Balance Sheet, Financial Ratios, Private Equity, Toys “R” Us, Bain Capital, Leveraged Buyout and Initial Public Offering

Posted by PITHOCRATES - May 29th, 2012

History 101

Private Equity guides a Business foundering in Rough Seas into a Safe Harbor to Refit it for Profitability

The balance sheet is the one of the two most important financial statements of a business.  It’s a snapshot in time of the financial position of a company.  In the classical format all assets are on the left side.  And all liabilities and equity are on the right.  And the total value of all assets equals the total value of all liabilities and equity.  In other words the business bought all of their assets with money raised by borrowing (liabilities), with money raised by selling stock (equity) or with money generated by the business (retained earnings/profits). 

Everything you ever wanted to know about a business you can find on the balance sheet.  Through numerous financial ratios you can determine if the business is using their assets efficiently.  Or have too many assets that cost more to maintain for the revenue they produce.  You can tell if a business has too much debt.  Or has so little debt that new debt can finance growth and expansion.  Which could attract new equity investors for further growth.  You can see if they’re matching the terms of their debt with the life of their assets.  Or if they’re taking on long-term debt obligations to provide short-term working capital.  A review of a firm’s balance sheet can also tell how well the management team is doing.  Or how poorly.

The financial picture the balance sheet provides of a business is an objective picture.  It gives an outsider a different view of the company than an insider.  Who may have a more subjective view.  They may not want to shutter a poorly utilized factory because of pride, sympathy for the employees or unfounded hope that business will improve soon.  So they will risk losing everything by not accepting that they must let some things go.  Like a cargo ship foundering in rough seas.  To save the ship and most of its cargo a captain may have to jettison some cargo.  If he or she doesn’t the captain can lose the ship.  The cargo.  And the lives of everyone on board.  Perhaps having a life or death decision in the balance makes it easier to make those hard decisions.  Perhaps that’s why some CEOs can’t let some things go.  Because they never accept the seriousness of their situation.  Perhaps this is why an outsider can read a balance sheet and see what the CEO can’t.  And act.  Like the captain of a ship foundering in rough seas.  And this is what private equity does.  Guides a foundering business into a safe harbor.  Refits it.  And then re-launches it on a course of profitability.

Toys “R” Us

Toys “R” Us was hitting its stride in the Eighties.  They were dominating the retail toy business.  Even expanding internationally.  And into other lines.  Children’s clothing.  Kids “R” Us.  And baby products.  Babies “R” Us.  There was no stopping them.  The secret to their success?  Sell every hot new toy kids wanted.  And sell it cheap.  At or below cost.  Using these loss leaders to get people into their stores.  Where they could sell them more expensive goods in addition to the most popular ‘must have’ toys. 

Then came the Nineties.  And serious competition.  From the big department stores, discount chains and warehouse clubs.  Target.  Wal-Mart.  Costco.  And then the Internet.  Who could use the Toys “R” Us strategy just as well.  And do them one better.  Toys “R” Us focused on selling the ‘must have’ toys at the lowest price.  Where customers came in knowing what they were looking for.  Finding it.  And heading to the checkout.  With a plan like that you don’t need customer service.  So when the competition matched them on selection and price they also threw in better customer service.  Wal-Mart surpassed Toys “R” Us.  Which was by then losing both profitability and market share. 

In 2004 a consortium of private equity (KKR and Bain Capital) and Vornado Realty Trust bought Toys “R” Us for $6.6 billion in a leveraged buyout.  And they turned the corporation around.  With a new management team.  Made the corporation more efficient.  In the brick and mortar stores as well as online.  The company is better and stronger today.  But it has delayed its Initial Public Offering (IPO) for about 2 years now due to a couple of lackluster Christmas seasons during the Great Recession.  They will use the capital raised from the IPO to pay down the debt from the leveraged buyout now sitting on Toys “R” Us’ balance sheet.  Making the turnaround complete.  Allowing the private equity firms to exit while leaving behind a healthier and more profitable company.

The Goal of the Leveraged Buyout was to make Toys “R” Us a Stronger Company

Private equity was successful at Toys “R” Us because Toys “R” Us was a good company.  From 1948 it consistently did the smart thing and grew into the giant it is.  But then it matured.  And the market changed.  Like a ship foundering in rough seas they just needed a little help to captain them through those rough seas.  And that’s what private equity did. 

Many will criticize the sizable debt they’ve left on their balance sheet.  But the plan was always to take the company public again.  Using the proceeds from the IPO to clean up the balance sheet.  Yes, the equity partners will also make a fortune.  But Toys “R” will emerge from this process a stronger company.  Which was the goal of the leveraged buyout.  They did not chop up the company and liquidate the pieces.  They purchased it in 2005.  And the company is still around today in 2012.  What have they been doing all this time?  Trying to make the company the best it can be.  So they can profit greatly from the IPO. 

No doubt the balance sheet of Toys “R” Us has never looked better.  Other than the debt added for the leveraged buyout.  Which they have been able to service since 2005.  So clearly the company is doing something right.  And just imagine how well they will do after they clean that debt off of their balance sheet.  After the IPO.  Suffice it to say that our grandchildren will be shopping there for their own children one day.

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Venture Capital and Private Equity

Posted by PITHOCRATES - May 28th, 2012

Economics 101

An Idea is only an Idea unless there’s Capital to Develop it and a Business Plan

People put money in the bank to save it.  And to earn interest.  To make their savings grow.  So they can afford a down payment on a house one day.  Or start up a business.  To start a college fund.  Or a variety of other things.  They put their money into a bank because they have confidence that the bank will repay that money whenever they want to withdraw it.   And confident that the bank will earn a profit.  By prudently loaning out their deposits in business loans, mortgages, equity loans, etc.  So the bank can pay interest on their savings.  And make it grow.  While not risking the solvency of the bank by making risky loans that people won’t be able to repay.  With responsible saving and responsible lending both parties achieve what they want.  And the economy grows.

A high savings rate means banks can make more loans.  And businesses can borrow more to expand their businesses.  This is a very critical element in capitalism.  Getting capital to the people who need it.  Who can do incredible things with it.  Create new jobs.  Develop a new technology.  Find a better way to use our limited resources.  Bringing consumer prices down and increasing our standard of living.  Because when prices go down we can buy more things.  So we don’t have to sacrifice and go without.  We have a higher standards of living thanks to capitalism.  And the efficient use of capital.

As technology advanced individuals had more and more brilliant ideas.  But an idea is only an idea unless there’s capital to develop it.  And a business plan.  Something a lot of brilliant entrepreneurs are not good at.  They may think of a great new use of technology that will change the world.  Their mind can be that creative.  But they don’t know how to put a business plan together.  Or convince a banker that this idea is gold.  That this innovation is so new that no one had ever thought of it before.  That it’s cutting edge.  Paradigm shifting.  And it may be that and more.  But a banker won’t care.  Because bankers are conservative with other people’s money.  They don’t want to loan their deposits on something risky and risk losing it.  They want to bet on sure things.  Loan money to people that are 99% certain to repay it.  Not take chances with new technology that they haven’t a clue about.

Venture Capitalists make sure their Seed Capital is Used Wisely so it can Bloom into its Full Potential

Enter the venture capitalists.  Who are the polar opposite of bankers.  They are willing to take big risks.  Especially in technology.  Because new technologies have changed the world.  And made a lot of people very wealthy.  Especially those willing to gamble and invest in an unknown.  Those who provide the seed money for these ventures in the beginning.  That’s their incentive.  And why they are willing to risk such large sums of money on an unknown.  Something a banker never would do.  Who say ‘no’ to these struggling entrepreneurs.  And tell them to come back when they are more established and less risky. 

This is responsible banking.  And this is why people put their money into the bank.  Because bankers are conservative.  But there is a price for this.  Lost innovation.  If no one was willing to risk large sums of money on unknowns with brilliant ideas the world wouldn’t be the same place it is today.  This is what the venture capitalists give us.  Innovation.  And a world full of new technology.  And creature comforts we couldn’t have imagined a decade earlier.  Because they will risk a lot of money on an unknown with a good idea.

Most venture capitalists have been there before.  They were once that entrepreneur with an idea that turned it into great success.  That’s part of the reason they do this.  To recapture the thrill.  While mentoring an entrepreneur into the ways of business.  Like someone once did for them.  But it’s also the money.  They expect to make a serious return on their risky investment.  So much so that they often take over some control of the business.  They do what has to be done.  Make some hard decisions.  And make sure they use their investment capital wisely.  Sometimes pushing aside the entrepreneur if necessary.  To make sure that seed capital can bloom into its full potential.  Perhaps all the way to an initial public offering of stock.  And when it does everyone gets rich.  The entrepreneur with the good idea.  And the venture capitalist.  Who now has more seed capital available for other start-ups with promise.

The Goal of the Private Equity Firm is to Get In, Fix the Problems and Get Out

Venture capital belongs to the larger world of private equity.  Where private equity investment firms operate sort of like a bank.  But with a few minor differences.  Instead of depositors they have investors.  Instead of safe investments they have risky investments.  Instead of low returns on investment they have high returns on investment.  And instead of a passive review of a firm’s financial statements by a bank’s loan officer they actively intervene with business management.  Because private equity does more than just loan money.  They fix problems.  Especially in underperforming businesses.

A mature business that has seen better days is the ideal candidate for private equity.  The business is struggling.  They’re losing money.  And they’ve run out of ideas.  Management is either blind to their problems or unable (or unwilling) to take the necessary corrective action.  They can’t sell because business is too bad.  They don’t want to go out of business because they’ve invested their life savings to try and keep the business afloat.  Only to see continued losses.  Their only hope to recover their losses is to fix the business.  To make it profitable again.  And selling their business to a private equity firm solves a couple of their problems fast.  First of all, they get their prior investments back.  But more importantly they get hope. 

The private equity firm uses some of their investment capital to secure a large loan.  The infamous leveraged buyout which has a lot of negative connotations.  But to a business owner about to go under and lose everything the leveraged buyout is a blessing.  And it’s so simple.  A private equity firm buys a business by taking on massive amounts of debt.  They put that debt on the business’ books.  Debt that future profits of the business will service.  Once the equity firm does its magic to restore the business to profitability.  Starting with a new management team.  Which is necessary.  As the current one was leading the firm to bankruptcy.  They may interview people.  Identify problems.  Find untapped potential to promote.  They may close factories and lay off people.  They may expand production to increase revenue.  Whatever restructuring is necessary to return the firm to profitability they will do.  Their goal is to get in, fix the problems and get out.  Selling the now profitable business for a greater sum than the sum of debt and equity they used to buy it.

But with great risk comes the chance for great failure.  When it works it works well.  Producing a huge return on investment.  But sometimes they can’t save the business.  And the firm can’t avoid bankruptcy.  The business then will be liquidated to repay the banks who loaned the money.  While the equity the firm invested is lost.  Which is why they need to make big profits.  Because they suffer some big losses.  But they typically save more businesses than they fail to save.  And the businesses they do save would have gone out of business otherwise.  So in the grand scheme of things the world is a better place with private equity.

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