Toy story

The battle for Toys “R” Us was one of the most hotly contested transactions of last year—can the victors walk away unscathed? By Paul Fruchbom

The theme song for Toys “R” Us, the toy retailer taken private by a consortium of private equity and real estate investors last year, is perhaps familiar to anyone who owns a television, parents a child or simply enjoys a catchy tune.

“I don't want to grow up, I'm a Toys “R” Us kid,” the lyrics begin. “There's a milliion toys at Toys “R” us that I can play with.”

Kids, of course, are not the only ones who play with toys, at least not these days. Private equity firms, real estate funds and other opportunistic investors have all been jumping into the playpen in recent years, albeit with mixed results. In 2000, Bain Capital acquired KB Toys for approximately $300 million; four years and one dividend recapitalization later, the company filed for bankruptcy. It was recently acquired by another private equity firm, Prentice Capital Management. A similar fate befell high-end toy retailer FAO Schwartz, which filed for bankruptcy twice in 2003—DE Shaw acquired the company's brand name and its flagship store in New York for $56 million; LA-based private equity firm Hancock Park walked away with the company's baby toy division, Right Start, for substantially less.

In comparison to Toys “R” Us, however, all those previous deals looked like, well, child's play. Not only did the battle for Toys have all the trappings of a classic takeover struggle—a stellar brand name; a “who's who” of private equity suitors; successively escalating bids; backroom partnerships; and, of course, disgruntled shareholders and lawsuits—it also had one of the largest sticker prices ever seen in the retail sector: $6.6 billion.

For the winning bidders—KKR, Bain and Vornado—recapturing one's youth did not come cheap.

Toys “R” Us was once the dominant force in the US toy market. In recent years, however, it faced increasing competition from discount retailers like Wal-Mart and Target, along with the migration of younger children away from traditional toy categories to other forms of entertainment— the same set of factors that led to the demise of KB Toys and FAO Schwartz. Since 1998, the company's net sales have remained essentially flat at $11 billion and its stock price fell from a 2001 high of $31 to approximately $12 in early 2004. Due to lackluster sales at its Kids “R” Us division, the company shuttered that operation in 2003, leaving it with two primary business lines: its global toys division and Babies “R” Us.

In January 2004, the company's chief executive officer, John Eyler, announced that Toys “R” Us was exploring strategic alternatives in an effort to boost its sagging share price. Soon thereafter, Credit Suisse First Boston (now renamed Credit Suisse) was hired as the company's financial advisor. Toys “R” Us was officially in play.

In June 2004, Credit Suisse presented the Toys “R” Us board with a number of strategic options including a sale of the global toy business or a spin-off/sale of Babies “R” Us. The investment bank did not focus on a sale of the entire business because, according to its presentation, “the universe of potential acquirors for the entire [Company] is extremely limited.” Based on its “sum of the parts” analysis, Credit Suisse estimated the total company's value between $4.3 billion and $6.1 billion.

In its pursuit of a sale of the global toys business, the investment bank contacted 29 potential buyers, including Apollo, Bain, Cerberus—who, along with GS Capital Partners, had already sent the company a formal expression of interest—CVC Capital Partners and The Blackstone Group. In early November, nine first-round bids came in, six for the global toys business and three solely for its European operations.

A month later, following extensive due diligence, the field had been whittled down to four teams: a consortium led by Cerberus including GS Capital and five other parties; a two-party consortium led by Apollo; a joint effort by Bain and Vornado; and KKR. In mid February 2005, “final” bids for the global toys business arrived, ranging between $3.4 billion on the high end (KKR) and $3.2 billion on the low end (Bain/Vornado). In its bid letter, Cerberus also proposed a valuation for the whole company, including Babies “R” Us, of $23.25 per share, or approximately $5.7 billion.

Given that wrinkle, Credit Suisse, as advised by the board, went back to the bidders in order to extract another “final” bid on the global toys division. Though KKR slightly increased its bid for global toys, the real mover was Cerberus. In an effort to pre-empt the process, Cerberus increased its bid for the entire company to $25.25 per share without a due diligence condition, a move that forced the board to recognize that a sale of all of Toys “R” Us would perhaps yield the highest overall value. On March 8, Credit Suisse asked all parties involved to submit an indication of interest for the whole business—and to move quickly. Bids were due approximately one week later.

“It is unusual to have a bid for part of the company and then have the rest of the company come into play,” says one lawyer who worked on the transaction. “Babies only added 200 or so stores— numbers-wise, it was not a huge increase. But value-wise, it was an entirely different part of the business. It required people to assess a part of the company they hadn't previously considered.”

It also required Credit Suisse and the board to navigate some tricky waters. Apollo, for its part, was hesitant to proceed so quickly—it asked for two to three more weeks of due diligence. KKR wanted to team up with Bain and Vornado. And Cerberus threatened to withdraw its $25.25 bid if it was not given exclusivity.

Nevertheless, the process proceeded and on March 16, “final final” bids arrived for all of Toys “R” Us. Cerberus remained at $25.25 per share, even though it had previously hinted it might increase its bid by approximately a dollar. While Apollo indicated it could offer between $24 and $26 per share, it still wanted more time. At that point, however, the issue was moot: KKR, Bain and Vornado had emerged as the clear winners, offering $26.75 per share, or $6.6 billion, approximately $350 million more than the Cerberus offer.

“It was a very competitive auction,” notes Robin Rankin, a managing director and head of the consumer and retail group at Credit Suisse. “Most people, even the buyers, would tell you that they paid a full price.”

A group of Toys “R” Us shareholders, however, disagreed. In late March 2005, they filed a lawsuit in the Delaware courts claiming that the board's decision to conduct a brief auction for the entire business did not yield the highest possible value for the company. The judge denied their claim, noting that the winning bid was approximately $500 million higher than Credit Suisse's initial valuation.

“It was a very competitive auction. Most people, even the buyers, would tell you that they paid a full price.”

According to many sources, the company's real estate holdings were one of the primary factors that enabled KKR, Bain and Vornado to pay such a high price. At the time of the sale, Toys “R” Us had 1,540 stores worldwide; at 424 of those locations, the company owned the underlying real estate.

“We were focused on it because Toys “R” Us was a great real estate play,” says one private equity real estate professional who analyzed the deal. “Most retailers don't own many, if any, of their locations.”

The real estate angle was certainly an important factor in shaping the make-up of the auction's final participants. Cerberus and Apollo, for example, both have dedicated private equity real estate arms. KKR manages a real estate investment trust. And Vornado is a real estate investment trust. Though representatives of Bain, KKR and Vornado declined comment, their public statements underscore the value they placed on the company's property holdings.

“We became interested in Toys “R” Us principally because it has lots and lots of terrific real estate, in the U.S. and abroad,” Steven Roth, chief executive officer of Vornado, said at a real estate conference last year.

The importance of those real estate holdings was not lost on the company's board of directors. As part of its strategic review, the board, beginning in early 2004, analyzed several options, including selling off the company's entire real estate portfolio or closing its least profitable stores and liquidating the underlying property. Other retailers such as Best Buy, Home Depot, Petsmart, Staples and Office Depot approached Toys “R” Us, each one expressing an interest in a portion of the company's real estate assets.

“There was a huge amount of value in the stores that [Toys “R” Us] owned,” says the private equity real estate professional. “If a store is underperforming, the public market is just not valuing its maximum potential, which is to operate it as a Linens 'n Things or something else.”

The KKR consortium is currently taking advantage of that discrepancy. Earlier this year, Vornado announced that Toys “R” Us would be closing 87 stores, 12 of which would be converted into Babies “R” Us locations. According to Vornado's SEC filings, the closing of particular stores had been considered during the acquisition process and was finalized following the holiday selling season, when Toys “R” Us generates a majority of its profits. The leasing and disposition of the remaining 75 stores will be handled by Vornado, highlighting the importance of their role in the winning bid.

“People like Vornado, who really understand real estate, were critical,” says Rankin.

One area where that knowledge was equally critical was financing the transaction. Not only was the debt package significantly large—approximately $6 billion—it was also immensely complex, involving an array of jurisdictions, real estate holdings and currencies. In addition to the $1.3 billion of equity provided by the three sponsors, the financing included: a $2.0 billion revolving credit facility, only a portion of which was drawn at closing; a $1.9 billion US bridge loan; a $1.0 billion European bridge loan; European multi-currency revolving credit facilities of £95 million and €145 million; and $800 million of mortgage loans. Since the closing of the transaction, approximately $1 billion of the US bridge loan has been refinanced via a new senior credit facility and the European bridge loan has been completely repaid through property financing and available funds.

“[The real estate] provided a way for the buyers to finance a transaction at pretty aggressive levels,” Rankin says.

Of course, now that the financing is in place and the company has begun its real estate restructuring plan, the real work begins. Toys “R” Us still faces many of the same issues affecting the industry including intense competition and shifting consumer preferences. Though the company's real estate may have enabled KKR, Bain and Vornado to secure a strong financing package and, perhaps, protect their downside, the price paid for the business necessitates a serious operational restructuring to improve sales and reduce costs.

“We became interested in Toys “R” Us principally because it has lots and lots of terrific real estate, in the US and abroad.”

Nevertheless, the company has made some major strides in recent months, particularly in building a new management team. Earlier this year, the company hired Jerry Storch, the former vice chairman of Target, to become the company's chief executive officer. And in May 2006, Clay Creasey, the one-time chief financial officer at Mervyn's, was named as the company's CFO.

In addition to the personnel hires, the company's financial results are also improving. According to Vornado's annual report, both the Christmas season and 2005 results exceeded expectations. Sales at Babies “R” Us division and, the company's online unit, were up 11.5 percent and 17.2 percent, respectively, versus the prior year. Perhaps that's why Roth, in his annual letter to Vornado's shareholders, stated that “The report from Toys “R” Us is so far so good.”

“[Toys “R” Us] has a terrific brand,” Rankin says. “They're the leader and the only company in their space—whether toys or babies. Their niche has been under pressure, but it remains a terrific brand that can be grown.”