A Pre-Nup to Discourage Private Equity Companies From Asset Stripping
In one of the largest settlements by creditors against private equity (or PE) companies, Cerberus Capital, Sun Capital Partners and Lubert-Adler/Klaff have agreed to pay $166 million to vendors of bankrupt department store chain Mervyn's. The proposed settlement will prove even costlier to the PE firms when settlement terms force them to withdraw their own financial claims against the Mervyn's bankruptcy estate.
When the leveraged buyout that carved Mervyn's out of retailer Target was consummated in 2004, Mervyn's brought 30,000 employees and 257 stores to the altar. The PE consortium brought $400 million in equity and borrowed another $800 million using Mervyn's real estate as collateral, all of which went to Mervyn's parent company, Target. The private equity group formed Mervyn's Holdings to operate the department store business, and transferred Mervyn's valuable real estate assets to MDS Realty. Mervyn's received no compensation for these assets and no residual interest in the property. Mervyn's Holdings had to lease back the real estate, paying high rents that enabled its PE owners to both service the debt and extract value for themselves. After holding the properties long enough to obtain capital gains tax treatment, MDS Realty sold most of the stores. The PE owners took a total of more than $400 million out of Mervyn's in the original transaction that split off the chain's real estate holdings, and subsequently, in management fees and dividends, they paid themselves out of the rents MDS collected from Mervyn's and out of the retail chain's cash flow. The PE owners were thus able to guarantee that they would do well no matter how things ended for the retail chain.
Like a bride led down the garden path, all the risk in this union fell on Mervyn's and its employees and creditors. Essentially making promises to workers and communities that it did not keep, the PE consortium used the marriage to put all of Mervyn's assets in a separate company, beyond the reach of creditors should anything go wrong with the retail business.
Struggling to pay its high rents as the recession took a toll on sales, Mervyn's sought bankruptcy protection in 2008. Unable to emerge from bankruptcy, Mervyn's closed its remaining stores, dismissed its last 18,000 workers, and was liquidated. Mervyn's owed the Levi Strauss & Company more than $12 million out of over $102 million in total to its vendors. The private equity owners, however, were little affected by the bankruptcy. Profits realized through real estate deals and dividends far exceeded losses on the retail side.
At the request of its vendors, Mervyn's sued Target, the PE firms and others involved in the transaction later that year. The complaint accused Target and the PE owners of engaging in a fraudulent transaction by knowingly causing Mervyn's real estate to be transferred without consideration of the effects of this action. The complaint also alleged that Mervyn's PE owners breached their fiduciary duties to Mervyn's and its creditors by paying themselves a dividend at a time when Mervyn's was essentially insolvent.
In a settlement reached earlier this month, Mervyn's PE owners and others involved in the 2004 deal agreed to pay Mervyn's creditors $166 million without admitting guilt to settle the charges. Years after destroying thousands of jobs and closing down stores that anchored hundreds of communities, proceeds from some of the assets stripped from the department store chain were used to pay the retail chain's creditors.
Imagine what a difference a prenuptial agreement could have made. A good marriage lawyer would have made certain that if the union ended in just a few years - if Mervyn's could not both meet the rent payments imposed on it by the transfer of its assets and remain a viable business - those assets would be pulled back into the bankruptcy estate to pay the creditors and provide some financial relief for the workers whose jobs were destroyed. That would ensure that the risks of stripping assets from the department store chain would fall on the PE owners, as well as on the chain's workers and creditors. Unfortunately, no legal requirement for such an agreement exists. How much better for the hundreds of communities Mervyn's served as a job creator, low-cost retailer and economic anchor if a "pre-nup" had protected the interests of the company by assuring that the risks of bankruptcy were shared.
Of course, just as not all marriages end badly, not all PE firms engage in asset stripping. While actions that strip assets and drive a company into bankruptcy are illegal now, the only recourse creditors have is to bring suit and endure years of litigation after bankruptcy occurs. A prenuptial agreement that discourages such behavior could go a long way toward protecting the interests of the company's creditors and its other stakeholders.
Eileen Appelbaum is a senior economist at the Center for Economic and Policy Research and the co-author of 'Leaves That Pay: Employer and Worker Experiences With Paid Family Leave in California.'