How about this setup for a joke: What does Toys "R" Us Inc. have in common with business software companies?
OK, not too much. Microsoft Corp. isn't selling Hatchimals to your kids. But like the toy retailer that collapsed into bankruptcy protection this week, corners of the technology industry have embraced debt-heavy deals to buy out public stockholders. Dell Inc., Rackspace Hosting Inc. and BMC Software Inc. are among the companies purchased in recent years by private equity firms with borrowed money, as Toys "R" Us was.
Those tech companies have mostly performed solidly since their buyouts. But Toys "R" Us shows how debt can leave a company little room to maneuver. The retailer had to pay roughly $400 million in interest a year on almost $5 billion of debt, so it couldn't afford to invest in changing with the times.
Tech often moves faster and more unpredictably than retail, and it remains to be seen whether some of the tech buyouts of the last few years are a ticking time bomb.
Tech became a surprise darling of private equity dealmakers in recent years. Specialists such as Silver Lake Partners, Thoma Bravo and Vista Equity Partners have collected billions of dollars to buy tech companies -- usually fixer-uppers -- with a combination of borrowed money and cash.
The biggest of them all is Dell Technologies, a creation of two debt-reliant buyouts of the computer maker of that name and digital storage company EMC. The combined company, owned by founder Michael Dell and Silver Lake, generated $2.1 billion in cash in the six months ended Aug. 4. It had $49 billion of debt. That's quite a load.
It was far from the only member of the tech buyout club. This year through Wednesday, nearly one in five private equity buyouts in the U.S. involved companies in the information technology sector, according to data from PitchBook. The industry's typical share in the last decade has been 10 to 15 percent.
The philosophy of debt-reliant tech buyouts is sound. Business technology companies tend to be financially predictable enough to handle borrowed money. BMC Software may not be the most cutting-edge company, but its corporate customers find it tough to ditch its offerings. And going private meant Michael Dell only answers to a couple of bosses, not a mess of unruly stockholders, as he's trying to reinvent his company.
But private equity ownership and the resulting debt loads are relatively untested on a large scale in technology. The buyout deal for Dell closed in 2013, about half a decade after the last serious economic downturn.
It doesn't take much for predictable cash flow to shrink suddenly -- a risk that private equity tech specialists have acknowledged. Lenders demand to be repaid, and investment priorities for the business have to come second. Imagine what Toys "R" Us could have done with the $6 billion it made in interest payments. That could have bought a legion of engineers to build better websites and apps, better investments in its critical baby business and a few e-commerce warehouses to go head-to-head with Amazon.
What happened at Toys "R" Us might never hit the buyout-happy software sector. Risk is so far theoretical for technology firms. But borrowed money can raise the threat of a company collapse, not just magnify investor returns. In technology, we won't know for years which outcome will win out.
A version of this column originally appeared in Bloomberg's Fully Charged technology newsletter. You can sign up here.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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