Private equity only part of Safeway merger story

Safeway Inc.'s pending $9.6 billion merger with Albertsons might be as much a real estate play as it is a private equity deal, but the real estate angle won't be revealed right away.

Sources close to the deal say roughly 60% of the merged company will be owned by a group of real estate firms, including Klaff Realty LP, a real estate investment firm; real estate investment trust Kimco Realty Corp.; and real estate money manager Lubert-Adler Partners LP.

The remainder will be in the hands of private equity and hedge fund manager Cerberus Capital Management LP and the merged grocery chain's management team, led by Albertsons CEO Bob Miller. The group is working together to squeeze the most return on both the private equity and real estate sides of the deal, sources say.

The deal is an example of the integration of real estate and private equity, with managers in both asset classes working together to gain the best risk-adjusted returns for investors.

This is not the first big retail deal to have a real estate component. Kmart Holding Corp.'s purchase of Sears, Roebuck & Co. in 2004 involved real estate, but a different investment strategy. In that case, hedge fund manager Edward S. Lampert, who engineered the deal as the largest shareholder of Kmart, opted to cut costs by closing stores right away.

The same was true when Cerberus led a virtually identical lineup of real estate firms in the $17.4 billion original purchase of Albertsons. That was also a transaction in which private equity and real estate investment firms worked together in what was a real estate-intensive deal.

The real estate strategy involved in the Safeway-Albertsons merger is different.

The consortium does not intend to close any stores; instead, members are biding their time, believing the real estate part of the deal will be most valuable if the combined Safeway-Albertsons is a success, sources say.

Then, the investment consortium plans to unlock the value of the real estate, in part, through a gradual series of sale-leaseback transactions, according to sources who wouldn't speak for attribution.

Traditional supermarket chains such as Safeway and Albertsons have been consolidating over the past decade, pushed by new competitors such as Wal-Mart Stores Inc. and Costco Wholesale Corp. Early grocery mergers added capital to the bottom line of the combined companies by selling underperforming stores, said Jason White, an analyst on the retail team of Newport Beach, Calif.-based real estate research firm Green Street Advisors Inc.

Past grocery mergers have provided nice returns for institutional investors. According to a recent Green Street report on Kimco Realty Trust, the original Albertsons transaction in 2006 was a “home run, but the deal had a heavy real estate component.” The Albertsons-Safeway transaction will be the third time Kimco is joining a Cerberus-led consortium on a grocery deal.

APG Asset Management, the fiduciary manager of the e292 billion ($381 billion) Stichting Pensioenfonds ABP, Heerlen, Netherlands, is a significant investor in Kimco, owning 16.5 million shares, representing 4.6% of the REIT's outstanding shares. Other Kimco investors include the $282.9 billion California Public Employees' Retirement System, $173.2 billion New York State Common Retirement Fund, $73.2 billion Ohio Public Employees Retirement System and the $176.2 billion Florida State Board of Administration.

But that past, early success doesn't signal strong returns in the future.

“The low hanging fruit has been picked,” Mr. White said.

“The landscape is different from 10 years ago,” said Jay Carlington, a Green Street associate research analyst.

Also, retail buyouts have not always gone well for investors, even when the deals had a heavy real estate component. One example is the $6.6 billion leveraged buyout of Wayne, N.J.-based retailer Toys "R Us, by private equity firms Bain Capital LLC and Kohlberg Kravis Roberts & Co. LP and Vornado Realty Trust.

APG owned 3.7% of Vornado's outstanding shares as of Dec. 31, according to Securities and Exchange Commission filings. Other Vornado investors include CalPERS, Ohio PERS, the New York State Common Retirement Fund and the $49.9 billion Alaska Permanent Fund Corp.

Vornado announced last month it suffered losses of $293 million from the deal.

Like the Cerberus-led consortium, investors in grocery store mergers are having to switch up their game plans, both as to how they turn around the businesses and how they handle the real estate, experts say.

“The big (grocers) will continue to expand and there will be some LBOs, but the focus will be on operations,” said Jeff Edison, chairman and CEO of two Phillips Edison REITs, Cincinnati. ”There will be less new development and more investment in the existing stores.”

And, selling stores right away could cause the newly combined company's balance sheet to take a hit, causing private equity investors to suffer. That is why the Cerberus-led group isn't in a hurry like most of the same players were when they originally bought Albertsons in 2006.

Rather, the group will wait until the combined Safeway-Albertsons business is humming along. At that point, the real estate will sell for a higher price, especially since many of the stores are on the West Coast, according to people close to the transaction.

While the investment strategy might be in flux, institutional investors still want to invest in grocery-anchored shopping centers, money managers say.

“There is still solid interest in grocery-anchored centers in the U.S.,” said Matt Khourie, CEO of Los Angeles-based real estate money manager CBRE Global Investors. “It was an attractive product type during most of the downturn, there hasn't been a tremendous amount of square footage added, and most of the good properties are held by retail REITs. When grocery-anchored centers come to market, there is a lot of interest because there is significant demand and not a lot of supply.”

Even so, investors have to be careful, given the consolidation, Mr. Khourie said.

“When Safeway is bought by the owner of Albertsons, the risk becomes higher that some of the existing stores will become shuttered, since they cannibalize the other stores held by the parent company,” he said.

“Prudent shopping center investors also have to be very thoughtful and take care that the center they are buying is not near a new Wal-Mart or Target that could be competing for the grocery dollar and impacting the sales per square foot,” he said.

What's more, consolidation in the grocery business is increasing the risk in these deals for investors because there are fewer grocers that can anchor a shopping center, Mr. Edison said.

Institutional investors, appreciating the risk inherent in what was once considered the ultra-safe investment in grocery-anchored shopping centers, are once again investing in power centers, said David Oakes, president of DDR Corp., a retail REIT.

Power centers, which hadn't fared as well as grocery-anchored shopping centers during the downturn, are open-air shopping centers with multiple national anchors including discount department stores and warehouse clubs, according to DDR, a big power center investor.

“After several years of institutions having a bias against power centers, we are seeing more and more institutional investment in the power center world,” Mr. Oakes said.

DDR has partnered with Blackstone Group's real estate funds on power centers and, last year, DDR bought out Blackstone Real Estate Partners VII's joint venture interest in 30 power centers for $1.46 billion.

Mr. Oakes said DDR and Blackstone continue to buy power centers and other properties together.

Still, major institutional investors are not avoiding investment in grocery-anchored shopping centers; they're just becoming more selective, he said.

“The risk profile of a retail center with a 50,000-square-foot grocer and 50 small shops has been meaningfully underestimated,” Mr. Oakes said.

Mergers are important for grocers to obtain economies of scale and to run the combined companies more efficiently because revenue and margins are under pressure, he said.

“It gives them (grocers) a chance to survive for a bit to figure it out,” Mr. Oakes said.

“Eventually, traditional grocers will be closing stores because their market share is shifting elsewhere,” Mr. Oakes said. “The last-ditch effort from retailers is to spin off real estate. When grocers start pulling capital from real estate it is a signal that operations are down.”