Can Kinder Care Put This Puzzle Together?

It was a lot like the kids' game "red light-green light." In 1990, investment banker Tull N. Gearreald Jr. was put in charge of Kinder-Care Learning Centers Inc. while it looked for a permanent boss. Much as he liked the job, he left the day-care chain in mid-year, when it hired someone with more marketing experience. Yet seven months later, the new top man had resigned, and (green light!) Kinder-Care's controlling shareholders called on Gearreald again. As one of the Wall Streeters who arranged the Kinder-Care buyout in 1989, Gearreald felt an obligation to help out the chain. Besides, he says, "I always wanted to run a company."

He's lucky there's a company left to run. Once one of the nation's most promising growth companies, Kinder-Care, based in Montgomery, Ala., ran into trouble in the late 1980s when former Chief Executive Richard J. Grassgreen led it on a disastrous, junk-bond-fueled diversification. Caught in a cash squeeze in January, 1991, Kinder-Care stopped paying interest on its debt, including off-balance sheet obligations now totaling $550 million--or fully 109% of capitalization. While results from its 1,257 centers have improved since then, Kinder-Care still hasn't been able to generate enough cash to cover its obligations. By most standards, it ought to be a goner.

GROWING ROOM. The main reason creditors haven't hauled it into bankruptcy court is self-interest: They stand to take huge losses, so they have been patient. But don't think they've been sitting still. For months, bondholders, bank lenders, and the controlling Lodestar Group Inc. buyout firm have quietly waged a fierce battle over how to share the restructuring pain. After coming close to an agreement in January, say people familiar with the talks, the deal fell apart. A new resolution, which could yet include bankruptcy, may come any day now.

Negotiators assume Kinder-Care can nurse itself back to health. But first they must figure out how to wipe out about $150 million in debt, eliminating $13 million in annual interest costs. With cash flow of about $60 million, negotiators figure, it ought to cover its debt payments and still have room to grow.

For a man with no line experience, Gearreald, 46, gets decent marks as a day care operator. Since moving to Montgomery and enrolling his youngest son in Kinder-Care, Gearreald has focused on sprucing up the chain's aging facilities. He has spent $35 million in the past two years improving centers--vs. about $10 million in the two previous years. If bondholders would rather see the money go for interest payments, only one has been angry enough to sue, and the case is not being actively pursued. "Everybody realizes the way to get their principal paid is by getting the company healthy," says Gearreald.

CUTTING BACK. To that end, Kinder-Care is trying to boost the caliber of employees and cut down on turnover. Last year, the only salaried workers who got raises were center directors. And for the first time, center operators got stock options. Meanwhile, Gearreald is turning a careful eye to the location of centers. Through much of the 1980s, few centers were closed when neighborhoods changed. Now, many older ones are in areas where there is no longer much demand. For future growth, Gearreald is also emphasizing corporate business: Kinder-Care operates on-site centers for companies such as Citibank and Cigna Corp. But Kinder-Care's financial woes have slowed the sales effort.

In truth, all of Gearreald's plans could be knocked for a loop if creditors force Kinder-Care into bankruptcy. Although no one is talking publicly about the debt negotiations, sources say they nearly reached an aggreement on Jan. 31 at the New York offices of Kinder-Care's adviser, Smith Barney, Harris Upham & Co. Creditors would have taken new common stock and a stronger secured stake in Kinder-Care's real estate in exchange for forgiving $150 million in debt. But a last-minute dispute broke out between bondholders, advised by Donaldson, Lufkin & Jenrette Securities Corp., and the bank group, headed by Citibank. "It was like a game of Twister," says one source. "People couldn't stretch anymore."

Further complicating the negotiations is a matter of image. Lodestar, the New York investment-banking boutique that controls 63% of Kinder-Care through a $300 million buyout fund, is working to keep its stake from being eliminated in a reorganization. In addition to souring relations with investors in the buyout fund, a wipeout could put a crimp in Lodestar's merger-advisory business. Lodestar Chief Executive Ken Miller, who until 1988 headed Merrill Lynch & Co.'s mergers-and-acquisitions department, disputes that notion. Strong relationships with investors mean his advisory business "does not depend on the outcome of any one investment, however significant," he says.

Lodestar never meant to get this deeply involved in the day-care business. It entered the picture in 1989 as the investment bank for Kinder-Care's then-parent, Enstar Group Inc., the holding company for Grassgreen's grab bag of businesses. To raise cash for Enstar, Lodestar cooked up a deal in which Kinder-Care would be spun off and Enstar stockholders could buy rights to acquire shares in the new company for $4.75 apiece. But when only a third of Enstar shareholders decided to invest, Lodestar got stuck with the rest.

TAILSPIN. Kinder-Care then tried to raise cash by selling and then leasing back a portion of its $500 million in real estate. But that plan fizzled when the real estate market went into its tailspin. The stock that Lodestar originally paid $160 million for is now worth less than $20 million. Still, Lodestar didn't take the biggest hit. That distinction belongs to Enstar's shareholders. Enstar, which included everything from an S&L to a shoe-store chain, has filed for bankruptcy protection, and its shares are worthless. In April, Grassgreen is scheduled to begin a three-month prison term for taking fees from junk-bond king Michael R. Milken that belonged to Kinder-Care.

The mess has been a huge distraction for Kinder-Care, but it doesn't seem to have hurt its core business. "Parents are concerned about what's happening in the schools, not what shape the balance sheet is in," notes Jack L. Brozman, president of rival La Petite Academy Inc. Full-year results for 1991 aren't out yet, but Kinder-Care should show modest gains in fourth-quarter earnings. Although it won't finish in the black, neither will it approach the 1990 loss of $85.5 million on revenues of $396 million.

In the last two months, investors betting on a positive outcome have bid up Kinder-Care's stock price 40%, to around 50c. They no doubt see a good turnaround play. But given the volatility of the restructuring talks, it would be a mistake to rule out a last-minute twist. Unlike the gentle yarns spun during story hour, Kinder-Care's tale may yet have a scary ending.

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