1. What are the risks and merits of the transaction?
This LBO transaction has both risk and profit potential. KKR, Bain, and Vornado Realty Trust face risk because the industry that Toys “R” Us (toys) is currently in, the retail toy industry, is in a decline. Industry sales have been down 4% in the last year, and analysts don’t have a positive projection for future sales in the US. This declining industry, and threat of new competitors such as Walmart and Target, make it hard to be profitable which makes it extremely risky for KKR, Bain, and Vornado.
Another factor that needs to be considered when calculating risk, is that this transaction is a club deal, meaning that more than one private equity firm will have control. This is risky to each firm because they will have limited control and will not have the power to dictate the transaction exactly how they wish. Although there is risk in this transaction, there is also some merit.
First, Toys is a very big company that has a lot of cash flow.
This is ideal for a LBO transaction because it has enough cash flow coming in to pay off debt that it leverages. Also, since Toys is facing some hard times and currently struggling to compete in the market, it is very likely that KKR, Bain, and Vornado can purchase Toys at a good premium. In addition, the retail toy industry is seeing new growth in Europe. This is a good thing for and LBO transaction because it offers more opportunity for an exit strategy since they will be able to expand into European markets.
2. Summarize the industry dynamics, including the major issues and potential catalysts for improvements. In 2005, the U.S. retail toy industry was not looking too promising. Sales were down 4% in the industry from 2004 to 2005. Although there was growth in some subcategories, dollar sales in the industry declined for a third consecutive year. One threat to the industry was the new trend of younger children choosing video games and electronics over traditional toys, and video game sales continued to outperform traditional toy sales.
At this point, analysts were expecting 0 to 2 percent growth in the retail toy industry over the next three to five years. Toys “R” Us and other incumbent firms in the industry were staring to see increasing competition from discount stores such as Walmart and Target. Toys “R” Us was feeling pressure from the discount stores, however since it was the largest firm in the specialty toy industry, it was better equipped to compete then its rivals. Now that these big discount stores were starting to enter into the industry, it made the retail toy industry highly competitive. Another issue in the industry was that the success of the incumbent firms depended on its ability to identify and follow product trends and demand. If a retailer over or underestimated the demand, it would have significant excess or shortage of inventory leading to lower profits.
Also, the industry was greatly effected by consumer spending, and if the economy was slowing, their sales would mirror this trend. Although the industry as a whole was facing declined/ sustained growth, there was one segment in the market that was showing potential growth: the infant, toddler, and preschool market. Since there was an anticipated increase in infant population, and spending per child was raising, experts estimated sales would continue to grow at 3 to 6 percent. The retail toy industry in Europe, however, was not doing as bad. Toy sales in Europe in 2005 grew 3 percent (compared to the US’s 4 percent decline) due to an increase in demand for infant/preschool toys. Industry analysts expected European toy sales to outpace sales in the US.
3. Summarize the debt in the transaction.
Before the acquisition, Toys “R” Us (Toys) had 35% of the firms capitalization financed by debt (65% equity). After the acquisition, Toys had $2.3 billion of assumed existing debt and $4.4 billion of new debt for a total of $6.7 billion of debt, meaning Toys debt represented 83.7% (compared to 35% before the acquisition). Toys became significantly more leveraged from the transaction. The debt sources are summarized (in millions) in the following table: Existing Debt:| $2,312 |
Senior secured credit facility| $700|
Unsecured bridge loan| $1,900 |
Mortgage loans| $800|
Secured European bridge loan| $1,000|
4. What are the potential exit alternatives for this investment? There are three potential exit strategies for this investment. First, to exit and sell the firm, they can participate in an IPO since Toy’s is not currently public. Another exit strategy is the consortium can sell Toys to a strategic buyer they are competing with such as Walmart or Target. Another exit alternative would be to sell it to another financial investor such as another private equity firm. 5. Recommend whether or not to join the consortium, and why. I would recommend on joining the consortium on this LBO transaction. First, Bain, KKR, and Vornado are purchasing Toys “R” Us at a huge premium, 122.5%. Since Toys is facing a difficult industry and weak performance, the consortium is able to purchase the company at a very good premium.
The consortium has chosen a perfect company to invest in at a perfect time at a great price. Second, the firms involved in this LBO make a very useful club deal together. Bain Capital has valuable resources in understanding and analyzing the nature of the industry’s downturn and will be able to accurately forecast. KKR is very established in the private equity industry and is know for their successful LBO transactions. Also, Vornado is an established REIT which will help in valuing and managing Toys’ massive real estate. Another reason why I would recommend a firm to join this consortium is due to the fact that there is a lot of growth opportunity in this industry with online sales, baby and toddler sales, and European sales. This opportunity will make it easier for the company to grow and could also offer more exit strategies when the time comes.