The Bain Bustout Is Alive And Well: The Toys ‘R Us Edition

This is how you kill an American institution (boldface mine):

As the story goes, Toys “R” Us was selling increasingly unpopular products inefficiently and at prices that didn’t reflect the current economic landscape. So is it really a surprise that the company was finally forced to file for bankruptcy, potentially closing its 1,600 stores in 38 countries for good?

…Upon closer examination, however, this analysis doesn’t hold up. First, the global toy industry isn’t in decline. In fact, it’s been growing consistently over the past five years. Physical toys may be less popular in the United States than they once were, but internationally—particularly in Asian and Latin American countries—the play business is booming. And most of Toys “R” Us’s profits actually come from its Babies “R” Us affiliate which sells not just toys but also health, safety and educational tools for infant care.

Yet most importantly, this analysis fails to account for how Toys “R” Us wound up so deeply in debt in the first place. In 2005, as the company’s stock was regularly losing value due to mediocre sales, management decided to sell the company in a leveraged buyout to a trio of buyers, real-estate-investment trust Vornado Realty Trust and private equity firms KKR and Bain Capital.

Did someone say Bain Capital, masters of the Bain bust-out? Yes:

Vornado Realty Trust, KKR and Bain Capital financed 80 percent of the purchase of Toys “R” Us, so while the company sold for $6.6 billion, the trio only contributed $1.3 billion. As part of the purchase agreement, the companies also agreed to take responsibility for all of Toys “R” Us’s long-term debt obligations, which at the time totaled $2.3 billion. Once Toys R Us was taken over, however, the debt Vornado Realty, KKR and Bain used to acquire it was pushed back onto the company, skyrocketing its debt obligations to $7.6 billion.

Toys “R” Us has been paying $400 million a year to service these debts. This money could have been used to lower prices or improve the company’s website—not to mention raising pay to its employees—but instead went to paying off creditors. Last year, the company reported a loss of $29 million. If it weren’t for these debt payments, Toys “R” Us would have run a substantial profit.

Vornado Realty, KKR and Bain tried to cash in by taking Toys “R” Us public from 2010 to 2013 but ultimately failed. Since then, Vornado has incrementally “written down” their investment in the toy company to zero, meaning they see their shares as essentially valueless.

The pattern followed by Toys “R” Us is typical in private equity takeovers. Management is bought off: John Eyler, CEO of Toys “R” Us, was compensated $65.3 million upon the buyout’s completion. Employees have no say in the matter. Then come the layoffs, debt transfers and shortsighted asset sales. Funds are earmarked to pay down debts—Toys “R” Us was spending more annually on debt payments than it was on its website and stores—even as cash reserves are depleted. Before the buyout, Toys R Us had $2.2 billion in reserves. As of 2017, that number is down to $301 million.

What’s interesting (in a horrific way) is that the bustout didn’t work: they couldn’t sell off the company. Apparently, investors occasionally get wise to the scam, and realize there’s more than just an artificially high return on equity (a return that exists because the company has been looted). Of course, the workers and the U.S. economy as a whole are worse off, but creative destruction, amirite?

And I’m sure ‘populists’ Donald Trump and Steve Bannon will get right on this sort of economic behavior…

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One Response to The Bain Bustout Is Alive And Well: The Toys ‘R Us Edition

  1. kaleberg says:

    This started slowly with the conglomerates of the 1960s, but got serious in the 1980s. As an investor, I remember making good money in the 1980s by basically liquidating companies by buying their credit rating and cash flow. Buy them. Stick them with the debt. Issue a dividend. Unload while the cash flow still covers the debt comfortably. Let the devil take the hindmost.

    More recently, it’s been about buying cash as well as cash flow. Some years ago I did a buyout spreadsheet for Apple. Even then, they had a huge capitalization, but also great cash flow and massive cash on hand. It would take a bit of work as no single bank could do the buy alone. The payoff would have been massive. There would be even more money in the slow liquidation, eliminating R&D, cutting service and milking the name. Apple started paying a dividend shortly after that. I presume they had put together a similar spreadsheet.

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