Mervyn’s

What does the Mervyn's settlement mean?

October 9, 2012: 4:14 PM ET

Private equity firms will pay out $166 million, but will it change behavior?

FORTUNE -- Cerberus Capital Management and Sun Capital Partners are part of an investor group that has agreed to pay $166 million to creditors of Mervyn's, a now-defunct retailer carved out of Target Corp. (TGT) for $1.2 billion in 2004.

The suit had accused the private equity firms of fraudulent conveyance, stemming from their decision to separate the company's retail business from its underlying real estate.

Such transactions are fairly common, particularly in retail, but the plaintiffs had alleged that this particular stricture had doomed the operating side to failure. Not only did the operating company not receive any compensation for its divestiture, but it was forced to pay higher leases that it ultimately could not afford (culminating in a July 2008 bankruptcy filing). Those higher leases, by the way, were demanded so that the real estate company could service debt related to the original buyout, and also to pay out dividends to the private equity shareholders. Cerberus, for example, reportedly made a 2.5X gain on its initial investment (in part through selling most of its ownership stake in the operating company to Sun).

Here was what I wrote about the situation at the time, while I was still with peHUB:

Great structure, unless you happen to work for Mervyn's or are an unpaid vendor. And that's what really pisses me off about this new private equity narrative, which is titled: Heads we win, tails you lose. Buying a company is first and foremost about making money, but it should also be about helping the company prosper – because so many people's livelihoods rely upon that prosperity. This isn't to say that all deals are going to work out for everyone, but interests should be closely-enough aligned that big gains or big losses are experienced by both company owners and the company itself. In this case, it looks like the owners are breaking around even, while the company loses everything.

I'm not making any judgments here on whether or not Mervyn's apparent failure is due to operational mismanagement or outside factors (probably a combination of both). But I do hold Cerberus and Sun accountable for helping to remove moral hazard from private equity. They should be losing more if Mervyn's is indeed liquidated.

As it currently stands, what is preventing them – or other firms — from making the exact same deal again? Nothing, which is exactly what many Mervyn's employees and vendors are about to be left with.

Well, $166 million should hopefully prove a bit of disincentive. Depending, perhaps, on where it comes from.

Most private equity funds carry insurance for these sorts of situations, although there are almost always fraud exceptions. The defendants obviously aren't admitting fraudulent conveyance as part of the settlement, but it's possible that an insurance company could make repayment difficult. Moreover, there is evidence that at least some of the settlement is coming from the firms themselves. For example, Sun has kept around $30 million in escrow related to this case, while the overall investor group has been slowly selling off the real estate properties and putting those proceeds into a separate escrow. Normally such money would be disbursed to fund investors, but apparently not in this case.

Calls to Cerberus, Sun and Lubert-Adler were not returned.

So let's imagine that this settlement at least puts a minor dent in these firms' wallets. Such an outcome certainly won't end such transactions going forward, but it could mean that firms are more careful about how they are structured. Namely: If the operating company is losing its underlying real estate, it should be compensated for the loss.

Unfortunately, this settlement won't do anything to help the tens of thousands of Mervyn's employees who lost their jobs. But at least they now can have some partial solace in knowing that those who caused their pain did not get to walk away unscathed, and that their experience may help prevent the next such situation from arising in the first place.

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