How Did Toys "R" Us Implode So Fast? The CEO Explains

Reviewing first day motions from a company"s chapter 11 docket, and more specifically the CEO"s declaration, can be a great way to learn exactly what happened in the days/weeks leading up to a bankruptcy filing.  The company spends millions of dollars every month on expensive lawyers (Kirkland & Ellis in the case of Toys "R" Us), investment bankers (Lazard), turnaround advisors (Alvarez & Marsal), claims administrators, etc., who all spend many sleepless nights in the days leading up to a filing trying to make sure the first day motions are as informative as possible.

With those high expectations, you can imagine our surprise when we opened the Toys "R" Us CEO"s declaration to find this "preliminary statement":

Yes, Kirkland & Ellis was paid $800 an hour (ish) to type up the Toys "R" Us jingle in a court filing.  Bravo!

In any event, once you get beyond the amateur-hour antics, CEO David Brandon explains why Toys "R" Us was forced to file for bankruptcy in such a hurry.  While debt service on a excessively levered capital structure was a big part of it, Brandon explains that media speculation over a potential bankruptcy filing led to a rapid tightening of trade terms just as the company was trying to build inventory ahead of the holiday season.  Here are the details:

1.  Debt - Apparently spending the majority of your FCF on debt service while ignoring capital improvements and store remodels is a bad long-term business strategy for a bricks-and-mortar retailer.

Toys “R” Us, however, has been operating for more than a decade with significant leverage, necessitating the use of substantial amounts of cash each year (approximately $400 million) to service the more than $5.0 billion of funded indebtedness.  But these substantial debt service obligations impair the Company’s ability to invest in its business and future.  As a result, the Company has fallen behind some of its primary competitors on various fronts, including with regard to general upkeep and the condition of our stores, our inability to provide expedited shipping options, and our lack of a subscription-based delivery service.

2. Vendors - Media speculation of an imminent bankruptcy filing starting on September 6th caused 40% of vendors to restrict shipments and demand "cash on delivery" for new inventory purchases which would have required $1 billion incremental liquidity.

More recently, the Company’s need for a comprehensive solution to its capital structure issues caused widespread “bankruptcy” speculation in the media, leading to a severe constriction in the Company’s trade terms.  More specifically, in late July the Company hired Kirkland & Ellis LLP and Alvarez & Marsal North America, LLC, complementing its retention of Lazard, to consider restructuring and capital structure solutions.

A news story published on September 6, 2017, reporting that the Debtors were considering a chapter 11 filing, 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.  Further, many of the credit insurers and factoring parties that support critical Toys “R” Us vendors withdrew support.  Given the Company’s historic average of 60-day trade terms, payment of cash on delivery would require the Debtors to immediately obtain a significant amount—over $1.0 billion—of new liquidity.

3.  Holiday Inventory Build - Finally, this all came at the exact moment that the company was trying to build inventory for the holiday selling season.

The timing of all of this could not have been worse, as the Company is in the process of building holiday inventory.  While birthdays, new game releases, and other special events drive year-round sales, the holiday season is the most important for annual results.  In the fourth quarter (the weeks prior to Christmas), the Company generates approximately 40% of its annual revenue.

To prepare for the holiday season, Toys “R” Us significantly increases inventory in September to fill store shelves with the selection and variety of products our customers expect.  Accordingly, I believe it is critical that the Company reopen its supply chain immediately to ensure a successful holiday season.

Given that, it"s somewhat ironic that Bloomberg notes this morning how important Toys "R" Us is to vendors and how Mattel and Hasbro couldn"t possibly allow the company to liquidate.

Rest easy, kids. Toys “R” Us Inc. isn’t going anywhere, at least not if the makers of Barbie and Transformers have their way.

Yet, the company, which operates about 1,600 stores globally, will likely survive because manufacturers such as Mattel Inc., Hasbro Inc. and closely held MGA Entertainment Inc. need the last remaining toy chain. These vendors are eager for whatever remaining leverage they have against the might of Amazon and Wal-Mart, the bane of all companies focused on a single category of shopping.

“Oh my God, they are very important, and people don’t understand,” Isaac Larian, founder and chief executive officer of MGA, said of the toy chain. “That’s the only place where kids can go and just buy toys. There is no toy business without Toys ‘R’ Us.”

In many respects, suppliers have been propping up Toys “R” Us for years, according to Moody’s Corp. analyst Charlie O’Shea; they give the chain exclusive products during the holidays and funds for promotions to help it compete with the general merchandisers. The manufacturers offer this support because they want a place to sell toys at full price, year round. Major brands have also been funding an overhaul of Toys “R” Us stores by adding more featured areas for top brands such as Mattel’s American Girl dolls.

In the toy business, the incentive is particularly powerful. Last year, Toys “R” Us accounted for 11 percent of sales at Mattel and 9 percent at Hasbro -- the second most at both companies after Wal-Mart.

Meanwhile, many have speculated this week over how/why TOY bonds traded off 75 points on the company"s filing?  How could they be so wrong?  While the timing of the filing was probably somewhat of a surprise, we can"t help but wonder whether this simplistic org structure might have contributed in some small way?

This Is What Happens When Private Equity Firms Run Out Of Things To Buy

What do you do when you"re part of an industry that has levered up $100"s of billions of dollars in investor capital and paid a handsome premium for pretty much every asset available all while "excess cash sits on the sidelines" because there are just no deals left to do at remotely attractive valuations?  Well, if you"re Investindustrial, a European private equity fund founded by Italian dealmaker Andrea Bonomi, then you simply raise a new fund to buy all the investments of your old fund.

And while that may sound like a joke, unfortunately it"s very true.  As the Wall Street Journal points out today, Bonomi has recently raised $800mm to buy assets that he initially acquired via a $1.1 billion fund originally raised in 2008. 

All of which raises a number of important questions like how exactly are valuations set for such a deal in the absence of a distinct buyer and seller negotiating a fair, market clearing price?  Presumably Bonomi tested the market for his assets but simply didn"t like the valuations he was offered?  If so, how could new Limited Partners ever possibly get comfortable with the valuations paid for assets being purchased from the old fund?  After all, the ole "mark to model" methodology didn"t work out so well for the Dallas Police and Fire Pension, among others.  

And then there is the question of fees.  Surely, LPs wouldn"t be willing to pay "2 & 20" for the runoff of an existing portfolio?  If so, sign us up.

Of course, according to the WSJ, Bonomi"s effort to buy his own prior investments has nothing to do with gaming fees but is rather just a creative way to be more competitive with sovereign wealth funds that don"t have term limitations on their funds...and if you believe that then Bonomi, a man who typically only sells assets to himself, would very much like to offer you the once in a lifetime opportunity to buy some ocean front property in Oklahoma. 

Buyout firms face increasing competition from patient investors like sovereign-wealth funds. One has found a way to play them at their own game: Investindustrial, a European buyout firm, is creating a new fund to buy €750 million ($800 million) of assets it already owns.

Investindustrial, founded by Italian dealmaker Andrea Bonomi, has decided on this novel course of action as it responds to greater competition for assets from institutions such as sovereign-wealth funds, which don’t have restrictions on how long they can own companies. The competition is pressuring buyout firms to devise new ways to own companies.

Moreover, the decision is in no way related to poor returns.  In fact, the primary motivator for recycling their old portfolio, at least according to the head of investor relations at Investindustrial, is that returns have been so amazing that it just makes sense to hold on to take advantage of further price appreciation. 

Historically, buyout specialists took pride in their ability to turn around the fortunes of ailing companies and sell them for a big profit within five years.

“There used to be no alternative to selling,” Carl Nauckhoff, head of investor relations at Investindustrial, said in an interview.

Investindustrial’s move to hold onto Port Aventura for longer comes as fierce competition is pushing up prices for companies, meaning it increasingly makes more sense to hold on to assets than to sell. Some sovereign-wealth funds and pension funds—traditional investors in buyout funds—are increasingly competing directly for assets. And they can hold them for as long as they want. In response, buyout firms like New York-based Blackstone Group LP are raising longer term funds so they can own companies for more than the traditional 10-year maximum.

Meanwhile, as Lazard notes, it"s only a matter of time before other funds attempt to copy Bonomi"s "innovative" approach to private equity investing. 

The deal could mark the start of a new trend because the increasing size of the buyout industry means many more funds are coming to the end of their lives than in the past, said Pablo de la Infiesta, a banker at Lazard Ltd. who advised on the transaction.

“Investindustrial has set a new direction,” Mr. de la Infiesta said in an interview. “I think everybody who has assets sitting in a fund that is coming to the end of its life will be thinking about it.”

Truly genius plan if we understand it correctly.