c.2013 New York Times News Service

c.2013 New York Times News Service

The endgame for the rue21 buyout is all about Apax Partners vs. Apax Partners, with one of them losing.

If you’re scratching your head about how this can happen, here is why Apax finds itself torn: Two of Apax’s funds — SKM Equity Fund II and SKM Investment Fund II — own about 30.2 percent of rue21, the fashion retailer. Apax inherited the investment when it acquired the firm of Saunders Karp & Megrue in 2005. The two funds have been around since the 1990s and are in their liquidation phase; the rue21 investment is their last holding.

On the other side of the table, four newer funds originated by Apax are buying rue21. These funds are collectively providing up to $283 million in equity to finance this acquisition. This compares with the approximately $300 million the SKM funds will receive in the buyout.

This is quite an unusual transaction even in normal times. Apax is essentially rebalancing rue21 among its funds, simultaneously giving a nice cash-out to its old investors paid for by its new investors. This form of “pass the baby transaction” has typically taken the shape of one private equity firm selling assets to another. It is a sale that has been heavily criticized by commentators for merely passing along overinflated assets, leaving the final, buying private equity firm holding the bag. The twist is that Apax is passing the baby to itself, raising a host of conflict-of-interest issues about whether Apax’s old or new investors are getting the better deal.

In Apax’s defense, it was well aware of the conflict and appeared to use best practices to address it. Apax recused itself from advising the SKM funds on this transaction, and the independent directors of these funds, advised by independent legal counsel, made the decision. Rue21’s shareholders are also suing the company in Delaware Chancery Court, contending that this conflict resulted in a lower share price being paid to benefit Apax’s new funds.

It all would work well if rue21 prospers, with the old investors receiving their profit and money back and the new investors profiting as well. The problem is that soon after rue21’s acquisition was announced, the retailer announced significantly reduced sales. In the wake of this announcement, the three banks financing this deal — JPMorgan Chase, Bank of America and Goldman Sachs — were reported to be struggling to sell the required $780 million in debt, even at as little as 80 cents on the dollar.

The deal for rue21 could collapse based on the contracts that the parties entered into. A key to this analysis is whether Apax and the banks actually want to exit the transaction. That depends on how much each will lose if the deal goes through.

It is here that Apax’s dual roles create some perverse incentives.

Essentially, if the deal goes through at the current $42-a-share buyout price, Apax’s old funds will post a gain but the new Apax funds will start well under water on their investment. There is likely not much overlap between the old investors and the new, so the question is how these new investors and Apax itself will feel about that paper loss. In addition, will Apax prefer to favor its new investors, who are its future, over the old investors? If Apax does scuttle the deal, it may be on the hook for a nearly $63 million termination fee, meaning that the loss has to be pretty severe for Apax to even think about leaving the deal.

Meanwhile, if the deal collapses, rue21’s share price is likely to plummet, leaving the old funds with a loss of possibly more than $100 million.

Weighing all these factors, the question is when Apax begins to feel nervous enough to try to get out of the deal, leaving its old funds with a big loss at the benefit of its new funds.

This depends on how bad the situation at rue21 is. If it is a hiccup, then Apax is likely to swallow hard and try not to torpedo the deal. The financing package is likely flexible enough to get through any period of short-term weakness. Under this option, Apax would rather close with some increased risk of loss then have its new funds eat the termination fee and its old funds take a big loss. Apax may even put up more equity to try to smooth over the deal with the banks. Alternatively, Apax may try to force a price renegotiation to spread the pain among its funds.

If something is placing rue21’s business in permanent decline, then all bets are off. It may just become too expensive for Apax to bear the burden for its new funds. Apax’s current investors may lobby for this outcome. By the way, the current head of its U.S. operations, John Megrue, is from SKM.

Because all of these decisions are being made in the shadow of this huge conflict, any such calibration cannot be overt or even stated. Even if the Apax executives use the best procedures here, it is hard to see how these issues cannot at least run through their minds.

Apax ultimately faces some difficult overt and implicit decisions about which funds to benefit. Even if Apax wants to exit the transaction, it will struggle to get around the requirements of the agreements the parties entered into. It could all come down to how willing the banks are to walk and whether a solvency certificate can be delivered.

Recent reports from LCD News say that the loan has been booked in the low 80-cents-on-the-dollar range and is pricing to close next week. If true, then this is a positive sign for the deal, assuming that solvency certificate comes through.

In the meantime, we will have to wait and see for answers to these questions. A representative of Apax declined to comment.

There is already one lesson here. When a private equity firm stands on both sides of the transaction, there are bound to be problems. If I were an investor in the new Apax funds, I would be wondering why I was buying out the old ones and how this conflict is affecting the decision-making. I would also be thinking that perhaps it would just be better to do what the rest of us do — sell at arm’s length.

In any event, this is now Apax’s problem, and one of its own making.