Discount department store operator Mervyn’s, which filed for Chapter 11 bankruptcy protection back in July, is suing its current owners and Target, alleging that the 2004 leveraged buyout of the firm from Target was a fraudulent transfer that ultimately doomed it to bankruptcy.
At first glance, Mervyn’s looked to be yet another casualty of the economic downturn and the difficult operating environment for retailers in general. With about 125 of its 175 stores located in California, where plummeting housing values and rising gas prices have put the squeeze on the chain’s core customers, Mervyn’s appeared to be a particularly vulnerable company in a teetering industry. But Mervyn’s, which has weathered previous downturns, says it has a bigger problem.
In papers filed by the company on Tuesday with the US Bankruptcy Court, Mervyn’s alleges that it was the victim of a plot by its new owners to strip it of its valuable real estate assets and then lease the properties back to the company at “substantially increased rates.” Mervyn’s claims that its annual occupancy expense (aka rent) has increased by about $80 million to $172 million after the sale. The filing goes on to claim that by “separating the firm’s real estate assets from its retail operations, the private equity owners — Cerberus Capital Management, Sun Capital Management, and Lubert-Adler and Klaff Partners — made sure that any residual value or upside in the real estate assets were reserved for themselves and not for Mervyn’s.” The three investors used loans against Mervyn’s real estate assets to finance the $800 million LBO from Target.
The company was founded in 1949 by Mervin Morris and acquired by Dayton Hudson (now Target) in 1978. Other defendants named in the suit include Goldman Sachs (Target’s investment banker), and the banks and real estate lenders involved in the deal.
Mervyn’s, which is still open for business but is shuttering 26 stores as it reorganizes, alleges that its owners have extracted $400 million from the company since acquiring it from Target, leaving it strapped for cash to pay vendors. The suit seeks the return of $58 million in transaction fees and other damages as well as a court order allowing Mervyn’s to reclaim its real estate.
The lawsuit may be among the first to address what has become a popular strategy among private equity firms in recent years. Acquirers take advantage of high real estate values to finance the purchase of retailers, such as Mervyn’s and ShopKo Stores (another Sun Capital deal), and then separate the underlying real estate from the retail business. Retailers who favor sale lease-back transactions say they provide money to open new locations and remodel existing ones. Indeed, ailing merchants like Sears and Kmart have attracted investors (enter Eddie Lampert) not for their retail operations but rather for the valuable land underneath their stores.
The current steep decline in commercial real estate values may put the brakes on the practice. But for Mervyn’s, and other ailing retailers who entered into real estate-backed LBOs, it may be too late.
Comments
Jim Kelly Says:
September 5th, 2008 at 8:21 am
You’re right “on the money” with the above article. My perception of Sun Capital is that they are a group of 21st Century thieves, disguised in suits. “Aquirers take advantage of high real estate values …” is exactly what SC has done.
I worked for a company called Indalex - an aluminum manufacturer. Prior to the “LBO” the company had been profitable, being able to gain market share in an industry buoyed by rising commodity prices.
Since the takeover, the results have been abysmal - plants closed and many people laid off. They have a similar track record at Sharper Image and Wickes Furniture (see Wall Street Journal 3/10/08).
These people are like leeches or vampires. They gain control of a company with the intent of sucking it dry of all value, then using that $ to buy another company - same results.
If they were playing monopoly, it would be OK - just a harmless board game. However, they are NOT playing a harmless game. They are contributing to the destruction of companies and people’s lives who depend on the companies in order to support their families.
Frank Norris did a great job exposing the railroads (viz. Southern Pacific)100 years ago in The Octopus. I think it’s time that someone brought to light the unethical practices that seem to be valued and encouraged by the LBO firms.
Danny K. Says:
September 6th, 2008 at 9:36 am
This populism sounds nice and all, but lets say you get a good deal on a house and it comes with 10 acres. You sell off the acreage and the house to different people. The guy who bought the house then gets foreclosed and gets nothing. Does he have a right to sue you because you sold off the 10 acres that came with the house? Absolutely not. It was yours, and you can do with it as you please.
Likewise with Mervyn’s, Sears and Penn Traffic, among others. If investors are stupid enough to pay inflated prices in sale-leaseback transactions, why shouldn’t the owners of these properties have the right to sell the properties off and make a killing?
There’s a funny joke among real estate developers: Do you know how to turn a bad real estate deal into a good one? Find a doctor to buy it. If Mervyns owners found a bunch of sucker doctors, more power to them!
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