Kmart's 2003 emergence under Lampert's ESL erased $7.8B of debt and brought profits

Kmart, the nation's third-largest discount chain, filed for Chapter 11 on January 22, 2002 after sales fell and some suppliers stopped making deliveries for fear they would not be paid. It was the largest retail bankruptcy in U.S. history at the time.

While Kmart was in bankruptcy, hedge fund manager Edward Lampert's ESL Investments bought much of its debt for less than $1 billion. The plan that won court approval erased $7.8 billion of debt while ESL provided about $2 billion in financing and received 49 percent of the new shares.

Kmart emerged on May 6, 2003 with 1,513 stores, down from 2,114, and named Lampert chairman. The old stock was worthless. The plan closed about 599 stores and reduced headcount by about 57,000, reshaping the chain toward urban and ethnic markets it believed Wal-Mart served less well.

The bet paid off faster than skeptics expected: by August 2004 Kmart had posted its third consecutive quarterly profit, earning $155 million in the second quarter, and its shares had surged 17 percent to $76.05 as Lampert gained freedom to invest $2.6 billion of surplus cash.

Emerged May 6, 2003 with $7.8B of debt erased and ESL owning 49%, then posted three straight quarterly profits and a stock price of $76.

Buying distressed debt for less than $1B let ESL dictate the plan's speed and terms.

Erasing $7.8B of debt removed interest costs the retailer could not carry.

Store closures and cost cuts quickly produced profit, if not sales growth.

Lampert's control of board and equity kept the strategy consistent.

A hedge fund that buys distressed debt can control a reorganization's pace and outcome; the risk is that cost and real-estate engineering substitutes for a retail strategy that grows sales.

Kmart's post-bankruptcy profitability made it one of the fastest financial turnarounds in retail, yet same-store sales kept falling even as profits rose. The case remains a classic study of using distressed debt to take control of a bankruptcy outcome, and of the limits of financial engineering without a retail growth plan.