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The Forbes family’s big deal causes big trouble

After default, emergency restructuring was needed to satisfy lenders.

Malcolm’s sons (from left): Timothy, Christopher, Robert, and Steve in 1993

FORTUNE — The Forbes family has poked itself in the eye with its “capitalist tool.”

Like many publishers, Forbes Media has struggled during the financial crisis. But according to nonpublic documents made available to Fortune, the company has been under more financial strain than previously believed. Forbes Media violated covenants on a revolving credit line that it took out in 2006, according to a letter sent to the company by J.P. Morgan. The loan, which was part of a series of transactions that allowed the Forbes family to cash out more than $100 million from the company, is due next July. Some lenders have been selling pieces of it at a discount from face value.

Since the death in 1990 of Malcolm Forbes — the unreconstructed tycoon who turned Forbes magazine into a celebration of business victory and its spoils — his children have held a decades-long yard sale of the family’s outré trophy collection. The island in the Fiji archipelago was sold to Red Bull founder Dietrich Mateschitz. A grand ranch in Colorado was picked up by hedge fund executive Louis Bacon. A sultan-worthy palace in Tangier, a custom Boeing 727, helicopters, the world’s largest private collection of Fabergé eggs, and stacks of Victorian art have all been auctioned off. Even the publishing company’s Fifth Avenue headquarters were sold to New York University.

But the Forbeses have held on to the asset that made them rich and famous in the first place: Forbes Media, the company that currently owns Forbes magazine (which dubbed itself the “capitalist tool” and has been a fierce competitor of Fortune’s), the Social Register, a stake in American Heritage magazine, and the websites and RealClear.

Holding on to that asset, however, has proved to be a gargantuan headache. The company went into technical default on some $90 million worth of revolving credit. The family and the minority owner, Elevation Partners, began an emergency plan to restructure the business and get back in the good graces of its lenders. They went so far as to hire Alvarez & Marsal — a firm that works with companies in dire financial straits or in bankruptcy to restructure their businesses — to bless the plan that Forbes Media’s board came up with.

J.P. Morgan (JPM) and six other lenders agreed to amend the loan in August 2010, lowering the monthly payment and adjusting the financial targets that Forbes Media would have to hit to be in compliance. In a twist of the knife, the amendment also set tough conditions for getting rid of Alvarez & Marsal. It stipulated that one of three things had to happen: the sale of Investopedia, an online financial dictionary; the replacement of Steve Forbes as CEO; or the achievement of certain financial targets. That month Forbes sold Investopedia for $39.6 million. Steve Forbes stepped down in November, replaced by Mike Perlis, a media investor who had worked at Playboy and Ziff-Davis Publishing. Forbes met the stipulated financial targets. Alvarez & Marsal was dismissed.

When asked to comment for this story, a Forbes Media spokeswoman wrote, “Steve Forbes remains Editor in Chief and Chairman of Forbes Media. Tim Forbes is Chairman of Forbes Digital. The Forbes family remains the controlling shareholder of Forbes Media.”

How did a family that once owned so much find itself in such a corner? It all began in 2006, when Forbes Media sold 45% of itself to private equity firm Elevation Partners. The price was never publicly disclosed, but a J.P. Morgan memo reviewed by Fortune says it was $237.2 million — which is less than previously reported. Forbes Media also opened up a revolving line of credit, which by 2010 was about $90 million. (Only $75 million could be tapped at the time of the deal.)

The 2006 deal was a windfall for the family, which took $107.4 million, about a third of the proceeds, for itself. Another $38.9 million went to the redemption of warrants, $101.8 million paid down debt, $41.4 million remained as cash on the balance sheet, and $22.7 million went to expenses and fees, including to J.P. Morgan, the bank that advised on the deal.

Elevation was supposed to bring expertise to the table. Co-founded by Roger McNamee, who had been an investing star at tech buyout firm Silver Lake Partners, and rock star Bono of U2 fame, Elevation billed itself as a partnership that “got” new media.

Elevation invested in Forbes Media based on rosy 2006 projections that looked downright absurd by 2008. When it bought into Forbes, Elevation believed that the value of its stake would rise sharply, but was clearly worried about being able to exit the deal. So Elevation’s contract includes a “put” option giving it the right to force Forbes to buy back the 45% stake at fair market value anytime between Aug. 4, 2011, and Aug. 3, 2016, according to a footnote in Forbes’s 2010 financial statement.

(In a twist that could prove lucky for Forbes, it has a “call” option to force Elevation to sell back its stake at fair market value anytime after Aug. 4, 2011. If the company’s value does not rise above what Elevation paid in 2006, Forbes could buy back the stake and stick Elevation with a loss.)

Elevation also got Forbes Media to give it a hitherto-undisclosed escape clause: After the put option expires, Elevation has a 90-day window during which it can sell its stake back to Forbes Media at its original price.

McNamee quit Forbes Media’s board in 2009 and was replaced by Elevation partner Bret Pearlman, who had a reputation as an aggressive cost cutter, which is evident in the company’s 2010 financials. In 2009 the company had an operating loss of $19.7 million. By 2010 the company showed operating income of $2.7 million. That $22 million improvement in profitability was driven by a revenue gain of around $9 million and about $13 million in cost cuts.

Forbes Media says its renewed profitability means that it is out of the woods, thanks to the business plan it worked out with Alvarez & Marsal in 2010. And it says the company is confident that it will be able to refinance its revolving line of credit when it comes due on July 6, 2012. Forbes Media said in a statement: “It is not up to the banks whether to refinance. It is up to Forbes. [We] have numerous financing options as we go forward.”

That is technically true, but what should not be forgotten is that the deal with Elevation that set this chain of events in motion has been a failure. It burdened Forbes Media with debt that it ultimately struggled to pay, so much so that the company had to be gutted. Five years later Forbes Media’s earnings power has declined precipitously, and Elevation is nowhere near the return on investment it had predicted. The Forbes family was able to take a lot of money off the table. That’s timely because it is running out of trophies to sell. Last year the Forbes family motor yacht, The Highlander, was put into dry dock, its crew laid off.

This article is from the August 15, 2011 issue of Fortune.