Corporate Downfall: Why Companies Fail
Corporate Downfall: Why Companies Fail
Introducing Cap Stack
In the competitive world of business, the line between success and failure can be razor-thin. What drives a company to thrive in one moment, yet falter in the next?
Corporate downfalls are a complex labyrinth. Even the most promising businesses can crumble in the face of unforeseen obstacles.
Thriving in these environments is challenging. Companies need to make large scale high-impact moves that often require a large amount of capital. To accelerate growth and beat the competition, capital is borrowed.
Effectively managing the capital structure is mission critical to a company’s success.
When mismanaged, companies meet an untimely demise and find themselves handing over the keys to their lenders. Over years of working in distressed situations, we’ve seen this story time and time again. Companies either get ahead of themselves or fall behind their competitors. Sometimes industries change, and companies fail to adapt. In other cases, their industry faces disruption to such an extent that adapting is impossible.
As we explore the mind-bending, knife-fighting world of corporate failure, you'll be equipped with valuable insights to help you identify risks and make more informed decisions. At minimum, getting a glimpse inside this secretive world will sure as hell be entertaining.
Join us at Cap Stack as we delve deep into the heart of financial missteps, uncovering the pivotal role that corporate capital structures play in the success or downfall of a company.
Why Companies Fail
A leveraged buyout (“LBO”) is the acquisition of a company where most of the purchase is financed by debt.
The acquirer, generally a “private equity” fund, will put up the equity portion of the deal and take loans from a range of lenders to finance the rest.
A birds eye view of the private equity playbook is:
Identify and acquire undervalued companies
Use debt to pay for most (50-75%) of the purchase
Increase profitability through cost-cutting and operational improvements
Optimize the capital structure
Exit through a sale or IPO
Private equity funds use far less leverage today than they used to, with average Loan-to-Values closer to 50% compared to nearly 70% in 2005.
2005 was a big year for LBOs. In the years following the dot com crash, the value of LBO transactions soared, reaching $130B in 2005 at an average multiple of 8.1x EBITDA. A number of private equity buyers turned their eyes to everyone’s favorite toy store - Toys “R” Us (“Toys”). A consortium of funds consisting of Bain Capital, KKR and Vornado Realty Trust (a REIT) bought Toys in a $6.6B LBO. 80%, or roughly $5.3B, was financed by debt. The funds were interested in Toys’ real estate assets as well as the prospect of expanding to Asia.
12 years later, on September 8th, 2017, Toys filed for Chapter 11 bankruptcy. Those outside the world of distressed companies were appalled. How could the beloved store they had shopped at as a kid go out of business?
Problems with Toys
Well, maybe they weren’t that appalled. Competition was fierce in the toy industry and customers had cheaper options. Big box retailers like Walmart were willing to use toys as loss leaders and make up the margin by selling other products in-store.
The ecommerce trend had been accelerating and Amazon was experiencing massive growth. Toys’ online business on the other hand was lackluster and uncompetitive. They were doing too little, too late.
Over the years Toys had been unable to shed its massive debt. Leverage is both a double-edged sword. By investing a tiny sliver of equity, you can increase your return on cash. The flipside is that highly levered companies have large interest burden — over $400mm a year in the case of Toys. Too much cash flow going towards interest increases financial risk and makes reinvesting in the business difficult.
When companies are performing poorly, it can become difficult to attract and retain executive talent. If performance bonuses are deeply out of the money and the writing is on the wall for the company, employees may start to look elsewhere. The relationship the CEO has with the private equity owners may start to break down. Mismanagement and turnover were not doing Toys any favors.
By Q4 2017, the company operated 1,639 stores including 926 traditional Toys “R” Us Stores, 234 Babies “R” Us stores and 479 outlet/express stores. Toys also licensed 267 stores internationally. The business was global, complex, and slowly bleeding out financially.
Toys’ issues came to a boiling point following a news report stating that Toys was considering a potential bankruptcy. This report spooked vendors, and a collapse in trade resulted in the Company filing for free-fall bankruptcy.
Free-fall bankruptcy: when a company files for chapter 11 without a negotiated or agreed-upon bankruptcy plan.
When vendors lose confidence in a buyer’s ability to pay they may ask for tighter payment terms. Whereas a healthy company may have 90 days to pay, a company rumored to be on the brink of bankruptcy could have to pay cash upfront in-full.
With limited liquidity on hand and an already strained financial position, Toys cratered.
Why did Toys fail?
Years of mismanagement led to an uncompetitive business
Debt burden resulted in high cash burn
Vendors lost confidence in Toys’ ability to pay
Toys did not adapt to secular industry trends early enough
The Toys failure is a masterclass in the world of busted LBOs, corporate downfalls and expensive bankruptcy proceedings. Toys was an international business with a complicated organizational structure, multiple competing creditor constituents and billions of dollars at stake.
The dynamics of the bankruptcy will make for a fascinating story in a future Cap Stack post. Here’s a teaser:
Final Takeaways
Private equity funds do not hold on to their investments forever. The holding period is typically between three and five years, after which they look to exit their position.
When a fund holds on to a portfolio for longer than normal (especially over a decade!), it usually means the fund is unable to exit at favorable returns for one reason or another. Perhaps the broader market is weak, the industry has fallen out of favor, prospective buyers aren’t interested, or the company has fallen apart under their ownership.
While it’s seductive to believe that private equity firms were the sole drivers of the downfall of Toys, the business they purchased in 2005 was already facing challenges. There were multiple missteps along the way dating as far back as the early 2000s when Toys made the grave mistake of allowing Amazon to handle fulfillment. This undoubtedly served as a boon for Amazon who played a huge role in taking them out almost two decades later.
It’s a wonder that Toys chugged along for as long as it did.
Some might like us to believe that Toys never needed to file for bankruptcy at all. Had an article speculating about their demise never been published, trade terms wouldn’t have been yanked, and Toys could’ve hidden its problems in perpetuity. We’re not convinced, but it’s a cute story.
As we’ll explore more deeply in future posts, the world of bankruptcies has many wonderful storytellers. Especially when there are bills to be paid.
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Disclaimer: We are not financial advisors. This content is for educational purposes only and merely cites our own personal opinions.