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Why Businesses Go Bankrupt: Mervyn’s

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Private Equity firms Cerberus Capital Management and Sun Capital Partners, along with real estate investors Lubert-Adler and Klaff Partners led a 2004 buyout of Mervyn’s discount retail chain for $1.26 billion in 2004.   Upon closing, the new owners split Mervyn’s into two companies, one owning the real estate, and the other operating the stores.   The real estate company borrowed $800 million to fund the LBO, and then dramatically raised store rents to the operating company.  In October 2008, Mervyn’s went into bankruptcy, with its remaining 149 stores liquidated, and more than 18,000 employees thrown out of work.

Lesson learned: Financial engineering often increases the risk of failure.  After the split of Mervyn’s into two companies, the retail stores were left with $674 million of assets and $664 million of liabilities and worse yet, negative working capital. According to a 11/26/08 “Business Week” article, the moves left Mervyn’s “so weak it couldn’t survive.”

The Buyout of America

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I devoured Josh Kosman’s “The Buyout of America” the day after Thanksgiving, and also took the time to listen to an audio replay of his November 16th interview with Terry Gross of WHYY’s Fresh Air.

Mr. Kosman lays out a broad indictment of private equity firms, making a case that they run down the companies they acquire for debt, with exorbitant price increases, poor customer service due to staff reductions and systematic underinvestment.

A few surprising, and unpleasant, discoveries from the book included:

  • That four of the past eight Treasury Secretaries joined the Private Equity Industry: James Baker (Carlyle), Nicholas Brady (Darby), Paul O’Neill (Blackstone) and John Snow (Cerberus), giving the industry significant influence in Washington DC.
  • The Boston Consulting Group predicted (in December 2008) that “almost 50 percent of PE-owned companies would probably default on their debt by the end of 2011.”
  • The degree to which private equity firms have been able to “create a deal-making system in which they reap profits while assuming almost no risk.”  The risk is shouldered by investors, including public pension funds.

One thing that bothered me about the book was how Kosman tarred the entire private equity industry indiscriminately, without even a hint that some private equity firms are operating with higher concern for how the companies they acquire ultimately fare, after they have carved out their special dividends and management fees.

My personal experience as part of a team doing due diligence for a NYC-based private equity firm was that they seemed strongly focused on developing strategies that would govern the expansion of the acquired firm into new markets and new product categories, creating value by building up, not tearing down the business.

Why Businesses go Bankrupt: Reader’s Digest

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Even before private equity firm Ripplewood Holdings loaded Reader’s Digest with untenable levels of debt, the company had grown over-reliant on direct marketing of books, music and video to its vast subscriber list, where it ran into fierce competition from Amazon and others.   Whatever new ownership structure emerges from the current bankruptcy proceedings, the key challenge for Reader’s Digest will remain how to manage its flagship publication for continuing profitability while the internet continues to sap away readers and advertisers.

Lesson learned: Focus on keeping your core business profitable and healthy.

Rare Glimpse at Linens ‘n Things Financials

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Linens ‘n Things provided an unexpected public posting of its financial results under private equity firm Apollo Management when it recently posted its 10-k report for 2007 in conjunction with the desire of some of its private shareholders to sell shares on the NYSE. Linens ‘n Things posted a $242 million net loss in 2007 on revenue of $2.8 billion. The company had a $36 million net profit in 2005 on revenue of $2.7 billion in 2005, the last full year of public ownership (Apollo Management took the company private in February, 2006.) Linens ‘n Things gross profit margin slipped from 40.8% to 37.5% over the two year period; Selling, General & Administrative Expense increased from 38.5% to 43.7% of revenue; and interest expense increased from 0.2% to 3.9% of revenue. By comparison, publicly-owned segment leader Bed, Bath & Beyond has 2007 gross profit margin of 41.6%; Selling, General & Administrative Expense at 30.4% of revenue; and no interest expense. The Linens ‘n Things 3/20/2008 10-k report lists numerous risks, including the following: “despite current indebtedness levels the Company and its subsidiaries may still be able to incur substantially more indebtedness. This could further exacerbate the risks associated with its substantial leverage.” On April 15th, Linens ‘n Things announced that it had decided to defer $16 million quarterly interest payments due to the holders of its senior secured floating rate notes.