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‘The Big Short 2.0’: How Hedge Funds Profited Off the Pain of Malls

Catie McKee was nervous. It was last October, and the 31-year-old hedge fund analyst, who had been scrutinizing the mortgages on the nation’s malls, was convinced that some of those malls would default on their loans. She and her colleagues had even bet a substantial amount of money on that likelihood.

Ms. McKee was about to make her case to Carl Icahn, one of the country’s best-known investors, who had made a similar wager and invited her team to discuss the trade. Nothing would bolster her confidence — and the prospects for her trade — more than if the billionaire and onetime corporate raider backed her up.

She needn’t have worried. As Ms. McKee sat in Mr. Icahn’s wood-paneled boardroom with a sweeping view of Manhattan’s Central Park, discussing her thesis with the 83-year-old investor, she realized they shared the same outlook. Both agreed that e-commerce, changing consumer habits and evolving demographics had pummeled all malls to some degree in recent years, but some were far worse off than others. So by betting on their demise, both could profit handsomely — which they did.

Mr. Icahn, whose hostile takeover of TWA in the 1980s established him as a major dealmaker, has made $1.3 billion on the trade since that meeting. And the investors that made the trade within Ms. McKee’s firm, MP Securitized Credit Partners, more than doubled their money. They are among a handful of investors who have, collectively, made hundreds of millions of dollars on similar trades this year.

There is something discomfiting about the idea of getting fantastically rich off someone else’s misfortune, which is what happens when a “short” trade — or bet against a stock or industry — succeeds. The contrast is even more startling given that the pandemic, which has devastated the economy and hurt the livelihoods of millions, has turbocharged the bets that Mr. Icahn, Ms. McKee and others placed on the downfall of malls.

But on Wall Street, such brazenness is celebrated. Investors love little more than a contrarian bet that pays off, a combination of math and seeming magic that allows them to find a market disruption before everyone else and score a big win.

The trade Mr. Icahn and Ms. McKee met to discuss, known as the “mall short” in financial circles, is the latest in a longstanding Wall Street tradition that some criticize as bottom-feeding because it preys on failure and can push a business over the edge while contributing little to the economy. Most investors buy stocks and bonds with the expectation that they will rise in value. A short is the opposite, and their defenders say they can help expose corporate fraud or deflate a dangerously overvalued asset, which can aid the smooth functioning of markets. More than a decade ago, some investors famously profited off the collapse of the housing market, even as the United States plunged into a financial crisis. Their trade came to be known as “the Big Short,” inspiring a book and a movie.

“We periodically do shorts, and this is one of the best that I’ve ever seen,” Mr. Icahn said in an interview last week, echoing what he had told Ms. McKee. The two, who were introduced by a former colleague of Mr. Icahn’s, have stayed in touch.

Daniel McNamara, a colleague of Ms. McKee’s, called it “the Big Short 2.0.”

Brick-and-mortar retail has been in distress for years. Trapped between the growth of online shopping and the popularity of discount chains, many retailers have struggled to find a foothold in the changing firmament. The nation’s roughly 1,000 shopping malls (excluding strip and outlet malls) have borne the brunt of the problems, with hundreds of them fighting low occupancy and the loss of major stores, known as anchors.

The coronavirus pandemic, which prompted stay-at-home orders, increased the financial strain on malls by choking off much-needed foot traffic and cash flow.

Credit…Michelle V. Agins/The New York Times

“The pandemic sped up the rate of demise for CMBX 6 malls by being the final straw for a lot of struggling retailers and mall owners,” Ms. McKee said, referring to the obscure real estate index that she bet against because of its exposure to troubled malls.

The private equity fund Apollo Global Management, which runs an internal hedge fund that focuses on credit investing, made more than $100 million shorting the CMBX 6 and other commercial real estate securities — one of the fund’s most successful trades of the year. Jason Mudrick, whose New York hedge fund, Mudrick Capital, focuses on distressed investments, estimated that he had made the same amount. So did Scott Burg, chief investment officer at Deer Park Road, a fund in Steamboat Springs, Colo.

So far this year, 16 percent of all retail industry loans are delinquent, according to statistics tracked by the data firm Trepp. Major retailers, including J.C. Penney, Neiman Marcus and Modell’s Sporting Goods, have filed for bankruptcy, and new tenant demand for mall space has never been weaker, according to an analysis of national malls by the advisory firm Green Street. The closure of anchor stores only exacerbated the financial duress, given that, as Green Street noted in a recent mall survey, their departure can allow other tenants to reduce the rent they pay. Some landlords have opted to hand ownership of their struggling malls back to their lenders, making distressed sales of those investments very likely.

“The malls were way overbuilt to begin with,” Mr. Icahn said, “but additionally, the real problem was that malls and physical retail were constantly losing ground to online shopping.” He has kept his trade, believing that certain shopping malls could be in far worse trouble.

The CMBX 6 index is intended to track a basket of bond products, each of which contains bundles of individual mortgages to commercial borrowers, more than 2,000 in total. Those products are then sliced into brackets, known as tranches, and assigned credit ratings ranging from AAA to BB, according to their perceived level of risk.

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The CMBX 6, which tracks the performance of mortgages issued in 2012, has been a target for short-sellers because of its relatively strong exposure to malls. According to an analysis by Trepp, 40 percent of the property loans tracked by the CMBX 6 are in the retail sector, giving it the highest exposure to retailers of any CMBX index. (The balance of the mortgages are in lodging, residential and office, and industrial sectors.) Of the retail mortgages the CMBX 6 tracks, 39 are in American malls, many of which have 10-year mortgages coming due in 2022.

Deer Park Road’s Mr. Burg, who specializes in complicated bond investments and said his firm had done well by betting heavily on risky home borrowers in the aftermath of the 2008 financial crisis, adopted the mall short before the virus hit. His research suggested similarities between the lax way that home loans were signed in the run-up to the last crisis and the underwriting of many retail mortgages. He also thought there were too many malls.

By the middle of May, the portion of the CMBX 6 with a BBB– rating, which had begun the year trading strongly but was especially popular with short-sellers, had fallen more than 30 points. It has recovered only a few points since then.

“It’s an absolute perfect storm, unfortunately, for the commercial real estate market,” Mr. Burg said. “We see very little that the Fed or government can possibly do to prop this up when there’s so much excess supply.”


Credit…Caleb Santiago Alvarado for The New York Times

To short any CMBX index — there are 13, each tied to a different origination year for commercial mortgages — investors pay various fees, including an annual amount to hold what is essentially an insurance policy that pays out if the mortgages the index tracks default. Those fees might be $300,000 to $500,000 a year for every $10 million of insurance the investor wants to hold.

Before making their bets, some investors who shorted the CMBX indexes engaged in labor-intensive research. Mr. Mudrick and his analysts walked all 39 malls in the CMBX 6 index, from the Northridge Fashion Center in Los Angeles to the Town Center at Cobb in Kennesaw, Ga. Wearing casual clothes, his group paced the perimeters and food courts, snapping photographs and taking notes.

A slide deck on the Crystal Mall in Waterford, Conn., that Mudrick Capital prepared in 2017, when the firm first did the trade, contains maps of the two floors, facts and figures on competing shopping centers and a summary of the tenants classified into categories like “distressed” (Gymboree, Claire’s), “local/non-national” (Lord’s & Lady’s Hair Salons, FroyoWorld) and “notable” (Hollister, Aéropostale). A caption above one picture that prominently displays a J.C. Penney store and few shoppers in the atrium reads: “Interior physical product ok, but tired. Vendor renting ride-able stuffed animals for kids in middle of photo.”

Mr. Mudrick said security workers in the malls sometimes hassled him or his employees. “When we took photos, we tried to do it sort of in a clandestine way,” he recalled.

When Ms. McKee, who this year became a portfolio manager at MP, and Mr. McNamara, her colleague, met Mr. Icahn, their main fund had already invested more than $100 million in the short trade. They were hoping to do more, but some of the investors they were pitching were uncertain, which was why Ms. McKee was hoping for Mr. Icahn’s endorsement.

In February, Ms. McKee and Mr. McNamara started a fund with $30 million in investor capital that was dedicated solely to the mall short. Within a month, they had more than doubled that money, so they closed out the fund in May and distributed the proceeds to investors. MP still retains a short position in its main fund.

“I’m definitely bearish on malls,” Ms. McKee said. “But I think it’s a very case-by-case basis. I don’t think all malls are dying.”

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A Hedge Fund Bailout Highlights How Regulators Ignored Big Risks

WASHINGTON — As the coronavirus began shuttering the global economy in March, critical parts of U.S. financial markets edged toward collapse. The shock was huge and unexpected, but the vulnerabilities were well known, the legacy of risk-taking outside of regulatory reach.

To head off a devastating downward spiral, the Federal Reserve came to Wall Street’s rescue for the second time in a dozen years. As investors sold a vast array of holdings and rushed to the comparative safety of cash, the Fed pledged to become a buyer of last resort to restore calm to critical markets.

That backstop bailed out many people and investment firms, including a class of hedge funds that had been caught on the wrong side of a trade with ample risks. The story of that trade — how it went wrong and how it was salvaged — offers a cautionary tale about important issues Congress did not address in the 2010 Dodd-Frank financial law and the Trump administration’s hands-off approach to regulation.

A decade after Dodd-Frank, America’s sweeping post-2008 crisis fix, was signed into law, commercial banks like JPMorgan Chase & Company and Bank of America are better regulated and safer, but they may be less willing to help smooth over markets in times of stress. Tougher regulation in the formal banking sector has pushed risk-taking to the shadowy corners of Wall Street — areas that Dodd-Frank left largely untouched.

In addition, the powers policymakers have to deal with persistent vulnerabilities have been undermined by Trump administration officials who came into office seeking to weaken financial rules. Treasury Secretary Steven Mnuchin, who leads a panel created by Dodd-Frank to identify financial risks, has moved to release big financial firms from oversight and abandoned an Obama-era working group that was examining hedge fund risks.

The result is a still-brittle system, one in which financial players rake in profits in good times but the government is forced to save them or leave the economy to suffer when things go awry.

“It’s very dangerous to have a regime in which you know this can happen,” Janet L. Yellen, the former Federal Reserve chairwoman, said in an interview. “The Fed did unbelievable things this time.”

Credit…Anna Moneymaker for The New York Times

Relying on the central bank to save the day is not a long-term solution, she said. There is no guarantee that the Fed and the Treasury Department, which must provide the money to support many of the central bank’s emergency programs, will be so aggressive in the future.

Hedge funds are one risk left unaddressed. Some regulators had warned for years that a certain type of hedge fund — so-called relative value funds — could struggle in a stressed market. Officials also warned that they could not tell how big a risk such funds posed because they did not have enough information about their trades and how much money they were borrowing.

Of particular concern: The hedge funds were using trading strategies similar to those employed by Long-Term Capital Management, a fund that collapsed in 1998 and nearly caused a financial meltdown.

The bet hedge funds were making earlier this year was simple enough. Called a basis trade, it involved exploiting a price difference in the Treasury market, generally by selling Treasury futures contracts — promises to deliver a bond or note at a set price on a set date — and buying the comparatively cheap underlying securities.

The hedge funds made a tiny return as the price of a security and its futures contract converged. To turn those mini payoffs into real money, they tapped a form of short-term borrowing, called repo, and used it to amass huge holdings of Treasuries. Such trades are often incredibly leveraged.

The problems started as markets became very volatile in mid-March. The repo funding essential to the trades was suddenly hard to come by as financial institutions that provide the loans backed away. Historical pricing patterns broke down, and many trades were no longer profitable. Some hedge funds were forced to dump government debt.

Banks could have acted as stress relievers by buying securities and finding buyers. But they were already holding many government bonds, and could not handle more in part because of regulations established after 2008. Everyone was selling — ordinary investors, foreign central banks and hedge funds. Hardly anyone was buying.

The market for U.S. government debt, the very core of the global financial system, was grinding to a standstill.

“The severe dislocation in one of the world’s most liquid and important markets was startling,” the Bank for International Settlements, a bank to central banks, wrote in its annual report last month.


Credit…Anna Moneymaker/The New York Times

Credit…Ting Shen for The New York Times

The Fed stepped in to avert catastrophe, pledging during an emergency Sunday afternoon meeting to buy huge sums of government-backed bonds.

It remains unclear how big of a role hedge funds played in March’s meltdown — even how many and which funds were involved remains hazy. The funds are not required to disclose detailed data about the size of their bets and what and when exactly they sold. By the Bank for International Settlements’s telling, the relative value unwinding was a “key driver” of the turmoil.

Researchers writing for the Treasury Department’s Office of Financial Research said in a report that basis trades definitely went bad in March and some hedge funds sold their securities, but it is not clear how much the sales impaired Treasury market liquidity. Still, the report acknowledged that the Fed’s intervention may have prevented more dire consequences.

Michael Pedroni, an executive vice president at the Managed Fund Association, which represents hedge funds, said in a statement that “a growing body of evidence” showed that “hedge funds were able to continue providing some liquidity even as banks pulled back on providing financing” and that the funds were not a systemic risk.

While few had predicted the pandemic, many experts had long warned that the financial system was vulnerable.

Long before the turmoil this spring, the Financial Stability Oversight Council, established by Dodd-Frank, had repeatedly identified hedge fund leverage as a risk. Under the Obama administration, it formed a hedge fund working group to consider the potential risks of many hedge funds employing similar trading strategies.

On Nov. 16, 2016, the working group warned that hedge funds could be a source of instability during turbulent times.

“Forced sales by hedge funds could cause a sharp change in asset prices, leading to further selling, substantial losses or funding problems for other firms with similar holdings,” Jonah Crane, the council’s deputy assistant secretary at the time, told the group. “This could significantly disrupt trading or funding in key markets.”

The working group recommended that regulators gather more information about hedge funds, including their trades — the type of granular data missing from the filing fund managers made to the Securities and Exchange Commission, known as Form PF.

“Our recommendation was to fix Form PF so we could get the underlying data,” Mr. Crane, now a partner at the consulting firm Klaros Group, said in an interview. “These strategies we thought we saw seemed an awful lot like the Long-Term Capital Management strategies and suggested to us that one should at least be aware of who had exposure to those.”


Credit…Jacquelyn Martin/Associated Press

The S.E.C. chairwoman at the time, Mary Jo White, agreed with the recommendation. But with a new administration coming in, there was little chance to address the issue in the last weeks of the Obama administration.

Early in 2017, Mr. Mnuchin, a former hedge fund manager, assumed control of the Financial Stability Oversight Council and the hedge fund working group was deactivated.

Richard Cordray, who sat on the council as head of the Consumer Financial Protection Bureau from 2012 to November 2017, said that once Mr. Mnuchin took over, discussion turned to relaxing oversight.

“It was clear from the beginning that he wanted to move the FSOC in a different direction, which was a deregulatory direction,” Mr. Cordray said.

A Treasury spokeswoman said that the council “continues to monitor hedge funds, as it monitors all sectors of the financial system.”

Relative value funds were not the only financial vulnerability exposed in March. Money market mutual funds, bailed out in 2008, required another rescue. Corporate bonds faced a wave of predictable ratings downgrades. That market ground to a standstill, prompting the Fed to undertake its first-ever effort to buy big-company debt.

Risks at lightly regulated financial firms “were not only predictable, but well-documented,” Lael Brainard, a Fed governor, said during a University of Michigan and Brookings Institution conference in late June. “We’ve now seen not once but twice in only 11 years” risks that were considered highly unlikely threatening the economy.

Ms. Yellen and other policymakers said Congress might need to make regulators responsible not just for individual institutions but for the overall safety of the financial system. Only the Fed has a financial stability mandate, and it applies just to banks.

“There was a flaw in Dodd-Frank,” Ms. Yellen said. “Dodd-Frank gave FSOC the responsibility for dealing with financial stability threats,” but did not convey it with the power to do much beyond cajole other regulators. “If FSOC is to be meaningful, it needs to have power of its own.”

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Hedge Funds Duel in Bankruptcy Court Over McClatchy Newspapers

A battle of the hedge funds is brewing in the bankruptcy auction of the McClatchy Company, one of the nation’s largest and most decorated newspaper chains, pitting Chatham Asset Management and Brigade Capital Management, both debt holders in the chain, against a newcomer to the proceedings, Alden Global Capital.

Chatham and Brigade seemed to have an advantage going into the planned court-supervised sale of McClatchy. In April, McClatchy said it had received an offer worth more than $300 million from the two firms, which had taken on much of McClatchy’s debt in a Chapter 11 restructuring. The two hedge funds planned to use that debt as part of the bid, which would keep the chain, with 30 newsrooms across the country, intact.

Alden, a New York hedge fund that has become a force in the newspaper business, tried to disrupt the Chatham-Brigade proposal on Wednesday by filing an emergency motion in a U.S. Bankruptcy Court. Alden asked Judge Michael E. Wiles to stop any attempt to buy McClatchy through a credit bid, a transaction that would allow Chatham and Brigade to use the company debt they had assumed toward the purchase price.

Alden’s maneuver suggested that it, too, had an interest in acquiring McClatchy, a 163-year-old chain that fell on hard times not long after its $4.5 billion purchase in 2006 of a much larger rival, Knight Ridder.

At a remote hearing on Thursday, Alden’s interest was confirmed by a lawyer for the hedge fund, Lisa G. Beckerman of Akin Gump Strauss Hauer & Feld. She said Alden was prepared to “top” the previous bid, but argued that Chatham and Brigade would have an unfair advantage if they were allowed to make the debt they had accrued part of their offer. Judge Wiles denied Alden’s motion, permitting Chatham and Brigade to go ahead with their plan.

The court also scheduled a new date for the start of the auction process, setting it for Friday. It had previously been scheduled to start on Wednesday.

Chatham is not a newcomer to the newspaper industry. It is the principal owner of American Media, which operates the National Enquirer supermarket tabloid, and a major investor in Postmedia, the publisher of Canadian newspapers including The National Post, The Montreal Gazette and The Ottawa Citizen.

A lawyer identified as a representative of the Knight Foundation listened in on the hearing as a nonparticipant. The Knight Foundation is a journalism nonprofit organization with an endowment of more than $2 billion. It originated with the family whose newspaper chain merged with another to form Knight Ridder, the company bought by McClatchy 14 years ago.

McClatchy, a business that has been in the same family since 1857, with the founding of the forerunner of The Sacramento Bee, is the publisher of The Miami Herald, The Charlotte Observer and The Kansas City Star, among other major dailies. A consistent winner of top journalism prizes, it says it is the second-largest newspaper chain in the United States.

The Alden-owned MediaNews Group has drastically cut costs at newspapers it manages. In 2018, staff members at The Denver Post, a MediaNews Group daily, openly rebelled, publishing a special section filled with articles critical of ownership. “If Alden isn’t willing to do good journalism here,” The Post’s editorial board wrote in the lead editorial, “it should sell The Post to owners who will.”

Alden owns 32 percent of Tribune Publishing, the chain that operates The Chicago Tribune, The Baltimore Sun and newspapers in nine other major metropolitan areas in the United States. Last week the hedge fund increased its influence on Tribune Publishing when it gained a third seat on its seven-member board. Alden also has an interest in another newspaper chain, Lee Enterprises, and its MediaNews Group controls roughly 200 publications.

From 2004 to 2019, roughly half of all newspaper jobs in the United States were eliminated as the cumulative weekday circulation of print papers fell to 73 million from 122 million, according to a University of North Carolina study.

At the same time, advertising revenue fell sharply as readers gave up print newspapers, a longtime home of lucrative retail ads and classified notices, in favor of digital devices. Google and Facebook came to dominate the online ad market, hampering publishers’ attempts to generate the necessary revenue from digital ads.

Wall Street ownership of newspapers has become common, and Alden helped drive that trend since the Great Recession, when it started grabbing stakes in distressed news media companies.

Alden’s emergency motion was first reported by McClatchy DC, a news site staffed by McClatchy journalists in Washington.

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Some Big Investors Smell Profit in Virus-Plagued Companies

The recent misfortune of American businesses — many of which are struggling to raise cash to stay afloat — is creating new moneymaking opportunities for hedge funds and private equity firms, big investors that have been relatively unscathed by the pandemic.With hundreds of billions of dollars sitting in reserve, these firms …

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Scary Times for U.S. Companies Spell Boom for Restructuring Advisers

Freedom Mortgage, one of the nation’s largest mortgage lenders, is looking for additional financing as millions of homeowners are expected to stop making mortgage payments. The Cheesecake Factory said this past week it wouldn’t be able to make rent payments on its leases because of lost business. And …

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Across furtive videocons, junior VCs wait for the layoffs to begin

Amid post-YC Demo Day discussions and online “coffee” catchups, there is a lingering sense of dread among VCs — particularly junior VCs — about their own job security.
Over the past few days, I have heard rumors — and they are just rumors, for now — about three recognizable venture firms and how they …

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How Private Equity Buried Payless

TOPEKA, Kan. — The financiers who had taken over Payless ShoeSource didn’t have much experience selling low-priced footwear, but they had big ideas about how things ought to be done. One was capitalizing on enthusiasm for the 2018 World Cup in the Latin American countries where the company had hundreds of stores.

When they saw an opportunity to buy a million pairs of World Cup-branded flip-flops, the money men turned shoe sellers overruled the midlevel supply managers at corporate headquarters in Topeka, who had pointed out a couple of problems.

First, the sandals mostly wouldn’t arrive on store shelves until after the World Cup was over.

Second, they were branded with the flags of countries like Mexico and Argentina — countries where Payless didn’t have any stores.

Ultimately, the flip-flops had to be unloaded at steep markdowns, one of many missteps at a company that by early 2019 would liquidate its stores in the United States and enter its second bankruptcy in rapid succession, putting 16,000 people out of work. (It emerged from bankruptcy last month, with its third ownership group in four years.)

As in any corporate failure, there is no one cause. Over seven years, Payless went through a wringer of private equity and hedge fund stewardship that left it with inadequate technology, run-down stores and no financial cushion to survive an era of upheaval in retail.

But the collapse of Payless is more than a story of one discount shoe company that couldn’t hack it in a changing business environment. It provides disquieting clues about one of the great mysteries of the modern economy.

Why hasn’t the finance-driven capitalism of the last few decades created faster growth? What if the masters of financial efficiency are making choices that don’t actually create the more dynamic, productive economy they promise?

In extreme cases, what if they don’t really know what they’re doing at all?

Credit…Daniel Acker/Bloomberg

The difference between economies that thrive and those that falter boils down to two related factors: how effectively capital is deployed, and how well corporations are governed.

When a nation’s savings are channeled toward worthwhile projects, and effective managers are put in charge of large companies, good things tend to result. When resources are devoted to boondoggles, and companies are run by incompetent cronies, everyone ends up poorer. Think of how much richer West Germany became compared with East Germany over the four decades the country was divided.

But there is no single answer to the question of what form of capital allocation and corporate governance works best. The United States has typically relied on stock and bond markets to determine which companies get money to invest, and on independent boards of directors to govern companies. Western Europe relies more heavily on banks. Japan and South Korea have relied on conglomerates in which families of companies help finance and govern one another.

In the last generation, the United States has experienced a revolution in how this corporate control works.

In the 1980s, the first generation of leveraged buyout kings — an industry now known as private equity — identified problems with American corporations. Many were poorly run, led by complacent boards of directors and executive teams reluctant to shake things up.

Buyout firms aimed to purchase those companies, fix what was holding them back, and profit by making them more valuable and selling them off again. All through the 1990s and early 2000s, this shift made billionaires of their founders and attracted trillions of dollars from investors.

Their imprint on the economy is enormous: Companies owned by private equity firms accounted for 8.8 million jobs in the United States in 2018, and 5 percent of G.D.P.

But if anything, that understates the scale of the financialization of American business, and the ways that management tactics of buyout kings have become the norm.

Some large hedge funds operate similarly to private equity firms, by buying and operating companies. One such fund, Alden Global Capital, controlled Payless from 2017 to 2019. Other hedge funds use votes to get executives of publicly traded companies to act more aggressively and thus increase returns to shareholders.

The result: Financial managers exert greater control over nearly all American companies than they once did.

Their willingness to cause some pain — to close factories, lay people off, renegotiate arrangements with longtime suppliers — is, many economists argue, a feature, not a bug. Society becomes richer over time by devoting resources to its most productive uses. The pain should be temporary, and in theory result in a more vibrant economy for everyone.

In 2012, private equity firms and hedge funds set their sights on the troubled retailing sector, and one set of investors made the pilgrimage to Topeka, where they acquired Payless.

Payless, founded in 1956 by two cousins in Topeka, Louis and Shaol Pozez, was a business built on an innovation: that shoe salesmen weren’t entirely necessary.

Rather than keep inventory in a back room and employ lots of salespeople, as department stores did, Payless kept boxes of shoes on open display in the store, where customers could help themselves to try on. It needed fewer workers for every pair of shoes sold, which, among other cost-savings measures, allowed it to keep prices lower than many competitors could. The company became a mainstay of the indoor malls and strip shopping centers that boomed in the second half of the 20th century.

By the time a private equity group led by Golden Gate Capital and Blum Capital, both of San Francisco, took over in 2012 in a $2 billion acquisition, Payless had 4,300 stores worldwide and $2.4 billion in revenue. But it also faced profound challenges.

Many malls and shopping centers were entering a death spiral, with falling foot traffic, store closings and underinvestment. People were increasingly buying shoes online, along with most everything else. Payless had underinvested in its information technology infrastructure.

It also had some distinctive strengths. In its 800-person corporate headquarters in Topeka, a former warehouse located between a women’s prison and a potato salad manufacturing plant, it had the personnel and systems to pull off an intricate feat of merchandising and supply chain management.

The company managed to commission the manufacture of millions of pairs of shoes, often imitating the look of more fashionable brands; ship them from factories in China, Vietnam and other countries to distribution centers in the United States; and then, just in time, get those shoes into the stores where they would most appeal to the customer base.

It did all this at remarkably low cost; its average pair of shoes sold for $17.

What needed doing was evident to Payless’s own managers and outside analysts alike: shutter underperforming stores, update others, and modernize its technology to compete in the digital age.

The new owners found a new C.E.O. in W. Paul Jones, a veteran of two retailers owned by financial engineers: Sears under the hedge fund manager Eddie Lampert and Shopko under the private equity firm Sun Capital Partners.

Mr. Jones had seen up close both the strengths and weaknesses of this form of financialized corporate control. “They’re incredibly valuable on the financial metrics of understanding how to get costs out of the business, how to be more streamlined, how to think about the organizational structure differently, how to find nickels and dimes throughout the organization,” and at getting maximum value out of real estate, Mr. Jones said.

“But they do not, do not, know how to operate a retail company,” he said.

That is to say, on the actual nuts and bolts of retail — creating a compelling shopping experience, with merchandise that buyers want — financial managers are out of their depth.

But he was confident that Payless under Golden Gate and Blum would be an exception. The new owners appeared to understand the business better than others in the private equity industry, Mr. Jones said, and they were committed to hiring a first-rate team of executives.

That optimism was conveyed to employees at the corporate headquarters in Topeka. Soon after the takeover, managers gathered in a small auditorium.

“Everybody was a little bit on edge,” Thad Halstead, a merchandise manager, recalled. “But it was positive. They were saying: ‘Our goal is to help you. We’re here to make sure you guys have the resources to succeed for the next hundred years.’”

Plenty of companies that go through this process do emerge better managed, with capital deployed more wisely.

The Carlyle Group, for example, took over Dunkin’ Donuts in 2006 and spun it off to public markets in 2011 financially stronger and with 2,800 more stores worldwide. The hotel group Hilton Worldwide nearly doubled the number of rooms it managed from 2007 to 2018, while under control of the Blackstone Group.

And some of the best research on how the buyout industry affects the companies involved suggests that, on average, they become more productive.

Steven J. Davis, an economist at the University of Chicago Booth School of Business, and five co-authors analyzed thousands of private equity buyouts between 1980 and 2013. Among other things, they found that in the two years after a firm was bought out, labor productivity — the revenue generated per employee — rose by 7.5 percent more than at otherwise comparable firms that were not acquired. The largest gains came at older and larger buyout targets.

This would seem to fit the story that the private equity industry tells about itself: that it is creating more dynamic, productive companies by running them more effectively than the traditional system of self-perpetuating boards of directors and publicly traded shares.

But there is a problem. During this same period in which American corporations have become more financialized than ever, the overall economy has had historically weak productivity growth.

In the 2010s, labor productivity — the amount of economic output per hour of work — has risen by less than 1 percent a year, the lowest of any decade on record (the data go back to 1947). It was 2.7 percent per year during the 1950s and 1960s, the high-water mark of the clunky, complacent, conglomerate-building era of American business.

That may not seem like a big difference, but sustained over time it has huge effects. At 1960s rates of productivity growth, incomes would be expected to double every 26 years. At 2010s rates, it would take 72 years.

The American economy has become markedly less dynamic. Fewer businesses are being started, and the newcomers are having less success unseating incumbents. Workers are less likely to change jobs, which suggests labor is not moving toward the most productive forms of work. Many major industries are becoming more concentrated among a few giants.

Mr. Davis, the University of Chicago economist, says these trends would be worse if not for the buyout industry.

“Private equity buyouts are a force pushing the other direction against the headwinds,” he said. “If you think the reallocation of jobs and capital and workers to more productive use is an important part of how we drive productivity growth and generate higher living standards, the role of private equity is more vital, because there seems to be less of that going on in the economy than 20 or 30 years ago.”

It also could be true that the slump in productivity and dynamism has nothing to do with the revolution in how companies are governed and capital allocated. The slump could result from fewer transformative innovations, for example — essentially bad luck.

But at a minimum, it doesn’t appear that the rise of this seemingly superior form of stewarding American business has created a more robust overall economy. And Payless offers some clues as to why.

The new C.E.O., Mr. Jones, and the rest of the executive team assembled by Payless’s new private equity owners in 2012 had a lot to do.

The company had modernized its logo and branding years earlier — but had been so stingy with capital spending that around 70 percent of stores still had 1980s vintage signs. The company’s outdated information technology systems updated inventory only once a day — making it impractical to offer buy-online, pick-up-in-store offerings.

Mr. Jones and his team started in on plans to upgrade technology, expand profitable international operations and invest in the high-growth areas of athletic footwear. But even with all those outdated stores and technology, capital spending remained only at levels comparable to the previous ownership: $75 million to $80 million per year.

Meanwhile, the company made huge payments to its private equity owners.

In the two-year period ending in January 2015, Payless generated $249 million in “Ebitda,” a common metric for operating profits; paid $352 million in one-time dividends to shareholders; and made $94 million in interest payments.

For every dollar that came in the door of the company in that span, it paid out $1.41 to its owners and 38 cents to its lenders. That left the company with less of a financial cushion to ride out any future challenges. And the future, as it turned out, held some major challenges.

In 2015, longshoremen at major West Coast ports went on a slowdown at the worst possible time for Payless: just as ships from Asia containing millions of pairs of discount shoes were steaming across the Pacific ahead of the crucial spring sales season.

Inventory waited offshore for weeks, creating a cascade of problems for the Payless supply chain: a pileup of out-of-season shoes that the company was able to sell only at deep discounts and with extra spending on marketing.

The resulting losses strained the company’s ability to repay its debts and led to credit downgrades. “It’s just this vortex that you’re stuck in, trying to get out of it,” Mr. Jones said. “And that’s what caused the crisis.”

But it was the financial structure of the company that made it possible for a labor disruption to push the company into that vortex. “Yes, taking out the money, in hindsight, made the business more vulnerable, susceptible, and in an environment of so much uncertainty that nobody understood,” Mr. Jones said of the dividend paid to shareholders. “In hindsight, we shouldn’t have done it.”

Golden Gate Capital said that it was focused on helping the company grow and that it was undone by powerful forces.

“We recruited a strong management team, and over $500 million was invested to support Payless’s turnaround strategy,” the private equity firm said in a statement. “Unfortunately, like many retailers, Payless ultimately faced challenges too strong to overcome without an operational and financial restructuring.”

Think about any company where you’ve worked. Suppose a new owner took aggressive actions to try to achieve immediate financial returns.

It might pay out cash on the balance sheet as dividends rather than let it sit around for a rainy day. It might rely more on borrowed money. It might raise prices abruptly, or cut payroll, or try to renegotiate deals with landlords and suppliers.

In other words, it might follow the private equity industry’s playbook.

And those efforts may create an apparent boost in productivity. So long as revenue and earnings rise faster than the amount of labor, it would look like a win for the overall economy, at least in the first few years.

But at the ground level, there would be no guarantee that the company was actually doing anything better. All those changes would make a company more profitable. But they wouldn’t necessarily result in a product that consumers preferred, or in a more effective deployment of workers and equipment.

Moreover, a riskier corporate balance sheet might be fine when things are going well, but increase the risk of a catastrophic failure when things go wrong — essentially hollowing out whatever productive capacity made the company successful to begin with.

Just maybe, in other words, what Payless went through in its run of private equity ownership wasn’t just one bad deal in one troubled industry, but a particularly clear example of what is holding the entire economy back.

Done right, a Chapter 11 bankruptcy is an opportunity for a company’s rebirth. It can shed the debts, lease obligations or onerous supplier contracts that might have gotten it in trouble.

The executives who led the company through its 2017 bankruptcy were confident they had done exactly that. The company shed about half of the debt on its balance sheet, closed about 700 underperforming stores, got its rent on remaining stores cut by as much as 50 percent, negotiated more favorable credit terms with suppliers, and formed a plan to invest in new technology and expand its profitable Latin American business.

“We were going the right direction, we had stability, we had a strategy, we had a team, and we had results,” Mr. Jones said. He said the new owners should have had at least four years of breathing room to get the business on track. Golden Gate Capital, in its statement, said, “When we exited Payless, we left it with a right-sized store footprint and meaningful earnings opportunities for future owners.”

“It’s the antithesis of what we’ve seen in other retail bankruptcies,” a restructuring expert, Christopher Jarvinen, told Reuters at the time.

Yet 18 months later, Payless was in bankruptcy court again. Its United States stores were closed.

What happened? Why did Alden Global Capital, the firm that took over Payless after the restructuring, fail so badly?

One answer is that it is hard to fix decades’ worth of problems quickly, even with the help of a bankruptcy court that can wipe out debts. For example, the Alden managers enthusiastically demonstrated a new system with which store employees could call up information on a tablet to see if desired shoes were available in another store.

That sort of thing was pretty standard in the retail industry in 2018. Yet many Payless stores had inadequate Wi-Fi for the tablets to be used. And the bankruptcy had fractured the company’s relationships with suppliers, many of them small Chinese manufacturers that had lost money when Payless experienced its cash crunch.

Former employees also described a series of mystifying errors by an Alden-installed leadership team with little or no experience in the retail industry. The chairman and interim C.E.O., Martin R. Wade III, was a longtime investment banker. His chief deputy, Jennifer Wild, was also new to the sector.

Executives from the earlier ownership were involved in the transition while the company was in Chapter 11; they recalled answering questions from the new team about some of the basics of retail supply chains and merchandising strategy.

Beyond their lack of retail experience, former employees said the Alden team cloistered itself in the executive suite and seemed to disdain the expertise of the staff in Topeka.

“What they thought was that people who live here are stupid, and that’s the way they treated us,” said Meghan Shreve, who was a manager in corporate communications. “It didn’t matter how great you were in your field or what other stuff you had done, it was, ‘You live in Kansas, so you’re an idiot.’”

Seeking to streamline the company’s supply process, the company shut down a lab in China where shoes were inspected before being exported. Instead, quality assurance workers inspected shoes in factories.

Bad orders began slipping through. At one point, a big order of shoes with mislabeled sizes — a size 6 shoe with size 3 printed on it, for example — showed up at the distribution center in Ohio.

“Missing one shoe can wipe out whatever you think you’re saving,” said Dustin Watson, a former planning and allocation manager.

Then there were the sandals. “Someone in Colombia isn’t going to buy Mexico-themed flip-flops, and they definitely won’t buy them if they don’t get there in time for the World Cup,” said Jason Tryon, a planning and allocation manager. Those concerns, he said, were ignored. “They became convinced that, ‘You guys don’t know what you’re talking about.’”

Mr. Wade, the interim chief executive during this period, said he and his colleagues had inherited a business in worse shape than it had appeared.

“The company had extremely deep flaws that had been building over the years,” he said. “One could argue that it was close to insolvency the day we took over.”

He said he had needed to “make terminations” with the Topeka staff “because we did not have runway and we needed to move quickly.”

He disputed the idea that his leadership group lacked retail experience, noting he had hired several seasoned executives and consultants. Moreover, he said, “the steering committee that hired me had their choice of at least 25 very experienced people whose whole careers were in retail.”

“So why me?” he said. “I believe they felt that they needed a leader; they needed someone who had experience changing culture, and who is not afraid of bringing in people with more expertise than he had in order to turn the company around.”

He attributed missteps like the World Cup flip-flops to the need to experiment and innovate — including successful efforts like a marketing stunt to trick fashion influencers into believing Payless shoes were from a luxury brand.

Payless is now a carcass of a company, with no stores in the United States and a relative handful of employees in a headquarters that once held 800.

There’s a certain model of capitalism under which this failure, painful as it was for those who lost their jobs, is a win over all. Strong, well-managed companies rise up and replace failures, producing a more competitive economy that benefits everyone over the long run.

But there’s an alternate way of viewing things.

For one thing, plenty of retail companies are doing reasonably well, making sound tactical decisions around store closings and smart investments in digital retail.

Payless wasn’t hopeless, said Beth Goldstein, a footwear industry analyst at NPD Group: “It would have needed significant investment and right-sizing, and it wouldn’t be up to the level of what it was 10 years ago, but there would still be a business.”

Instead, Ms. Goldstein concludes, much of the sales Payless once made migrated to just three other retailers: Walmart, Target and Amazon, including through its Zappos subsidiary.

What do the most successful markets look like? They feature lots of rivals in constant competition, always testing new strategies as they compete for workers, suppliers and customers. That’s what makes a truly dynamic economy, the kind where creative destruction of all types can occur.

The death of Payless eliminated several hundred well-paying corporate headquarters jobs in Topeka, as well as thousands more jobs in stores. And it hurt creditors, landlords and suppliers.

But it also left behind a discount shoe industry that is much more dominated by a handful of the biggest companies, which will have that much more power and incentive to entrench their advantages and keep dynamism at bay.

When you look at it that way, the private equity paradox is no more a mystery than why you hold on to plenty of cash for a rainy day, or why a Colombian doesn’t want Mexican-themed World Cup flip-flops after the World Cup is over.


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