Financing package of the year: Toys R Us $7.5 billion LBO

Combined bank and bond deals used to be the preferred way to finance leveraged buyouts. That’s no longer the case. As sponsors went after bigger and more complex buyouts in 2005, they came up with new capital markets solutions to suit the cashflow and assets of individual targets. Customized real estate and asset-backed loans and bonds became particularly popular. The October 2005 Neiman Marcus financing [see M&A deal of the year] involved a $600 million asset-backed loan and the buyout of rental car company Hertz involved a large securitization of its vehicle fleet. However, the Toys R Us financing trumped everything else. By the time the refinancing is completed it will have tapped six or seven different asset classes, in Europe and the US, and in three different currencies. The company had three main areas of value: the European Toys R Us business, the global Babies R Us business and real estate owned by the troubled US Toys R Us franchise. The leads decided that the best way to finance all the different cashflows, real estate assets, operating divisions and geographic locations of the company was to find individual financing solutions for each portion, which would make sense together as a complete package and work around the covenants in the company’s $1.7 billion of existing bonds.

“This financing could only be optimized by working from the bottom up,” says Sean Mahoney, managing director and vice-chairman of corporate finance at Deutsche Bank. “Our senior team average about 15 to 20 years in the business, and the final product turned out to be the most complex financing any of us had seen.”

This included a $2 billion asset-backed loan, the largest done to date, secured on the inventory and receivables of the US operations, $800 million of commercial mortgage-backed securities and real estate mezzanine debt, a $350 million revolving credit facility at the international business, an unsecured bridge loan in the US and a property-secured bridge loan in Europe. There was also $1.3 billion of cash from the sponsors. The refinancing of the $1.9 billion US bridge provided by Deutsche Bank and Bank of America had still not been finalized at press time, but could involve any combination of real estate-backed financings, asset sales, sale and leasebacks, high-yield notes, equity offerings or financing secured on royalty fees. The refinancing of the European property-secured bridge will be completed with more real estate-backed securities. In fact, the financing tapped so many different markets that there were 40 to 50 people from Deutsche Bank alone working on the deal in the US and Europe.

To complicate matters further, the initial plan of the company had been to sell just the Toys R Us business; but when Bain Capital, Kohlberg Kravis Roberts and real estate investment trust Vornado Realty said they wanted to buy the whole company in March, including the Babies R Us business, the lead arrangers had two weeks to rejig the whole deal. “For about 95% of the sale process, we focused on financing the Toys R Us division,” says Mahoney. “Two weeks before the final deal was announced, the whole process shifted, and we had to scramble to integrate Babies R Us without sacrificing the balance we were targeting across different markets.”

Yet the effort was worth it. By tapping a combination of real estate and asset-backed markets, the sponsors could put around seven times debt to earnings on a retail company with some troubled divisions, yet still achieve a lower cost overall financing than a traditional bank and bond deal. “Using the asset-backed, real estate-backed and CMBS market, the resulting leverage was materially more than what could have been achieved in a straight cashflow deal yet the average cost of capital was actually cheaper,” says Karim Assef, managing director in the financial sponsors group at Bank of America.

Real estate-backed financings of buyouts will get more popular as private equity firms and Reits go after the non-performing real estate assets of targets, particularly in the retail sector. In addition, with sponsors looking for the cheapest financing methods for larger and more leveraged targets, financings tapping multiple markets are set to take off. “Financing packages for buyouts are tapping many more markets than they did previously,” says Assef. “As sponsors are trying to buy bigger companies at higher valuations, they are having to get a lot more creative.”