Toys “R” Us declared bankruptcy earlier this month and said it would reorganize its business to cope with an increasingly challenging retail environment.
The reality is that the iconic retailer went bust because a group of private equity firms used it as a toy in a game of “Borrow, Overpay and Pray.” They lost the game, broke the toy and have now moved onto other things while the little people (the employees and suppliers) are left to suffer, advisers make millions cleaning up a mess that other advisers made millions creating, and PR-hacks work to deflect the blame by pinning it on Amazon (or is it Walmart?). It’s all pretty absurd.
But after we’ve had a good laugh and savored the schadenfreude that comes from the disastrous investments of others, we should reflect on what this debacle tells us about the damage done when investors stray from taking risk, the useful work of private equity, into making risk, its malevolent doppelganger.
Risk taking occurs when an investor assumes risks that already exist in the world. An investor taking risk usually does so by putting money into a company that faces it.
Risk making occurs when an investor creates risk as part of an otherwise unattractive investment. An investor makes risk by taking money out of a company, leaving it more fragile but juicing the potential returns from owning it. (The most common way to do this is by forcing company to take on excessive debt to finance its own acquisition.) The risk associated with the weakened company is largely borne by its employees, suppliers and customers who get little (if anything) in return.
Value of risk taking
Risk taking plays a vital role by allowing companies to pursue activities that, while potentially rewarding, carry a lot of associated operational, technological, market or financial risk.
This provides important direct benefits — profits for successful companies, new and innovative products, employment and knowledge — while also giving individuals and institutions the opportunity to exercise their rights to buy, sell and pursue their dreams. Start-ups need risk taking investors, but so too do high-growth companies, turnarounds and restructurings.
By contrast, risk making adds nothing to our economy. It may be legal, it may be lucrative, but it’s a nasty thing to do and a shameful way to make a living. (If I set up a dangerous obstacle course and force you to run through it so that I can bet on your time, I am a monster. If economists blather on about how these “high-powered incentives” are necessary to improve your performance, they are fools.)
If risk is a bad thing, why do investors make it? Because in a remotely efficient market without risk there’s no reward. But at any given moment, there is a finite amount of risk out in the world driven by factors beyond any investor’s control: the state of technology, the actions and attitudes of large companies, the level of entrepreneurial spirit, etc. And even when there are risks out there worth taking, some investors may not have the skills to find and evaluate them.
By contrast, there’s a practically limitless amount of risk that can be created by clever financiers. So when their supply of money exceeds the amount of risk they can find, impatient financiers can be tempted to manufacture more risk to soak up the excess: idle spreadsheets are the devil’s workshop.
Too much risk?
Private equity firms are particularly prone to risk making since they raise “use it or lose it” funds; get 20% of the profits but bear almost none of the losses; have engine rooms filled with young partners and others desperate to join their ranks, under pressure to “do deals”; and don’t care if some companies they invest in go bust provided their portfolio is profitable as a whole. Given this, it’s no surprise that private equity firms make a lot more risk than is fair to impose on those involuntarily along for the ride.
The Toys “R” Us debacle began in 2005 when private equity firms bought the company for $7.5 billion.
Over the last 12 years, this original “take private” deal has probably sucked more than $5 billion out of the company: $470 million in “advisory” fees and interest to the private equity firms and $4.8 billion ($400 million per year for 12 years) in interest on the acquisition debt plus the tens of millions of dollars in legal fees Toys “R” Us will spend in bankruptcy. (It’s ironic that the investors who bankrupted the company won’t be paying any of these fees.).
Yet despite a tough retail environment, Toys “R” Us actually made $460 million from selling toys in 2016 but that didn’t help much since all of it — 100% — went to pay interest on the debt.
A few things are worth noting in this story:
The financial loss to the investors is probably quite small. Net of fees received from the company and the commitment fees earned on the underlying capital, it’s probably no more than $800 million of which the firms themselves might only bear $160 million given the standard 20%/80% split of profits between private equity firms and their underlying investors. Now $160 million seems like a lot of money to lose but given the enormous asset base of the investment groups, I’d guess it’s less than a month or two of compensation for the partners. Sure it’s embarrassing and a few folks probably got fired but financially it’s no big deal for the investors who have a portfolio of other investments to offset the loss.
By contrast, the bankruptcy is a big deal for real people despite what finance theory may say about “frictionless recapitalizations.” Unlike the investors, all their eggs are in one basket. And the needless suffering of Toys “R” Us employees and suppliers is only partially offset by the joy felt in Amazon’s headquarters in Seattle and Walmart’s in Fayetteville as a once viable competitor was brought to its knees.
The fees paid by the company since 2005 have added to inequality. They were paid to lawyers, bankers and private equity investors all comfortably ensconced in the 1%. Although we can’t know how this money would otherwise have been used, it’s safe to assume that some of it would have found its way to the 65,000 employees and thousands of suppliers that “are” Toys “R” Us. None of these fees had anything to do with selling toys.
Since the interest paid on the acquisition debt was tax deductible, all US taxpayers were de facto partners in the deal. Why did we agree to do that? What was in it for us?
Piling on the debt
The most perverse element of this story is that the investors were able to burden a company with debt without themselves being on the hook. If you buy a car with borrowed money, you are on the hook even if your lender also takes the car as collateral. But if you buy a company it’s different. It’s ironic but the limited liability corporate structure developed in the mid-19th century as a “corporate veil” to encourage investors to put money into companies is what allows investors to take money out without being on the hook.
The investors would never have agreed to pay $7.5 billion for Toys “R” Us if they’d had to borrow the money themselves. But they were delighted to make the company borrow it on their behalf while staying safely outside the corporate veil.
While Toys “R” Us is a sad story, some amount of risk making is unavoidable in an economy where investors are free to take risk. And rules to prevent risk making would conflict with other things we value, such as the ability of a company to sell itself to the highest bidder. But some simple changes could at least make risk making a little harder and thereby encourage more risk taking by investors with cash to spare. And the country desperately needs more risk taking given its paltry level of new business formation and the dilapidated state of its infrastructure.
Rules against “financial assistance” — common in some international jurisdictions — could be put in place to limit the extent to which companies can pledge assets to fund their own acquisition. (Companies could still be acquired with borrowed money but the investor would need to be the one borrowing it.)
The tax code could be changed to reduce the tax-advantage of interest over dividends. Under the United States tax code, companies can deduct interest paid on acquisition debt as an expense, unlike dividends paid to shareholders, which cannot be expensed. (The tax overhaul proposed by President Trump this week would make this change.)
Laws could make it easier to “pierce” the corporate veil or to bring suits for fraudulent conveyance when investors knowingly make decisions that leave a company materially weaker in order to enrich themselves.
Since these changes won’t come any time soon, risk making will remain an ever present danger regardless of the good that private equity may do taken as a whole. So if a private equity investor comes knocking on your company door singing sweet songs of risk and reward, be sure he really is a risk-taker, and not the malevolent doppelganger, before you let him in. And this Christmas, as you enjoy buying toys at “going out of business” prices, remember who to thank.