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  • Gretchen Morgenson and Lillian Rizzo

Who Killed Toys ‘R’ Us? Hint: It Wasn’t Only Amazon

When Toys “R” Us sought bankruptcy protection last September, there was good reason to believe the iconic retailer would work through its problems and emerge a leaner but viable company. Its suppliers were confident enough they continued to fill its shelves with toys.

On March 15, however, to the surprise of most people involved, the 70-year-old company announced it was shutting for good. Some 33,000 workers lost their jobs. Vendors now face at least $350 million of losses. The toy maker Mattel Inc. took a big hit to its bottom line.

Many factors contributed to the retailer’s troubles, including the costs of a leveraged buyout, competition from Inc. and a disastrous Christmas season. What pushed it over the edge, however, was a small group of hedge funds.

Solus Alternative Asset Management, a New York hedge fund, pressed four other Toys “R” Us debtholders to conclude that the company was worth more dead than alive, according to two Toys “R” Us directors. That was enough to halt the company’s frantic restructuring effort.

Toys “R” Us “had real people, credible institutions, engaged in a serious discussion around potentially reorganizing the company,” said David Kurtz, head of restructuring at Lazard and an adviser to the company, at a March court hearing. There was a deep-pocketed investor talking to the company about backing the effort, he said.

Yet before the company could finish pulling together a reorganization plan, the five debtholders ran out of patience. They held a critical piece of secured debt with a face value of $668 million—a minority of the $5.3 billion of debt the company listed when it sought chapter 11 protection, bankruptcy court records show. Under the company’s complex capital structure, they had the power to essentially stop the clock on the reorganization effort. Toys “R” Us concluded it had no choice but to liquidate.

Creditors have long played a key role in determining whether companies operating under chapter 11 bankruptcy protection will live or die. The five funds in this case—they also included Angelo, Gordon & Co., Franklin Mutual Advisers, Highland Capital Management and Oaktree Capital —were exercising their rights as creditors and their duties to generate returns to their investors.

In an Aug. 21 letter to a Toys “R” Us employee-advocacy group, lawyers for Solus and Angelo Gordon said, “the unfortunate result for Toys “R” Us was neither our clients’ desired result nor caused by our clients.”

Today, as the Toys “R” Us case shows, these kinds of creditors wield more influence than ever. Since the financial crisis, the practice of layering companies with tiers of debt has become more common, restructuring experts say, which adds to the complexities of bankruptcy filings. As hedge funds and other investors accumulate stakes in these tiers of debt, they can gain a so-called fulcrum or crucial position in restructuring negotiations.

“Secured creditors have developed greater power to control the process than Congress expected them to have when it created chapter 11, and probably more than is healthy for a system in many cases,” says Jonathan Lipson, a Temple University professor focused on bankruptcy. “Hedge funds have their own liquidity needs, their own investors looking for certain kinds of returns in certain periods. It can be hard for them to be patient with a reorganization process.”

The chapter 11 bankruptcy system is designed to provide a transparent and fair process for resolving creditors’ claims against financially troubled companies. It sets up a pecking order among those who are owed money, with secured bank lenders generally sitting at the top, bondholders in the middle—secured, then unsecured—and stockholders at the bottom.

The $5.3 billion in debt Toys “R” Us listed when it filed for bankruptcy on Sept. 19 was a hangover from a $6.6 billion leveraged buyout in 2005 at the height of that decade’s buyout boom. Private-equity firms Bain Capital and KKR & Co., along with Vornado Realty Trust, led the buyout and have been taking heat for the retailer’s demise, partly because their deal loaded up the company with debt. The rise of online competition and the company’s outdated stores also contributed to its woes. Bain, KKR and Vornado say they invested more than $1.3 billion in the Toys “R” Us deal and wanted the company to stay alive, but were unwilling to put in more money.

The role played by Solus and the other funds in the company’s demise has attracted less attention.

Distressed-debt investors typically buy debt at a discount to the original dollar value. It couldn’t be learned how much the five funds paid for their Toys “R” Us holdings, but court records and price data indicate that Solus bought much of its position for less than 50 cents for each dollar of face value.

Solus, a $6.3 billion hedge-fund company founded in 2007, was among Toys “R” Us’s smaller debtholders early on. By this June, it had become the largest holder in the debt issue known as B4, with $221 million in face value of the $1 billion issued. That layer of debt became pivotal to the reorganization effort because its holders had supplied collateral for additional bankruptcy financing.

Solus contributed $31 million at the time of the bankruptcy filing for what is known as debtor-in-possession financing, which kept the retailer operating through last Christmas—money that, under bankruptcy law, is first in line for repayment.

A research report from HSBC says Solus also bet against Toys “R” Us debt by placing a $25 million short position in another debt security, possibly in an effort to hedge its debt holdings.

Solus has said that buying into troubled companies that are likely to be liquidated generates higher and more reliable returns. “Unlike traditional distressed opportunities, liquidations remove valuation and process risks,” the firm noted in a 2012 presentation at a hedge-fund conference, meaning its money wouldn’t be tied up in lengthy reorganizations.

At Toys “R” Us, the decision by vendors to continue shipping merchandise after the chapter 11 filing meant shelves were loaded with new and in-demand goods that could be sold quickly and easily in going-out-of-business sales. That would make for a speedy payoff for creditors.

The company’s management, directors and advisers met twice a week throughout the bankruptcy process searching for ways to save the company, according to the two board members.

The group considered finding a new investor or buyer, slimming down the chain to a smaller number of stores and anchoring the North American business on its Canadian operations. A U.S. without a Toys “R” Us presence was never under consideration, say the two directors. All the options would have required some leeway from the B4 lender group, the two directors say.

The company and its representatives pleaded with Solus and the other B4 debtholders to waive a requirement that the company’s forecast maintain a certain level of cash flows in its operations, court records show. The funds agreed to such a waiver in January. That deal was set to expire on March 3.

Mr. Kurtz, the company’s adviser from Lazard, recalled in a later court hearing what he told the funds. “You guys really should get on board and help us support” the company’s effort to continue operating, he recalled saying, because that is where the most value will be created. He said he then described “why the management team believes that we can and will be successful.”

The company hadn’t yet put together a formal restructuring plan, which would have laid out exactly what each class of debtholders would receive in exchange for their defaulted debt. Yet certain conditions were clear, court documents show. Although Solus and the other funds wouldn’t have had to put additional money into the company, they would have had to subordinate their claims to any new investor who put in money to help the company reorganize.

Earlier this year, some of the funds holding B4 debt alongside Solus were supportive of the reorganization, a person familiar with the situation said. One of them was Marathon Asset Management. Solus bought out Marathon’s stake earlier this year. Marathon declined to comment.

In March, when the waiver was set to expire, there was still no deal in place. On March 5, the B4 debtholders told the retailer they would extend the waiver for one week on two conditions—Toys “R” Us had to stop paying its landlords and some vendors.

The company felt that wasn’t enough time to put together a deal. Up against the wall, it decided to liquidate.

The fund companies told the bankruptcy court they recognized a liquidation would cause pain. Acknowledging the funds would benefit from the wind-down, their lawyers told the court in April that a liquidation presented creditors with “a path to stability and value preservation in a very difficult situation.”

Not all creditors saw it that way. Crayola LLC, the crayon manufacturer, was owed roughly $2.3 million for goods shipped between December and early March, one week before the liquidation announcement. “These Debtors have called it quits and are liquidating solely for the benefit of their senior secured lenders,” a Crayola representative said in court papers.

The decision to liquidate Toys “R” Us and its 800 stores has affected suppliers, employees, even the taxing authority in Wayne, N.J., where the retailer was based. According to Moody’s Investors Service, the company was Wayne’s third-largest taxpayer, contributing $2.1 million to town coffers in the 2016 fiscal year, or 2.5% of its operating revenue.

Toy makers large and small are bracing for possible revenue declines. Toys “R” Us was Mattel’s second-largest customer. Mattel recently reported that sales declined 14% in the second quarter. It could lose millions on shipments made to the retailer after January, court documents indicate, and it has announced large layoffs.

When Circuit City Stores Inc. and Borders Group Inc. sought chapter 11 protection in 2008 and 2011, respectively, vendors still had Best Buy Co. and Barnes & Noble Inc. After Toys “R” Us stores went dark in June, the industry had no dedicated big-box outlets.

Vendors who kept shipping goods to Toys “R” Us hoping for a reorganization will receive at least 22 cents on the dollar for the $800 million they are owed, according to court papers.

The fund holding the proceeds from the Toys “R” Us liquidation allocated money to pay employees for two additional months of work, along with $74.3 million to cover some bills, including professional fees. All told, roughly $370 million is expected to be paid to professionals working on the case, the records show.

Maryjane Williams, 50 years old, a mother of five, worked for Toys “R” Us for more than 20 years in New York state, and more recently, Waco, Texas. She says she worries that her health insurance, which expires in November, won’t cover the medical expenses of her husband, who is recovering from an accident.

Ms. Williams is among a group of Toys “R” Us employees fighting for severance pay. The company notified workers they would receive no pay beyond its final day of operations. Some workers say the company had promised severance pay, then reversed course.

The liquidation strategy appears to be paying off for Solus. Court records and market data suggest it will receive more than it paid for its stake.

Courtesy : The Wall Street Journal


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