Why the Linens Probe Could Be Worse for PE Than The Mervyns Lawsuit

Linens ‘n Things could become the subject of a probe from a disgruntled bondholder, LBO Wire reported today. Bondholder Levine Leichtman Capital Partners is suspicious of Linens ‘n Things’ “quick demise” under the private equity ownership of Apollo Management.

It’s true that Apollo only owned Linens around two and a half years before it went bankrupt. And it’s also true that there have been reports of strange management behavior at the company (but come on, it’s The Post…). Even so, this filing is significant for any PE firm facing a leveraged, unplanned disaster with potential for bankruptcy. The key word here is “unplanned.”

If Levine Leitchtman’s probe is (a) granted and (b) fruitful, it’s bad news for private equity’s image and potentially, its deal flow. The probe follows a similar line of thinking as the Mervyns lawsuit from last week. (You might remember, bondholders accused its PE backers of basically sabotaging the company to make money on its real estate.)

I’ve already covered why the Mervyns suit probably won’t be successful, but let me explain why this probe could be worse:

Mervyns was failing before Sun Capital and Cerberus bought it. From the start, the buyout was painted as a real estate play. Mervyns was basically seen as unfixable by parent company Target. Even though Sun and Cerberus stripped the company of its real estate and burdened it with debt, at least they warned us.

Linens ‘n Things, on the other hand, was a fundamentally healthy company that was just struggling with competition from Bed Bath & Beyond and public market scrutiny. Apollo Management purchased it under the guise of a turnaround. But it didn’t have to be sold.

If the probe turns up evidence that Apollo’s management and debt additions caused Linen’s bankruptcy, then I think a lot of managers and shareholders will rethink their interest in selling to private equity. Furthermore, it could prompt bondholders of other bankrupt (or even distressed) portfolio companies to get suspicious of their buyout partners.

Yes, Apollo Management does not represent all private equity. And yes, the probe could be utterly unsuccessful. The saving grace (I suppose) is that Apollo Management’s interest was fully aligned with the company. The firm will lose all of its $633.4 million investment in Linens, unlike Cerberus, which made 2.5 times its money on Mervyns’ sale lease-back.