Removing Moral Hazard from Private Equity

WSJ today reports that department store chain Mervyn’s may be the next PE-backed retail bust, just four years after the company was carved out of Target Corp. for $1.2 billion. Certain vendors have stopped shipping, longtime lender CIT has cut ties and there is no rising economic tide to lift all boats (unless your vessel is made of petroleum).

By any objective standard, this should be a disaster for Mervyn’s current owners: Cerberus Capital Management, Sun Capital Partners, Lubert-Adler and Klaff Partners. But this is private equity, where operational failure can be rewarded with financial hedging.

According to WSJ, the original transaction was structured in two parts: One for the retailer and one for its real estate. While the former is an apparent failure, the latter made money off rising valuations (remember, this is compared to 2004) and leases to both Mervyn’s and other retailers.

Great structure, unless you happen to work for Mervyn’s or are an unpaid vendor. And that’s what really pisses me off about this new private equity narrative, which is titled: Heads we win, tails you lose. Buying a company is first and foremost about making money, but it should also be about helping the company prosper – because so many people’s livelihoods rely upon that prosperity. This isn’t to say that all deals are going to work out for everyone, but interests should be closely-enough aligned that big gains or big losses are experienced by both company owners and the company itself. In this case, it looks like the owners are breaking around even, while the company loses everything.

I’m not making any judgments here on whether or not Mervyn’s apparent failure is due to operational mismanagement or outside factors (probably a combination of both). But I do hold Cerberus and Sun accountable for helping to remove moral hazard from private equity. They should be losing more if Mervyn’s is indeed liquidated.

As it currently stands, what is preventing them – or other firms — from making the exact same deal again? Nothing, which is exactly what many Mervyn’s employees and vendors are about to be left with.