Sebastien Canderle, former director at The Carlyle Group, recently published his latest book. The following is an excerpt illustrating how specialist retailer Toys “R” Us wrestled with its demanding leveraged buyout debt obligations years before even contemplating a bankruptcy scenario.
No doubt Toys “R” Us would have agreed to make sacrifices just to engineer its relisting. Management kept working its way through the balance sheet, tackling each tranche of debt one at a time. In August 2010 it extended the maturity of the working capital facility and increased the group’s borrowing capacity. The same month it issued a new $350 million bond and $700 million in term loans to repay existing facilities. That gave the retailer the luxury to wait until the IPO window opened with more conviction.
Early the following year, all parties – lenders, underwriters, investors – waited to see how the year-end trading figures would look. They needed to be robust to win over the markets. Especially because the IPO plan faced a major challenge. Comparable valuations had tanked since the time of the toy retailer’s delisting. Bain, KKR and Vornado had bought the business at a rich valuation exceeding 9 times trailing EBITDA, or 10 times prior-year earnings. With comparable companies trading below 8 times in 2010, down from 10 times five years earlier, the PE owners were looking at a negative-multiple arbitrage upon exit. That is, if they could exit
EBITDA was up two-fifths since the leveraged buyout, but it had been hovering at around $1 billion for the past four years. The lifeless state is not a healthy one in a leveraged buyout situation. Debt payments accrue according to the all-powerful and universal law of compound interest, the eighth wonder of the world according to no less an authority than Albert Einstein. If debt commitments go up, so must EBITDA as a cash proxy and safeguard against the threat of loan covenants. Logically, the company’s financial sponsors were eager to get on the IPO bandwagon. Proceeds raised from the markets would be more than welcome. They would help pay down some of the loans; bonds worth $500 million were falling due in the summer of 2011.
Alas, the retailer’s new-found prosperity proved evanescent. The year-end holiday season of 2010 saw sales fall on the prior year, both domestically and internationally. American consumers were bargain-hunting while the UK and Spanish economies were still reeling from the financial crisis. Sales were only up 2% despite the company’s extensive use of pop-up stores. With fourth-quarter trading accounting for two-fifths of group revenues, only a great festive season could have provided the perfect background to an IPO. Instead, poor results hurt the group’s financial position. In the year to 29 January 2011 cash flows from operations crashed 80% due to aggressive marketing and discounting. Net debt shot up 10%, while the interest cover reverted to 2, meaning that earnings were only twice as large as interest payments, an uncomfortably tight level even for a covenant-lite leveraged buyout. The relisting had to be parked away for now. The NYSE would have to wait.
To secure more runway, the company actively tried to refinance a quarter of its debt, if only to benefit from the all-time low interest rates. But all the market would let management do is amend and extend part of its existing loans. Ongoing trading difficulties prevented a more favourable negotiation. In the year to January 2012 competition intensified, affecting profitability and cash flows. Over the previous two years, EBITDA margin had fallen from 8.5% to 7%. For the second year in a row, operating cash flows failed to cover either capital expenditure or interest expense.
With $1.4 billion in near-term maturities, the company was soon forced into another round of re-engineering. In March 2012 management launched a $300 million issuance to refinance domestic loans. In April, it was the turn of the British operations to be restructured ahead of a deadline to repay more than £400 million of loans. Then, in July, the group launched a high-yield note worth $350 million. In the face of competitive pressure, throughout 2012 Toys "R" Us continued to experience poor trading, to such degree that revenues from new store openings no longer compensated for the ferocious slump in like-for-like sales. Full-year revenues and EBITDA to 2 February 2013 were both down more than 2%.
The frustrating situation was made even more untenable by the successful portfolio exits that private equity firms achieved in these early stages of the economic recovery. In March 2011 Bain Capital and KKR themselves scored America’s biggest ever PE-backed IPO by listing hospital operator HCA, finally heading for the door five years after buying the target at the peak of the cycle. KKR also made over 2.2 times its equity on the partial realisation of British wholesaler Alliance Boots when, in June 2012, it sold 45% of the business to US giant pharmacy store chain Walgreens. Because of its weakened market position, Toys "R" Us was proving a more problematic exit candidate.
Article by Sebastien Canderle
Sebastien Canderle is the author of The Good, the Bad and the Ugly of Private Equity