MATTHEW KANDRACH – PRESIDENT, CASE

August 7, 2018 – https://bit.ly/2vKwq7K

As the dust settles from the final going-out-of-business sales and the remaining assets are sold off to satisfy the bankruptcy court claims, many former Toys R Us kids turned industry pundits continue to try to make sense of the loss of the beloved and iconic American toy store.

For weeks now, we’ve been inundated by news coverage evaluating KKR & Co., Bain Capital and Vornado Realty Trust’s actions after they took over Toys R Us in a $7.5 billion leveraged buyout attempting to answer the questions that are top of mind for investors and consumers alike: What went wrong, what could have been done to prevent this, who is to blame, and what are the lessons learned?

With the preponderance of evidence pointing to the Amazon-spurred retail apocalypse (which killed roughly 7,000 stores and eliminated more than 50,000 jobs in 2017), many reached the conclusion that online competition from Amazon was inevitable and predictable, but leverage is what did Toys R Us in – with some even claiming that private equity firms swooping in to buy struggling retailers may be hastening their demise.

News coverage recounting the steps leading up to the liquidation has relied on the fact that Toys R Us was a leveraged buyout with excessive debt as the silver bullet that set the bankruptcy proceedings in motion. The role of debt and credit in the American economy and the sustainability of Toys R Us was never considered beyond the company’s demise and the connection to the private equity firms that tried to save the business and its employees.

Debt and credit are the lifeblood of our American consumer-driven industry. A retailer’s ability to create cash by buying goods from suppliers and selling them to consumers is directly contingent on the retailer’s ability to secure capital and the consumer’s access to credit. Rapidly decreasing distressed-investing opportunities have resulted in increasingly more aggressive and litigious behavior among credit managers seeking gains in the speculative grade credit market, and this was the tipping point that ultimately led to the shuttering of Toys R Us.

During the summer of 2017, Toys R Us executives negotiated with lenders, hoping to extend $400 million debt maturity due the next spring. For the first time in a decade, though, Toys R Us and its financiers couldn’t come to terms on an agreement, and the company prepared to file for Chapter 11 bankruptcy protection with the intention of reorganizing on firmer ground.

That option perished when the company lost its ability to access trade credit to maintain its inventory levels and purchase toys from its core suppliers in the United States and abroad. Weeks before the key holiday selling season, almost 40 percent of Toys R Us suppliers refused to ship their products without a cash advance, cash on delivery or payment of all their outstanding obligations. The company pledged all of its remaining cash as collateral to secure a $3.1 billion rescue loan so it could stay in business through the holidays.

In spite of these efforts, holiday sales significantly underperformed as brick-and-mortar and online competitors waged a massive price war and the company was unable to access the working capital it needed to survive.

Several potential financial suitors looked at the company, and strategic retailers considered buying Toys R Us outright. Sycamore Partners even produced a plan that could have kept half of the U.S. stores open, but because the debtor-in-possession financing came with a special guarantee in the event of a liquidation, creditors calculated they would reap a bigger payout if the company closed its doors and sold off its assets. These creditors, led by Solus Alternative Asset Management, turned toward liquidation to maximize their recovery; this move was not initiated by KKR, Bain Capital and Vornado Realty Trust.

Distressed-debt investors such as Solus play a pivotal role in the bankruptcy process. They capitalize on cash-strapped businesses and strip them of their value, even if that means liquidation. Here, Solus and others stand to collect $1 billion before any toy supplier that is owed money.

As capital structures have become increasingly complex, creditors are generally finding more gray areas to exploit, and the practice of manufactured defaults in the credit default swap market may be emerging as manufactured liquidations in the distressed debt market.

In the end it was lack of access to credit, not debt, that crippled Toys R Us as it attempted to restructure and emerge from bankruptcy. There was a plan to save the iconic brand – albeit with fewer stores – but ultimately, the creditors took control, and their resolve to maximize their returns blocked any realistic proposals.

The lesson here for consumers isn’t an easy one. Lack of access to credit shuttered a beloved toy store. The diminished consumer choice and limited competition will likely lead to holiday shopping price hikes in the years ahead.

Toys R Us should be the canary in the distressed-debt coal mine for all of us; ignoring the creditors’ role and exclusively laying blame at the feet of KKR, Bain and Vornado create a false narrative that does nothing to serve consumers. As creditors continue their pattern of restructuring debt in a way that favors liquidation over preserving value continues, so will store closings at the expense of retail jobs, market competition and consumer choice.