Four years after initiating legal action, creditors of the bankrupt US retailer Mervyn's have won a major settlement from the private equity firms and banks which drove it out of business by piling on debt and stripping the company of cash. Bankruptcy resulted in the elimination of 18,000 jobs. Will it change the terms of the private equity debate which has resurfaced in the US with the nomination of former Bain boss Mitt Romney as the Republican presidential candidate?
The lawsuit charged the private equity owners (Cerberus, Sun Capital and real-estate specialist Lubert-Adler) and the banks which provided financing with vacuuming cash out of the company by using Mervyn's real estate assets - whose value inflated with the property bubble - to finance the heavily leveraged deal and then immediately separating the company's retail operations from the real estate. The real estate was parked in bankruptcy-proof companies to shield it from creditors' claims; the new owners of the properties then doubled the cost of the leases paid by the retail stores.
For the privilege of paying higher rent, Mervyn's paid its new owners USD 59 million in fees. Mervyn's then took on an additional USD 60 million in debt to fund a 'dividend recapitalization' for the private equity owners. Four years after the deal, Mervyn's was bankrupt.
In agreeing to a USD 166 million settlement, the PE firms acknowledge no guilt, and the terms of the settlement enjoin the creditors from mentioning the buyout firms by name in any public announcement, filing or meetings with more than 100 persons in attendance. According Reuters, "Less than half the proceeds [of the settlement] are destined for pre-bankruptcy creditors, who probably will recover around 20 cents on the dollar after their four-year fight."
The 18,000 workers who lost their jobs of course get nothing.
The IUF drew attention [1] to the potential importance of the lawsuit at the time it was filed 4 years ago. Now that a settlement has been reached, will it become the potential "game changer" for the private equity industry suggested by CNN [2]?
That of course depends on the political response to this illuminating story in what has become a politically charged issue in the US elections.
The current US debate on private equity has so far focused on two issues: outsourcing jobs and the tax loopholes from which the buyout brokers benefit.
Outsourcing, or offshoring, jobs is not unique to private equity. For decades, there has been an epidemic of outsourcing by all companies, whether publicly listed or privately held, which has destroyed jobs and devastated the lives of US workers.
The debate on taxes has largely focused on the tax benefits realized individually by private equity owners and fund managers. There is of course justifiable outrage (though not nearly enough) at the obscenity of top earners paying a fraction of their income in taxes compared with working people. The continued treatment of 'carried interest' - the profits resulting from successful buyout operations - as capital gains, rather than income which is taxed at a higher rate, has been one element. The spotlight on Bain, now that Romney has finally released his tax returns, has exposed the manifold layers of offshore accounts which the buyout firms use to minimize or eliminate other taxes. And some of the biggest private equity firms are now coming under legal and regulatory examination for their booking of management fees as 'future profits' rather than income.
What has been missing until now has been critical discussion of the key tax break at the heart of the leveraged buyout mechanism itself: the tax deductibility of interest which is carried to grotesque levels. As described in the IUF's A Workers Guide to Private Equity Buyouts [3], "While all businesses benefit from the tax deductible status of interest on borrowed money, buyout funds clearly benefit to a much greater extent because of their exclusive reliance on debt as a tool for 'unlocking value'. In fact the buyout power of debt only functions because of tax loopholes and the absence of significant restrictions on the balance of debt to equity ratios in companies."
This absurd situation - which is not unique to the US but applies universally - functions as a regulatory subsidy which favors debt over equity and encourages asset stripping. While finance and their lobbyists scream about the need to reduce public deficits, the buyout industry has been creating trillions of dollars in private debt, much of it highly toxic. Some of this debt was transformed into public debt when governments acquired a backlog of toxic loans through the bailouts.
Limits on the tax deductibility of interest in the context of debt-funded acquisitions and the taking on of new debt to fund dividend recapitalizations would ensure that companies taken private would not be at immediate risk through the predatory cash-stripping practices which sank Mervyn's and many other companies. The Mervyn's settlement could refocus debate on the pressing need for financial and fiscal re-regulation of private equity, but the real debate will only happen by zeroing in on the business model itself, the elephant at the table which has so far eluded critical enquiry.