to determine which companies get money to invest, and on independent boards of directors to govern companies. Western Europe relies more heavily on banks. Japan and South Korea have relied on conglomerates in which families of companies help finance and govern one another.
In the last generation, the United States has experienced a revolution in how this corporate control works.
In the 1980s, the first generation of leveraged buyout kings — an industry now known as private equity — identified problems with American corporations. Many were poorly run, led by complacent boards of directors and executive teams reluctant to shake things up.
Buyout firms aimed to purchase those companies, fix what was holding them back, and profit by making them more valuable and selling them off again. All through the 1990s and early 2000s, this shift made billionaires of their founders and attracted trillions of dollars from investors.
Their imprint on the economy is enormous: Companies owned by private equity firms accounted for 8.8 million jobs in the United States in 2018, and 5 percent of G.D.P.
But if anything, that understates the scale of the financialization of American business, and the ways that management tactics of buyout kings have become the norm.
Some large hedge funds operate similarly to private equity firms, by buying and operating companies. One such fund, Alden Global Capital, controlled Payless from 2017 to 2019, the years that included the World Cup blunder. Other hedge funds use votes to get executives of publicly traded companies to act more aggressively and thus increase returns to shareholders.
The result: Financial managers exert greater control over nearly all American companies than they once did.
Their willingness to cause some pain — to close factories, lay people off, renegotiate arrangements with longtime suppliers — is, many economists argue, a feature, not a bug. Society becomes richer over time by devoting resources to its most productive uses. The pain should be temporary, and in theory result in a more vibrant economy for everyone.
In 2012, private equity firms and hedge funds set their sights on the troubled retailing sector, and one set of investors made the pilgrimage to Topeka, where they acquired Payless.
More shoes, fewer salesmen
Payless, founded in 1956 by two cousins in Topeka, Louis and Shaol Pozez, was a business built on an innovation: that shoe salesmen weren’t entirely necessary.
Rather than keep inventory in a back room and employ lots of salespeople, as department stores did, Payless kept boxes of shoes on open display in the store, where customers could help themselves to try on. It needed fewer workers for every pair of shoes sold, which, among other cost-savings measures, allowed it to keep prices lower than many competitors could. The company became a mainstay of the indoor malls and strip shopping centers that boomed in the second half of the 20th century.
By the time a private equity group led by Golden Gate Capital and Blum Capital, both of San Francisco, took over in 2012 in a $2 billion acquisition, Payless had 4,300 stores worldwide and $2.4 billion in revenue. But it also faced profound challenges.
Many malls and shopping centers were entering a death spiral, with falling foot traffic, store closings and underinvestment. People were increasingly buying shoes online, along with most everything else. Payless had underinvested in its information technology infrastructure.
It also had some distinctive strengths. In its 800-person corporate headquarters in Topeka, a former warehouse located between a women’s prison and a potato salad manufacturing plant, it had the personnel and systems to pull off an intricate feat of merchandising and supply chain management.
The company managed to commission the manufacture of millions of pairs of shoes, often imitating the look of more fashionable brands; ship them from factories in China, Vietnam and other countries to distribution centers in the United States; and then, just in time, get those shoes into the stores where they would most appeal to the customer base.
It did all this at remarkably low cost; its average pair of shoes sold for $17.
What needed doing was evident to Payless’s own managers and outside analysts alike: shutter underperforming stores, update others, and modernize its technology to compete in the digital age.
The new owners found a new C.E.O. in W. Paul Jones, a veteran of two retailers owned by financial engineers: Sears under the hedge fund manager Eddie Lampert and Shopko under the private equity firm Sun Capital Partners.
Mr. Jones had seen up close both the strengths and weaknesses of this form of financialized corporate control. “They’re incredibly valuable on the financial metrics of understanding how to get costs out of the business, how to be more streamlined, how to think about the organizational structure differently, how to find nickels and dimes throughout the organization,” and at getting maximum value out of real estate, Mr. Jones said.
“But they do not, do not, know how to operate a retail company,” he said.
That is to say, on the actual nuts and bolts of retail — creating a compelling shopping experience, with merchandise that buyers want — financial managers are out of their depth.
But he was confident that Payless under Golden Gate and Blum would be an exception. The new owners appeared to understand the business better than others in the private equity industry, Mr. Jones said, and they were committed to hiring a first-rate team of executives.
That optimism was conveyed to employees at the corporate headquarters in Topeka. Soon after the takeover, managers gathered in a small auditorium.
“Everybody was a little bit on edge,” Thad Halstead, a merchandise manager, recalled. “But it was positive. They were saying: ‘Our goal is to help you. We’re here to make sure you guys have the resources to succeed for the next hundred years.’”
Dunkin' Donuts is an example of a company that emerged from private equity ownership stronger than it went in.
The private equity productivity puzzle
Plenty of companies that go through this process do emerge better managed, with capital deployed more wisely.
The Carlyle Group, for example, took over Dunkin’ Donuts in 2006 and spun it off to public markets in 2011 financially stronger and with 2,800 more stores worldwide. The hotel group Hilton Worldwide nearly doubled the number of rooms it managed from 2007 to 2018, while under control of the Blackstone Group.
And some of the best research on how the buyout industry affects the companies involved suggests that, on average, they become more productive.
Steven J. Davis, an economist at the University of Chicago Booth School of Business, and five co-authors analyzed thousands of private equity buyouts between 1980 and 2013. Among other things, they found that in the two years after a firm was bought out, labor productivity — the revenue generated per employee — rose by 7.5 percent more than at otherwise comparable firms that were not acquired. The largest gains came at older and larger buyout targets.
This would seem to fit the story that the private equity industry tells about itself: that it is creating more dynamic, productive companies by running them more effectively than the traditional system of self-perpetuating boards of directors and publicly traded shares.
But there is a problem. During this same period in which American corporations have become more financialized than ever, the overall economy has had historically weak productivity growth.
In the 2010s, labor productivity — the amount of economic output per hour of work — has risen by less than 1 percent a year, the lowest of any decade on record (the data go back to 1947). It was 2.7 percent per year during the 1950s and 1960s, the high-water mark of the clunky, complacent, conglomerate-building era of American business.
That may not seem like a big difference but sustained over time it has huge effects. At 1960s rates of productivity growth, incomes would be expected to double every 26 years. At 2010s rates, it would take 72 years.
The American economy has become markedly less dynamic. Fewer businesses are being started, and the newcomers are having less success unseating incumbents. Workers are less likely to change jobs, which suggests labor is not moving toward the most productive forms of work. Many major industries are becoming more concentrated among a few giants.
Mr. Davis, the University of Chicago economist, says these trends would be worse if not for the buyout industry.
“Private equity buyouts are a force pushing the other direction against the headwinds,” he said. “If you think the reallocation of jobs and capital and workers to more productive use is an important part of how we drive productivity growth and generate higher living standards, the role of private equity is more vital, because there seems to be less of that going on in the economy than 20 or 30 years ago.”
It also could be true that the slump in productivity and dynamism has nothing to do with the revolution in how companies are governed and capital allocated. The slump could result from fewer transformative innovations, for example — essentially bad luck.
But at a minimum, it doesn’t appear that the rise of this seemingly superior form of stewarding American business has created a more robust overall economy. And Payless offers some clues as to why.
Trouble in the supply chain
The new C.E.O., Mr. Jones, and the rest of the executive team assembled by Payless’s new private equity owners in 2012 had a lot to do.
The company had modernized its logo and branding years earlier — but had been so stingy with capital spending that around 70 percent of stores still had 1980s vintage signs. The company’s outdated information technology systems updated inventory only once a day — making it impractical to offer buy-online, pick-up-in-store offerings.
Mr. Jones and his team started in on plans to upgrade technology, expand profitable international operations and invest in the high-growth areas of athletic footwear. But even with all those outdated stores and technology, capital spending remained only at levels comparable to the previous ownership: $75 million to $80 million per year.
Meanwhile, the company made huge payments to its private equity owners.
In the two-year period ending in January 2015, Payless generated $249 million in “Ebitda,” a common metric for operating profits; paid $352 million in one-time dividends to shareholders; and made $94 million in interest payments.
For every dollar that came in the door of the company in that span, it paid out $1.41 to its owners and 38 cents to its lenders. That left the company with less of a financial cushion to ride out any future challenges. And the future, as it turned out, held some major challenges.
In 2015, longshoremen at major West Coast ports went on a slowdown at the worst possible time for Payless: just as ships from Asia containing millions of pairs of discount shoes were steaming across the Pacific ahead of the crucial spring sales season.
Inventory waited offshore for weeks, creating a cascade of problems for the Payless supply chain: a pileup of out-of-season shoes that the company was able to sell only at deep discounts and with extra spending on marketing.
The resulting losses strained the company’s ability to repay its debts and led to credit downgrades. “It’s just this vortex that you’re stuck in, trying to get out of it,” Mr. Jones said. “And that’s what caused the crisis.”
But it was the financial structure of the company that made it possible for a labor disruption to push the company into that vortex. “Yes, taking out the money, in hindsight, made the business more vulnerable, susceptible, and in an environment of so much uncertainty that nobody understood,” Mr. Jones said of the dividend paid to shareholders. “In hindsight, we shouldn’t have done it.”
Golden Gate Capital said that it was focused on helping the company grow and that it was undone by powerful forces.
“We recruited a strong management team, and over $500 million was invested to support Payless’s turnaround strategy,” the private equity firm said in a statement. “Unfortunately, like many retailers, Payless ultimately faced challenges too strong to overcome without an operational and financial restructuring.”
How to boost profits and impress investors
Think about any company where you’ve worked. Suppose a new owner took aggressive actions to try to achieve immediate financial returns.
It might pay out cash on the balance sheet as dividends rather than let it sit around for a rainy day. It might rely more on borrowed money. It might raise prices abruptly, or cut payroll, or try to renegotiate deals with landlords and suppliers.
In other words, it might follow the private equity industry’s playbook.
And those efforts may create an apparent boost in productivity. So long as revenue and earnings rise faster than the amount of labor, it would look like a win for the overall economy, at least in the first few years.
But at the ground level, there would be no guarantee that the company was actually doing anything better. All those changes would make a company more profitable. But they wouldn’t necessarily result in a product that consumers preferred, or in a more effective deployment of workers and equipment.
Moreover, a riskier corporate balance sheet might be fine when things are going well, but increase the risk of a catastrophic failure when things go wrong — essentially hollowing out whatever productive capacity made the company successful to begin with.
Just maybe, in other words, what Payless went through in its run of private equity ownership wasn’t just one bad deal in one troubled industry, but a particularly clear example of what is holding the entire economy back.
A swift return to bankruptcy
Done right, a Chapter 11 bankruptcy is an opportunity for a company’s rebirth. It can shed the debts, lease obligations or onerous supplier contracts that might have gotten it in trouble.
The executives who led the company through its 2017 bankruptcy were confident they had done exactly that. The company shed about half of the debt on its balance sheet, closed about 700 underperforming stores, got its rent on remaining stores cut by as much as 50 percent, negotiated more favorable credit terms with suppliers, and formed a plan to invest in new technology and expand its profitable Latin American business.
“We were going the right direction, we had stability, we had a strategy, we had a team, and we had results,” Mr. Jones said. He said the new owners should have had at least four years of breathing room to get the business on track. Golden Gate Capital, in its statement, said, “When we exited Payless, we left it with a right-sized store footprint and meaningful earnings opportunities for future owners.”
“It’s the antithesis of what we’ve seen in other retail bankruptcies,” a restructuring expert, Christopher Jarvinen, told Reuters at the time.
Yet 18 months later, Payless was in bankruptcy court again. Its United States stores were closed.
What happened? Why did Alden Global Capital, the firm that took over Payless after the restructuring, fail so badly?
One answer is that it is hard to fix decades’ worth of problems quickly, even with the help of a bankruptcy court that can wipe out debts. For example, the Alden managers enthusiastically demonstrated a new system with which store employees could call up information on a tablet to see if desired shoes were available in another store.
That sort of thing was pretty standard in the retail industry in 2018. Yet many Payless stores had inadequate Wi-Fi for the tablets to be used. And the bankruptcy had fractured the company’s relationships with suppliers, many of them small Chinese manufacturers that had lost money when Payless experienced its cash crunch.
Former employees also described a series of mystifying errors by an Alden-installed leadership team with little or no experience in the retail industry. The chairman and interim C.E.O., Martin R. Wade III, was a longtime investment banker. His chief deputy, Jennifer Wild, was also new to the sector.
Executives from the earlier ownership were involved in the transition while the company was in Chapter 11; they recalled answering questions from the new team about some of the basics of retail supply chains and merchandising strategy.
Beyond their lack of retail experience, former employees said the Alden team cloistered itself in the executive suite and seemed to disdain the expertise of the staff in Topeka.
“What they thought was that people who live here are stupid, and that’s the way they treated us,” said Meghan Shreve, who was a manager in corporate communications. “It didn’t matter how great you were in your field or what other stuff you had done, it was, ‘You live in Kansas, so you’re an idiot.’”
Seeking to streamline the company’s supply process, the company shut down a lab in China where shoes were inspected before being exported. Instead, quality assurance workers inspected shoes in factories.
Bad orders began slipping through. At one point, a big order of shoes with mislabeled sizes — a size 6 shoe with size 3 printed on it, for example — showed up at the distribution center in Ohio.
“Missing one shoe can wipe out whatever you think you’re saving,” said Dustin Watson, a former planning and allocation manager.
Then there were the sandals. “Someone in Colombia isn’t going to buy Mexico-themed flip-flops, and they definitely won’t buy them if they don’t get there in time for the World Cup,” said Jason Tryon, a planning and allocation manager. Those concerns, he said, were ignored. “They became convinced that, ‘You guys don’t know what you’re talking about.’”
Mr. Wade, the interim chief executive during this period, said he and his colleagues had inherited a business in worse shape than it had appeared.
“The company had extremely deep flaws that had been building over the years,” he said. “One could argue that it was close to insolvency the day we took over.”
He said he had needed to “make terminations” with the Topeka staff “because we did not have runway and we needed to move quickly.”
He disputed the idea that his leadership group lacked retail experience, noting he had hired several seasoned executives and consultants. Moreover, he said, “the steering committee that hired me had their choice of at least 25 very experienced people whose whole careers were in retail.”
“So why me?” he said. “I believe they felt that they needed a leader; they needed someone who had experience changing culture, and who is not afraid of bringing in people with more expertise than he had in order to turn the company around.”
He attributed missteps like the World Cup flip-flops to the need to experiment and innovate — including successful efforts like a marketing stunt to trick fashion influencers into believing Payless shoes were from a luxury brand.
Definitely destruction, but was it creative?
Payless is now a carcass of a company, with no stores in the United States and a relative handful of employees in a headquarters that once held 800.
There’s a certain model of capitalism under which this failure, painful as it was for those who lost their jobs, is a win over all. Strong, well-managed companies rise up and replace failures, producing a more competitive economy that benefits everyone over the long run.
But there’s an alternate way of viewing things.
For one thing, plenty of retail companies are doing reasonably well, making sound tactical decisions around store closings and smart investments in digital retail.
Payless wasn’t hopeless, said Beth Goldstein, a footwear industry analyst at NPD Group: “It would have needed significant investment and right-sizing, and it wouldn’t be up to the level of what it was 10 years ago, but there would still be a business.”
Instead, Ms. Goldstein concludes, much of the sales Payless once made migrated to just three other retailers: Walmart, Target and Amazon, including through its Zappos subsidiary.
What do the most successful markets look like? They feature lots of rivals in constant competition, always testing new strategies as they compete for workers, suppliers and customers. That’s what makes a truly dynamic economy, the kind where creative destruction of all types can occur.
The death of Payless eliminated several hundred well-paying corporate headquarters jobs in Topeka, as well as thousands more jobs in stores. And it hurt creditors, landlords and suppliers.
But it also left behind a discount shoe industry that is much more dominated by a handful of the biggest companies, which will have that much more power and incentive to entrench their advantages and keep dynamism at bay.
When you look at it that way, the private equity paradox is no more a mystery than why you hold on to plenty of cash for a rainy day, or why a Colombian doesn’t want Mexican-themed World Cup flip-flops after the World Cup is over.
