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New Era in Litigation? Bankrupt US Retailer Charges PE Funds with Asset Stripping

Litigation has proliferated since the onset of the credit crisis, with buyout funds, banks and target companies engaging in a spiral of lawsuits and counter lawsuits over collapsing deals and termination fees.

Banks have sued to walk away from the deals, companies have sued to press their claim to be taken private, and the funds have sued just about everyone, invoking everything from fiduciary responsibility to regulatory concerns to issues of national security. And as increasing numbers of portfolio companies fall into bankruptcy, one can anticipate a growing number of lawsuits being filed by creditors against private equity funds - like the suit filed in August by creditors of US generator manufacturer Powermate Corporation. The suit charges pe owners Sun Capital and York Street Capital Partners with bankrupting the company through dividend recapitalizations which smothered it in debt.

However, the lawsuit announced on September 2 by US retailer Mervyn's may be the first of its kind (and it certainly won't be the last). The suit charges the pe owners (Cerberus, Sun Capital and real-estate specialist Lubert-Adler), the banks which provided financing, and the parent retail chain Target, which sold off Mervyn's in 2004, with using the company's real estate assets to finance a heavily leveraged deal, then bankrupting the company through substantially jacked up leases. The result, according to company lawyers, "ultimately led Mervyn's to bankruptcy and is a fraudulent transfer that cannot withstand scrutiny." The company, which employed some 18,000 workers, is seeking to reorganize under bankruptcy protection.

The classic mechanism for "unlocking value" involved the creation of separate companies for the retail operations and the leases and property. According to an article in the Minneapolis/St. Paul Star Tribune of September 3:

"Mervyn's lawsuit tackles a favored technique of the last wave of leveraged buyouts, which have begun washing up in bankruptcy. Acquirers took advantage of the high value of real estate to finance the purchase of retailers such as Mervyn's in transactions that separated the real estate from the underlying business.

"'The amputation of the real estate legs from the body of the retail operations ... was all done in a split-second series of concurrent transfers orchestrated by' the private equity firms, Mervyn's attorneys said.

"According to Mervyn's, it received only $8.3 million out of the deals that deprived it of its real estate, while the private equity firms, lawyers and investment bankers split $58 million in fees. Mervyn's lawyers say the real estate was worth about $1.68 billion.

"Mervyn's real estate wound up in the hands of bankruptcy-proof companies so that creditors of the retailer could never reach the assets, the company alleges. According to the lawsuit, those behind the deal knew at the time that this would leave Mervyn's without sufficient assets to survive.

"In stage two of the real estate-based leveraged buyout, acquirers lock in a stream of cash flow through advantageous leases to the acquired companies. Mervyn's says its $172 million annual occupancy expense is $80 million higher than it would have been had the private equity firms not acquired it from Target and started charging rent."

Under the new leaseback arrangements, Mervyn's annual lease payments nearly doubled - to USD 172 million. According to the lawsuit, "By separating Mervyn's real estate assets from its retail operations, the private-equity players made sure that any residual value or upside in the real estate assets were reserved for themselves and not for Mervyn's,"

With inflated rents and a healthy dividend recapitalization, the pe owners more than doubled their initial stake in the 2004 USD 1.26 billion buyout. The Wall Street Journal, not generally known for its critical stance towards the buyout industry, had this to say on September 4:

"The transaction involving Mervyn's was struck during the earlier part of the decade when private-investment firms were snapping up struggling retailers less for their fashion sense and more for their real-estate value.

"Hedge-fund manager Eddie Lampert earned a fortune gaining control of bankrupt retailer Kmart and then selling off its real estate. Kohlberg Kravis Roberts & Co., Bain Capital and Vornado Realty Trust acquired Toys 'R' Us Inc. in part because of the value of its stores.

"The case against Sun and Cerberus is especially fraught for the private-equity industry, which is trying to shake off decades of criticism that the funds "strip" healthy companies with little regard for employees or institutions."

The separation of real estate assets and operations from the provision of services has also become a favorite mechanism for pumping cash out of hotel chains, notably through property selloffs to Real Estate Investment Trusts (REITS), and does not require taking a company private. Hedge funds and "activist investors" have pressed for these changes as they acquire growing shares in listed companies. Workers pay the price in layoffs, speedup, wage cuts and attacks on pensions and benefits.