Saturday, February 16, 2008

Cerberus to partners: Eat our humble pie

As the year 2006 drew to a close, a MarketWatcher opined
U.S. stock market shrinks by $600 billion [but] Fueled by LBOs and buybacks, contraction may bode well for 2007:

2006 was the year of the incredible shrinking stock market, when a record amount of shares left public markets amid a flurry of leveraged buyouts and share repurchases. If the supply of equities continues to dwindle and retail investors also rediscover their former penchant for U.S. stock mutual funds, it could mean the market in 2007 would get a significant push higher, some strategists said.

Still, others are dubious about the benefits of the recent LBO boom and warned that an unexpected spike in interest rates next year could derail stock markets.

The U.S. stock market is on course for its best year since 2003, with the Standard & Poor's 500 Index up more than 13% through Dec. 28. The benchmark has climbed for four straight years and recently hit six-year highs.

For some observers, this bull market can be partly explained by the fundamentals of supply and demand: The supply, or number of shares outstanding, has declined while demand, in the form of investor optimism, has stabilized and recently begun to increase. [The ceteris paribus assumption is that demand will continue.]

"The more you shrink it, the more it has the potential to rise, all other things being equal," said Rod Smyth, chief investment strategist with Wachovia Securities. "If you're shrinking the market with buyouts, you're putting money back into people's pockets, which in a bull market they're likely to keep re-investing in the market."

In 2006, a pair of record-setting factors took a major chunk of supply off the market. More than $400 billion worth of new cash takeovers have been announced this year, while companies bought back in excess of $600 billion worth of their own stock, both records, according to estimates compiled by TrimTabs Investment Research, a Santa Rosa, Calif.-based firm that tracks market trends for institutions.

One of those monster take-overs was the private equity purchase by Cerberus (who also bought out Chrysler) of GMAC, as reported by BusinessWeek:
Cerberus To KKR: Eat Our Dust

It was an epic showdown between legendary buyout king Henry R. Kravis and New Age hedge fund manager Stephen A. Feinberg -- and Feinberg won. On Apr. 3, General Motors Corp. (GM ) announced that it would get about $14 billion over the next three years for selling a 51% stake of its highly profitable [sic] GMAC finance division to a group led by Feinberg's firm, Cerberus Capital Management LP.

Ever since, Wall Street has been buzzing over how the 46-year-old Feinberg snapped up a huge financial-services company for little more than its book value from Kravis, age 62. Kravis may someday look wise for having turned his back on a deal heavily laden with risk. But losing to Cerberus has to sting.

A big battle between established buyout firms such as Kohlberg Kravis Roberts & Co. and scrappier hedge fund groups like Cerberus -- named after the three-headed dog in Greek mythology that guards the gates of Hades -- has been brewing for a while. In a 2004 speech to a few hundred private-equity investors and bankers, Kravis warned that hedge funds had little experience managing companies or "creating value."

Since then, Kravis has been forced to fend off Feinberg multiple times to buy companies. In 2005, a KKR group beat out Cerberus for troubled retailer Toys 'R' Us Inc. by paying $6.6 billion for it. In January, a Cerberus group picked up the grocery chain Alberston's Inc. (ABS ) that KKR had been eyeing.

The next round came when GM sold most of GMAC's commercial mortgage unit to a group led by KKR on Mar. 23. (GMAC sells auto financing, mortgages, and insurance.) Little more than a week later, Cerberus beat out KKR for the big kahuna -- a majority stake in GMAC itself. That means Cerberus is indirectly a part-owner of KKR's commercial mortgage business. Kravis may have to deal with Feinberg whether he likes it or not.

For Feinberg, snagging GMAC means much more than besting Kravis. He hopes the deal will propel Cerberus from a behind-the-scenes operator into a well-respected financial-services company. That's a big leap for a private investment firm that started with a grubstake of $10 million in 1992. Cerberus now manages $18 billion in assets, excluding the GMAC deal (BW -- Oct. 3).

GM's advisers presented what were expected to be the final two bids for majority stakes in GMAC to the board. KKR, with Wachovia Corp. (WB ), had submitted a highly conditional letter and term sheet. By contrast, Cerberus, which had code-named the GMAC deal "Hercules," had marked up every section of a purchase agreement and had spent tens of millions of dollars for roughly 300 people to pore over 8,000 GMAC files and other documents.

Feinberg won the day in part by accepting risks that every major bank and marquee buyout firm that GM approached about the deal turned down. For starters, Cerberus will take control of more than $300 billion of leases, loans, mortgages, and insurance policies. The auto-related leases and loans could be a drag if GM's problems get worse. Feinberg also agreed to invest GMAC's aftertax earnings and dividends for five years, and not to break GMAC apart without GM's consent. In addition, he promised to continue to support loans to dealers and leases to buyers of GM autos for 10 years.

Nevertheless, Wall Street is agog over the unprecedented $6 billion check that Cerberus and some of its limited partners are writing.

Fast forward to January 22, 2008. Mr. Feinberg is writing to his investors. The letter is reproduced by the WSJ here and is must reading. Some excerpts below:
Dear Investors,

The last six months have been brutal for the credit markets. [Thus begins a "dog ate my homework" explanation.]

Banks were far to easy with credit for too long. Their aggressive lending practices have caused them to be stuck with large amounts of loans on their balance sheets that they cannot sell. [This from a hedgie- cum- privateer!]

Nobody, no matter how big, has been unscathed. UBS, Bear Stearns, Merrill Lynch, Morgan Stanley, and even Citigroup .... [Oh come on Mom, everyone's doing it. Well, jeez, Dad, everyone was doing it.]

The stock market has also declined sharply.

We do not know what will happen with the markets or the economy. We are not macroeconomists....

[N]ow is the time to raise cash.... We also expect to use some of the committed but uncalled capital to take advantage of possible buying opportunities....

Speaking of pain [oh, let's] brings us to United Rentals .... [W]e negotiated an exit arrangement that allowed us to walk away from the deal for any reason and incur a maximum exposure of $100 million dollars, a loss of 1/2 of 1 percent for [y]our funds.

[W]e will protect you even if we have to take a lot of grief in the process.

In general, we despise all the public attention we are getting. We do our best to avoid the spotlight but, unfortunately, when you do some large deals, such as Chrysler and GMAC, it is hard to avoid.

If any one, two or even three deals fail, fail, however, our people will feel awful and will find it unacceptable, but it will not hurt the funds terribly. Because Series Four is very diversified, its overall success does not depend on the future of GMAC, Chrysler, or any other single investment.

One the one hand we must have a thick skin, and on the other hand, we must keep our humility... because once you lose your humility you will collapse as a money manager. We must remain humble and also hungry.

We need to remain vigilant, humble .... Most of all, we must have humility....

We must also have a thick skin.

Management fees are expensed as incurred and tend to be heavily front-end loaded. [So, we'll tend to get ours before you get yours, especially if the markets tank.]

Sincerely,

//

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