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In Depth November 26, 2008, 5:00PM EST

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

By Emily Thornton

Morris, founder of Mervyns at the site of the original store in San Lorenzo, Calif. Eric Millette

The site of the original store in San Lorenzo, Calif.

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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 (TGT) 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 (MHP).

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. Page 1 2 3 4 5 Next Page

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