At the time, it appeared life-saving surgery for Toys R Us. In 2016, a trio of private equity firms that had paid almost $7bn for the toy retailer 11 years earlier offered owners of about $600m of unsecured bonds new debt that came sweetened with a stronger claim on the company’s assets.
As a result, the deadline for debt that had been due to mature in the next couple of years was pushed out to beyond 2020, giving the battered retailer a shot at recovery. Salvation never came though, and in September 2017 Toys R Us filed for bankruptcy.
Fierce competition from the likes of Amazon took most of the blame for the company’s demise. But observers also pointed to a $5bn debt structure so complex it made a job-destroying liquidation the best choice for Toys R Us’ creditors. The company could have pursued a reorganisation, but its web of debt and other liabilities was simply too tricky to untangle.
That kind of messy denouement will not be the last, warn bankruptcy and restructuring experts, after a decade in which private equity firms have put together a string of buyouts fuelled by cheap money and with weak protections for debt investors.
“There are now companies whose once-conventional capital structures have been turned partially upside down,” said Joshua Feltman, a partner at law firm Wachtell, Lipton, Rosen & Katz in New York. “That’s going to make workouts much more difficult to get done.”
The consequence may be a sharp divide in the type of corporate bankruptcies the next US recession delivers. On the one hand will be smaller companies not owned by private equity firms, which can reorganise themselves relatively swiftly. On the other will be billion-dollar companies with private equity owners, such as Toys R Us, whose byzantine debt structures will lead to lengthy, litigious and very costly bankruptcies.
The workout of Toys R Us, for example, cost $200m in adviser fees.
These battles may appear to be waged between private equity owners and often sophisticated credit hedge funds, but individual investors are likely to get caught in the crossfire too.
In recent years, leveraged loans, a favourite funding tool for buyouts, have become more popular with retail investors, lured by a buoyant market and relatively few defaults.
That extra demand has stretched balance sheets, as companies have piled on debt. Private equity-backed borrowers had an average ratio of first-lien debt (a company’s most senior obligation) to ebitda of just under four times in 2005 and 2006, according to Fitch. But that had jumped to nearly six times by the third quarter of 2018.
“Going into the last cycle, leveraged loans and high-yield bonds were mainly held by institutions,” said Bruce Bennett of Jones Day, referring to the banks and insurance companies that previously dominated ranks of buyers.
But between the start of 2016 and the end of 2017, more than $20bn flowed into retail leveraged-loan funds, according to Lipper. Such investors “may not be ready for the effects of higher rates, larger spreads and increased default rates”, said Mr Bennett.
Another factor adding to complexity: documents on the bonds and loans underpinning buyouts have been written loosely enough to allow companies to move corporate assets out of reach of senior creditors, or to sell them, for the benefit of the private equity owner.
Take intellectual property. Perhaps the most notable case was J Crew, the US fashion chain, which shunted $250m of intellectual property to a new subsidiary out of the reach of senior creditors in 2016. That entity then issued debt to repay holders of the junior debt, which had been trading at distressed levels.
Other retailers have since done similar deals; Neiman Marcus was the most recent.
However, lawyers are warning that credit hedge funds and mutual funds are increasingly likely to pursue legal action to challenge such transfers of assets.
In the case of the 2015 bankruptcy of the Caesars casino chain, for instance, an independent examiner found that the private equity sponsors breached their fiduciary duties to creditors by selling assets perhaps $4bn too cheaply. The sponsors, Apollo and TPG, ultimately settled with bondholders out of court, while denying any wrongdoing.
“The norms that used to restrain managers of distressed firms from declaring all-out war on creditors have been fading since the financial crisis,” wrote Jared Ellias, of the University of California, Hastings, and Robert Stark, a lawyer, in a recent paper entitled “Bankruptcy Hardball”.
A huge wave of defaults may not be imminent. Moody’s, the rating agency, expects that the US corporate default rate will edge up to 3.4 per cent by year’s end, from 2.8 per cent at end-2018.
However, when a slowing economy does eventually trip up overleveraged companies with convoluted capital structures, the battle to carve up whatever spoils are left will be messy, said Jim Millstein, a restructuring veteran who now co-chairs Guggenheim Securities.
“Whether there are valid claims or not, it becomes a field day for the lawyers,” he said.
