The downfall of Toys R Us is bringing renewed attention to leveraged buyouts and the role private equity firms have played in the recent string of retail bankruptcies.

In this episode of Industry Focus: Consumer Goods, Vincent Shen and Motley Fool contributor Dan Kline explain how a leveraged buyout works, why things can go wrong, and how everything played out for Toys R Us.

The team also looks at the latest headlines from Walmart (NYSE:WMT) .

A full transcript follows the video.

This video was recorded on March 27, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen. Consumer and retail is back in the studio for a second time this week, as we're pre-recording this episode for March 27th.

Earlier this week, Asit Sharma and I had the opportunity to take a closer look at Hudson Ltd, one of the more recent initial public offerings in the retail sector. Today, I'm hoping to take a step back to cover a couple of different stories, one being more company-specific and the other will speak to a broad industry trend. Joining me via Skype today is Motley Fool contributor and jack of all trades, Mr. Dan Kline. Hey, Dan! Thanks for being here!

Dan Kline: Hey, Vince! Thanks for having me! I'll point out, I was there when we first scheduled to tape this.

Shen: Yes, that's true. We had to reschedule. I know you have a quick turnaround this morning as you prepare to hit the road. Where are you going again?

Kline: I'm going to Naples, Florida. I live in West Palm Beach, which is on the east coast, and I'm going to Naples, which is on the west coast, so just a little bit of a change in the type of the sand on the beach.

Shen: Well, that sounds pretty good to me, a beach, that is.

Kline: Yeah, there's no snow here.

Shen: A lot of us here at Fool HQ would be happy to trade shoes with you, I think, given the storm that just hit the East Coast.

Kline: Well, you're welcome any time.

Shen: Our first story for today goes back to Walmart. I've been pretty much actively trying to avoid talking about this company for a while now, but I'm giving in today because there have been several recent developments that I think deserve our attention. First, a little bit of bad news. A whistleblower has accused Walmart of using deceptive practices like delaying customer returns and collecting inflated commissions from vendors in their online marketplace to juice the growth and results from its e-commerce business. That raised some eyebrows here at Fool HQ, given how important digital growth has been to the bull case for this company. What are your thoughts here, Dan?

Kline: It does, but let's put this into context. This is a single person who is a laid-off employee making these accusations. That doesn't automatically make them untrue, but we haven't seen any vendors come forward and say they were charged inflated fees. We haven't seen any customers say they've had issues with returns. Even the amount of returns alleged to be improper was about $7 million, which in the terms of the Walmart digital business, is kind of like me forgetting that I owed you $1.

Shen: Yes, I understand that.

Kline: [laughs] It's not a huge amount of money. The bigger concern here is, how healthy is Walmart's digital business? In the last quarter, the growth slowed. They've been having 50% quarter-over-quarter growth, and it slowed to, was it 20% in the most recent quarter?

Shen: About 23%.

Kline: 23% and people got very panicked about that, even though overall sales increased. And I think some of the big picture is being mixed here, that the Walmart digital effort is really an omnichannel effort. And if it drives more people to stores instead of driving more people to buy online, as long as overall sales go up, it really doesn't matter.

Shen: OK. I will stress that these are allegations. Walmart has denied these allegations, no surprise there.

Kline: Vehemently.

Shen: And there's a lawsuit that will have to work its way through the courts before we know more. But you mentioned some of the reasons and the points behind why I wanted to bring this up. One, we know that Walmart is pretty laser-focused on building out its digital channel since they acquired and handed the reins over for e-commerce to Marc Lore. And all of that is part of the strategy to not only better compete with Amazon but also just gain market share in general in this channel. 

And two, as you mentioned, the stock has taken a beating in the past month. I think it's down over 15% since the company reported fourth quarter earnings. And top line, same-store sales results were strong, but because that digital growth came in at that 23% year over year that we talked about, a deceleration from the approximately 50% levels that Walmart reported for most of 2017, a lot of investors dinged the stock for that slowdown. I think that's a clear indicator, at least, of how much weight and value the market has placed on sustainable and robust growth in the e-commerce for Walmart.

Kline: And I think the market is looking at this incorrectly. When you look at an omnichannel model, you might be standing in a store and place a digital order that will be brought to your house. You might be at home and place an order that you pick up in your store. You might get it home, not like it, and have it shipped back from your door or bring it back to a store. The definition of where a sale counts is where the transaction occurs. So, if you buy it online and pick it up in store, it's still a digital sale. 

But, again, I go to the importance of being the overall sales number. Walmart is building out its supply chain. It's building out its ability to have what you want where you want it. And it's also forcing people or trying to train people to buy certain items in stores. There's actually lower prices on certain hard-to-ship items if you physically go to a store. That's trying to get you to do that. So the whole story isn't digital sales. This isn't Amazon reporting slowing growth where really their only business, at least as a retailer, is digital sales. With Walmart, it's easy to pick apart these numbers, but again, I think this is market overreaction.

Shen: OK. Something, then, that's more on a positive note, and I think probably more impactful to the overall business, is another piece of news that caught my attention. This is the company's potential investment in Flipkart. So this is still related to e-commerce, as Flipkart is the biggest e-commerce player in India. If Walmart does end up pouring the reported $7 billion in the company, it'll be Flipkart's biggest investor.

Dan, the big pieces of this story to me are, one, the exposure to the Indian market and Flipkart itself, and also because Flipkart's valuation has soared in just the past year. Anything with this news jump out to you?

Kline: Really, anything you can do to access the Indian market, that's a market that American retailers have generally struggled to go into on their own. So getting in through a backdoor is a smart play. And anything that enhances your technology infrastructure has proven to be a good investment. We're seeing Target snap up delivery companies. Walmart has made a bunch of big and little investments. Amazon has acquired some players in the space. It's really all about the ability to get things to consumers. And if you can invest in a company that helps you there, that also lets you have better access to the incredibly large market in India, it's hard to see that as bad.

Shen: Amazon is also spending billions of dollars trying to establish its position in India. Flipkart has been able to stand apart as a strong, viable competitor in that market. The potential deal with Walmart is definitely an interesting one. And it could end up paying for itself soon enough if Flipkart's valuation continues to increase as it has recently. 

So just to illustrate that, I'll end our Walmart discussion on this tidbit -- one of the entities that's reportedly looking to divest part of its stake in Flipkart with this Walmart deal is SoftBank. That's the Japanese conglomerate that has come up on Industry Focus in the past due to its holdings in companies like Sprint and Alibaba. SoftBank poured about $2.5 billion into Flipkart just last August. And if this Walmart deal actually comes to fruition, SoftBank will be pretty darn close to doubling the value of that original investment in a very short period of time. I'll stress one last time before we change gears that the situation with Flipkart is not yet finalized. But if that day comes, we'll be sure to follow up with more updates.

Now, let's transition to our main topic. Anyone who actively follows the retail sector or has been listening to this show in the past year is likely aware of the challenges faced by retailers, especially those of the traditional brick-and-mortar variety. There's been store closures, bankruptcies, and the "retail apocalypse". They come up pretty often. 

But in our previous discussions of these companies and retailers and the sector overall, we've addressed headwinds like online competitors, shifts in consumer spending and preferences, declining foot traffic, and the cost of some of these omnichannel investments. But what we haven't really touched on is the role that certain investors have often played in worsening the declines for some of these retailers. Specifically, I'm referring to private equity investors and how their playbook can end up hobbling a retail operation for short-term gains at the expense of the overall longevity of the business. 

Dan, you came to me specifically wanting to cover this topic, so I'll pass you the baton. Can you give listeners, really quick, a high-level take on the situation? Once we have that framework, we can talk about some more specific examples.

Kline: It's called a leveraged buyout. And what a leveraged buyout means is, let's pretend a company is worth $3 billion. The investors, the private equity, put up a very small amount of money, maybe $300 million. Then, they use the equity the company has to issue debt to then fund the purchase of the company. So essentially, they're taking a company that's very healthy, that has a great balance sheet, and they're saddling it with all sorts of debt. 

That model made sense back in the early 2000s, when retail was sort of just a straight line. You couldn't see Amazon coming. You could look and see what was happening. And eventually that that would get paid down, the investors would make money. The problem is, when everything changed, the companies that had this huge debt did not have the leeway of, say, a Macy's or even, ridiculously, a Sears, to go, "Wow, all of these things are happening, we have to pivot." Now, obviously, some of those pivots didn't work. But if you look at certain retailers, they either limped along because they couldn't change and then eventually went out of business, or they're scrambling and closing stores and they just don't have the ability to get the money they need to make huge investments in order to change their strategy.

Shen: Yeah. I think, what this comes down to is the lack of flexibility that this kind of strategy ends up resulting in. And also, a lot of the changes that have come about in retail as a result of some of those other variables and headwinds that I mentioned earlier. At their core, though, the way these private equity investors operate is, one, they raise money from wealthy investors and large institutional investors to establish an investment fund. Two, they seek out underperforming or undervalued businesses, but they should have, as you mentioned, strong balance sheets, strong cash flows. Three, they acquire this business. Four, they make changes where they're trying to improve things like profitability and cash flow, and five, ultimately, they hope to profit through their investment through various dividends, management fees, and then sales or IPOs of those businesses to return that original capital to the wealthy and institutional investors.

Next up, we'll get into more of the nitty-gritty behind this kind of playbook, and some of the examples of how this strategy has backfired. Going back to that framework that I just mentioned, finding the buyout targets, I think it's interesting to note, you mentioned how in the early 2000s, when retail was going more in a straight line, in that time period, too, I think it was in a Harvard Business Review piece, they mentioned that private equity transactions, especially the larger deals, were weighted heavily toward individual segments and business units of existing public companies around that time. If you consider the downsizing that we've seen at big consumer retail companies like Procter & Gamble, lots of brands or segments that aren't really core anymore to the company, and as a result they're not really integrated as efficiently, or they don't get the necessary attention and resources from management. It makes sense to me that those businesses are spun off to avenues where their value can be maximized. 

While those kinds of deals do still happen, in the last decade, we've seen them make a shift toward entire deals for companies. That takes us to part three, the buyout process. This is the area, Dan, that you seem to have the most qualms with because of that debt part of the equation, and how that really weighs down these companies.

Kline: Yeah. Imagine if you bought a house for cash, you paid $300,000 for a house, and then you immediately took 99% of the house's value in a home equity loan and spent it on candy and gum. Then, if your sink breaks or you need a roof repair, you don't have a source of cash to tap to make those repairs.

So maybe at first you tack the tarp up on the roof, and then maybe you don't use your kitchen sink. Then, eventually, you live in an uninhabitable house that you have to walk away from or sell or declare bankruptcy. That's what's happening when you look at some of these companies. If you strip away the debt, a lot of struggling businesses, companies like Gymboree, Payless, Toys "R" Us, which is the big one we'll talk about, their operations themselves were maybe not healthy, but they were certainly not as damaged as they appear when these companies can't meet their debt payments and end up going bankrupt.

Shen: Yeah. The big thing here to keep in mind for why these investors will do this is, these kinds of leveraged buyout deals can generate really incredible returns, think 15% to 25% or more, in a very short period of time. And that's to the fund's backers. As you mentioned, the buyers invest only a small portion of equity in the buyout target. The rest gets funded with all that debt. 

Kline: And in many cases, not every case, they can also take out some of their original investment in management fees and other payments and ways.

Shen: Dividends, yes.

Kline: So as long as the company survives a few years, even if you don't get the returns of an IPO, you might still come out of it whole. So in a lot of ways, you're playing with other people's money.

Shen: Yeah. And the debt amount for these deals typically comes out to about 50% to 80% of the total financing for a deal. We don't have time to get into all the finer mechanics of this, but really what's important to know is, the resulting company has this large debt load on its balance sheet that they have to service. Ideally, that debt gets paid down over time. And when the private equity firm and investors exit the investment, they get a very healthy valuation for the company after putting in very little money up front, or relatively little money up front. 

I think the focus on debt, and also how these investors often rework the businesses they acquire, is behind some of the problems we're encountering now. That debt load and the large interest payments associated with it leaves very little room for error for these portfolio companies, as you kind of mentioned, Dan. And you have to keep in mind, as well, that the typical window or timeline for these investors, because they're thinking with a short-term mindset of just maybe two to six years, there's actually a cap for these funds, so the original backers have an expectation of when their investment gets returned to them. 

But as long-term minded Fools, we're all too familiar with how some of Wall Street's short-term focus can result in a lot of less than desirable outcomes. Taken at face value, I don't think anybody will argue against the idea that if you want to optimize a company's operations, potentially change its management team to improve the company's overall prospects and outlook. But these investors that are focused on reducing that debt and increasing profitability for a better valuation, come harvest time, that often means cutting costs, as firms like 3G Capital are very well known for. They might sell off assets, reduce workforces. And a lot of times, these interests will align. You end up with stronger businesses that can IPO successfully or get acquired by someone else. But a lot of times, too, and this is where we're talking about our retail sector focus, you get companies that failed to make the investments they needed to compete in the current retail environment. 

The list of these failures is pretty long. You have Payless ShoeSource, True Religion, and just recently, Claire's. And the big one we're going to talk about, Dan, is Toys "R" Us, which we covered not long ago after it initially declared bankruptcy, hoping for reorganization.

Kline: Yeah, it's been a very sad story. [laughs] 

Shen: Yeah. Why don't you give us a better idea here of how things ended up panning out for Toys "R" Us?

Kline: Three different companies arranged a leveraged buyout of Toys "R" Us. They took on about $6 billion worth of debt. And the way the business was operating at that moment, in theory, they would have paid off the debt and been able to go public. The problem is, the internet happened, and Target and Walmart both decided that toys would be a very attractive, call it a loss leader. The toy section in Target or Walmart is so the parent can get the kid a justification to do their shopping, and maybe they buy a few things. The prices at those chains forced overall prices down, as did Amazon. 

So that puts Toys "R" Us in a position where margins are lower, there's less reason to go to the store, and in theory, they should be investing heavily in their website. Now, we know Toys "R" Us had a misstep where Amazon used to provide its website, and that set it back for years. But when it got out of that deal, it should have done two things. We talked about this on the last show. It should have made its stores destinations. There should have been gaming and events and demonstrations and areas where you can ride a bike and play with different expensive toys and all sorts of things to make a kid say, "Oh my God, I want to go to Toys "R" Us." The second thing it should have been doing is figuring out how to build out its digital channel. 

And the reality is, not only did it do neither of those things, it actually slipped on maintenance in its stores. Stores that once at least had interesting displays became more pedestrian. And because of debt, the company stopped doing the things that probably, I assume, management knew it should have been doing, but it could only move in very small ways, because cash got tight. If you have that much debt anyways, you can't borrow $1 billion to revamp all of your stores or hire new specialists in different product areas. It becomes a self-fulfilling prophecy.

Shen: Yeah. So here, we had a company with profitability on the rise, the e-commerce business was growing, I think it logged over $1 billion of digital sales recently. But it failed to get refinancing on just a small portion of its debt, about $400 million that was coming due this year out of $5 billion total. The crazy thing is, the bigger picture beyond Toys "R" Us for the sector overall looks pretty daunting in the years ahead.

After the financial crisis, we had a lot of the struggling retailers getting scooped up at bargain prices with cheap debt financing thanks to the low interest rate environment. But a Bloomberg report mentions that only $100 million of high-yield debt in the retail sector matured last year. That number increases to almost $2 billion for 2018. Then, it balloons further to about $5 billion annually from 2019 through 2025. So the report mentions further that outside of retail, including all industries, that high-yield debt worth $1 trillion will come due in the next five years, which means a lot of companies are clamoring to refinance in the near future. Given the bearish view of retail, a lot of companies similar to Toys "R" Us might not get that refinancing that they need. 

Last couple of minutes here, Dan, any takeaways you want to leave our listeners with?

Kline: Yeah. I think there's going to be a huge ripple effect because of this. If you look at just the toy space, obviously Mattel, Hasbro, but every independent toy company, is losing a major showcase. And I think it's possible, you're seeing some rumblings with Toys "R" Us of some different private groups, maybe some toy companies, buying some of the more successful locations and relaunching the brand. I don't know if that will happen with Toys "R" Us. But I think that will happen with some of these other struggling retailers, because if you're a sneaker company or a shoe company and Payless goes away, you're losing thousands and thousands of outlets. So I do think you're going to see some creative financing to keep some of these chains afloat, but a lot of people are not going to get paid back for debt that's already owed, and it's going to cause suppliers and malls and a lot of other people to go out of business.

Shen: Yeah. And that has a pretty big impact for the workforces there, as well. I'll wrap up our discussion. There's honestly a lot more to cover with private equity and the many deals that industry has executed in the past few decades, we just don't have enough time to cover it all in a single episode of IF here. But my business program at the University of Virginia had an entire course in the semester dedicated to just this topic. 

I'll also say on the flip side, there have been many successful private equity transactions as well, a recent one even, that we covered on this show was with Canada Goose Holdings. So this is not a boogeyman scenario as we've tried to avoid painting Amazon to for retail, as this boogeyman that's the cause of all these issues that traditional brick-and-mortar players have had. 

But, more importantly, I think it's just important context for investors to have as they evaluate the retail sector and various reasons why you've seen thousands of store closures, dozens of bankruptcies make regular headlines in this space. So thanks again, Dan, for hopping on today. Enjoy your trip!

Kline: Thanks for having me!

Shen: Thanks to Fools for tuning in! People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.