How Private Equity Strangled Mervyns

Cerberus, Sun Capital, and Lubert-Adler stripped the 59-year-old retailer of its assets and threw 30,000 people out of work

Business Week Article - By Emily Thornton

On the morning of Oct. 23, Mervin G. Morris went to the Hayward (Calif.) headquarters of Mervyns department stores one last time. As the retail chain's founder walked into the rust-colored concrete building, scores of shell-shocked employees were shuffling out with boxes full of their personal effects. Dozens rushed up to tell Morris, 88, how much they had enjoyed working at Mervyns. One woman told him she had been there 42 years. "It was a horrible scene," he says. As Morris walked past a lunch room, some 70 workers rose to give him a standing ovation. He later walked out in tears.

The grief is understandable. Mervyns, the chain that Morris founded six decades ago with $25,000 and two employees, is about to disappear. Its 149 remaining stores are being liquidated. More than 18,000 people have been thrown out of work—without severance and, in many cases, weeks of vacation pay—amid the toughest job market in a generation.
It didn't have to be this way. Mervyns, a midrange seller of apparel, housewares, and other department-store fare, might have weathered the economic storm that's battering so many of its rivals. Much of the blame for its demise lies with three private equity titans: Cerberus Capital Management, Sun Capital Partners, and Lubert-Adler.

When those firms bought Mervyns from Target for $1.2 billion in 2004, they promised to revive the limping West Coast retailer. Then they stripped it of real estate assets, nearly doubled its rent, and saddled it with $800 million in debt while sucking out more than $400 million in cash for themselves, according to the company. The moves left Mervyns so weak it couldn't survive.
Mervyns' collapse reveals dangerous flaws in the private equity playbook. It shows how investors with risky business plans, unrealistic financial assumptions, and competing agendas can deliver a death blow to companies that otherwise could have survived. And it offers a glimpse into the human suffering wrought by owners looking to turn a quick profit above all else.

BUYOUT SHOPS GONE WILD

Private equity firms buy companies with the goal of improving them and then selling them for a profit. To pay for their deals, they often take on debt, hence the term leveraged buyout. In recent years the buyout shops went wild, taking advantage of unusually low interest rates and easy borrowing terms. At their peak in 2006 they acquired 667 companies worth $372 billion. But debt levels soared: From 2005 through the third quarter of 2008, private equity firms loaded a staggering $741 billion of debt onto their companies' balance sheets, according to Standard & Poor's/LCD Group, which, like BusinessWeek, is owned by The McGraw-Hill Companies.

When the credit crunch hit, lenders pulled back and dealmaking ground to a halt. Debt-heavy companies were left unable to refinance just as the economy was slowing. The optimism and confidence of the buyout boom gave way to fear—and massive layoffs.

What's happening at Mervyns is happening elsewhere at an alarming rate. While private equity firms control just a tiny fraction of U.S. corporations, their companies are disproportionately troubled. Of the 105 big U.S. companies that have filed for bankruptcy this year, 66 have been owned by buyout shops or been spun off by them, according to Capital IQ, another unit of McGraw-Hill. Investors, meanwhile, remain skeptical of many of the recent buyouts that haven't yet blown up but soon could. Loans made for those deals are now trading for as little as 33 cents on the dollar.

Mervyns, to be sure, had been in decline for years. Founded by Morris in San Lorenzo, Calif., in 1949, the company grew over the next several decades into a midsize chain with more than 50 stores in three states. In 1978, Morris sold the company to Dayton Hudson (now Target) for $300 million. Retail analysts say Dayton neglected the brand as it focused on building the Target franchise (funded, in part, by Mervyns' earnings). Over time it opened fewer new Mervyns stores; existing ones took on a shabby look. By the time Target sold the chain in August 2004, the company, with 257 stores and some 30,000 employees, appeared ripe for improvement. "At first, there was total excitement," says Kathi Finley, a former information systems specialist and 34-year veteran laid off in October. "It was like, 'Yahoo! We're on our own!' "  But while the buyout firms wanted to fix up Mervyns, an obsession with real estate got in the way. Mervyns' new owners were eager to turn the company's real estate into gold. When the acquisition closed, they split the company into two main pieces—the retail operation and a much more valuable entity that held the real estate. Over time the owners would shut down 90 underperforming stores and close two of its four distribution centers in order to sell some of the land they owned. They also sold the decades-old property leases on many other stores to outside companies—and then turned around and rented the property back at current market rates. The owners kept the proceeds from the land and lease sales for themselves.  But the real estate strategy had a glitch: According to court documents, the rent payments to the new landlords were practically double what the old payments were, since many of the original leases had been negotiated back in the 1980s. To prevent big losses, Mervyns' new owners had to cut other costs—drastically.

"WE CAN'T EVEN HAVE WATER?"

Slashing expenses, it seems, was always baked into the plan. Soon after Mervyns' new owners took control, they laid off scores of people at company headquarters. They canceled some charity efforts and training programs and outsourced some human resources and marketing services. Even though sales were solid, the owners told managers to clamp down on spending for supplies, and they downsized the annual Christmas party. At headquarters, they took away water coolers. For recently laid-off employee Cindy Fajardo, that was a signal of doom: "People thought, 'we can't even have water?' "

It appeared to some outsiders that the real estate plan, rather than a desire to revive the brand, was driving the restructuring. One executive approached by Cerberus to run Mervyns says he declined the job because the buyout firms seemed "more focused on closing the first 50 to 75 stores than anything else."

But former J.C. Penney executive Vanessa Castagna, recruited to be Mervyns' first chief after the buyout and given an equity stake, believed the owners wanted to turn Mervyns around. She was comfortable with the real estate strategy. "The owners," she says, "wanted to maximize the value of the transaction and to monetize the real estate value."

Early on, there were some positive signs. Even amid the closures, Mervyns opened 11 stores in Hispanic neighborhoods to tap what it saw as an underserved market. It invested $200 million in a new information technology system—a necessity to separate the chain from Target's system—and held a barbecue in its headquarters' parking lot to celebrate the launch. Morris, who kept close ties at the company over the years, made an appearance at the event.

But Mervyns' operating income slipped right away, from $160 million in 2003 (the last full year of results at Target) to around $100 million in 2005 and the same in 2006. During those years, the private equity firms took a total of $137 million in "distributions" directly from company coffers, according to people familiar with the finances.

The higher lease costs and distribution fees came back to bite. As the California economy softened, Castagna found it more difficult to maneuver financially. She says she tried to persuade the owners to renegotiate lease payments but was told "those were the going market rates." In February 2007, when her two-year contract ended, Castagna left. Now she's a director at Levi Strauss.

Mervyns' owners replaced Castagna with Richard B. Leto, a former Kohl's executive who had been brought in as Mervyns' president after the buyout. Leto says he promptly advised his bosses to sell the chain to another retailer. "Because of the age of the company, the age of our stores, and the condition of our physical plants [as well as] the intrusion in the West by Kohl's and Penney's," Leto says, "I felt the best thing to do, given the appropriate opportunity, was to sell the business."

But the owners were rarely on the same page, many insiders say. The messy structure of their deal created competing agendas from the start. Cerberus, the $27 billion private equity behemoth that owns Chrysler and many other corporations, had equal stakes in both the Mervyns chain and the separate real estate company. Lubert-Adler, a Philadelphia firm specializing in real estate, had a larger stake in the real estate entity. Sun Capital, a $10 billion owner of 90 companies, held a bigger stake in Mervyns' department store operation. "I could never figure out how they planned on running the company when there was this natural fight built into the structure," says a former Mervyns executive. "And the answer is, it didn't work very well."

In late 2007, having soured on the prospect of further profits, Cerberus sold its stake to Sun, which assumed majority control. Sun in turn promised to buy out Lubert-Adler, too, for an additional $20 million.

Mervyns' 2006 profit turned into a $64 million loss for 2007 as sales fell by 7.4%. Leto says Sun executives fired him shortly before Christmas. He was replaced on an interim basis by Vice-President Chuck Kurth. Then, in March 2008, Sun brought in the fourth CEO in 12 months: John Goodman, a highly regarded former president of the Dockers brand at Levi Strauss.
Just weeks into the job, Goodman found himself in crisis. Mervyns relied heavily on CIT Group, the big corporate lender, to guarantee transactions with vendors. By March, CIT grew so worried about Mervyns' creditworthiness that it started cutting back on new deals. That sparked fears among other creditors and vendors that Mervyns couldn't pay its bills. Suppliers began refusing to ship merchandise unless Mervyns agreed to tougher payment terms. Stores posted signs announcing they didn't have advertised merchandise. Out of desperation, Goodman started circulating Mervyns' balance sheet to vendors and some of his own managers to show that the retailer had ample financing. "That scared me even more," says former Mervyns manager Yasmin Zialcita.

Sun, meanwhile, reneged on its promise to buy the Lubert-Adler stake, a sign that it, too, might not have been interested in sticking with Mervyns for the long term. It didn't offer to make further investments to stabilize the company, either—a disappointment to some creditors. One of them charges that "the Sun people acted like the classic short-term-oriented Wall Street guys: 'I want to get my money and run.' "

PEP TALK

With losses mounting, Sun and Lubert-Adler decided to take Mervyns into bankruptcy. On July 29, 59 years to the day after the company was founded, Goodman addressed the troops at headquarters. Although the owners were closing 26 more stores, Goodman said, Mervyns could pull through as a leaner retailer or as part of another company. "He told us to hang in there. Be strong. We're going to make it," recalls former employee-relations representative Michelle Diaz.
Creditors soon approached Goodman with an odd idea: On behalf of Mervyns he should sue the private equity owners who had seemingly run the company into the ground. As the CEO, they reminded him, it was his fiduciary responsibility to preserve as much of the company's value as possible. Normally creditors do the litigating in such situations, but the four-year statute of limitations to bring suit against the buyout was about to expire, and they couldn't get organized in time to file a complaint of their own. Goodman was being asked to sue the very people who had hired him five months earlier.

On Sept. 2, Goodman announced in a memo to staff that the company was planning to file suit. In the memo he alleged that the buyout firms had used financial engineering to acquire Mervyns' "considerable real estate holdings, and then leased back properties to the company at substantially increased rates," moves that helped force the company into Chapter 11. The complaint, filed in Delaware bankruptcy court, alleges that Mervyns' private equity owners deliberately rendered the company insolvent.

About 1,000 employees at headquarters were summoned to separate rooms at 10 a.m. on Oct. 7. Most were told they had been selected to "take the company to a higher level." At least 100 were told they had to be out of the building by noon. They would be paid for the day, but that was it—no severance. "There were a lot of people in tears," recalls 19-year vet Steve Sunyog. He says the treatment "was a slap in the face." Loretta Robinson, a former merchandise coordinator with 32 years at the company, was fortunate to find another job at an office-furnishings store. But the new job is a 50-mile commute and pays less. She says she's borrowing money from her parents and adding ham and beans to pots of soup to stretch them further. "I need every dime," she says.

At the time of the firings, Goodman was furiously shopping Mervyns to potential buyers. But there was a deal-breaker: the new rent payments. Mervyns' landlords wouldn't agree to lower them enough to attract a buyer. Absent cheaper rents, no suitor thought the chain could survive the recession.

Soon rumors began to circulate that no deal would transpire. Executives started packing up their things and walking out. As fears of liquidation spread, "there was mass panic," says Zialcita, 37, the former manager. Employees lined up to hand in their resignations on the belief that it would give them a better chance of getting paid for unused vacation days. "There weren't enough hands in human resources to handle all of the people," says a former executive.

Their worst fears were realized days later when Sun and Lubert-Adler, unable to dig themselves out of their mess, decided that liquidation was the only option. Says Sun Capital Partners in a written statement to BusinessWeek: "When it was acquired, Mervyns was struggling. Significant improvements were achieved, but financial headwinds and the challenging retail environment proved insurmountable." (Lubert-Adler didn't return phone calls or e-mails seeking comment.)
The move rippled through Mervyns' supplier network. Ben Coons, CEO of Advanced Wireless in Lakeville, Minn., is out a major customer and as much as $30,000 for unpaid services: "That's about a third of the biweekly payroll. That stings."

Goodman, for one, has landed on his feet, starting a new job as CEO of mall-based specialty retailer Charlotte Russe in November. But most of the thousands thrown out of work are faring much worse. A bankruptcy court recently ruled that some creditors must be paid before employees, meaning many former workers may not receive vacation pay.

"THERE IS NO MONEY"

Those people are scrambling. Former communications analyst Jeff Rainey, a 28-year veteran, says he feels "powerless" and may have to file for bankruptcy. Numerous others say they're asking their families for help—from single mother Barbara Durden, who's leaning on her brothers, to marketing veteran Katherine Begley, who may have to move herself and her husband (who suffers from Alzheimer's) into the home of her 93-year-old father. David Magallon, a former security manager and father of three girls, says he has cut off his family's cable TV and turned off the heat. "There is no money," he laments. Christmas this year will be "stuff that we make, and cards."

On Nov. 20, employees filed a suit against Mervyns seeking class action status, alleging the company violated the law by not giving them 60 days notice that they would be terminated. Mervyns declined to comment on pending litigation.
The collapse has prompted many Mervyns lifers to rue the day the company was sold to private equity. "I feel like we were robbed," says Zialcita. Private equity "is so nasty." Devastated by her experience, she vows never to work for a company again. Zialcita now hopes to start a wedding floral business.

Morris, meanwhile, is heartbroken to see the chain he built crumble. "There was no way it could survive," he says. On Oct. 23, having gotten a call from Goodman's assistant asking if he wanted to pick up some old pictures, he stumbled into the company's final day of existence before liquidation. "I couldn't believe it," he says. His wife, he says, had one thought when she heard about the bankruptcy: "Maybe you shouldn't have sold the company."