Nota bene: Toys don't fung

If you live in the USA, your local Toys R Us is closing down, with the loss of all the associated jobs. And if your Twitter feed looks anything like mine, you will have see a link to a Jeff Spross essay blaming the demise of the company on “vulture capitalists”:

 If Bain, KKR, and Vornado had never come along, Toys 'R' Us wouldn't be doing stellar, but it probably could've muddled through. As recently as last year, the company still accounted for 20 percent of all U.S. toy sales.

Instead, the legacy of the leveraged buyout turned this into an existential crisis, and Toys 'R' Us filed for bankruptcy midway through last year. Then, when holiday sales didn't pan out, the company's leadership decided to sell or shutter all its stores. And 33,000 working people could lose their jobs.

This is… half true. If Toys R Us hadn’t been bought by private equity in a leveraged buyout, then, yes, it would still be muddling along. The massive debt burden from the buyout caused the bankruptcy, and the bankruptcy caused the liquidation.

On the other hand, it wasn’t the company’s leadership which decided to shutter all those stores, it was the company’s creditors. The company’s leadership would have loved to keep on running their business, under different ownership; it was the creditors who decided to opt instead for a liquidation.

As Bloomberg has covered in depth, the amount of debt in the retail sector is staggering — which is bad news indeed if you own equity in highly-leveraged retailers, or in shopping malls, or really in anything exposed to that sector.

But when an industry is over-levered, bankruptcy is the perfect solution! Or should be, anyway. If a company like Toys R Us is struggling under $6 billion of debt, then once you take away that debt burden, it should be light and nimble and able to go out and beat the world! And in the retail sector, specifically, there’s the added advantage that bankruptcy can help companies renegotiate onerous lease obligations. If Toys R Us is paying above-market rents in certain malls, bankruptcy should help fix that problem.

All of which raises the question: Why is bankruptcy bad for retailers, when by rights it should be good?

I suspect the answer is that Wall Street has become too specialized. The leveraged loan market has two sides — the borrowers and the lenders — and those two sides have significantly different skill sets. While the lenders can judge the borrowers’ ability to run companies, they don’t particularly like to run companies themselves. Creditors generally have very little say in how companies are managed, and that’s how they like it; they don’t have the time or the ability to start hiring managers, holding them to performance targets, owning shares, and the like.

The result is that unless creditors can see a clear path to being able to sell their equity quickly and pretty easily, they’re generally going to prefer to liquidate.

A similar dynamic plays out at VC-backed startups facing difficulty. Once the VCs realize that they’re unlikely to make monster returns on their investment, they tend to swing for the fences, and urge drastic changes (a/k/a “pivots”) which have a low chance of success and which will leave the company worthless if they fail. That’s vastly preferable, from the VC perspective, to simply carrying on a relatively small yet sustainable business which it would be hard to make lots of money on. A small return, or a 1X return, just isn’t worth a VC’s time. Much better to take a high chance at a zero return, if it comes with the slimmest possibility of something greater.

All of this is deeply inefficient, and represents a clear failure of capital allocation. But it’s also very, very hard to fix. Back when Capital owned companies and Labor ran them, a process like bankruptcy could be incredibly effective. Now, however, Capital has been sliced up into all manner of different flavors: debt, equity, leveraged loans, venture capital, you name it. They’re not fungible: you might say they don’t fung. And that carries a large human cost.