Dog Days at Cerberus

The bad news for the investment powerhouse keeps coming—and it goes deeper than Chrysler and GMAC

by David Welch and Christopher Palmeri

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Carlos Osorio/AP Photo; Chris Rank/Bloomberg News

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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."