Mervyns Bankruptcy Won’t Be Total Loss For Sun Capital, Cerberus Capital

Ending speculation about its ability to continue to stave off creditors, Mervyns, the West Coast general merchandise retailer that Cerberus Capital Management and Sun Capital Partners purchased from Target Corp. in 2004, filed for bankruptcy protection on July 29. While this is far from good news for these turnaround specialists, the firms aren’t expected to lose their full investment.

In fact, Cerberus Capital has already banked a 2.5x return on its investment, sources told Buyouts. In the initial $1.2 billion buyout, valued at around 8x EBITDA, the firms divided the retailer into two parts: a real estate company and an operating company. They brought in real estate private equity firm Lubert Adler to invest in the real estate business and execute lucrative sale-leaseback transactions, whereby the firms recouped their initial $400 million equity investment and then some. Reports had pegged the Mervyns deal as a “real estate play” from the start.

A divided deal structure is common in real-estate-oriented buyouts and many LBO firms bring in experts to help them cash in on the property value of a retail or restaurant chain. Bain Capital, Kohlberg Kravis & Roberts, and real estate firm Vornado Realty Trust did the same thing with their 2005 buyout of Toys ‘R’ Us.

At this point, Cerberus Capital and Sun Capital no longer hold equal shares in the real estate and operating companies. In November, Cerberus Capital sold its stake in the operating company to Sun Capital for an undisclosed price. Presently Cerberus Capital holds roughly 15 percent of the Mervyns real estate company and Sun Capital’s stake in the real estate company is larger than that. Media reports have said Sun Capital will break even on the deal as a whole. Both Sun Capital and Cerberus Capital declined to comment.

In addition to taking advantage of the real estate to extract cash, Sun Capital and Cerberus also attempted operational improvements. Since its carve-out, the store shuttered at least 82 stores and laid off around 4,800 employees, leaving the Midwest and Southeast markets to focus on California and Arizona. The company hired retail veteran Rick Leto as its CEO and unveiled plans to spend more than $100 million on store refurbishment, up-to-date IT systems and other operational improvements.

But the Hayward, Calif.-based business, which operates 177 stores in seven states and relies heavily on discounts, failed in attempts to target Hispanic customers and struggled in the distressed real estate markets of Arizona and California. In recent months, some vendors have halted shipments to the mall-based retailer, and its lenders, which include CIT Group and Wachovia, pulled financing, according to a report.

In a statement on its Web site, Mervyns said its stores will remain open and business will continue as it moves through the bankruptcy process. The company, whose origins stretch back to 1949, is seeking up to $465 million in debtor-in-possession financing.