Private Equity hates inventory. Their first trick in buying a retail business is slashing in-store inventory. They also treat suppliers like dogshit, playing games with payment terms, etc. End result: stores don't have the products customers want and quality suppliers fire them as customers.
Was in Walgreens, and a woman was restocking the shelves. She had a series of reusable plastic boxes, but they were all labelled by isle. So she'd take the box to isle 5 or whatnot, and there'd be 5 products in it. Literally the products sold the day before. EG, one box of toothpaste, one brush, that sort of thing.
Asked her about it, and she loved it. Said before, she had to walk all over the store to restock, but not now. Later that week, I was in again and noticed a van unloading about 10 of the same reusable boxes.
Definitely a powerful way to keep stock levels down, even if not working towards a squeeze to close-out path. I wonder on the comparative on daily van delivery costs vs say.. a larger truck once a week, along with stock levels. Some very interesting math there, including regional supply depots stock levels, maintenance costs of larger trucks versus a van, and so on.
1) Buy a company from the stockholders by having the company take out loans (secured by future earnings) to pay for the stock. Do not pay for it with more than a token amount of your own money.
2) Slash company expenses in a way that generates short-term returns (but which normal companies don't do because it causes long term problems) like:
- don't buy new inventory to replace items sold (mentioned above)
- stop doing maintenance (saves money for a while, until everything breaks)
- delay paying outside vendors (works for a few months, until they stop shipping you stuff unless they get their money and/or sue you)
- sell physical assets (like the stores themselves) to an outside holding company (possibly owned by you) and rent them back, getting short term income for the company from the sale (but collecting the rent yourself, and also retaining the right to sell the real estate later).
3) pay yourself huge bonuses on the basis of your cost savings.
4) When the company is no longer viable, leave the empty husk behind. The company has a bunch of loans it will never be able to pay off (sucks for the lenders) but you keep your paychecks, bonuses and any assets you sold to yourself at below-market prices.
5) move on to the next company.
(basically, "the bust out" sequence from Goodfellas)
If you've heard of "Junk Bonds", this is (one source) of where they come from.
It's like a financial game of "hot potato" - you can make money as long as you're not the last person to hold the debt. So the answer to "who lends the money?" is "anyone who thinks they can sell the debt to someone else before it explodes".
In the end, a lot of it goes to "unsophisticated" individual investors, who will buy it based on "Sears (or whoever) is a great company, why wouldn't I buy their bonds" without realizing the full extend of what's happening.
Unfortunately, a lot of these and similar financial schemes end with the phrase "...eventually retail investors end up holding the bag and taking the losses." LBOs, collateralized mortgages, crypto, every equity that gets pumped and dumped. When every layer in the banking industry has skimmed its profit and did their own renaming/reselling/repackaging of these "products" finally there's some individual investor chump who takes the loss, making the numbers add up.
Competent risk management so that doesn't (generally) happen is a core competency for a bank, and if regulators think you're doing it wrong they will come down on the bank's leadership like a ton of bricks.
If anybody reading this comment would like to learn more from people who understand the area far better than I do, I would recommend patio11's 'Bits About Money' and Matt Levine's 'Money Stuff.'
But that's not what happened to Toys'R'Us.
"Raider" PE doesn't care about the high interest rates because they don't intend to pay them for long enough to matter, and - as mentioned in other replies - usually the sophisticated counterparty to the loans has identified a less-sophisticated other counterparty to sell the loans to and sees this as a risk-free deal that nets them origination fees. Suckers exist. Banks make it their job to find them.
Warren Buffet would insist that he's not in private equity because Berkshire's stock is publicly traded and there's no lockup. He has publicly stated that he thinks being a PE LP is financial malpractice.
The banks don't end up being the bag-holders in any case, because they securitize the loans.
PE firms mostly make money on the management fees they charge the company, and by stripping assets, so they're often OK if they lose money on the ownership stake. In any case, the PE principals make money from their LPs with fat fees on assets under management so even if the entire investment goes south, it's the LPs who ultimately take the hit (5-10 years later) and not the principals.
But then how does it pass banks's audit?
I.e. the deal for the bank is not "we're going to issue this loan and collect payments for it over the next 20 years", it's "we're going to issue $20M loans and simultaneously sell $21M of bonds backed by that loan. We skim the $1M difference for ourselves at basically no risk, and if the bonds default, they default. Not our problem."
Why do people buy the bonds?
- they think they can do the same thing - repackage the bonds as CDOs (collateralized debt obligations), skim a percentage and dump the risk on someone else. This possibly includes hiding the risk by combining multiple different kinds of debt, and then issuing different 'tranches' with different risk/reward levels. (this is what happened to a lot of mortgages in the 2008 financial crisis)
- they only plan to hold the bonds for a short time (the company will probably make the first few loan, and hence bond payments) and sell them to someone who's further removed from the original sale (who may have not done their due diligence) before things go badly
- they believe the private equity propaganda (propaganda works! at least sometimes) and actually think the bonds will be paid off.
How does that work exactly though? Loans from whom? Lenders watch Goodfellas too. They know the game here. Oh, a private equity firm wants to take out loans on the future earnings of this company they just bought. That sounds like it must be very profitable! Let's call off our due diligence.
Said no lender ever.
For a company like Toys R Us, there is still value in that brand name. You can reduce the quality of the store and coast on that recognition for a little while before people change their shopping habits. Put another way, how many bad meals would you have to have at your favorite restaurant before you stopped going? I bet it's more than one or two, as long as the experience isn't super terrible.
So for a lender, the questions you ask yourself are:
1. With cost cutting and other measures, how long do I think this business can last?
2. Once this business reaches bankruptcy, how much am I likely to recover on my loan? This involves figuring out how much in assets the company has.
3. What are the chances this business is able to be turned around?
There are situations where even if the company goes bankrupt, the lenders still made money.
Lenders aren't dumb. They know the reputation of the PE performing the buyout. If that particular firm has a terrible track record money to lenders, the lender will want to be compensated for that risk.
Ultimately, the people that "pay" for this are shareholders (who get zeroed out in bankruptcy) and consumers (who get degraded product/service quality for the same price; that's how the company stays afloat in the short term).
That's not a bust out then. If the lenders get compensated for their risk it's just a business decision.
The accusation was "The company has a bunch of loans it will never be able to pay off (sucks for the lenders)".
The accusation was that the lenders were in fact dumb.
So which is it?
The PE firm knows what they plan to do. The lenders know in a general sense what the PE firm plans to do, along with the track record of that firm's other LBO's and loans. Even if the outcome of bankruptcy is fairly certain, it's hard to predict how long it will take until that happens.
The point I'm making is that if you only look at the failures, LBO's look like a bust out. But I don't think the entire concept of an LBO is a bust out, which is why I don't think the lenders are dumb for underwriting these loans.
This looks a lot like selling some bad assets to some sucker investors. But the question a lot of people seem to ask in this thread is: when will the world run out of suckers? (Maybe this question shows how naive I am? Maybe some people know how to find these suckers one after the other?)
- Folks trying to ‘get a better retirement’ by buying riskier products.
- folks targeted by Wolf of Wallstreet types (or their more ethical brethren)
- folks trying to ‘get rich quick’
- folks trying to ‘double or nothing’ after a bad decision.
Etc, etc.
‘There is a sucker born every minute’ and all.
That assumes the PE company can predict exactly how long the expect the business to survive after takeover. They can't.
Both sides (the lender and the PE firm) are evaluating the company being purchased and the plan set out by the PE firm. The loan terms are set such that both sides feel they can make money on the deal.
The fact that PE doesn't make money on every deal indicates that they can be wrong.
The first thing is that, if at all possible, the PE wants to do a leveraged buyout where the acquired company itself has borrowed most of the funds to buy itself. This cashes out the previous investors, but leaves most of the risk with lenders rather than the PE firm. Sometimes the PE may get a cut of the financing revenue. Most of the loan will be sold on the bond market, typically as junk bonds. Junk bonds have high interest rates, because there's a good chance the loan won't be repaid, but maybe you'll collect enough between interest and the bankruptcy settlement.
While the company operates under the PE's management, it's getting paid management fees.
It's also likely to move valuable assets out of the company; for real estate, sale and leaseback is common; when the company implodes, the PE keeps the land and can sell or lease it to someone else. The sale price was probably under market and the lease over market, so the PE earns money here. Having a high lease payment helps the PE finance the purchase, and may help it finance similar property as well.
When the company goes bankrupt, the lenders have first priority for remaining assets, sometimes lenders will takeover a business and run it away from the shore and earn a profit that way, too.
Guess the key is:
1) Find a suitable monetary situation
2) Find companies that still have long term value but are struggling
3) Find a loan
4) Execute
Planet Money did an excellent podcast back in 2012 about Bain Capital buying and effectively destroying an iconic American manufacturer of legal pads. It's a great example of exactly this behavior: