Millbrook Capital’s Clay Lifflander On Cerberus' GMAC Purchase

In a battle royale between hedge funds and buyout firms, the hedgies scored a big victory when General Motors agreed to sell 51% of its highly profitable finance arm, General Motors Acceptance Corp., to New York-based Cerberus Capital Management, in an enormously complicated deal that will earn GM about $14 billion over the next three years. The deal was a coup for Cerberus and its senior managing director, Stephen Feinberg – not least because, just a week earlier, GM had sold a controlling stake in GMAC's commercial mortgage division to Cerberus' competitor for GMAC, the venerable Kohlberg Kravis Roberts – and it was not a move absent of substantial risk. Indeed, according to Business Week, which last week chronicled how the deal went down, one person close to GM's board said, "I don't think there is any financial institution in the world that would have done this deal."

A dubious deal, two masters of the universe – one young, one not so young – and a very pretty, if not potentially poisonous feather for one of their caps, compelled dailyii’s Rob Veksler to sit down with Clay Lifflander, president of New-York based hedge fund, Millbrook Capital. The quesiton on the table was why. Here is an excerpt from their conversation.

RV: Why would anyone do this deal, Clay?

CL: Looking at it, people are having such trouble putting capital to work. It’s clear to me [Cerebus] is betting the ranch in terms of their reputation. They clearly didn’t get this [money] from their fund; they had to go to their limiteds and get co-investments. At the end of day, [it is] asking the limiteds to make investment decisions that they asked you to make, so you do wind up betting you’re reputation big time with your investors.

[Still] what they did to protect their downside was pretty clever. They made GM take back $20 billion of presumably the worst receivables – car lease receivabables – before the deal closed. So they got rid of some of the worst credits on the book first. Now that still doesn’t solve the problem that if GM goes bankrupt and you’re a marginal player and you don’t like your car and you’re worried about it getting serviced and you’re not sure what’s going on with the dealership, you just stop paying.... and a similar thing cascades on you in the residual market.

RV: What’s the worst case scenario for Cerberus?

CL: If I assume that residual values go down by 25% and default rates go up by 15% because GM goes bankrupt, maybe it’s a 20% downside on the deal. That’s a guess. I have no inside knowledge.

I mean [Cerebrus] does get to control this without having bought 100%, which is always kind of nice. In fact, they’re kind of using GM's money a little bit. But it looks to me like it’s structured with very little downside and probably they get a bigger share of the upside – if it goes well – than GM does, not in proportion to their 51, 49.

RV: A condition of the deal was that GM would have buy-back rights after three years if they could up their rating.

CL: ...I don’t think GM is ever going to be buying this back. I think they’re going to hell in a hand basket. That’s why Cerberus' bet is more on the mortgage business and on getting more finance business on the auto side than what currently exists. To me this implies GMAC must have some good systems, some good back office and some good execs.

I wonder, though, from GM's perspective, how they would compete not controlling this business anymore without controlling incentive offers if the other guys start putting incentives through the financing structure. I mean really this has got to be a pretty scary move for GM. They must be pretty desperate to get the cash.

I do view this as ‘bet the ranch for Cerberus... [Cerebrus] is either gonna look like geniuses or like goats.

RV: So who would make this deal?

CL: Look, I wouldn’t buy it. But I will say my initial reaction was more along the lines: What a bunch of idiots, what nuts, how can they do this? But then when I looked at how they protected their downside, I turned around on it a little bit.

I’m starting to think about the dynamic of what’s going on in the [private equity] world: If you have a very limited downside but execute a [business] plan and make a double or triple on one of your deals when no one else would, you look like a genius.

Remember the Cerberus guys are distressed debt guys by origin. And distressed debt guys are really good at protecting their downside and buying low. If it doesn’t work out, they don’t get hurt that bad. If it does work out they get huge pops. That’s their game and this one looks like [Stephen Feinberg] did a pretty good job on it.

RV: Would you assume that Feinberg is protecting himself?

CL: Besides the discount to book, getting rid of the $20 billion in receivables, and making GM put some preferred in – which I assume gives him more of the opportunities than is proportioned – those are really the keys. Plus a lot more of the business is residential mortgage, which I think people miss.

RV: I’m wondering if personality or ego had anything to do with this deal.

CL: I don’t know. This one seems more classic for Feinberg than it does for Kravis. I mean this is a distressed deal – [GM] wasn’t in bankruptcy yet – and it’s structured like it.... If you look at the advisors to GM board – the Evercorp guys – those are all restructing guys. David Ying... He's a bankruptcy guy. So this really is that. More than a typical buyout in my view...

There’s definitely ego involved here, but I don’t know if its ego vs. Henry or not.