Toys “R” Us and the Rigged Economy
When Toys “R” Us filed for bankruptcy it was the latest casualty of the private equity industry. In 2005 a trio of private equity firms, including Mitt Romney’s Bain Capital, purchased Toys ‘R’ Us in a leveraged buyout or LBO. The LBO is the favored acquisition method of private equity firms. It’s also a classic example of the “rigged” economy.
An LBO is a heads-I-win, tails-you-lose gamble for private equity firms. An LBO works a bit like a home purchase with a mortgage: the private equity firm puts in a bit of its own money as a down payment, but most of the purchase price comes in the form of a loan. Here’s the catch: the borrower in an LBO is not the private equity firm, but the company being purchased. The target company—like Toys “R” Us—incurs the massive debt needed to buy out the existing public shareholders for the private equity firm. The private equity firm doesn’t owe any money as a result of the LBO and yet has acquired the target company for a fraction of the purchase price. If this leaves you scratching your head, it should.
Once a private equity firm has purchased a company through an LBO, it puts in its own management team. That management team doesn’t come free, however. The private equity firm will charge the target company handsomely for the privilege of its management expertise. The management team’s main goal is to make the company run lean and mean because there’s no other way it will be able to pay off the enormous debt it incurred in the LBO, 8x annual earnings in the case of Toys “R” Us. To pay down the debt, all non-essential expenses will be cut: research and development will be slashed, maintenance postponed, employees axed, pension obligations jettisoned. The whole LBO transaction is a gamble on whether the company will be able to cut operating expenses enough to pay down the debt it incurred to enable the LBO.
Sometimes the LBO gamble works: the cash-starved company is able to hang on and pay down the LBO debt. If so, the private equity firm will sell the slimmed down company back to the public after a few years. This is the heads-I-win scenario. The private equity firm put in perhaps 20% of the purchase price, but gets back 100% of the sale price, having extracted substantial fees along the way.
Sometimes, however, the LBO gamble doesn’t work: the target company, like Toys “R” Us falters under the weight of its LBO debt burden (which rendered it uncompetitive with Wal-Mart) and ends up in bankruptcy. By the time the company is in bankruptcy, it’s already severely damaged because of the starvation diet it’s been on trying to repay the LBO debt. This means that there’s a greatly reduced chance of the company being able to reorganize effectively in bankruptcy. In the bankruptcy, there are large losses borne by creditors, and they fall first on workers, suppliers, tort victims, and pensioners. Tails-you-lose. The banks that financed the LBO tend to do just fine—they get to cut to the front of the line for repayment—so they’re happy to keep on financing the transactions.
To be sure, private equity firms will lose most or all of their investment in the bankruptcy, but don’t feel too bad for them. The private equity firm isn’t on the hook for the debt incurred in the LBO. Moreover, the private equity firm’s losses are offset by the management fees it m has been charging for all the years prior to the bankruptcy as well as by the gains on successful LBOs. To cap it off, the private equity firm’s income is taxed at the low capital gains rate, rather than at the higher rate paid by regular wage earners and salaried employees. The LBO presents a lopsided gamble of substantial upside and limited downside. This is the very definition of a rigged economy.
Historically there were legal rules that limited this sort of gamble with other people’s money. Fraudulent transfer laws, which date back to the reign of Queen Elizabeth I, allow transactions to be voided when a firm incurs an obligation or transfers assets without receiving a reasonably equivalent benefit and is rendered insolvent as a result. LBO target companies, like Toys “R” Us fit this bill perfect—they incur large debts that render them insolvent, but receive no benefit themselves; the benefit all accrues to the private equity firm, which is gambling on the target companies being able to earn their way back into solvency.
Yet one doesn’t see LBOs unwound as fraudulent transfers. This is because Congress immunized LBOs through a provision in the bankruptcy laws that makes it near impossible to use fraudulent transfer laws challenge any securities transaction involving a bank. The provision dates back to the early 1980s—just when the LBO took off as a transaction form—although courts have subsequently interpreted it ever more broadly. The statutory protection of LBOs from attack as fraudulent transfers is a huge regulatory subsidy of the private equity industry as it lets the industry avoid any responsibility for the economic carnage created when LBOs fail (and fail they frequently do). It’s time to repeal this law. There’s no reason to subsidize LBOs. The gains go to private equity firms, while the costs are borne by American workers and businesses. If private equity firms and their financiers get the upside of LBOs, it’s only fair that they should bear the downside as well. Ending the heads-I-win, tails-you-lose gamble of LBOs is an important step in ending the rigged economy.