On the one hand, the punishment that some pension funds are considering meting out to private equity kingpin KKR over its role in the Toy ‘R’ Us bankruptcy would be so small as to amount to couch lint.
On the other, as we’ve documented at considerable length, private equity investors, and in particular, public pension funds, are so badly captured by the private equity industry that they haven’t even criticized, much the less done anything about, SEC speeches and enforcement actions that revealed widespread abuses, including ones that were tantamount to stealing. Informed sources tell us that virtually no public pension funds asked private equity firms about specific abuses they had engaged in, much the less told them to cut it out.1
Since it is completely out of character for public pension funds to make even a feeble protest over the well-established private equity practice of company wreckage, which they depict as an unfortunate but inevitable risk of their tender ministrations, one has to wonder what’s afoot.
Although it is way too soon to determine what this incident portends, at a minimum, some investors are flexing badly atrophied muscles. The open question is whether Toys ‘R’ Us is a special situation, or whether investors are finally starting to become skeptical of private equity even as they continue to throw money at the strategy. Cognitive dissonance would still be an improvement compared to blind faith.
But why would the death of Toy R Us be different than any of a myriad of other private-equity-induced business failures? One reason is that the overleveraging of the retailer was more directly responsible for its collapse than in other company deaths. Another was that the media, and more important, Congresscritters took interest.
Recall that Toys ‘R’ Us filed for bankruptcy last September and shuttered one-fifth of its stores in January in an effort to keep the chain going. In March, the company threw in the towel, announcing it was liquidating its US operations, which destroyed 33,000 jobs.
The fact that Toy ‘R’ Us is stiffing workers on severance, after petitioning the bankruptcy court in September to pay executives $20 million in incentive bonuses, was too obvious a case of looting to ignore. A story in The Week, How vulture capitalists ate Toys ‘R’ Us, recapped the slow strangulation under too much debt, after Bain, KKR, and Vornado bought the company in 2004 for $6 billion, with only $1.2 billion of that in equity:
Whatever magic Bain, KKR, and Vornado were supposed to work never materialized. From the purchase in 2004 through 2016, the company’s sales never rose much above $11 billion. They actually fell from $13.5 billion in 2013 back to $11.5 billion in 2017.
On its own, that shouldn’t have been catastrophic. The problem was the massive financial albatross the leveraged buyout left around Toys ‘R’ Us’ neck. Just before the buyout, the company had $2.2 billion in cash and cash-equivalents. By 2017, its stockpile had shriveled to $301 million, even as its debt burden ballooned from $2.3 billion to $5.2 billion. Meanwhile, Toys ‘R’ Us was paying $425 million to $517 million in interest every year.
This enormous cash drain probably made it impossible for the company to invest or innovate even if its trio of buyers had been up to the challenge. It also made it impossible to sustainably turn a profit. Toys ‘R’ Us consistently saw net losses from 2014 to 2017. But in the last three years, those net losses were considerably smaller than its debt payments. In fact, the losses were shrinking amidst a general boom in toy industry sales; by 2017, its losses were all the way down to $36 million.
In other words, if Bain, KKR, and Vornado had never come along, Toys ‘R’ Us wouldn’t be doing stellar, but it probably could’ve muddled through. As recently as last year, the company still accounted for 20 percent of all U.S. toy sales.
The Week states, with no citations, that the three partners took out $200 million in fees. If anything, that figure is light.
Very large buyout funds, and the Bain and KKR funds could have been in that category even back then, charge somewhat lower management fees than the prototypical 2%. But a fund from the early 200s would almost certainly have had less than full management fee offsets, so the manager would also have been collecting fees directly from portfolio companies like Toy ‘R’ Us and would up retaining some of those monies on a net basis. So 2% per annum across all charges, particularly given that Toys ‘R” Us made a raft of add-on acquisitions, which means transaction fees on top of the usual “money for nothing” monitoring fee, is a reasonable guesstimate. If you assume 12 full years of fees on $1.2 billion, you get close to $290 million in fees.2
Next remember that that $1.2 billion was almost entirely limited partner money. We’ll charitably assume the general partners put up 5% (1% to 3% is the norm, but KKR puts more of its own money into funds than typical general partners). That means they had $60 million (more likely less) of their own money in the deal, and pulled out nearly five times that much in risk-free fees.
You can see why some people might be upset. But private equity is a “heads I win, tails you lose” proposition. Unless they so badly miscalculate that a company implodes quickly, private equity firms make out very nicely even when they wreck companies and let the limited partners absorb the losses.
The shafted workers have gone to legislators to try to get help in getting their severance. Sadly, with the company in the hands of the bankruptcy court, this campaign is certain not to go anywhere. But as a consolation prize, officials are at least having a go at the private equity barons, which is unusual given their status as alpha campaign funders.
As Jerri-Lynn noted, USA Today featured an op ed by Bill Pascrell, a New Jersey Congressman whose district included the company’s headquarters for 16 years: Amazon didn’t kill Toys R Us, greedy Wall Street profiteers did it. Pascrell, along with New Jersey Senators Cory Booker and Bob Menendez, sent a letter to the three investors and led a protest at the old Toy ‘R’ Us headquarters. Former employees also demonstrated at the firms’ head offices.
In a sign of a possible major shift, the Washington Post published a sympathetic article on June 1, How can they walk away with millions and leave workers with zero?’: Toys R Us workers say they deserve severance. And notice the bomb in the story (emphasis ours):
Now, some workers are calling on lawmakers to create new rules that would require bankrupt companies backed by private-equity firms to provide compensation to their workers.
On Friday, more than a dozen workers met with lawmakers in New Jersey, where Toys R Us is based, to push for severance pay. Workers also called for new regulations on leveraged buyouts, as well as windfall taxes that would prevent private-equity firms from running a business into the ground and then walking away with huge sums of money.
Given how much private equity firms rip out of companies, it wouldn’t dent anyone’s net worth to pass legislation that would require a private fund, or better yet, the general partner, to be obligated to fund employee commitments, such as severance and pensions, in the event of bankruptcy. I leave it to the legal mavens; perhaps the monies could be collected as a fine and then paid to workers.3 However, private equity firms treat anything that gets between them and their perceived God-given right to unimaginable amounts of lucre as a mortal threat. So if any proposals like this were to move forward, you can rest assured that the ferocity of opposition will be vastly out of proportion compared to the probable economic impact.
So in a form of Toys ‘R’ Us blowback, the press is validating the notion that state or national government should intercede on behalf of workers against private equity firms. How have public pension funds, whose monies come from state and local employees, reacted? From the Financial Times, KKR faces pension fund ire over Toys R Us collapse:
Pension funds that have invested billions of dollars with KKR are re-examining their relationship with the investment group amid anger over the treatment of workers at the bankrupt retailer Toys R Us.
One state investment board has suspended new capital commitments to KKR while it evaluates the group’s conduct, and another has referred an investment in KKR’s new Europe-focused fund back to its board…
…officials at the Minnesota State Board of Investment told the Financial Times that they would commit no new capital to KKR while they investigated “testimony that raised concerns about the management of Toys R Us and its employees”.
The story mentions early on that several public pension funds “invited testimony” from former Toy ‘R’ Us employees. Misleadingly, the first worker statements it mentioned are from the CalPERS board meeting last week, and that most assuredly was not solicited by CalPERS. It isn’t uncommon for workers from companies bankrupted by CalPERS funds to come to Sacramento to plead their case in public comments, as they did for instance, with the Caesars bankruptcy.
In fact, the live webcast for the CalPERS Investment Committee meeting last week cut out precisely when the Toy ‘R’ Us employees came forward to speak. The CalPERS live webcast almost never goes down, and the last time I saw it happen was when Real Desrochers was floundering. In other words, the outage looked to have been awfully convenient then too.
Not only does CalPERS have institutional reasons to blunt the effect of well-warranted criticism of private equity,4 but personal loyalties may also have played a role. CEO Margie Frost has said she regards KKR co-founder and co-CEO George Roberts as a friend.5
In addition, the Washington state pension fund, where Frost spent virtually all of her career, is even more of a private equity enthusiast than CalPERS and is extremely loyal to KKR. If you have read any of the classic accounts of the growth of the leveraged buyout business, they make clear that KKR being the first LBO fund to win a public pension fund commitment, which was from Washington, was a watershed. Washington even promoted KKR to other public pension funds, including CalPERS.6
With that background, this section of the Financial Times story comes off in a different light:
“We feel terribly for all these employees who lost their jobs,” KKR’s Nate Taylor told an investment board in Washington state, which had committed about $10bn to the group since investing in the first KKR buyout fund in 1982…
Washington state ultimately decided to proceed with an investment in KKR’s new infrastructure fund, after two public meetings in which senior executives were asked to account for the firm’s actions.
However, officials signalled they would subject the group to extra scrutiny in future. A mooted commitment to a Europe-focused KKR fund, which had already received conditional approval, will now be referred back to the full board for consideration.
In other words, this looks like political theater in light of KKR’s widely known tight relationship with Washington. But at least Washington feels the need to show some sensitivity to appearances. CalPERS’ response, as when it cut off board member Margaret Brown’s microphone, is instead to silence anyone they regard as a threat.
1 More accurately, FOIAs of public pension funds revealed that while some did send out questionnaires, they were so poorly formulated as to allow the private equity firms to provide vague and potentially misleading answers. Even the few that were sufficiently specific often elicited responses that if you parsed them carefully, were de facto admissions of bad conduct, yet the investors did not act on them. While it is hard to prove a negative, there was also an absence of evidence of investors expressing displeasure or even much concern about the conduct sanctioned by the SEC.
2 The 2% management fee applies only to the investment period, which is usually the first five years of a fund, and then steps down. However, that also means there is less management fee against which to offset all of those juicy portfolio company fees that are opaque to investors.
3 Note the law would need to ding the responsible party, which is the fund manager, and not the fund. This idea would be administratively untidy since the unemployed workers would have to apply and prove they were eligible. I welcome suggestions as to how to achieve this end.
The usual objection is “Oh, no, you can’t do that. Any state that implemented legislation like that would be red-lined by private equity firms.” First, the red lining means not having PE companies buy businesses that have any/many employees in states with worker protections against private equity asset-stripping. Given how even the largest scale study, when read properly, showed that private equity firms reduce headcount even faster than other similar employers, I don’t see why this is a bad thing, since fewer jobs means lower state and local tax revenues. Second, if the state legislators are still worried, they can include a clause that the law does not become effective until either X more states or states with a total of at least Y in population in total pass similar legislation.
4 When the live webcast goes down, the video typically has not failed, so the missing section is part of the video on YouTube, as well as captured in the official transcript. However, Toys ‘R” Us workers who watched the board meeting to catch the public comment were stymied, as would have been any television outlets who might have considered recording from the live webcast and including clips in a segment.
5 The context of the remark was that Roberts called Frost after she joined CalPERS, and the party who heard Frost describe the exchange said he thought that Frost was utterly sincere in saying that she thought Roberts was a friend by virtue of his keeping up with her. The source was shocked and appalled to see Frost act as if she did not understand that Roberts is a friend only of the money she represents.
6 Frost has also been engaging in revisionist history to boost private equity. In last week’s Investment Committee meeting, she falsely claimed CalPERS started investing in private equity in the early 1980s. I got the entire record of CalPERS’ private equity program, the same data they once used as the basis for making statements about returns “since the inception of the program.” That data starts with the first quarter of 1990 and shows only one fund as of then, a $100 million commitment to Warburg, Pincus Investors, L.P., with the vintage year 1990. I am told CalPERS made its first private equity investment in 1988 but I am at a loss to see how it would not have been included in the records starting in 1990 (Perhaps CalPERS made a commitment to a fund that didn’t close, or the Warburg Pincus closing was very much delayed due to upheaval in the LBO industry?).