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Cerberus: Victim of Private Equity Hubris

By The Prince ⋅ December 22, 2007 ⋅  Email This Post ⋅  Print This Post ⋅ Post a comment

"Hubris itself will not let you be an artist."  Cerberus’ hasn’t been much of a deal artist recently.

Cerberus sure has been busy recently putting out fires on the deals they did when the LBO game was at its peak.  Cerberus’ troubles are illustrative of the tendency of private equity firms to throw caution to the wind when money was cheap before this summer.  Cerberus is getting is now getting its just deserts for the Hubris it and other private equity firms exhibited.  Before we launch into the three major bad stories that Cerberus is facing I must ad that Cerberus, given its hedge fund pedigree, was one of the most cooperative private equity firms when Wall Street firms tried to renegotiate terms this summer.  See my previous post on this.  This may give them a competitive advantage going forward and certainly builds up some good will.  Yet, enough about that, let’s move onto the problems that Cerberus is currently facing on their portfolio and deal pipeline.

GMAC: ResCap Blowup

We obviously have to start with GMAC.  What an awful investment that has turned out to be.  It has to be one of the most high profile bad Private Equity investments made in this last period of frenetic LBO activity.  GMAC’s mortgage unit, ResCap, has been hit hard by the housing market crisis and its portfolio of CDOs and MBS has been dramatically written down.  GMAC has cut 3,000 jobs at ResCap with restructuring costs of $110mn but the unit continues to lose money.  Some of the bleeding was stopped by Cerberus when they choose to sell off subprime loans at a loss and tighten lending standards to curtail new loans to weak credit borrowers.  This investment looks even worse when you consider that GMAC has had its credit downgraded or its outlook lowered by the major credit rating agencies.  GM had to inject money into ResCap to get Cerberus to take it off its hand but it looks like GM probably got the better side of this deal.

Recently, it has only gotten worse for Cerberus when it comes to GMAC.  GMAC reported a loss of $1.6 billion for the third quarter, a steep increase to its $173 million loss in the same period last year.  The company said its Residential Capital LLC unit posted a net loss of $2.3 billion during the quarter, due to “unprecedented disruptions in the mortgage financing markets and adverse trends in home price appreciation.”  “The third quarter financial performance of ResCap is a major disappointment,” said GMAC Chief Executive Officer Eric Feldstein.  “We are moving aggressively to restructure our real estate finance business as weakness in the housing market and mortgage industry continues to prevail.”  The loss is a significant reversal for the mortgage finance unit which posted net income of $83 million during the third quarter of 2006 which we must assume Cerberus used to arrive at its valuation.  During the third quarter, GMAC infused $1 billion of equity into ResCap to boost the company’s liquidity base, which stood at $6.2 billion as of September 30.  GMAC and ResCap were also downgraded by Moody’s, lowering ResCap’s debt rating two notches to “Ba3,” its third-highest junk grade, from “Ba1,” and GMAC one notch to “Ba2″ from “Ba1.”  Needless to say, its a good thing the leveraged loan market is closed, because it has got to be all hands on deck at Cerberus to fix GMAC.  What was a PE firm doing buying a financial services company in the first place, especially one as large as GMAC.  Financial services LBOs are a fairly new invention and most have had mixed returns (See failure to complete Sallie Mae LBO by J.C. Flowers).  Cash flows are heavily influenced by the state of the macro-economy and its difficult to determine the risk on these firms balance sheets before purchasing.  Many private equity firms are leery of doing deals for financial services companies but Cerberus was clearly confident enough to take the leap.  

Chrysler - The Turnaround that May Never Happen

Chrysler was obviously just too high profile for Cerberus to pass up.  This buyout definitely conjures up memories of KKR over-bidding for RJR to secure its status then achieving sub-par returns.  Looking at Chrysler for a potential buyout the story looks juicy.  Cerberus must of been thinking they could turn this company around by closing dealerships, laying off employees, negotiating aggressively with the unions, and cutting down the amount of models offered by Chrysler.  It gets even more glamorous when you bring in Bob Nardelli, GE wunderkind and deposed CEO of Home Depot, to lead the turnaround.  Yet, Wall Street has had a hell of a time trying to sell the bank and high yield debt to finance this thing because everyone knows that this company is grossly over-levered.  I personally have never liked auto-companies for the same reasons I hate airline stocks i.e. terrible unions, correlation with oil prices, tendency to build too much capacity in good times and brutal competition.  Cerberus definitely overpaid when it dumped $5bn into this weak asset but debt was cheap back then so they bid what it took to win.

None of this bodes well for Cerberus considering the press they have been putting out about the company’s performance.  Chrysler, like all automakers, is going to be facing slowing growth in the U.S. and a consumer which is increasingly under pressure from multiple directions i.e. high debt, flat wages, etc.  Cerberus’ battle with the union hasn’t gone as smoothly as anticipated by Cerberus as evidenced by strike skirmishes at certain plants when layoffs started taking place.  If you need proof the Cerberus is in over its head on Chrysler look at the "dreamy" comments that Nardelli put out today.  Nardelli said the company was "operationally" bankrupt.  "We remain extremely enthusiastic about our investment in Chrysler," Cerberus chief operating officer Mark Neporent said in a statement.  "Our underwriting assumed, and fully planned, that Chrysler would incur losses in the near term," Neporent said.  I’m really convinced.  Nardelli told employees that the automaker’s losses may more than double to $1.6 billion this year, people with direct knowledge of his statements said.  The Wall Street Journal reported the loss and said Chrysler’s costs will exceed $64 billion.  A 2007 loss would be the second in a row for Chrysler.  The Journal said Chrysler’s revenue will fall short of $63 billion, citing unnamed people who attended the meetings.  Nardelli also recently said that the company would eliminate 12,000 more jobs than it originally anticipated.  Chrysler is in a serious financial crunch and the word on the street is that they are looking for assets to sell for cash.  The environment for Chrysler is challenging and Cerberus’ exit strategy of selling this to a strategic is many years down the road given that acquisition finance probably wouldn’t be there for someone to buy this also ran car company.

United Rentals - Cold Feet on the Deal

Luckily Cerberus was able to extract itself from this deal.  However, it still distracted resources since they had to go to court to try and enforce the agreement they had put in place with United Rentals which had clauses for Cerberus to walk away after paying a breakup fee.  Shares of United Rentals Inc. plunged more than 17 percent Friday as a Delaware court ruled that Cerberus was not obligated to complete its $4Bn buyout that it abandoned last month.  Cerberus agreed in July to acquire the construction-equipment-rental company but had a change of heart amid turmoil in credit markets.  The case has been followed by Wall Street because buyout firms rarely abandon a deal unless there is a serious decline in the target company’s business.  United Rentals shares dropped sharply after the decision, falling 17% to close at $17.91. Cerberus originally had agreed to pay $34.50 a share to acquire the company.  The buyout contract contained conflicting clauses.  One clause appeared to suggest that United Rentals could force Cerberus to complete the transaction under certain circumstances and another appeared to allow Cerberus to walk away and pay no more than the $100 million breakup fee.  United Rentals has yet to claim the $100 million fee, according to a Cerberus spokesman.  Cerberus, purportedly a firm built on buying assets on the cheap, may have just gotten its best bargain ever by saving $1.5Bn by not having to go through with the UR LBO.  Its ironic that the best deal Cerberus may have recently done was one that they walked away from.  Maybe Cerberus could have walked away from Chrysler and GMAC had hubris not obscured the best interests of their LP investors.

In Greek mythology, Cerberus or Kerberos (Greek Κέρβερος, Kerberos, "demon of the pit") was the hound of Hades, a monstrous three-headed dog with a snake for a tail (sometimes said to have 50 or 100 heads) called a hellhound. Other hell hounds included Orthus, his two headed brother. Cerberus guarded the gate to Hades and ensured that spirits of the dead could enter, but none could exit (additionally, no living person was to come into Hades). Among his siblings are Chimera and the Hydra. He is the offspring of Echidna and Typhon. In Dante’s Inferno, he is described as having a human head. This symbolizes the possibility of Cerberus being more human than animal. - Wikipedia