🔑 2 nearly identical deals: Why one made 5x and the other failed

Private equity loves to buy retail businesses.

Staples, Macy's, and PetSmart are a few mega PE buyouts you might know about.

But today I want to focus in on two fascinating PE deals that closed just before the 2008 recession.

One was a disaster. And one wasn't.

Deal #1: Toys "R" Us

In March 2005, a consortium of KKR, Bain Capital, and others bought out Toys "R" Us.

The deal went down in infamy.

Here are the details:

• Close date: July 2005.
• Target: Toys “R” Us, Inc. (toy stores + Babies “R” Us)
• Buyers: KKR, Bain Capital, and Vornado Realty Trust (about 32.9% each) plus others.
• Deal value: $6.6 billion
• Sponsor equity: $1.2 billion
• New debt at close: $4.4 billion

The new owners of the business added billions in debt to the balance sheet and eventually drove the company into bankruptcy within a decade.

They also drew scrutiny by pocketing about $450 million in interest and $185 million in advisory fees along the way.

The former leader of the toy industry, Toys R Us filed for Chapter 11 bankruptcy in September 2017 after years of slipping sales and mounting debt. While intense price competition from mass retailers Walmart, Amazon, and Target has contributed to the company’s woes, experts place the blame squarely on the shoulders of management. They said Toys R Us has failed to innovate its business model, incorporate technology or adapt to changing consumer behavior.
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The day of reckoning may have been delayed through a $7.5 billion leveraged buyout in 2005 by private investors Bain Capital Partners, Kohlberg Kravis Roberts, and Vornado Realty Trust. But the debt payments proved to be too much for the company,
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- Wharton case study,

By the mid-2010s the company was generating operating profit ($378 million in 2015),

But interest and capex ate it all up (and then some).

Interest expense alone was $450 million annually.

The business recorded a net loss of $130 million for 2015.

Sadly, that was one of the better years of the decade (the loss was $1 billion for 2013).

The business couldn't escape this death spiral of interest payments and a struggling business model.

It went bankrupt in 2017.

Was this a case of blatant greed by PE?

Well, not exactly.

Yes, there were some misaligned incentives. But Toys "R" Us was fighting a losing battle against Amazon.

They needed billions to retrofit the company from the huge big box store model to an e-commerce business.

But they didn't have the time or the cash.

Ultimately, the company failed and equity went to zero.

Let's take a look at a different deal from the same time.

Deal #2: Dollar General

Nearly two years after the Toys "R" Us deal, KKR agreed to take Dollar General private at $22 a share.

The deal valued Dollar General at $7.3 billion including assumed debt.

The deal terms:

• Close date: July 6, 2007
• Target: Dollar General Corporation
• Buyer: KKR (TPG dropped out before the final bid; Goldman Sachs PE later participated on the equity side)
• Premium: about 31% to the March 9, 2007 close
• Deal value: $6.9 billion for the equity, or $7.3 billion including net debt assumed

The plan was to take Dollar General private, fix up the business's glaring weaknesses, and take it public again for a profit.

Some of those weaknesses included:

• Too many weak stores
• Sloppy expansion
• Declining same-store sales.

To close the LBO, the group of investors added about $5.4 billion in new debt to Dollar General.

To fund the $22-a-share take-private, the company raised a large new stack of loans and bonds. Around close it expected about $5.4 billion of total debt. The new paper included a $2.43 billion term loan B, plus large senior and subordinated notes (the bond package was resized in the market; one early plan was a $1.9 billion high-yield sale on top of the term loan). Equity from KKR and co-investors was about $2.8 billion, so more than 60% of the ~$7.3 billion enterprise value was debt.
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- Supermarket News, June 2007

KKR bought the company just at the right time before credit markets dried up- this deal would not have been possible a year later.

And ultimately their new plan worked.

Just two years later, they re-IPOd Dollar General after fixing up the company.

Because there were several investors and they sold off their stakes gradually over several years, there isn't an exact ROI figure.

But here are a few pieces of information we have:

• The buyout group put in about $2.8 billion of equity in July 2007
• They exited in slices from the November 2009 IPO at $21 through a final block in December 2013 at $60.71. That last sale was 3x the IPO price.
• Goldman put in $605 million and nearly quintupled that stake by spring 2013.
• Estimates put KKR's return at about 5x over a 5-year average hold period.

Same strategy, two different results

The Toys "R" Us and Dollar General deals look similar at first.

They happened around the same time, were for similar amounts, used similar structures, and even had the same investors.

Both companies were struggling retailers at the time.

So what was the difference?

It wasn't the structure that caused Toys "R" Us to fail, like many think.

At the end of the day, the turnaround was just too difficult to execute and Amazon was too fierce a competitor by the mid-2010s.

There were external forces that caused both business to struggle.

Sometimes you have the cash and time to pivot (like Dollar General).

And other times, interest expense eats up the business before you can execute a turnaround (like in the case of Toys "R" Us).

Sieva

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