In the first six months of the COVID-19 slump, at least six million people working in retail lost their jobs and more than a dozen big names in retail filed for bankruptcy, including JCrew, Neiman Marcus, JCPenney, and Brooks Bros.
Certainly, bad news for these companies – but not for everyone employed there. Despite what we have been told, we are NOT all in this together. The strategic use of Chapter 11 bankruptcy filings has actually been good for some, especially executives of these companies as well as the private equity firms that executed retail leveraged buyouts (LBOs).
Why hasn’t the pain been shared? The answer lies in the difference between personal bankruptcy and corporate bankruptcy.
Bankruptcy: Personal and Corporate
When an individual files for bankruptcy (under either chapter 7 or chapter 13), a trustee is appointed by a bankruptcy court to handle the assets of the bankrupt individual.
In contrast, most of the COIVD-19 triggered corporate bankruptcies are filed under chapter 11. In this case, the bankrupt company retains possession of the assets of the company (referred to as “debtor-in-possession” or “DIP”). The bankruptcy court will issue a stay on creditors seeking to collect from the chapter 11 filer. And, a DIP may raise new money by issuing new debt.
Why would anyone lend to (buy the debt of) a bankrupt company? Because DIP financing is senior to any other outstanding debt or equity in the bankrupt company in the event of actual liquidation of the business. Vulture capital funds are attracted to this kind of debt, because it jumps the queue in seniority and will pay a higher rate of interest.
Retail: Reaping the Whirlwind of Private Equity
Private equity firms have been attracted to retail, especially clothing, stores, for more than a decade. Between 2002-2019 private equity firms spent at least $116.5 billion on 95 retail acquisitions. What attracted private equity to retail?
Retailers usually carried small amounts of debt but generated significant cash flows. Although the profit margins in retail are often small, many retail stores, such as Sears and JCPenney, own the land on which a number of their stores are located. This real estate is an asset that can be used as to secure the debt that private equity issues to finance the takeover, including the always huge initial payout to the private equity firm itself.
Let’s see how this works out in two recent filings.
In 2011, the mid-range clothing retailer JCrew was taken private in a $3 billion leveraged buyout (LBO) led by TPG Capital and Leonard Green and Partners. The debt raised to execute the LBO became a part of JCrew’s balance sheet, and JCrew was responsible for interest on and eventually principle repayment of this debt. But the burden imposed by the LBO firms did not stop there. JCrew then borrowed another $787 million for dividend payments to – you guessed it–TPG Capital and Leonard Green.
By 2020, cost cutting and layoffs had reduced JCrew’s workforce by 10%, and its debt load was $1.7 billion. JCrew filed for chapter 11 in early May, the first major clothing retailer to do so.
Too bad for many of the firm’s 14,000 employees – but not for the LBO firms or JCrew executives. According to the bankruptcy court filing, in the year prior to chapter 11 filing, the firm paid out over $17 million to various insiders. In 2016, as the company was struggling financially, the new management pioneered another financial boondoggle by transferring JCrew’s intellectual property rights – its brands – to a Cayman Islands shell corporation, where they are out of the reach of JCrew’s creditors but securely under the control of the LBO firms. This approach to asset stripping is now referred to as the “JCrew trapdoor” (sometimes also called “J.Screwed”).
As of mid-August, the firm’s website lists only 170 stores open of the pre-COVID 500.
In 2013, the very upscale Neiman Marcus was acquired via a second LBO by the private equity firm Ares Management, along with the Canada Pension Investment Board, for $6 billion. Despite heavy debt, the company continued to expand. The high-water mark occurred in March 2019, when Neiman Marcus opened its first store in Manhattan, a 188,000 square foot Hudson Yards anchor.
Within a week of JCrew’s bankruptcy filing, Neiman Marcus also filed for chapter 11 protection, threatening the livelihood of its more than 13,000 employees. In February Neiman Marcus had paid a bonus of $4 million to its CEO; a week before filing chapter 11, other executives received another $25 million.
But, as with JCrew, that is not the end of the story. In 2014 Neiman had acquired German-based MyTheresa, a “luxury” online clothing “destination.” In 2016, Neiman Marcus Group LLC transferred ownership of MyTheresa to its parent company, The Neiman Marcus Group. This insulated the MyTheresa assets from creditors in the recent bankruptcy because it is the LLC, not Neiman Marcus Group that filed chapter 11. And, of course, the LBO firms retain control of the parent and the assets of the parent.
Neimann Marcus told the bankruptcy court that 21 locations will close permanently.
What Should be Done?
The stories of JCrew and Neiman Marcus highlight three problems. First, the outrageous payouts to insiders in the run up to bankruptcy. Second, highly leveraged LBOs that saddle the target with debt, and third, the “special dividends” paid to LBO firms.
Once a firm has filed chapter 11, bankruptcy courts are unlikely to approve large payouts to insiders. So, we need a mechanism to stop the payments that are made as bankruptcy looms. The Office of the United States Trustee should have the power to review and revoke such payouts made in the previous year.
In a perfect world, we would prohibit LBOs because they are primarily predatory and often destructive of value and jobs. In this world, we could at least put restraints on the LBO market. In 2013, the Federal Reserve issued “guidelines” on LBO financing: the maximum leverage – the amount of debt assumed by the target company compared to the company’s earnings before interest, tax, depreciation and amortization (EBITA) – should be 6.0. Making the leverage guideline mandatory (and preferably below 6.0) would require LBO firms to put up additional equity, because it would limit the debt that could be loaded onto the target company.
Even more useful: prohibit banks from financing any LBO where the private equity buyers are proposing to pony up less than 50 percent of the purchase price; after all, in the midst of the 2008-9 crisis, when credit markets were tight, LBO firms provided an average of over 50% of their own capital in LBOs.
The acquired firm usually issues a large dividend to the acquiring firms, piling additional debt on the acquired firm. Any dividend payout to the acquiring firm for some period after the acquisition should be prohibited. The result might be investment in improving the operations of the acquired firm, the alleged reason for most LBOs.
A first step: last year, senators Elizabeth Warren and Sherrod Brown introduced the Stop Wall Street Looting Act, which was co-sponsored in the House by Pramila Jayapal and Mark Pocan. Chapters should ask their congressional representatives to sign on to this legislation.