AP Photo/Julio Cortez
The fate of 33,000 Toys “R” Us employees will be sealed in a bankruptcy court this week, as the nation’s last remaining specialty retailer seeks to liquidate all its U.S. stores. It’s a dark moment for the future of retail, and also one to question the business model that drove Toys “R” Us into the grave.
After all, it was a leveraged buyout in 2005 that dumped over $6 billion in debt on Toys “R” Us, making it liable for $450 to $500 million annually just in interest payments. Take away that and the company was profitable, with growing operating income the past three years. Last year, it was responsible for 1 out of every 5 toys sold in the U.S.; no company should hit bankruptcy with that market share. But the debt proved too burdensome for Toys “R” Us to survive.
In other words, it was a classic private-equity bust-out. The firms in the deal—private-equity giants KKR and Bain Capital and real-estate firm Vornado—made back their small personal investments through advisory and management fees. Bankruptcy or liquidation doesn’t hurt them, only the tens of thousands of families who depend on Toys “R” Us for their livelihoods. It’s a familiar story: private equity loads up companies with debt, strips out the profits, and leaves the carcass along the road in the aftermath.
Payless ShoeSource, The Limited, Wet Seal, Gymboree, rue21, True Religion and most recently Claire's were all acquired by private equity in leveraged buyouts, and they all went bankrupt. In all, 40 percent of retail bankruptcies between January 2015 and April 2017 were private equity-owned chains. Another study points to private equity accounting for 61 percent of all retail job loss over the past two years.
The leveraged buyout business model played the defining role in this tragedy. “There's this idea that Amazon disrupted retail, but retail is constantly being disrupted,” said Eileen Appelbaum, co-director of the Center for Economic and Policy Research and co-author of Private Equity at Work, a critique of the industry. “Zara came along and changed high fashion every two weeks. The difference with private equity is that traditionally retail is low debt, which gives them breathing room. It’s not that they didn’t know to do e-commerce, they had no resources.”
It may surprise you to know that this business model is unlikely to continue in its current form due to government action—from Republicans in Congress and Donald Trump, no less. Leveraged buyouts with high degrees of debt have become far less attractive because of a small section of the Tax Cuts and Jobs Act that limits the deductibility of interest for corporate taxes.
This provision, which made it into the bill because it raises $253 billion over ten years, really targets the biggest private-equity deals, which are predicated on the ability to load up on debt cheaply. The new tax limitations make such maneuvering more expensive.
That's not to say that Republicans dismantled one of the most powerful industries in the financial sector. It more likely just altered the structure of private equity deals, and perhaps the targets of their business model. “Private equity will adapt,” said William Cohan, former Wall Street investor and author of three books about the financial industry. “They are nothing if not an incredibly adaptive organism.”
Those adaptations could be seismic. Just as they might give workers and businesses a fairer chance to survive, they might simultaneously unleash wreckage on renters and homebuyers in marginal communities. It's like putting a finger in one spot of a leaky dam, only to see water shoot through another hole. Either way, the water gets out, but in different ways with different effects. Republicans didn't knock out the private-equity industry, but they might have fundamentally altered it—and perhaps made it even more dangerous.
LET'S CONSIDER THE new tax provisions in the context of the Toys “R” Us deal. Under Section 13301 of the law, businesses with revenues over $25 million will only be able to deduct net interest expense less than or equal to 30 percent of a company’s adjusted taxable income in a given year. This restriction tightens over time: At first adjusted taxable income equals earnings before interest, taxes, depreciation, and amortization (EBITDA); starting in 2022, the measure narrows to just earnings before interest and taxes (EBIT).
Toys “R” Us owed $450-$500 million in annual interest payments after the leveraged buyout. The company's reported EBITDA in 2005 was $662 million, and EBIT was $304 million. So it would only be able to deduct either $91 million or $198 million from taxes, depending on the formula. That would be a huge hit to the deal’s financial structure. Private-equity firms often have tax-sharing agreements with portfolio companies, where they capture some of the deductions. So the firms’ personal bottom lines would suffer. “Limiting the deductibility of interest removes one of the incentives to use high leverage to juice returns,” said Jim Baker of the Private Equity Stakeholder Project, which spotlights industry practices.
A report from Hamilton Lane, an advisory firm to private-equity clients, states that once a company’s debt level is over five times EBITDA, the inability to deduct interest begins to cancel out the benefits of the tax law, like the lower corporate tax rate. Toys “R” Us’ net leverage was seven times EBITDA in 2005, when they shouldered this debt. In other words, had the current tax law been in place back then, it’s highly unlikely Toys “R” Us and its private equity owners would have consummated the deal.
Indeed, the tax law disrupts the worst kind of vulture fund private-equity deals. The easiest way for firms to compensate would be to simply throw in more equity. We've seen this in one of the first post-tax law deals: Rhone Capital buying Brazilian steakhouse chain Fogo de Chao for $560 million, all of it in cash.
Reducing corporate debt across the board through discouraging its existence through the tax code is a very good thing. Debt-loaded companies are riskier, with less of a safety net in an economic downturn. Most corporate debt operations finance financial engineering with little productive value, like share buybacks or acquisitions. We could certainly use less of that in America. And putting private-equity firms more on the hook for its mismanagement would be beneficial as well.
But we cannot assume that the private-equity industry will be static in their reaction to the tax law. After all, more equity would lower returns, and we can't have that. The industry's lawyers and accountants are surely already at work on alternative solutions.
For example, the price of leveraged buyouts could fall, to compensate for the lower debt benefits. Investors could take a preferred equity stake in portfolio companies instead of lending money. They would still receive regular payments, but as a dividend instead of interest, evading the taxman. Additionally, the firm could engage in a leasing arrangement instead of buying the portfolio company outright. That would embed interest payments in the cash flow of the lease and possibly avoid deduction limits.
The most glaring option comes from a gaping loophole in Section 13301. Several business types are exempted from the interest deduction limitation, including car dealerships, electric and water utilities, and agricultural cooperatives. But for private equity's purposes, the big exemption is for “any electing real property trade or business;” in other words, real estate.
The serendipity of the president being a real-estate tycoon and wanting a special carve-out for himself has widespread implications for private-equity firms.
They could now jump from purchasing portfolio companies into the real-estate businesses. In fact, some firms have gotten a head start.
SINCE THE FINANCIAL CRISIS, large private-equity firms have pioneered buying up and renting out single-family homes. Blackstone, the world’s largest private-equity firm, built its rental portfolio under the aegis of Invitation Homes, acquiring over 48,000 homes since 2012. It was expected to be a quick play, selling the homes as their value recovered. But instead they created a new asset class as they found rentals to be quite profitable.
They also began to securitize the rental revenue, selling bonds to investors backed by the stream of payments, in an eerie similarity to mortgage-backed securities whose implosion rocked the economy in 2008. Currently there are $17.5 billion in outstanding bonds on the market.
Last year, Invitation Homes merged with Starwood Waypoint, the nation’s number-three rental empire, with the combined company owning 82,000 properties nationwide. The total number in the asset class is at least 200,000. While this represents only 2 percent of single-family rentals nationwide, they’re concentrated in so few regions that the market impact is much higher. Invitation Homes is currently the largest landlord in Sacramento, and the second-largest property owner besides the city itself. Atlanta, Houston, Phoenix, Charlotte, and several cities in Florida have high concentrations of private equity-owned homes as well.
A report from three advocacy groups details how private equity-fueled rental companies offer substandard properties and resist making repairs. They promise “competitive rents” to keep bond ratings high and investors happy, with some tenants reporting spikes of hundreds of dollars a month. They evict quickly, with no forgiveness for late or partial payments. And they bill tenants “charge-backs” for routine repairs, covering costs by burdening the inhabitants.
If you think it's a good idea for Wall Street to become your landlord, just wait until the tax code pushes more money in that direction. It could enable a second wave of rental buying, into more distressed markets where tenants have fewer options. Blackstone has already begun to fund these purchases made by smaller firms. Private-equity firms are also constructing single-family and multi-family properties specifically for rentals, going well beyond the initial strategy. Locking up all these properties in rentals limits housing stock for would-be first-time homebuyers, who are shut out of the market. And constricted supply drives up the costs for all housing.
So while limiting the interest deduction remains an important policy to reduce leverage and make corporate America more stable, it's not sufficient to defang the private-equity industry, whose tax planning and legal departments far outpace whatever the government can devise. In fact, it just transfers the problems workers face with private equity to the problems renters face with them; those are often the same people.
If you really want to go after private equity, you must look at other options. Having firms conform to definitive performance measurement, with transparency on monitoring fees and other costs, would let investors understand whether investments in private equity are worth it. Firms could be held responsible for worker retraining and pension liabilities instead of the companies they field-strip, perhaps by making them joint employers. And on the tax side, you could close the carried interest loophole if you really wanted to treat private equity managers' income the way every other income-earner gets treated.
What you can't do is expect a small provision of the tax code, however disruptive, to do all the work of bringing these firms out of the shadows. “Tax reform replaced complexity with other complexity,” said Jim Baker of the Private Equity Stakeholders Project. “These firms have been masters of using that complexity to their own benefit.”