Oct 5, 2017

Toys "R" Us not a total loss for private equity fund managers

Dan Primack, author of Pro Rata

Toys 'R Us closed its flagship store in Times Square in 2015. (RW/MediaPunch/IPX / AP)

When Toys "R" Us filed for Chapter 11 bankruptcy last month, there was a lot of talk about how the company's private equity owners were out the $1.3 billion they invested back in 2005. But it's not exactly true.

Bottom line: Private equity funds can get paid big fees by their own portfolio companies, and don't always distribute those monies to their own investors.

Specifically, I've calculated at least $180 million that Toys "R" Us paid its sponsors in management and advisory fees, not inclusive of an $81 million transaction slug nor fees and interest related to subsequent debt financings. All of that comes via federal regulatory filings.

Assuming the equity check was split evenly among the three sponsors — Bain Capital, KKR and Vornado — it would work out to around $433 million each. Bain has an abnormally high GP commit of 10%, so that means Bain partners paid out around $43 million. But the fund received around $61 million in management and advisory fees related to the deal, which puts it in the black. LPs, of course, were wiped clean. KKR's relevant fund had a 57.5% offset for such fees but a smaller GP commit, so it too brought back more than it sent out. Some alignment of interests.

Caveats: Yes, private equity funds should be judged portfolio-level, and both relevant funds here performed well. Moreover, the sponsors spent tons of time working on Toys "R" Us (i.e., opportunity cost), didn't employ any dividend recaps and LPs knew the offsets (or lack thereof) upon investing. In fact, a Bain source puts its own time spent on Toys at 72,000 hours. But...

Takeaway: We've seen a strong move toward 100% advisory fee offsets in recent years, caused both by LP agitation and SEC scrutiny. Situations like Toys "R" Us are a stark reminder why that trend should continue and never backslide.

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