As Toys ‘R’ Us heads for liquidation, a common refrain has it that the toy retailer failed to successfully reorganize in Chapter 11 because it took on too much debt.  The 2005 leveraged buyout (LBO) of Toys ‘R’ Us by a group of investors led by KKR Group, Bain Capital, and Vornado Realty Trust is a particular target for blame.  But this ignores the larger issue, of which the LBO and the subsequent bankruptcy are merely symptoms.  In short, Toys ‘R’ Us collapsed, like many companies have, because of a failure to innovate.

Unmanageable debt and capital structures – though primary motivations behind Chapter 11 reorganization attempts – are rarely the cause or the explanation of a failed Chapter 11 reorganization attempt.  The reason is simple: The financial distress associated with debt can usually be dealt with through the reorganization process.  Chapter 11 is a tool for firms to shed onerous debt and adopt new capital structures that are better suited to their business model. On the other hand, bankruptcy law does not cure economic failings, and the weaknesses of a bad business model can be difficult to overcome by the time a company reaches bankruptcy. The inability to respond to technological disruption in a timely fashion has devastated not just Toys ‘R’ Us, but other big name companies such as RadioShack, Kodak, Borders Bookstore, and Blockbuster.

The recent history of once-proud companies at the top of their fields falling into liquidation for failing to respond to a changing market is detailed in Technically Bankrupt, by Brook Gotberg.  Like Toys ‘R’ Us, Borders and Blockbuster used business models that relied on a public that would purchase items in a brick-and-mortar storefront rather than ordering online.  As public preference for online shopping shifted, these companies failed to keep up, continuing to pour resources into the maintenance of expensive real estate.  Despite the early cooperation of lenders and the best intentions for a sale of assets as a going concern, management was unable to change their business models in time to salvage corporate going-concern value, and liquidation became the only option.

The Toys ‘R’ Us LBO is simply a symptom of this trend.  The company was experiencing notable declines in its retail toy business in the early 2000s, even as it still represented nearly 20 percent of the total market.  It was competing with both Walmart and Target and struggling to maintain a profit. The retailer’s one big bet on innovation, an exclusive 10-year deal signed in 2000 with a then-much-smaller Amazon, soured and headed for litigation. But it was still making money off of Babies ‘R’ Us—a smaller business that produced more than half of Toys ‘R’ Us profits in 2004.  The large cash flows of Toys ‘R’ Us and potential for profit growth in Babies ‘R’ Us attracted investors to the prospect of an LBO.

Unfortunately, things didn’t play out the way that investors had hoped.  Amazon continued to grow and to absorb ever-larger portions of the market share.  Only three years after the 2005 LBO, a global financial crisis pounded Toys ‘R’ Us and other retail stores as consumers cut back on their spending, especially for less necessary items.  Technology developed and spread further into the field of toys and play, so that children spent more and more time on electronic devices and less time with physical toys.  Babies ‘R’ Us struggled both from the rise of competitors and the decline of birth rates.

The challenges and opportunities that should have spurred innovation didn’t at Toys ‘R’ Us, which failed to alter its business plan in any meaningful way.  Instead, for over a decade the company stuck with the structure implemented by the LBO, which is a powerful tool for cost cutting and for encouraging efficient operations, but not for innovation.  Large debt payments limit managerial flexibility and force management to implement cost cutting measures to survive. This structure has long been recognized as a tool to discipline management toward efficiency, but it limits spending on innovation.

That is to say, the LBO was the wrong tool for innovation. But it didn’t prevent innovation. The LBO structure can always be changed if it turns out that innovative spending is the way to go.  Sometime during the 12 years between the LBO and bankruptcy in September of 2017, someone in management might have produced an innovative proposal that would have justified an alternative capital structure. The problem for Toys ‘R’ Us was that no one did.  In other words, the Toys ‘R’ Us strategy was discipline and cost cutting implemented through a high debt LBO structure. The strategy – not the implementation – was flawed. The company actually required a new business model that responded to developing and shifting technology.

It is perhaps easier, and more comforting, particularly to other retail companies, to blame the fall of Toys ‘R’ Us on a bad balance sheet, reflecting the debt associated with a leveraged buyout that occurred over a decade prior to the bankruptcy.  But the reality is that, with the continuing march of technological disruption encouraging the continual evolution of shopper preferences, more such bankruptcies are likely to follow for companies that do not adjust their business model in response.

This post comes to us from Professor Anthony J. Casey at the University of Chicago Law School and Professor Brook E. Gotberg at the University of Missouri Law School.