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Merry-Go-Round shares at risk?


Major shareholders of Merry-Go-Round Enterprises Inc. are increasingly worried that Fidelity Investments and other creditors will make a bankruptcy-court power play for a big piece of ownership in the Joppa-based fashion retailer, sharply reducing or even wiping out the holdings of existing stock owners.

The fear is fueled in part by the track record of Fidelity and other so-called "vulture investors" who have reaped spectacular profits using their institutional muscle to exchange debt for stock in recent bankruptcy cases.

The concern also is prompted by Merry-Go-Round's continuing financial problems, which could play into Fidelity's hand in a contest for ownership.

This risk to Merry-Go-Round's shares, believed genuine by some of the savviest players on Wall Street, may be an eye-opener to the many small, local investors who have been buying the stock in hopes of a turnaround.

The large, trendy boutique chain may indeed emerge from bankruptcy court and recover from its difficulties. But by the time it does, bankruptcy experts believe, Fidelity and fellow vulture player Bear Stearns & Co. might hold most of the marbles.

That could make Merry-Go-Round stock worth far less than the $2 a share it has been fetching, eating into some prominent fortunes that have already been hurt by the company's problems.

Leonard "Boogie" Weinglass, local folk hero and Merry-Go-Round's co-founder, still holds 5.13 million shares, worth $10.26 million at $2 a share. Beth H. Goldsmith, widow of co-founder Harold Goldsmith, controls 5 million shares.

At the least, yielding a big ownership stake to creditors would substantially reduce the benefit existing shareholders could gain from Merry-Go-Round's revival.

The vulture funds "have got to make a 25 to 35 percent return" to satisfy their investors, said one large shareholder, who spoke on the condition of anonymity. "The only way they can do that is if they take the shares away from the equity holders. Anybody who thinks Bear Stearns and Fidelity are in it for any other reason is out of their mind."

Fidelity, a large, Boston-based mutual fund company, and Bear Stearns, a New York investment firm, declined to comment.

A big grab for stock by Merry-Go-Round's creditors won't be easy. The creditors will be firmly resisted by stock owners and their lawyers. They'll have to secure the bankruptcy court's approval. A sudden recovery by Merry-Go-Round could thwart the plan.

Large shareholders aren't unloading their stakes.

Mr. Weinglass, Merry-Go-Round's chairman, discounted the risk to Merry-Go-Round stock. "I don't know about that, Fidelity taking a lot of equity in this company," he said. "Things are going well. I don't think that's going to happen."

But Fidelity owns enough Merry-Go-Round debt to block any reorganization proposal that doesn't dish out a generous helping of stock to creditors. Fidelity has hired one of the toughest law firms in the "corporate reorganization" business -- Weil, Gotshal & Manges, of New York.

And it's accustomed to wringing large gains from bankruptcy situations, as demonstrated by the case of R.H. Macy & Co.

Defending the value of Merry-Go-Round shares against the interests of Fidelity and other creditors "is the general tactical problem in this bankruptcy right now," said Hubert M. Stiles Jr., ,, who manages a big chunk of Merry-Go-Round stock for Baltimore-based T. Rowe Price Associates Inc. and its investors.

It didn't always seem that way.

A few months ago, analysts believed Merry-Go-Round might be among the few big Chapter 11 cases in which the value of the company's shares wouldn't be wiped out or reduced to pennies.

Merry-Go-Round seemed to have the wherewithal to pay off creditors in cash or IOUs, without touching its stock. The company's mistakes -- putting unpopular clothes in its stores -- were deemed quickly fixable. When it landed in bankruptcy court on Jan. 11, its reported assets of $463 million outweighed liabilities by almost $200 million, which was unusual in a bankruptcy case.

Some of the smartest money was buying Merry-Go-Round common stock, which had been beaten down from more than $17 a share last year to the $2-$3 range. Fidelity itself acquired 5.12 million shares -- 9.5 percent of the company.

Smaller players took the plunge, too. Clients of regional brokerage Ferris, Baker Watts Inc. currently hold more than 100,000 Merry-Go-Round shares, said research director Jeffrey Saut. "There were a lot of people -- old-line Baltimoreans -- who bought it on the flop, at 1 7/8 or $2 a share," Mr. Saut said.

But Merry-Go-Round didn't rebound.

The company lost $17.1 million for the three months ended April 30, not counting $7.0 million in reorganization costs, on revenue of $169 million. Managers had trouble getting enough merchandise for spring and summer. Sales have been down sharply every month so far this year.

Fidelity's tactic now, analysts and Merry-Go-Round shareholders believe, will be to try to push the case through bankruptcy court while Merry-Go-Round is still floundering, arguing that the retailer isn't worth very much and can't pay off its debts. That would allow Fidelity to corral big pieces of Merry-Go-Round stock -- substantially shrinking or wiping out the stake of existing shareholders -- and then reap equally big profits later if the retailer recovers and the stock price goes up.

In major Chapter 11 filings, "the game that has gone on in the last year or so is [for creditors] to try to put a low valuation on a company" in an attempt to increase the amount of stock they get for their trade-in debt, said a shareholder adviser in the Merry-Go-Round case.

Merry-Go-Round stock owners, on the other hand, will favor a leisurely bankruptcy process that allows the company time to recover and pay off debt without giving up their stake.

In most Chapter 11 cases, "the equity holders try to push the value of the company up so there's a bigger pie to cut," said Scott Stagg, an analyst for The Delaware Bay Co., a New York firm that specializes in low-grade securities. "The debt holders usually try to show a smaller pie so they can retain the majority of the company."

The fact that Fidelity itself owns 9.5 percent of Merry-Go-Round might not prevent it from pursuing a strategy that hurts shareholders, analysts said.

Fidelity has purchased more than $90 million in face-value of Merry-Go-Round debt at a fairly high price -- 85 cents on the dollar, according to various documents and Wall Street sources. By contrast, it has spent about $10 million or a little more on its Merry-Go-Round stock.

Fidelity "will obviously look to maximize the value of their total holdings in Merry-Go-Round, and it is very possible that there'll be a situation that, in order to do that, their stock holding will end up being worthless," said George Putnam, president of New Generation Research, a Boston firm that specializes in bankruptcy investing.

"Obviously, you're not going to hurt your $90 million holding to help your $10 million holding," he added. Plus, Fidelity could sell its Merry-Go-Round shares at any time.

Why would Fidelity want stock in a struggling retailer instead of fully collecting its debts? Because the chances of huge profits are much greater.

If Merry-Go-Round pays creditors in full, Fidelity would earn about 17 percent for the period from January, when it bought the debt, to when Merry-Go-Round emerges. That's a good profit but far less than, say, the 100 percent return Fidelity reportedly earned by swapping debt for equity in the bankruptcy case of National Gypsum Co. or the healthy double-digit percentage gains analysts believe it will earn through the same mechanism in the Macy's case.

Companies emerging from Chapter 11 proceedings often perform very well: They have little or no debt; they've shed poorly performing stores and other operations; they've fired managers who didn't measure up.

There seems to be agreement among investors on many sides that Merry-Go-Round indeed will recover -- eventually, to some degree. Managers are optimistic. They've re-established supply lines, are filling stores with apparel and expect sales results to improve for the fall season.

What's uncertain is how quickly a recovery will happen and who will own the company when it does.

Much of the contest will go on behind doors, as creditors, shareholders, managers, directors, lawyers, accountants and investment bankers jockey for position.

But there will be public glimpses, as the fight spills into the federal courthouse on Lombard Street.

Fidelity has already delivered some jabs.

* Last spring it tried to speed the bankruptcy process by objecting to Merry-Go-Round's request for an extension of the period in which Merry-Go-Round has an exclusive right to file its own plan of reorganization.

The extension expires Aug. 31. Merry-Go-Round has said it will ask for another extension, and Fidelity is expected again to object.

* On June 29, Fidelity signaled just how involved it will be in Merry-Go-Round's future by taking the extraordinary step of filing a statement with the U.S. Securities and Exchange Commission. The document said Fidelity intends "to participate actively in the formulation of a Chapter 11 plan of reorganization for the company."

* Earlier this month, Fidelity lawyer Bruce Zirinsky tried unsuccessfully to prevent Merry-Go-Round's shareholders committee from hiring investment banker Wilbur Ross, of Rothschild Inc., as its financial adviser.

Mr. Zirinsky tried to humiliate Mr. Ross on the witness stand, challenging him to name Merry-Go-Round's primary competitor. Mr. Zirinsky's stated reason for objecting to Rothschild was that its $70,000 monthly fee would drain capital from Merry-Go-Round. But analysts said he may have had another motive: to deprive Merry-Go-Round shareholders of expert advice.

Said T. Rowe Price's Mr. Stiles: "I think the case was already settled, but he was continuing to persist to try to embarrass Wilbur for some reason, just to say, 'We're going to be right in your face this whole time, guys.'"

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