A great article by Matt Levine
-By: Matt Levine from Bloomberg View Money Stuff
One thing to say about Toys “R” Us Inc.’s bankruptcy filing yesterday is that Toys “R” Us’s business is basically fine. It had $460 million of GAAP operating income last year, up from the year before; its adjusted earnings before interest, taxes, depreciation and amortization — the company’s preferred metric — was $792 million. Like all retailers, Toys “R” Us faces a tough environment and competition from Amazon and Wal-Mart, but that’s not what brought it to bankruptcy.
Instead, Toys “R” Us’s problems are “the legacy of a $7.5 billion leveraged buyout in 2005 in which Bain Capital, KKR & Co. and Vornado Realty Trust loaded the company with debt to take it private.” It currently “has more than $5 billion in debt, which it pays around $400 million a year to service.” “If they didn’t have the debt they would be making $500 to $600 million a year in profit,” said one analyst. “The problem is the debt.”
One possible conclusion here is that the retail business is fine, but the private equity business is bad. “The only good to come out of Toys ‘R’ Us troubles is that people are finally waking up to the damage done to the sector by private equity,” tweeted my Bloomberg View colleague Joe Nocera.
But another thing to consider is that the point of modern Chapter 11 bankruptcy reorganization law is to make sure that a business that can cover its operating costs is allowed to keep operating, even as it changes its capital structure. If Toys “R” Us stores are a good business they can just stay open and be good stores, while if the leveraged-buyout debt is bad it can just go away. And in fact that seems to be the plan: The company has gotten financing to “fund operations while it restructures the liabilities,” and it “doesn’t plan to close stores and says its locations across the globe will continue normal operations.” Major suppliers seem to be strong supporters of the company’s continuing operations. Toys “R” Us plans to raise store employees’ wages in bankruptcy.
Bain Capital, KKR & Co. and Vornado Realty Trust stand to have their Toys “R” Us Inc. investment erased as the retailer they bought in 2005 for $7.5 billion seeks bankruptcy protection.
The three firms and their co-investors sank $1.3 billion of equity into the takeover of the Wayne, New Jersey-based toy company, financing the rest with debt, according to company filings. The debt included senior loans in which they held a stake.
The investors have marked their equity stakes down to zero. “The owners didn’t pay themselves any dividends and though they have been drawing advisory fees, the amounts represent a small fraction of their overall losses.”
Obviously things don’t work out perfectly in practice. Bankruptcy imposes real costs; a September 6 news report that Toys “R” Us was considering bankruptcy earlier this month spooked its suppliers and, according to the company’s bankruptcy declaration, “started a dangerous game of dominos: within a week of its publication, nearly 40 percent of the Company’s domestic and international product vendors refused to ship product without cash on delivery, cash in advance, or, in some cases, payment of all outstanding obligations.” And the debt itself has probably impaired Toys “R” Us’s competitive position: “Cash has run short and Toys ‘R’ Us has fallen behind competitors, without the ability to invest in its business and future, Chief Executive Officer David Brandon said in a court declaration.”
Still it is worth noting that this is what bankruptcy is for: not to destroy a good business because it took on too much debt, but precisely to save a good business even though it took on too much debt. The point is to make the debt go away and keep the business around. Maybe that won’t work — maybe the process will fail and the creditors will obstruct the turnaround, or maybe the process will work great and the turnaround will fail anyway because retail is doomed — but reading this story as “private equity destroyed an otherwise fine business by driving it into bankruptcy” is too simplistic. Private equity drove Toys “R” Us into bankruptcy, sure, but that isn’t quite the same thing as destroying it.