Is A Sale Leaseback Evil, or Just Smart Business?

Bankrupt retailer Mervyns is suing Sun Capital and Cerberus for pushing it into Chapter 11 with its sale-leaseback-driven LBO. We previously covered the method used by Mervyns’ PE backers to profit from the otherwise-failed buyout by selling off its real estate, and also exactly how much money they made.

It’s also detailed on page 13 of Mervyns’ 57-page claim, which I posted after the jump.

Depending on your outlook, you might see Sun and Cerberus’ move as either brilliant business or sheer evil. The sale-leaseback is nothing new, but doing it for hefty dividends to an already hurting company like Mervyns doesn’t exactly scream “turnaround saint.”

Mervyns, its debtors and its 4000-plus employees obviously fall into the latter camp.

And take note: This isn’t the only bankrupt company to be suing its private equity backer. Sun Capital’s own Powermate, which filed Chapter 11 in March, has done the same thing (scroll to bottom of story).

So as bankrupt PE-backed companies pile up, I have to ask, are these plausible cases? Will the debtors win?

Unlikely. The firms took the money out of the company before Mervyns was insolvent, so fraud would be difficult to prove. The PE backers are likely to pay a settlement to avoid going to court, since, as one PE pro told me, Sun and Cerberus don’t want the embarrassment of an analyst model called “Liquidation of OpCo” (which certainly exists) to surface during a discovery process.

Notably, Mervyns is also suing Target—its former parent—for knowingly selling it into this unfavorable situation. The thing is, I didn’t see anyone else stepping up to save the declining chain back in 2004. Target proved it was incapable of running it profitably, and it was widely seen as a “tough sell.” Strategic buyers would have probably done a sale-leaseback similar to Sun and Cerberus’s. And besides, no retailers expressed interest for the entire company. They, too, only wanted chunks of Mervyns’ real estate.

Maybe it took a recession to prove that Mervyns is no longer a viable business. Maybe Sun and Cerberus unfairly took advantage of that fact, screwing the company’s employees and debtors in the process. And maybe everyone was wrong and Mervyns could’ve been revitalized. Unfortunately, it’s doubtful we’ll see the issue decided in a court.

Download the full complaint here.