Private Equity and Asset Stripping: The Fall of Toys ‘R’ Us
As a child, my favorite place on earth was Toys “R” Us: the bright aisles, the endless rows of dolls, the excitement of choosing just one toy to take home. But that joy was shattered on January 29, 2018, when the company filed for bankruptcy.
It left many, including me, wondering: What happened? How could a beloved giant, a store that had operated for nearly 70 years and shaped the childhoods of millions, suddenly collapse under crushing debt?
At first glance, you might think it was because of online competition or shifting consumer habits. Well, in reality, they fell victim to one of Wall Street’s biggest but less publicly discussed moves: asset stripping. But what exactly is asset stripping? How does it work, and why should we care? Let me walk you through it.
Most famous in the 1970s and 1980s, this practice, now widely used by private equity firms, consists in purchasing an undervalued or struggling company at a low price and extracting every bit of value possible out of it. This doesn’t just mean profits from operations; it means everything: equipment, real estate, intellectual property : every individual asset that can be sold is liquidated, and the proceeds are funneled into the shareholders’ pockets. This generates more profit than selling the entire company by itself.
But here’s the subtle part: the money used to buy the company initially is not the firm’s own capital :it’s borrowed. This means the company itself, not the private equity firm, takes on the massive debt. For example, when Toys “R” Us was acquired, it took on $5 billion in debt virtually overnight. And instead of covering this initial debt with all the money the firm acquired through the selling of assets, it simply turns that into dividends for the investors, leaving a barely viable company.
However, there’s more to this concept than just buying a company and selling off its assets. Before bankruptcy comes recapitalization, which refers to restructuring the company’s debt. To put simply, it’s a name for a part of this practice ,which, while legal, is often criticized as a kind of financial exploitation.
When companies go through recapitalization, they often no longer have valuable collateral (assets to back loans), meaning they must rely on leveraged loans : high-risk loans with high interest rates, popular among companies already deep in debt. Banks typically don’t like to keep such risky loans on their books, so they either sell them directly to mutual funds or ETFs (which regular people invest in) or bundle them into collateralized loan obligations (CLOs) :packages of loans sold to large institutional investors, not individuals.
In short: after such a buyout, the company ends up with more debt and higher interest payments, weakened operations (since they sold off their valuable assets), and empty coffers. Slowly but surely, they fail to generate enough cash flow to cover the mounting debt. As investors lose confidence, the company runs out of money and eventually files for bankruptcy. Or in certain cases, it does survive but in a leaner form which is what happened for J. Crew.
When you think about it, this practice is perhaps less ruthless than it might first appear. After all, investors are within their rights to acquire companies, which are often the ones that are already struggling , and pursue strategies to maximize profits.
However, many are harmed in the process, as a key part of this strategy often involves cutting costs of the acquired business by laying off employees or squeezing suppliers. While this may seem like one of Wall Street’s most controversial tactics, it also stands as a testament to the power, strategy, and influence wielded by Wall Street’s brilliant minds.
Image credit: www.northjersey.com
