Detroit Automakers: Private Equity's Bog

Last month in a large conference room at a white-shoe law firm in New York, a group of power brokers gathered to bail out bankrupt auto-parts maker Delphi Corp. After more than two years of battles, Delphi had finally arranged $6.1 billion in financing it needed to emerge from Chapter 11. But as the creditors, lenders and lawyers gathered around a long conference table to close on the complicated deal, one seat remained empty.

The chair had been reserved for Appaloosa Management, an A-list private-equity player that was leading a group of hedge funds providing $2.55 billion of the bailout money. But like a prospective homeowner getting cold feet, Appaloosa's absence signaled it was backing out of the deal. In a letter sent just hours earlier, Appaloosa accused Delphi of scuttling the deal by, among other things, giving former parent General Motors too much influence. Delphi chairman Steve Miller disputes that, and believes his company—now looking for a new bankruptcy exit strategy—is just a victim of bad timing. "I'm disappointed," he says, "that we had the bad luck to do this at this very difficult time."

Whatever its true motives, Appaloosa may have gotten out just in time. (The company didn't respond to a request for comment.) Detroit's dire circumstances are testing the smarts and stamina of private-equity players, those fearsome financial wizards who—until now—seemed able to turn around any ailing industry and pocket cool millions while they're at it in what's known as a "strip and flip" strategy. For much of this decade, Motown seemed like the classic private-equity play: lots of distressed merchandise that could be bought on the cheap, cleaned up and sold at a tidy profit. It attracted players like the Carlyle Group, the Blackstone Group and Carl Icahn. Together, private equity came to own one quarter of Detroit's auto suppliers, according to the consulting firm A.T. Kearney. The biggest deal came last May, when giant Cerberus Capital Management took Chrysler off Daimler's hands for $7.4 billion. That came shortly after Cerberus took control of GMAC, the huge financing arm of General Motors. But it was more than just business, Cerberus officials claimed. Detroit has long been viewed as emblematic of the overall U.S. economy, after all. At the time of the deal, Cerberus officials spoke confidently of fixing Chrysler and restoring an American icon. "We're believers in American manufacturing," Cerberus chairman John Snow declared a year ago.

Under the cloak of private ownership—without Wall Street breathing down their necks for ever-rising quarterly profits—the billionaire big boys were out to show the hidebound American auto industry how to make the hard choices: close factories, kill slow-selling models, cut workers and wages. That's how Cerberus swiftly turned around the rental-car companies Alamo and National—and tripled its money.

Suddenly, however, the smart money doesn't look so smart. As gas prices soar, credit dries up and unions dig in, Detroit is becoming a quagmire for private equity. The situation is especially grim for Cerberus. Chrysler's sales are down 18 percent this year and strikes are shutting factories all over town. GMAC is hemorrhaging cash because of its exposure to both the auto and mortgage markets. "They dropped into the wrong industry at the wrong time," says University of Michigan business professor David Brophy. "And it's not going to be a quick turnaround."

Rolling into Motown with patriotic promises of reviving the industry will make it tricky to pull off a cut-and-run exit strategy. In a January letter to his investors, Cerberus founder Stephen Feinberg warned that "GMAC could run into substantial difficulty." He offered only guarded reassurance on Chrysler. "We bought the company very cheaply," he wrote, "and we do not need to be heroes to earn a good return." The remarks triggered fears in Detroit that Cerberus had given up on its battered auto businesses. Cerberus quickly backed off. "Steve has made it perfectly clear that no one here can be cavalier about Chrysler," says Cerberus managing director Tim Price. "This is an American icon and failure is not an option."

Private equity's problems in Detroit have as much to do with the credit crisis as the car crisis. Buyers are losing access to cheap car loans, which is cutting into sales. Meanwhile, automakers can't borrow the billions it takes to underwrite new models. "You cannot fix the automobile business without fixing the products," says GM vice chairman Bob Lutz, "and fixing the products takes four years." But for private equity, which favors a fast buck, four years is a lifetime.