In a world awash with money, Toys “R” Us ran out of it.

The company spent 12 years backed by some of the top deal makers. It used every financial-engineering move in the book, deploying them into one of the friendliest credit markets in history.

And somehow, the last hope for Toys “R” Us, which filed for bankruptcy in September, may be a crowdfunded Hail Mary by a billionaire toy maker.

When Bain Capital, Kohlberg Kravis Roberts, and Vornado Realty Trust teamed up to buy Toys “R” Us for $7.5 billion in 2005 during the megabuyout boom, they invested $1.3 billion and charged much of the balance to the company, saddling it with expensive debt.

Over the years, the competition and the creditors changed, but the original sins persisted: Toys “R” Us wasn’t making enough money, and owed more than it could afford.

“The seeds were in the buyout,” says Moody’s Investors Service analyst Charlie O’Shea. “Debt has a way of winning. You try to outrun that, and sometimes you can, and sometimes you can’t.”

The demise of Toys “R” Us—recounted here based on company and bankruptcy filings and interviews with people close to the situation—is a sobering lesson for investors seeking opportunity in risky credits. Superlow interest rates had allowed many companies to buy time, and produced returns for investors willing to take a chance. But the liquidation is a sign that the era of forgiving financing has ended.

The amount of money that needed to be refinanced to stave off bankruptcy was arguably small: just some $400 million, compared with a total debt burden of about $5 billion. Still, that was enough to “upset the apple cart,” according to O’Shea. The lending environment had changed, the lenders had changed, and the retail landscape had changed.

Today, Toys “R” Us stores are papered over with “Everything Must Go” signs. Customers can no longer return purchases. Bed Bath & Beyond (ticker: BBBY) was accepting Toys “R” Us gift cards for BB&B store credit, at 64 cents on the dollar, until Friday.

In 2005, Toys “R” Us was already in a battle with Walmart (WMT) and Target (TGT), and needed a shake-up. But there were bright spots: Its international businesses were growing, and the retailer was expanding offerings for babies.

In 2010, the private-equity sponsors sought to sell the Wayne, N.J.–based company in an initial public offering, but then sales started flagging, and they shelved the IPO plan.

Competition was intensifying. became the margin-eating juggernaut it is today. While competitors were investing to improve technologies and slashing prices, Toys “R” Us was stuck with $400 million in annual interest payments.

The company “didn’t have a ton of capacity to invest back in the business,” says Citigroup’s Jenna Giannelli. It fell behind on improving its website to bolster online sales, trimming the cost structure, and improving the in-store experience.

Toys “R” Us did try to make itself and its wares more appealing: Under a “clean and bright” initiative, the company redid the lamps in stores, brushed up inventory, cleaned the floors, and replaced the cart corrals outside the stores. It showcased products tied to hit movies, and ramped up experience-focused in-store offerings like “Geoffrey’s Birthday Club” parties, free “build-and-take toy” events, “collect-and-trade days,” and toy demonstrations.

“It was too late,” Giannelli says. “The issues were deeper-rooted.”

The company lost $1 billion in its fiscal-2013 year. Its debt ratio ballooned back to buyout levels, according to Moody’s.

“The buyout financing required—and this is where the company got stuck—almost serial refinancing of the capital structure,” O’Shea says. “Almost every year, 18 months, there was meaningful debt to refinance.”

Toys “R” Us kept having to cajole credit investors to lend it money. It pulled every lever it could—moving assets, selling real estate, and leasing it back to itself, creating new entities, swapping debt—to extend whatever maturity was staring it down. The cost of all that refinancing adds up, from pledged assets to higher coupons and stricter covenants. It also changes who is lending.

By 2017, the toy merchant’s obligations, and thus its fate, was in the hands of distressed-debt investors, hedge funds that trawl credit markets for bargains: bonds trading at pennies on the dollar, issued by companies running out of options. They amass positions at relatively little cost, buying a seat at the negotiating table. Their job is to recoup money.

And Toys “R” Us’ ugly capital structure resulted in disparate units with stakeholders asserting claims on a finite pile of money and assets. That made coming to an agreement more challenging

Last summer, Toys “R” Us was putting together a prepackaged bankruptcy filing. When new of that leaked, it started a debilitating chain reaction.

The timing was awful. In late summer and fall, retailers are preparing for the do-or-die holiday season, buying and receiving products.

Vendors are skittish about retailers’ financing stress; they think they have more certainty of getting paid back in bankruptcy. Rattled by the news reports, some stopped shipping to Toys “R” Us. So, just as the company was negotiating with litigious creditors, it was also frantically trying to repair a fractured supply chain.

Toys “R” Us filed for bankruptcy in September. All told, the private-equity sponsors had poured $3.5 billion into the company, partially offset by the roughly hundreds of millions in fees and expenses they paid themselves. They did refrain from paying themselves dividends.

The creditors now had to work out how best to extract value: Slim the company and build a leaner, cleaner, more competitive version, or liquidate.

Toys “R” Us had a fair amount to sell: inventory, real estate, data, intellectual property, website licensing, and income-generating international units. Lenders driving the bankruptcy process seemed constructive.

They tried to work it out: The company said it would close almost 200 stores and was looking for solutions.

As the holiday sales figures came into focus, the support evaporated, giving way to a harsher analysis: The company was out of money. No one wanted to give it more.

The holiday shortfall triggered defaults. Some lenders, trying to protect themselves from losses, imposed new restrictions, further crimping liquidity. And six months after filing, the company still hadn’t delivered a new budget proposal that could help it exit bankruptcy, and it said it couldn’t.

The parties were at an impasse: U.S. operations would run out of cash in May, the creditors said. The best way to wring out what they could was to liquidate inventory and wind down the business.

That was a huge hit to the toy industry. Toys “R” Us was not only a big retailer; it was also the best testing ground for toy makers to try out new products—one of the few places where smaller players could start out. Hasbro stock (HAS) has dropped 10.4% since reports surfaced that Toys “R” Us could liquidate, and Mattel (MAT) has tumbled 17.9%.

Still, there is some hope.

Isaac Larian, CEO of toy maker MGA Entertainment, wants to cobble together money for a bid for some of the company’s assets. With $100 million of his own money and $100 million from others, he started a crowdfunding campaign last month, #SaveToysRUs.

So far, his GoFundMe has raised an additional $56,000, rewarding donors with prizes from #SaveToysRUs bumper stickers to MGA-manufactured toys and factory tours. Larian is aiming to raise $1 billion by May 28.

He has put together an investment team and worked through due diligence with the company. But he has yet to submit a formal bid, and time is running out.

His campaign has attracted more than 1,800 donations, of varying sizes, like those from 23-year-old Matthew Arenson, a toy collector who has given a total of $45.

“I don’t really care about the stickers,” Arenson says. “I care more about trying to save something that was a big part of my childhood, and I think should be a part of other kids’ childhoods.”

Source: Barrons April 7, 2018 | By Mary Childs