05-21-07
They have to get what they need to remain viable. Otherwise, it's not a matter of if they go out of business, it's a matter of when. Those health care costs will kill them.
- Erich Merkle, auto industry consultant
Red hot mama, velvet charmer... time's come to pay your dues...
- Nazareth, ‘Hair of the Dog'
Think back to the lousiest investment you ever made. Not a pleasant memory, right?
But hey, look at it this way—at least it didn't cost you $37 billion.
$37 billion is roughly what Jürgen Schrempp, the ex-CEO of Daimler-Benz, agreed to pay for Chrysler nine years ago. Last week, Daimler agreed to sell off the ailing Chrysler for less than zero. They basically paid a fee to have it hauled away. (More on that shortly.)
The historic union was hailed at the time of its announcement (May 1998). Billed as a "merger of equals," The Economist gushed that "Daimler-Benz's merger with Chrysler will launch an overdue rationalization in the global car industry."
Whoops.
In retrospect, it wasn't really a merger of equals at all; it was a takeover. The Germans had intended to wear the pants in the family from day one. (The cocky, chain-smoking Schrempp admitted this two years after the deal was done, triggering a lawsuit from a major Chrysler shareholder.)
What's more, Daimler's timing could hardly have been worse. For most of the nineteen-nineties gasoline was cheap, soccer moms were in full bloom, and sport-utility vehicles (SUVs) ruled the roads. Chrysler, which churns out light trucks and SUVs at a rate of 3 to 1 over cars, was in a sweet spot. Profits were about as high as they would get—and thus so was the deal price. (Don't it always seem to go, as Joni Mitchell once sang.)
In paying $37 billion for Chrysler, Daimler-Benz basically top-ticked the SUV market. They might as well have rung a bell; oil prices bottomed for good less than nine months later, and the gas-guzzling SUV culture soon peaked. (No pun intended. "Peaked," get it? Peak oil? Okay, moving on.)
Fast forward to 2007. Jürgen Schrempp has left the building; the once-hailed merger has deteriorated from bad to awful to even worse. With all of Detroit struggling, the flailing Chrysler booked a $1.4 billion loss in 2006. As if that weren't bad enough, Chrysler then proceeded to lose $2 billion in the first quarter of 2007 alone... more red ink than the previous year in full.
What to do? Layoffs of 13,000 workers (16% of Chrysler's workforce, including 2,000 white collar jobs) were not enough. Plans to dramatically cut production were not enough. German shareholders were becoming all too familiar with the American expression, "bleeding like a stuck pig."
This was all the more frustrating because, on the German side of things, Daimler was doing quite well. Even as Chrysler found itself caught out by rising costs and a lukewarm response from middle America, Daimler's Mercedes brand was minting money in the luxury end of the global car market.
Worst of all, German shareholders saw a fiscal crisis looming. Chrysler was on the hook for an estimated $18 billion in labor costs, even as the bleeding continued. It was time to cut the cord; Chrysler had to be sold. But to who?
Enter Cerberus.
In the original Greek, Cerberus translates to something like "demon of the pit." In Greek mythology, Cerberus was known as the "Hound of Hades" – a giant three-headed dog with a reptilian tail.
According to legend, this fearsome monster's job was to guard the gates of hell. Like a bouncer behind the velvet rope, Cerberus would let dead spirits in but keep the living out. Cerberus had three heads so that, even if two heads slept, a third would always be on watch.
Given that back story, "Cerberus Capital" is a rather odd name for a private equity firm. But it makes more sense when you look at the company's roots.
Cerberus was founded in 1992 by Stephen A. Feinberg, an alumni of the infamous Drexel Burnham Lambert. As Feinberg and a partner originally dreamed it up, Cerberus was a hedge fund focused on distressed debt deals—buying up bonds of bankrupt or near-bankrupt companies for pennies on the dollar, hoping to make big profits when the situation improved. (That's where the "gates of hell" motif came in. If your once high-flying company crashed and burned, you wound up dealing with fearsome netherworld types like Cerberus.)
Feinberg the man is a notable study in contrasts. His thinning light brown hair and slight mustache give him an almost mousy exterior, but that only serves to mask a tough-as-nails interior. A bona fide "master of the universe" worth hundreds of millions, Feinberg nonetheless drives a Ford pickup and likes to drink Budweiser. He enjoys playing chess, but also likes hunting pheasant and elk. At Princeton, where he majored in politics, Feinberg was captain of the tennis team… but also jumped out of planes with the 82nd Airborne Division. Last but not least, Feinberg is a fiercely private man who shuns social events and hates to be photographed. And yet, with the Chrysler purchase, he is thrusting his organization into the spotlight like never before.
Cerberus switched from a distressed-debt focus to a private equity focus after the dot com bubble burst, once it was clear the market landscape had changed. After Greenspan's massive injection of cheap money into the system, vulture opportunities began to dry up; at the same time, investors were literally throwing their money at hedge funds. So Feinberg took Cerberus in a new direction, looking to buy and fix whole companies. The three-headed dog abandoned its underworld post, climbing into the light.
Feinberg's stroke of brilliance (or luck, depending on how you look at it) was staffing up Cerberus with high-powered executives just as the deal universe was set to explode. Businessweek put it like this back in 2005:
While many funds stick to a single, sharply focused strategy, Feinberg casts a wide net. Not content simply to trade securities the way other funds do or to assemble assorted companies for resale in the same way as many buyout firms, he's forging what looks more like an integrated industrial conglomerate than an investment firm. His secret weapon: a deep bench of 80 seasoned executives who troll the world for investment opportunities and stand ready to parachute in and run the companies he buys. Put all the elements together, says David M. Rubenstein, Carlyle Group co-founder and managing director, and "Feinberg may have perfected a new business model."
This "deep bench" of executives went a long way in helping Cerberus win the Chrysler deal. There were a number of interested bidders, including other big private equity players, a Canadian auto company, and Chrysler shareholder Kirk Kerkorian (he of the lawsuit seven years earlier). But none of them could offer the management depth of team Cerburus, which included a trio of seasoned auto execs.
When the Chrysler deal was announced, Feinberg dispatched former Treasury Secretary John Snow (now chairman of Cerberus) to chat up the press. The hiring of John Snow (and former VP Dan Quayle many years earlier) was part of a crucial public relations move, helping Cerberus develop an acceptable public face. (A golden retriever it ain't... but hey.)
Now back to deal specifics. On the face of it, Cerberus has agreed to pay $7.4 billion for an 80% stake in Chrysler. But most of that represents cash infusions into the company's bleeding automotive and finance units. With all the numbers toted up, Fortune reports, "Daimler will actually record a net cash outflow of $650 million to be rid of Chrysler."
Some racket! Rather than picking up a broken-down business for free, Cerberus is actually getting paid to do this deal. Like the tow truck guy who hauled off your cousin's Camaro... except on a much larger scale.
Things aren't quite that simple, of course. In keeping with the tow truck analogy, this clunker has $18 billion worth of liabilities packed in the trunk. For Cerberus, the ultimate success (or failure) of the deal may hinge on how things unfold with the unions.
Chrysler will have serious challenges in clawing its way back to profitability. As previously mentioned, a truck-heavy production line in a new era of fuel economy doesn't help. Nor do the deteriorating finances of the American consumer, or Chrysler's poor showing in the global car market. But the real elephant in the room is labor costs.
Lee Iacocca, renowned for saving Chrysler from oblivion in the 1980s, likes to point out that Toyota averages $200 per vehicle in health care costs. General Motors, in contrast, has to shoulder $1500 per vehicle in health care costs. (Chrysler is closer to the GM end of the scale.) Detroit's labor situation is unsustainable as it stands; budding competition from automotive upstarts (in China, India and Eastern Europe) guarantees the status quo will fall.
Paradoxically, Cerberus may be counting on the fact that the labor situation looks so bad. Savvy observers agree that, in spite of the excellent terms, the Chrysler purchase only makes sense if big union concessions eventually come through. Without those cost concessions, Cerberus won't be able to turn a profit. Thus, with Detroit's big three auto makers all on the verge of death, the Hound of Hades is betting hard that the unions will play ball.
Many were surprised that the unions okayed the deal in the first place. Ron Gettelfinger, president of the United Auto Workers, was griping about the "strip and flip" habits of private equity firms mere weeks before the sale was announced. Yet Gettelfinger suddenly changed his mind, cautiously endorsing Cerberus, after meeting with top Daimler executives in Germany. Chances are they painted him a very stark picture: Chrysler gets sold... or else. Price wars, bloodletting, downward spiral... use your imagination.
Many rank-and-file union members are still mistrustful, wondering if Gettelfinger has sold them out. There are no easy answers; everyone knows the unions are between a rock and a hard place, and that the status quo is toast. Gettelfinger has voiced cautious optimism on behalf of the UAW, and it's a given that Cerberus is putting on a cheery face. Nonetheless, like a rusty old Plymouth, relations with Chrysler's new owner could break down at any time.
One whispered option is the possibility of a lump-sum contract buyout. In the past, Detroit's big three have offered cash incentives to workers willing to break their employment contract and retire early. Cerberus might be willing to scale up this concept, offering a huge bundle of cash to the unions—say, $10 billion or more—in exchange for release from all future healthcare liabilities.
A move like that would let Cerberus pay off the unions now, while financing is still cheap, and sell off Chrysler as a much more valuable asset later. But, as with everything else, all aspects of such a deal would prove incredibly tricky.
In sum, the Chrysler-Cerberus deal is fascinating because it encompasses so many trends: the rise of hedge funds and private equity firms; the twilight of America's unions in an era of globalization; and, last but not least, the awesome reach of cheap money.
When DaimlerChrysler was formed in 1998, the merger marked the pinnacle of Detroit's big-iron, gas-guzzling culture. It also foreshadowed a wave of globalization yet to come.
The 2007 Chrysler buyout could hold similar portent, as the pinnacle of cheap finance and "the deal that went too far" for ambitious financiers.
In other words, the question to ask is this. Has the mighty Hound of Hades bitten off more than it can chew? Does the sheer audacity of this deal—not in terms of upfront costs, but rather the incredible challenges in pulling it off—indicate a peak in hubris for private equity players? Is this a deal gone too far?
The answer, be it yes or no, could come from the debt markets. In an article titled "Chrysler Deal May Test Appetite for Risk," The Wall Street Journal reports:
With the landmark sale of Chrysler Group to a New York buyout firm, the world's exuberant debt markets are being put to an unusual new test.
Abundant credit and modern ways of accessing it from hedge funds and other new investors has been the fuel that has driven the boom in private-equity buyouts. Investors have exhibited little worry about default risk in the process. But in this case, they'll be getting behind an especially wobbly business.
"This deal has a lot of aspects of risk that we don't see in a traditional [leveraged buyout] where companies have fairly stable businesses," says Peter Andersen, a junk-bond manager at Dreman Value Management. "Here we're concerned about product quality, the company's plan for its health-care benefits and how it will reduce debt in the future."
As if the upfront numbers aren't big enough ($7 billion here, $18 billion there etcetera), far larger amounts are being shifted around behind the scenes to make this deal happen.
To get its house in order for the Chrysler purchase, the WSJ reports, Cerberus will have to raise a whopping $62 billion (yowza) in new debt. Daimler itself will have to raise $50 billion in new debt, to support Chrysler-related obligations it is still on the hook for. (Don't forget, either, that Chrysler itself is a colossal beast, with roughly $60 billion in annual sales. The power of leverage means Cerberus wins big if it can move Chrysler into the black. But if it goes deeper into the red, well, don't ask.)
All this aggressive financing comes into play as the debt markets show early sign of wobbling. In a recent piece titled "Saps take umbrage," Grant's Interest Rate Observer reports:
...Doormats to private-equity promoters, real-estate speculators and hedge fund titans, creditors have actually staged a revolt. They have ordered the rotten apples removed from the barrel of collateral that was to support a pending sale of commercial mortgage-backed securities. Otherwise, they said, they would sit on their wallets. The issuer, none other than General Electric, submitted.
This pushback, against a respected GE finance unit no less, is a sign that what-me-worry lender complacency is starting to wane. Grant's goes on to note that
Many were stressed by this unaccustomed show of spine by members of the creditor class. In the contraction phase of the cycle, of course, lenders do talk back and frequently forget where they put their checkbooks, but then they act on fear more than conviction.
What is that faint sound? Perchance a ringing bell?
Merger and acquisition activity is now the key driver of bullish optimism. With private equity players focused on huge (and hugely complex) deals, one can see this phenomenon unfolding in the divergence between the Dow Industrials and the Russell 2000 index. The hidden parts of the market are sagging as the big boys celebrate their bigness.
If lenders balk at the byzantine complexities of the Chrysler deal, watch out below. A fall from grace on this riskiest of bets could send Cerberus tumbling back down to the underworld... and pull its private equity brethren down with it.
