J.Crew, Neiman Marcus, Hertz and Chuck E. Cheese's have two things in common: They all piled on crushing amounts of debt during leveraged buyouts. And they've all filed for bankruptcy during the pandemic.
The sudden nature of this recession is exposing the inherently risky nature of these private equity takeovers.
Most companies are vulnerable during downturns when cash flow dries up. But that risk is magnified by the financial engineering used to fund leveraged buyouts, or LBOs, which saddle companies brought private with dangerous amounts of leverage and hefty interest expenses.
LBO companies often have fragile balance sheets that leave them teetering on the brink of bankruptcy and at the whims of turbulent financial markets.
"The more debt a company has, the more likely it is to default on that debt," said David Silverman, senior director in corporates at Fitch Ratings.
The LBO model can work well -- especially for private-equity firms -- during booms. Boosted by an influx of cash, the newly private companies are revitalized and flipped in IPOs or strategic sales. But these deals can blow up in spectacular fashion when markets and economies crash.
"Private-equity backed LBOs are the most vulnerable to any kind of economic downturn, whether it's a pandemic or traditional recession," said Chris Padgett, head of the leveraged finance practice at Moody's Investors Service. "Their intent is to use a lot of debt. That is part of their business model."
'Fragile balance sheets'
It's not just the debt that makes LBOs risky.
Private-equity firms cut costs -- sometimes drastically through aggressive layoffs -- to make the companies look more attractive in a future IPO or sale. And private-equity firms often pay themselves dividends and fees -- sometimes by forcing the companies they take over to borrow further.
Dennis Kelleher, CEO of Better Markets, slammed what he called the "predatory private equity business model" of firing workers and unloading pension obligations.
"Once a private equity firm extracts the maximum amount of value it then tries to flip it into the public markets so it can cash out on the near-carcass of a corporation," Kelleher said.
Last month, Moody's warned that the weak credit ratings of companies owned by private-equity firms suggests an "elevated default risk." A stunning 80% of companies with risky companies with a B3 rating are private-equity backed LBOs, the credit ratings firm said.
"The proliferation of lower-rated, PE-owned companies with high leverage, small scale, niche business models, and fragile balance sheets may exacerbate this default cycle," Moody's said.
From LBO to Chapter 11
The pandemic has caused a spike in bankruptcies from a wide spectrum of companies, including some that are owned by private-equity firms.
Hertz, a company that Axios described as a "Frankenstein of financial engineering," filed for bankruptcy in May. The company, which had been renting cars since 1918, was sold by Ford in 2005 to a trio of private-equity firms for nearly $15 billion. That leveraged buyout included just $2.3 billion of equity -- with the rest of the purchase borrowed money.
After just six months under private-equity ownership, Hertz executed a $1 billion dividend recap, adding more debt to its balance sheet. When Hertz went public in 2006, it created a windfall for its private-equity owners but the company had very little cash and a balance sheet riddled with debt.
Still, David Yermack, a professor at NYU Stern School of Business, argued the Hertz bankruptcy had little to do with its previous private equity ownership.
"It was inevitable that a firm like Hertz, which had grossly over-expanded, would have needed to restructure itself," Yermack said. "The rental car industry needed to shrink."
Neiman Marcus went through two separate LBOs before its bankruptcy last month. The luxury department store, whose history goes back 113 years, had nearly $5 billion of debt on its balance sheet when it filed for Chapter 11.
In 2005, private-equity firms TPG and Warburg Pincus paid about $5.1 billion to take Neiman Marcus private. Eight years later, Neiman Marcus was sold to private-equity firm Ares Management and the Canada Pension Plan Investment Board for $6 billion.
Chuck E. Cheese owner CES Entertainment also filed for bankruptcy this month. The Chapter 11 filing comes six years after it was acquired by private-equity firm Apollo Global Management for $1.3 billion.
J.Crew goes bankrupt. Abercrombie is hanging on
But it may be the bankruptcy of J.Crew that is the best case study. In 2011, J.Crew was taken private by TPG and Leonard Green for $3 billion. But by 2013, like other mall-based retailers, J.Crew was struggling.
J.Crew hoped to raise much-needed cash by spinning off its promising Madewell brand in an IPO. However, the market turmoil caused by the pandemic forced J.Crew to shelve those plans.
Unlike J.Crew, Abercrombie, another mall-based retailer supported by a secondary brand (Hollister), resisted the allure of an LBO. Although Abercombie's share price remains depressed, the company's balance sheet is solid and analysts aren't worried about an imminent bankruptcy.
Abercrombie "generates more cash because it isn't getting siphoned off to pay interest expenses," said Fitch's Silverman. "It can reinvest in the business. And management time and attention aren't focused on capital structure concerns."
The fact that J.Crew was banking on the Madewell IPO made it vulnerable to the market turbulence that erupted during the pandemic. Not only did the IPO markets shutter, but companies with junk bond ratings were briefly shut out of the capital markets.
LBOs are a 'common factor' for distressed retailers
None of this is to say that LBOs are the sole reason these companies filed for bankruptcy. They all operated in challenged industries made more challenging by the pandemic.
For example, mall-based retailers were already struggling because of the surge of online shopping and rise of fast fashion brands. The coronavirus crisis has only exacerbated the shift to e-commerce and death of malls.
"These firms are often occupying real estate that could be put to better uses than retail sales, and when they go bankrupt, the real estate is freed up for redevelopment," said NYU's Yermack. "Not to allow these firms to fail would simply slow down a process that will have long-term benefits for the economy by repurposing assets and creating different types of jobs."
And many companies have filed for Chapter 11 even though they have no links to private equity.
Still, there is a long history of LBO bankruptcies in the retail industry.
In February 2018, Fitch put out a report that argued LBOs are a "common factor for many distressed retailers." Although the capital structures "appeared sustainable" at the time of the LBOs, weakening cash flow and mis-execution made it hard to repay those "heavy debt burdens," the Fitch report said.
Countless retailers that were purchased by private firms have since gone bankrupt, including Toys "R" Us, Payless ShoeSource and Gymboree. The biggest bankruptcy may have been Sports Authority, which was acquired by Leonard Green in 2006 and shut down in 2016 -- costing about 14,500 jobs.
Out of the 11 large grocery chains that have filed for bankruptcy since 2015, eight of them were backed by private-equity firms, according to S&P Market Intelligence and PitchBook Data cited by The Wall Street Journal. That included the pre-pandemic bankruptcies this year by Earth Fare and Fairway Market.
PE firms are major employers
Last year, Senator Elizabeth Warren introduced legislation that would close loopholes she says allowed private-equity firms to capitalize on their investments while passing risk on to target companies, shareholders, employees and customers.
"Private equity has bankrupted hundreds of formerly profitable companies by loading them with debt, charging excessive and unnecessary fees and stripping them of wealth," Senators Elizabeth Warren and Bernie Sanders wrote in a letter last fall.
The lawmakers cited a 2019 Harvard Business School working paper that found "large post-buyout employment losses" and "poor productivity performance" during recessions at companies that were taken private. Employment shrinks 13% at those LBO companies, while compensation per worker declines nearly 2%, the paper said.
The American Investment Council, which represents the private-equity industry, did not respond to a request for comment. But the group pointed out in a recent statement that 8.8 million American workers were employed by private-equity-backed businesses last year.
"Private equity can often be the only source of support for businesses struggling during a recession or economic crisis," the ACI said. "Public investments often dry up in a bear market, while banks and other providers of credit are hesitant to invest in companies that may not survive."
The next dominoes to fall
The recent LBO bankruptcies could just be the tip of the iceberg.
Countless retailers backed by private-equity firms are on Fitch's list of top bonds and loans "of concern." That list includes Guitar Center, a retailer of musical instruments that was taken private in 2007, and Fresh Market, a grocer purchased by Apollo in 2016 for $1.4 billion.
JoAnn Stores, which was taken over by Leonard Green in 2010 for $1.6 billion, is also on Fitch's list of vulnerable companies. So is Belk, a Southeast department store chain taken private by Sycamore Partners in August 2015 for $3 billion.
Even some very recent LBOs are suddenly teetering.
In April, medical staffing group Envision Healthcare hired restructuring advisers in a bid to avoid bankruptcy amid a sharp decline in elective surgeries, the Financial Times reported. The stress comes not even two years after Envision was brought private by KKR in a richly-valued $9.9 billion deal that saddled the healthcare company with debt.
The Envision troubles underscore one the central challenge facing LBOs today. The decade-long bull market in stocks caused private-equity firms to pay top-dollar for some takeovers. Those lofty purchase prices in turn amplified the leverage.
The past dozen years of near-zero interest rates from the Federal Reserve not only encouraged companies to binge on debt, but they made pension funds and insurance companies desperate for high-yielding investments. They plowed an ocean of money into private-equity firms -- which then had to put that capital to work by purchasing companies.
"They can't sit on cash forever," said Padgett, the Moody's analyst. "If you paid a very high multiple and then you end up with an asset that's not performing -- and then you go into a pandemic, it's a lot to absorb."
In other words, more LBO bankruptcies are coming.