The LBO has had its fair share of critics. Even before the days of Barbarians at the Gate, private equity as a business model was viewed with suspicion and hostility by politicians, unions and even some investors.
Last month, however, the LBO defamation came from a former portfolio company: bankrupt US department store Mervyns. Filing a lawsuit against its private equity owners, including funds controlled by Lubert-Adler Real Estate, Cerberus Capital Management and Sun Capital Partners, Mervyns claimed it was the victim of a “fraudulent transfer” whereby the company's real estate assets were “stripped” from the operating business in order to leverage the buyout. The deal, said the plaintiff, eventually forced the retail business into bankruptcy this summer.
To detractors, private equity practitioners are financial manipulators and corporate raiders. To industry defenders, private equity GPs make companies much more efficient. However, the 2004 acquisition of Mervyns – and the ensuing lawsuit – does prompt the question: at what point does the unlocking of real estate value in a deal structure cross the line into irresponsible financial engineering? And can GPs prove in court this line hasn't been crossed?
In buying Mervyns, the private equity sponsors set up a specially formed entity, MDS Companies, to acquire the department store from US retailer Target and take control of Mervyns' real estate assets. According to the lawsuit, in transferring a majority of the leases and freeholds for Mervyns' 177 stores, located in California and six southwestern US states, MDS was able to use the assets to help finance the deal, and later charge Mervyns, and other retailers, market rents for use of the properties.
The company argues, that it lost $1 billion worth of real estate “in the blink of an eye. Mervyns received nothing in return [for the transfer],” the lawsuit states. Throughout the 57-page complaint, Mervyns executives don't attempt to hide their emotions. In being charged market rents, Mervyns' says its occupancy expenses roughly doubled in order to “both service the acquisition debt and to continue to extract over time, the significant excess value of the real estate assets over the debt piled onto those assets.” Words such as “helpless pawn,” “siphoned,” “stripped,” appear with regularity. Spokesmen for both Cerberus and Sun Capital say the lawsuit is “without merit,” with the Cerberus spokesman adding that the firm will “vigorously defend itself.” Lubert-Adler was unavailable for comment at the time of press.
In judging the Mervyns deal one can agree there is a sound business case for separating the retail operations from the real estate assets in a bid to capitalize on the rental incomes generated by such properties. Mervyns counters that the separation of its prized assets – its stores – ensured that any “residual value or upside in the real estate assets were reserved for [the private equity firms] themselves and not for Mervyns.”
But Mervyns' success – or ultimate failure – wasn't dependent solely on any one factor. Being taken private should have acted as a spur to greater efficiency by removing it from the “tyranny” of quarterly reporting. Indebtedness, as many have argued, should focus managers on running their businesses much more efficiently. And for four years, Mervyns felt no need to file a lawsuit against its private equity owners. Instead it only challenged the acquisition in 2008 once it had gone bankrupt. (A spokesman for Mervyns says the lawsuit was timed to fall within the timeframe for the Statute of Limitations.)
However, Lubert-Adler, Sun and Cerberus surely recognize in taking private the retail store, and in separating the real estate assets from the operating company, they too have played a part in the Mervyns tale. A court will now decide whether, or to what extent, these former owners are responsible for the sad ending. If the court decides that the Mervyns deal constituted illegal asset stripping, the precedent could bode poorly for GPs who have used similar techniques.