Portfolio companies collapse all the time, but it’s not every day that GPs then pay a nine figure settlement to creditors when the dust settles.
That’s why it caught a lot of people's attention last week when Mervyn’s collected $166 million from Cerberus Capital Management, Sun Capital Partners and other defenders to settle charges they had fated the department store chain to bankruptcy after purchasing the chain for $1.2 billion in 2004 and later splitting off its property assets.
Mervyns: deal gone wrong
At the root of Mervyn’s claim was the concept of “fraudulent conveyance”, which in plain English is when a company’s assets are moved around out of the reach of creditors. Mervyn’s claims that through a complex series of holding companies its new private equity owners were able to ring-fence the chain’s lucrative real estate assets into an entity controlled by them, and important to their case, away from the reach of creditors. That splitting of retail and real estate, according to Mervyn’s, represented fraudulent conveyance and the first link in the chain of events that led to its insolvency.
Would a hypothetical court agree with this interpretation of events? Or would all the legal fees and potential reputational damage have been worth it if defendants decided instead to fight the case? Answers to these questions would help other firms accused of asset stripping gain a sense of their own litigation risks. And more importantly the trick in mitigating that risk may rest in how well GPs document financing decisions taken at the portfolio company level. Here’s what we mean:
Mervyn’s is probably not the last company from the credit glut of yesteryear to bring a private equity firm to court. In fact the large settlement here will only encourage other failed portfolio companies (and their fee-hungry lawyers) to launch similar claims
To prove fraudulent conveyance Mervyn’s creditors would essentially need to demonstrate two things: that the transfer of the real estate assets was for less than their fair market value, and that as a result of the transfer Mervyn’s was no longer able to manage its debt. Considering Mervyn’s retail stores were paid nothing for their underlying land (and paid higher rents following the divesture to boot), it would seem the defendants’ lawyers would have their work cut out for them.
But in court defendants would counter that it would have been impossible to know that separating Mervyn’s real estate from its retail operations would leave the company unable to service its debt. The real cause for the department store chain’s 2008 bankruptcy, defendants would argue, was a once in a lifetime market downturn entering its peak that very same year. But why isolate Mervyn’s real estate assets in the first place? Defense lawyers would likely raise two points. One, that doing so provided the necessary security for banks to provide acquisition financing to a struggling retail company. And two, that the company’s private equity parents had simply done what any owner has the right to do: dispose of their assets on the terms and conditions as they see fit. Sun Capital, Cerberus and other investors found an opportunity to monetise some of the value in the company’s real estate and took action.
One can’t easily predict which side of the contest a court would land on, but the decision may rest on what kind of paper trail Mervyn’s private equity owners left for examination. If defendants believed that Mervyn’s was financially fit enough to have its real estate assets spun out, then it would be useful to present any documents from 2004 showcasing all their estimates, valuations, projections and even internal presentations made to justify the transfer.
For more risky portfolio company financing options, GPs should hire an independent valuation service provider to double-check their math. That way if a dividend recapitalisation or asset sale is found to have played a part in a company's failure', the private equity firm has the credibility of an outside party confirming a fraudulent conveyance had not taken place.
Mervyn’s is probably not the last company from the credit glut of yesteryear to bring a private equity firm to court. In fact the large settlement here will only encourage other failed portfolio companies (and their fee-hungry lawyers) to launch similar claims. With a warning shot now fired for how expensive a fraudulent conveyance suit can become, GPs should come prepared.