The fire sale of bankrupt retailer Toys “R” Us Inc.’s Asian arm may struggle to fetch as high a price as bondholders expect due to clause in the shareholder agreement which gives the Hong Kong-based Fung family the right to match any bid for the business, according to people close to the process.
Private equity firms have offered over $1 billion for Toys “R” Us Asia hoping to ride the fast growth in the region’s consumer sector, driven by an economic updraft, an expanding middle class and rapid urbanisation, the people said.
However the Fungs are in a strong position to block them all. The Fung Retailing Group, a privately held entity and a member of the Fung Group, holds 15% of Hong Kong-headquartered Toys “R” Us Asia and a range of rights over the whole business.
The sale of Toys “R” Us Asia kicked off as the 70-year-old retailer, Toys “R” Us, Inc., floundered. Online shopping and gaming firms have been hammering bricks-and-mortar retailers for years and Toys “R” Us was ill-equipped to cope given it was still saddled with expensive debt after its July 2005 leveraged buyout.
As part of its fight to stay viable, Toys “R” Us merged its businesses in Japan, Greater China and Southeast Asia on May 3, 2017 to create Toys “R” Us Asia. Toys “R” Us Inc. said on June 17, 2017, that the merger had completed.
Toys “R” Us, Inc., finally capitulated and filed for Chapter 11 bankruptcy protection in September 2017 and then said in March it would liquidate inventory.
The auction of its Asia arm could result in another US household name exiting China, following in the footsteps of Uber, McDonald’s and Yum! The operating business is also sizeable and a rare blend of operations spanning Japan and China. There are also distressed debt holders in the mix mulling a debt-for-equity swap, making for a potentially landmark transaction in Asia.
Distressed debt investors have been trading in and out of the bonds in Toys “R” Us Inc.’s international subsidiary Tru Taj LLC. They are higher up the capital structure than equity holders in Toys “R” Us Asia but their tactics are unclear and represent a wild card in the auction.
The auction of Toys “R” Us Asia is key to raising capital to meet the retailer’s obligations as debt repayments peak in 2019. Toys “R” Us bondholders have pushed hard for the sale’s organiser, Lazard, to send invitations far and wide to rustle up the highest bid possible.
Interested parties so far have included Chinese private equity firms FountainVest and Primavera, according to people involved in the process.
Japanese private equity firms, Advantage Partners — which announced the final close of its inaugural Asia Fund with commitments of $380 million on April 30 — and Japan Industrial Partners have also shown interest, they said.
So has the Japanese trading company Itochu and state-controlled Chinese conglomerate Citic Group, they said. Itochu invested in Citic Ltd in 2015.
However, the auction may test the resilience of the bidders given that they may have put in a lot of spade work to properly value Toys “R” Us Asia only to have the Fungs trump their bid by the smallest margin possible.
Toys “R” Us Asia operated 223 stores in Greater China and the Southeast Asian markets covering Brunei, China, Hong Kong, Malaysia, Singapore, Taiwan and Thailand, and licensed an additional 34 stores in the Philippines and Macau, as of May, 2017.
The integration of Toys “R” Us Japan added 160 Toys “R” Us and Babies "R" Us stores and about 6,600 staff.
JAPAN & CHINA COMBINED
Japanese companies are particularly interested in the sales process because Japan continues to be a huge market for toys and baby products despite the country’s rapidly aging population.
While the Japanese birth rate dropped to the lowest level since records began in 2017, according to the Ministry of Health, Labor and Welfare’s annual survey, adult collectors who prize the Toys “R” Us products have propped up sales, said a person familiar with the business.
The “kawaii” or cuteness aesthetic has become a prominent aspect of Japanese popular culture, seen in people's enthusiasm for charming or childlike objects.
Sales in Japan are also helped by popular Nintendo products, such as the Switch video game console.
Japan contributes about two-thirds of the revenue of the enlarged joint venture, a person familiar with the business said.
The Japanese business is growing more slowly than the much smaller Chinese operations, whose revenues are ramping up in double-digit percentages each year. Sales in China are likely benefitting from the phasing out of China’s One-Child family planning policy.
The China business generates about $150 million in Ebitda annually, the person said, although profits have been dented recently by blow-back from the US parent’s bankruptcy filing. On September 19 Toys "R" Us Asia said it was unaffected by its parent's financial restructuring as it was a separate legal entity and its stores remained open for business.
MOVING PARTS
There are many moving parts and interested parties in the rapidly progressing sale process.
Lazard is running an auction to sell the operating business in Asia including intellectual property. It has already orchestrated two rounds of bids for Toys “R” Us Asia and is now asking for binding bids by late June.
A big fly in the ointment for pulling together a binding bid would be the Fung’s right to reject putting any debt on the operating company, which is virtually debt free, one of the people familiar with the process said.
This is particularly a key concern for a private equity firm because it would look to pay most of the asking price with debt. Banks typically would be leery of lending to a fund if a shareholder in the target business had such extensive rights over the operations and might block debt repayments.
As a result their bids could be lower than if the Fungs' did not have this right.
The Fungs also have a right to block any dividends sucked up to the holding level, the person said.
Initially, the shareholders agreement detailing the Fungs' rights was not widely available to the bidders. It is still not public information.
The Fungs have been partners in the Toys “R” Us business in Asia for more than 30 years. It owned about 50% of its joint venture in China with Toys “R” Us.
Toys “R” Us Inc. was first introduced to Asia by Fung Retailing in 1985 under a licensing agreement and have brought on board many of the senior management.
The Fungs introduced Toys “R” Us to Harbour City, a large shopping mall in Tsim Sha Tsui, Hong Kong. Broadly speaking, the Fungs favoured a small-store format across Greater China, unlike the big box format the US parent adopted, which put it into direct competition with the likes of Walmart, Target and Amazon.
Fung Retailing also owns the omnipresent Circle K convenience stores in Hong Kong.
To be sure, the deal process may still fall apart or one of the bidders could place a knock-out bid that would tempt the Fungs to tender their stake in the business instead of bidding for the whole operation.
But at the moment the Fungs are determined to exercise their rights.
