Dog Days at Cerberus
Cerberus Capital Management sweated for months over its $7 billion bid to buy the construction equipment leasing company United Rentals (URI). With the financial markets in turmoil, the investment management firm pushed hard to renegotiate the price. When that failed, Cerberus abandoned the deal on Nov. 14, just days before it was set to close. The news chopped $1.2billion off United's market value. Two days later, United sued a Cerberus-affiliated group for pressuring its board to accept a lower price.
That isn't the only headache for Cerberus these days. In recent months two of its other deals have fallen apart, several investments have soured, and the problems at its big plays, Chrysler and GMAC, have worsened. In hindsight, Cerberus' bets on housing, financials, and autos look perilous. It bought GMAC Financial Services, which owns a mortgage lender, as the real estate bubble was bursting.
Now, say sources close to Cerberus, the $26 billion firm has slowed its pace of dealmaking with the credit crunch in full force. It's also focusing more rigorously on the troubled holdings in its portfolio—some of which may have blindsided the firm. The situation has prompted concern that Cerberus' returns may suffer. This comes at a time when all players are under pressure. "Industry returns have been extraordinary, 20% to 30% a year," says Katharina Lichtner, managing director of the private equity advisory firm Capital Dynamics. "Returns will come down, revert to a more normal 16%."
Cerberus—named for the three-headed hound at the gates of Hades—has seen its reputation reach mythic heights in recent years. Founded by former Drexel Burnham Lambert bond whiz Stephen Feinberg in 1992, it emerged as the ultimate example of prosperity during the recent stock market boom, posting outsized returns with an investment strategy that's part hedge fund and part private equity firm. Its returns routinely rank among the top funds tracked by researcher Private Equity Intelligence. Among its recent coups: selling Vanguard Car Rental, parent of Alamo Rent A Car and National Car Rental, to Enterprise Rent-A-Car for $1.2 billion in 2006—making a killing on its three-year investment.
Unlike more concentrated portfolios, Cerberus has dozens of investments across a number of industries. The firm also specializes in distressed companies. As a result, Cerberus often juggles a mix of winners and losers. Even so, Cerberus faces an especially tough slog on some major fix-it jobs—at a time when the investment climate remains challenging. "We're not market-timers," says Cerberus Managing Director Timothy F. Price. "We buy things other people can't make work. Because of our operational expertise, we make them work."
It's unclear just how much work it will take to fix GMAC, the financing arm of General Motors (GM). A Cerberus-led group paid $14 billion for a 51% stake in September, 2006. Cerberus wasn't exactly an industry newcomer. It had a front row seat at the subprime show with Aegis Mortgage, a lender it took control of in 1996. Yet Cerberus jumped into GMAC at exactly the wrong moment. Price defends the move: "There was one time to buy GMAC. We wanted it and took action."
The short story? Aegis filed for bankruptcy in August, and GMAC's mortgage group ResCap has been bleeding red ink. Cerberus watched GMAC continue to make subprime loans in the first quarter but has since reined it in. It wasn't fast enough to prevent the pain. ResCap has lost $3.4 billion so far this year, forcing GMAC to pump $2 billion into the business to help it survive the mortgage mess. And Lehman Brothers analyst Brian Johnson forecasts an additional $1.3 billion hit this quarter and $600 million in 2008. "I don't think anyone is panicked," says one Cerberus insider. But "we sure as hell didn't expect GMAC to be what it turned out to be."
Those problems may put a kink in the firm's strategy. Cerberus, which also owns 80.1% of struggling automaker Chrysler, wants to merge the lending operations of both companies. By doing so, it could reap massive savings on back office and loan processing operations, boosting returns at both GMAC and Chrysler.
The unexpected losses at ResCap could forestall a deal. Sources close to Cerberus and GM, which still owns 49% of GMAC, say the situation at ResCap needs to stabilize before they can move forward. If Cerberus can't shore up ResCap, GMAC's credit rating could drop and Chrysler too would suffer.
And even if ResCap can be revived, clearing hurdles with regulators and GM may be tricky. One GM executive who asked not to be named said the carmaker wants to preserve the right to buy back its financing arm one day and doesn't want to pony up more capital.
Cerberus also has its hands full with Chrysler. After backing the carmaker's initial turnaround strategy, dating back seven months, Cerberus' new executives decided they needed deeper cuts. In November, with inventory climbing rapidly, Chairman and CEO Robert L. Nardelli announced the company's second restructuring this year, slashing 10,000 more jobs and reducing production by 400,000 cars.
That will help keep expenses down, but Chrysler's real problem stems from an outdated car line. Most of its top sellers are gas-guzzlers. And its smaller vehicles, especially passenger cars and crossover SUVs, need a complete overhaul to attract buyers in satisfactory numbers.
Cerberus is trying to do both things without laying out more cash. That may prove difficult. When Magna International (MGA) was bidding on Chrysler, the parts maker figured it would need $2 billion up front—in addition to the existing $3 billion annual capital budget—to improve Chrysler's cars and upgrade plants.
Price has said in the past that "failure's not an option" with Chrysler. But the carmaker may require a lot of patience. And lately Cerberus has shown it doesn't have a problem cutting losses when situations prove too dire. The firm sold auto sealant maker GDX International Holdings at a loss in October to private equity firm Wynnchurch Capital. In 2004, Cerberus bought a collection of three houseware brands from Newell Rubbermaid for $310 million. But the newly formed company, Global Home Products, filed for bankruptcy two years later, and Cerberus offloaded the assets for $124 million.
Not surprisingly, Cerberus has ruffled some feathers with its slash-and-burn approach at those companies. At GDX, it laid off 1,500 workers and reduced the union's medical benefits. After the bankruptcy of Global Home Products, the Pension Benefit Guarantee Corp., a quasi-government group, had to step in and pick up the $8.5 million shortfall at one division's pension fund. Says Gary Bone, president of the United Steelworkers Local 626, which represented some of GDX employees: "They're ruthless."
Meanwhile, Cerberus has bailed on a few deals. In early December, it pulled out of a deal to buy Option One Mortgage (HRB) from H&R Block (HRB) as conditions deteriorated in the housing market. Earlier, Cerberus walked away from its bid for Affiliated Computer Services (ACS), after the ACS's independent directors sought other offers.
Cerberus seems unfazed by it all—and confident that it can turn around the troubled companies. "We believe at the other end of the current deep, dark valley is a sunny one from which we'll emerge with a bunch of great companies," says Price. "We do well in good times and bad."