When we think about the holidays and the season of giving, we can’t help but feel some nostalgia for Toys “R” Us, the toy superstore which closed its doors in 2018. But in all honesty that nostalgia brings with it anger towards the two-word culprit responsible for Toys “R” Us’ demise: private equity.
The growing influence of private equity is one of the biggest threats facing our country, yet most people don’t know it, let alone how ubiquitous private equity is in their day-to-day lives. You may be one of the 13 million Americans employed by companies owned by private equity funds managed by firms like Blackstone, the Carlyle Group, and Apollo Global Management. But even if you’re not, it’s safe to assume that private equity has touched your life in another way or two. Today, private equity owns, among other things: hospitals, nursing homes, daycare centers, universities, food stores, pet stores, voting machine manufacturers, local newspapers, lumberyards, plumbing companies, and more. They even owned the rights to Taylor Swift’s first six albums up until this past May, when the pop star bought them back. In short, private equity is everywhere.
Private equity firms and their executives like to paint themselves as emergency surgeons that swoop in and resuscitate dying companies, but the facts and the experiences of workers and customers at places like Toys “R” Us tell a very different story. For this week’s Closer Look, we’d like to tell that story. We’ll start by explaining what private equity is and how their business model is harmful, and then use the tale of Toys “R” Us’ demise as a case study. Finally, we’ll close by highlighting some steps that can be taken to check some of private equity’s worst practices and mitigate the threat they pose to our economy and society.
Before we get started, we want to note that much of the source material for this week’s newsletter comes from journalist Megan Greenwell’s new and riveting book, Bad Company: Private Equity and the Death of the American Dream. Greenwell uses the personal stories of four different workers adversely affected by private equity firms to offer a broader critique of the industry. It is a great read, and we highly recommend it!
What is private equity and why is it bad?
Private equity firms collect money from outside investors—including public pension funds, university endowments, wealthy individuals, and state-owned investments funds—which they then use to invest in private companies or to take public companies private. They typically purchase companies entirely and take full charge of their operations. The investors then earn returns on their investments.
“Leveraged buyouts” are a key term to know in the private equity world. They work like this: private equity companies acquire companies with the purported aim of growing and strengthening them for a profitable exit, i.e. either selling them or helping them go public. Most of the money used in leveraged buyouts comes from bank loans though, and not from the firms or their investors.
Private equity firms and their executives don’t assume a lot of risk in their investments. For one thing, the debt that they take on to acquire companies in leveraged buyouts is technically not their responsibility to pay back; rather, it becomes the company’s responsibility. Also, most private equity firms have a pay structure that guarantees that they make money, and lots of it, no matter how their portfolio companies fare. Specifically, their deals with outside investors often follow a “2-and-20” structure: the private equity management company gets 2% of the total investment as an annual management fee, and the firm receives 20% of profits from deals beyond a set threshold. In addition to many other fees, the 2% management fee ensures that firms will make money even if their portfolio companies do poorly. In fact, research has found that two-thirds of private equity firms’ revenues come from their fixed fees and not from profits made by their portfolio companies.
The real risk-takers, then, in the world of private equity are the companies that private equity firms own—more specifically, their workers, their customers, and the broader communities in which they are situated.
You would think that private equity firms’ financial success would hinge on the success of their portfolio companies, but that’s not necessarily the case. That’s because the sole aim of private equity firms is to make money for the private equity fund managers—that’s it, plain and simple. And not in the long term, but in the short term. (The median “holding period” for private equity-backed companies is about six years.) Sometimes this involves strengthening and improving their companies by helping them improve products, marketing strategies, etc. But oftentimes, it literally involves letting companies go under and then selling their remaining assets, e.g. real estate, for parts. It’s no wonder, then, why Senator Elizabeth Warren has labeled the private equity industry “vampires.”
To be sure, some companies do well with private equity’s backing, but many, many others do not. On average, 4.4% of jobs are cut at companies in the first two years after a leveraged buyout. Private-equity backed companies are also much more likely to go bankrupt: In the first quarter of this year alone, 70% of bankruptcies among large companies were owned by private equity. Also, among companies that declare bankruptcy, those backed by private equity are more likely to go out of business.
The icing on this very bad cake is that research has found that, when you factor in all their exorbitant fees, private equity firms don’t actually offer much larger returns to their investors compared to what they’d get if they invested in the public stock market. In the end, the real and only winners in all this mess are the executives at the helm of the firms, many of whom are, not coincidentally, billionaires.
The sad case of Toys “R” Us
In its heyday, Toys “R” Us had 1,400 stores around the world. The superstore was so successful that business schools invented the term “category killer” to describe it, given that it dominated one part of the retail industry—toys—so effectively that it drove out all its competition from department stores.
Things started to change, however, in the 1990s with the growing dominance of Walmart and Amazon. Walmart’s one-stop-shop megastores and low prices proved difficult for Toys “R” Us to ignore. Meanwhile, Amazon ushered in the era of online shopping; Toys “R” Us initially made a deal with Amazon to be its exclusive provider for toys in exchange for giving up its own online sales platform, but this ended up costing Toys “R” Us more money than it gained.
Enter KKR, Bain Capital, and Vornado Realty Trust—two private equity firms and one real estate firm, respectively. They purchased Toys “R” Us for $6.6 billion in March 2005, over $5 billion of which was comprised of debt that Toys “R” Us then became responsible for repaying.
Things were relatively stable in the first few years under Toys “R” Us’ new private equity overlords, but ultimately, the company closed all of its 735 stores in 2018 and laid off all its 33,000 employees after filing for bankruptcy a year earlier.
Some may say that Toys “R” Us’ demise was inevitable in the face of Walmart and Amazon even if private equity didn’t get involved, but that’s not necessarily true. Toys “R” Us was so bogged down by interest payments from the debt that KKR, Bain, and Vornado saddled on its back that there was no money left over to spend on operations to properly compete. Among other things, they could have invested heavily to develop their web presence or revamped their stores to focus more on children’s experiences and entertainment, but they did not. And that’s KKR, Bain, and Vornado’s fault.
Perhaps the worst part of the story of Toys “R” Us’ downfall is how its 33,000 workers were treated in the aftermath compared to its executives and private equity owners. While the store’s workers did not receive severance pay, Toys “R” Us’ top brass received massive bonuses before the decision to close shop was announced. (KKR and Bain eventually gave Toys “R” Us workers a “hardship fund,” but it was $55 million less than what workers would have been owed through severance.) And KKR and Bain ended up making more money from Toys “R” Us than they originally spent on the deal.
Since its official closure, Tru Kids, which took ownership of Toys “R” Us’ intellectual property, opened several hundred Toys “R” Us stores within Macy’s. But it’s safe to say that it’s not the same, and the pain of losing Geoffrey the Giraffe as a fixture in American family life is particularly hard this time of year.
What’s to be done about private equity?
Toys “R” Us is probably the most well-known private equity horror story, but if you look around, it’s not too hard to find others. Residents of nursing homes owned by private equity firms are 10% more likely to die. Three years after they are acquired by private equity firms, hospitals experience a $407 increase in total charge per inpatient day.
Thankfully, legislators like Senator Warren have recognized the problem that the private equity industry poses and have devised solutions. In 2019, Warren introduced the Stop Wall Street Looting Act, which would, among things, force private equity firms to share responsibility for the debt they take out to acquire portfolio companies; prioritize workers’ pay in bankruptcy proceedings; increase transparency requirements; and close the carried interest loophole, a favorite tax break of the private equity industry.
Financiers like many of us have plenty of opportunities to become rich without completely destroying livelihoods and communities. The two aren’t necessarily mutually exclusive. But it just makes sense to have some guardrails to rein in some of our peers’ worst excesses to ensure that both risk and prosperity are fairly shared between workers and their owners, private equity or not.
In hindsight, the harms of private equity may have been more appropriate to highlight at Halloween given how scary the industry is and how much it is seeping into people’s everyday lives. But we still wanted to make sure you knew the truth about it before the end of the year, and especially if you were feeling nostalgic over Toys “R” Us this holiday season.