Reinsurer Downgrade Newest Blow To Cerberus

Bad news continued to pummel Cerberus Capital Management LP’s portfolio last week, as Standard & Poor’s lowered its ratings on another of the firm’s companies.

The ratings agency lowered its counterparty credit ratings on reinsurer Scottish Re Group Ltd., a Bermuda-based reinsurer in which Cerberus Capital invested $300 million in May 2007. The company was perhaps the insurance industry’s most exposed to sub-prime and Alt-A mortgages, which accounted for about 30 percent of its investments. “When that segment had difficulty, the market values on those investments tanked,” S&P analyst Robert Hafner told Buyouts.

The rating agency lowered its counterparty credit rating to ‘CCC-‘ from ‘B’ and its counterparty credit and financial strength ratings on Scottish Re’s operating companies to ‘B-’ from ‘BB.’

The downgrade is the latest bad news for Cerberus Capital, which makes a specialty of buying downtrodden and distressed assets. The downgrade doesn’t appear to have fazed the firm’s managers, however, because Scottish Re is one of its smaller investments. “Nil,” a source close to the firm said, when asked what impact the downgrade has on its portfolio. “It’s a tiny investment.”

The downgrade reflects the rating agency’s estimate of expected losses on Scottish Re’s residential mortgage-backed securities investments since placing the ratings on CreditWatch on Jan. 31. S&P’s Hafner said he believes the company’s disclosure of a material weakness in its accounting controls, and a pending revised application of accounting principles to its distressed assets, could severely limited its financial flexibility. Scottish Re’s condition also resulted in a discretionary payment default on its $125 million of 7.25 percent noncumulative perpetual preferred shares.

The collapse of the subprime mortgage market has also walloped GMAC Financial Services, in which Cerberus Capital acquired a 51 percent stake in 2006 in a deal valued at $14 billion. The General Motors Corp. carve-out, which provides automotive financing, insurance policies and residential mortgages through its subsidiary Residential Capital LLC, reported a net loss of $1.6 billion for the third quarter of 2007 and $589 million for the first quarter of 2008. Standard & Poor’s and Moody’s Investors Service both downgraded the company, and the situation inspired Cerberus Capital’s reclusive founder, Stephen Feinberg, to warn investors in a widely publicized letter that more pain could be forthcoming.

The outlook for Chrysler, which Cerberus Capital bought last summer in a landmark deal for $7.4 billion, is murky. The company exceeded Cerberus Capital’s expectations, with $9 billion cash on hand at the end of 2007—a billion more than the firm had anticipated. But high gas prices and an economic slowdown are hindering consumers’ ability to buy new cars, and the lingering effects of the credit crunch are hampering Chrysler’s ability to borrow more money. Sales are down 18 percent this year, though they are up 15 percent in May versus April. Our source close to Cerberus Capital said it is too early to judge the investment because Cerberus Capital has a multi-year plan for the car maker.

Moody’s in January also downgraded the corporate family rating for IAP Worldwide Services, a defense contractor Cerberus Capital owns, to ‘Caa3’ from ‘Caa1’ and changed its outlook to negative. The downgrade was the result of the company’s failure to negotiate an amendment with its lenders for the default of interest coverage and leverage covenants as of June 30, 2007. Standard & Poor’s had also placed IAP on its “Weakest Links” list because of risk it might not be able to meet its debt payments.

The Scottish Re downgrade, meanwhile, was the latest in a long slow slog for the reinsurer. The company provided one of many lowlights in a rough 2006 for Cypress Group, a buyout firm that bought a roughly 15 percent stake in Scottish Re in 2004 for $180 million. That investment was pretty much wiped out when, in July 2006, Scottish Re’s stock lost three-quarters of its value following a quarterly loss and diminished outlook. The company tried unsuccessfully to sell itself before Cerberus Capital and MassMutual came to the rescue, each investing $300 million and replacing Cypress Group as the majority shareholder.

“Cerberus and Mass Mutual stepped in as investors to try and breathe new life into this organization, but somewhat unbeknownst to everybody involved, the subprime mortgage investments that Scottish Re had taken a significant position in were about to erupt and cause even further difficulty to right the ship,” S&P’s Hafner said.

How badly these deals will impact Cerberus Capital’s returns is not entirely clear. The firm owns 34 companies around the world generating more than a combined $1 billion in revenues. Executives at Cerberus Capital and Scottish Re declined to comment.—B.V.