Big investors are losing $1.3 billion on the Toys R Us bankruptcy

David Brandon, the CEO of Toys “R” Us, said in his bankruptcy declaration filed Tuesday that his company “delivers children their biggest smiles of the year.” But the big private equity and real estate firms that own Toys “R” Us have long stopped smiling about their investment in the company and the damage they helped cause.

KKR, Bain Capital, and Vornado Realty Trust, financial firms run by billionaires, pushed Toys “R” Us into bankruptcy protection in Virginia on Tuesday, abandoning any hope of ever recovering the $1.28 billion they invested to purchase Toys “R” Us over a decade ago. Vornado was already carrying its $428 million investment in Toys “R” Us at zero prior to the trip to bankruptcy court, according to its Securities & Exchange Commission filings.

KKR, Bain and Vornado purchased Toys “R” Us in 2005 in a $6.6 billion leveraged buyout, but more than $5.3 billion of the purchase price was paid using debt. Toys “R” Us has adapted to many changes in the toy industry since Charles Lazarus started the company as a baby furniture store in 1948, but spending $400 million annually to service its debt made it impossible in 2017 for Toys “R” Us to deal with the competition coming from online and big box retailers like Amazon and Wal-Mart.

“The company’s overleveraged capital structure has constrained it from making necessary operational and capital expenditures, including investing in the revitalization of stores,” said Brandon in his bankruptcy-court declaration. “As a result, the company has fallen behind some of its primary competitors on various fronts.”

Whatever business expertise Toys “R” Us’ owners brought to the company did not help the retailer avoid bankruptcy court. The Toys “R” Us leveraged buyout brought together KKR, founded by billionaires Henry Kravis and George Roberts, who are known for bringing creativity and genius to financial engineering; Vornado Realty Trust, founded by billionaire real estate expert Steve Roth; and Bain, the private equity firm that prides itself on being a good corporate consultant, particularly to retailing companies. Under their watch, the company spent about $250 million annually on capital expenditures, which was used to grow internationally and create a side-by-side store model with Toys “R” Us and Babies “R” Us.

Since they took it over, Toys “R” Us has recorded $183 million in advisory fees to its owners, which translates into $61 million each to KKR, Bain, and Vornado. Public filings make it unclear how much of the advisory fees were paid, but Forbes reporting suggests that the majority of the fees were paid. They are described as “recorded” in Securities & Exchange Commission filings. The list of unsecured creditors filed in bankruptcy court excludes corporate insiders.

A representative of Vornado could not be reached for comment. KKR and Bain declined to comment. Toys “R” Us does say in its SEC filings that $47 million in transaction fees that it owed KKR, Bain and Vornado, have been waived. The advisory fees were also voluntarily reduced by the investment firms in recent years.

Toys “R” Us management claims that it had no choice but to file for bankruptcy protection. The company has $400 million of debt coming due in 2018 and speculation about its bankruptcy had “started a dangerous game of dominos,” according to a court-filed document, going into the key Christmas season when Toys “R” Us generates 40% of its revenues. Nearly 40% of the company’s product vendors had started to refuse to ship product without cash being paid on delivery or in advance, and in some cases, they insisted on payment of all outstanding obligations. Toys “R” Us also lost many of the credit insurers and factoring parties that support its business.

Toys “R” Us has secured $3.1 billion in debtor-in-possession financing and will try to use the bankruptcy process to reorganize its capital structure so it can try to compete with the likes of Amazon. Still, the bankruptcy process will impose more fees on Toys “R” Us, from the likes of Kirkland & Ellis, whose lawyers charge upwards of $1,000 an hour. The same firm advised Bain Capital when it purchased its stake in the Toys “R” Us leveraged buyout in 2005. In his filing, Toys “R” Us CEO Brandon estimates that based on his conversations with investment bank Lazard, there will be $96.5 million in fees just to procure the debtor-in-possession financing.

“Chapter 11 was certainly not the company’s preferred outcome,” CEO Brandon said.

Nathan Vardi

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