With the somewhat surprising recent Chapter 11 filing for Toys “R” Us, renewed skepticism concerning the fate of brick and mortar retailers emerges. However, a closer examination of the causes for the Toys “R” Us reorganization attempt points a finger not solely at the retail environment, but, more importantly, at the underlying and inherent anatomy of a leveraged buyout (LBO). Apparently, Toys “R” Us has been suffering from many of the maladies that affect traditional retailers today, and that environment has contributed to the many insurmountable obstacles facing the toy and children's retailer. Moreover, an analysis of the structure and foundation of an LBO points to a prescription for a potential financial disaster when monstrous LBO debt burdens a brick and mortar retailer.

An LBO occurs when a profitable publicly held company receives a tender offer from an acquirer (usually a hedge fund or some other investment vehicle). Shareholders of the target company are offered a multiple of net worth of the company as an inducement to sell their shares and relinquish their ownership interests in the profitable entity. In order to finance the purchase of the shares of stock, the acquirer has the target company borrow the funds necessary to purchase the stock from the public shareholders and uses the assets of the company as collateral for the loan.

An example will demonstrate why most LBOs (especially those that have a retail component) are destined to fail. Suppose that the target company has a net worth of $1 billion. That means that its assets are $1 billion greater than its liabilities, and in a perfect world, if the company were to be liquidated, the shareholders would divide the $1 billion. In an LBO scenario, shareholders demand a premium in order to sell their shares. For this example, we will use a premium which is three times a multiple of the net worth. Thus, for the calculations, the acquiring entity will need to pay $3 billion in order to acquire the shares of stock in order to affect the leveraged buyout and take the company private. In order to do so, the acquiring entity will cause the company to borrow the $3 billion to purchase the shares, with the company's assets serving as collateral for the loan. Since loans of this nature are traditionally high risk, the interest charged on the loan will be substantially above market. Thus, the company will now be required to pay interest and reduce the principal of the debt where the company received no benefit from the massive loan.