Friday, December 13, 2013

A Special Deal on Guns and a Bad Precedent

A Special Deal on Guns and a Bad Precedent

A year ago I wrote a post called “Divesting Guns: Public Funds Deserve No Credit” (December 19, 2012) in the wake of the Newtown shooting.  The California State Teachers’ Retirement System (CalSTRS) immediately announced its intention to divest its ownership in gun manufacturers, and Cerberus, one of CalSTRS’s private equity managers, said it would accede to the pressure and sell Freedom Group.   According to various press reports, Cerberus hasn’t found a buyer despite a sales process run by Lazard.[1]  Nonetheless, Cerberus has apparently arranged a financing to allow CalSTRS and other investors to sell their pro-rata stake in Freedom Group. 
 
Replacement (1996)
Why would Cerberus accommodate CalSTRS?  The Teachers’ fund has invested over $625 million in three Cerberus funds over the past ten years, and the returns as of CalSTRS last published report in March 2013 show returns of 5.6%, 8.0%, and 12.6% respectively.[2]  These aren’t exactly stellar numbers.  Moreover, Cerberus will probably want to launch a new fund in the not too distant future since they’ve committed virtually the capital they raised in their last general fund.  In other words, Cerberus’s efforts aren’t about CalSTRS’s moral position on firearms.  Rather, Cerberus is trying to make sure that they continue doing business with one of their anchor investors.  I’d guess that Cerberus has made more than $50 million in fees from CalSTRS over the years.

So CalSTRS may get its wish and divest its position in Freedom Group.  However, CalSTRS won’t have accomplished a thing.  As I said in my original post on this subject, “We’d be better served if the public pension plans held onto their gun investments and forced Cerberus to take an active stand on gun and ammunition control.  The public pension plans have washed their hands, but they haven’t removed the dirt.” 

Meanwhile Freedom Group has had a stellar year.  As of September, firearm sales were up over 50% for the year led by assault rifles.  EBITDA (earnings before interest, taxes, depreciation and amortization), one measure of the company’s cash flow, was also up 50%.[3]  Since Newtown, Freedom Group has added three more businesses to its firearms platform.  While the trustees, teachers, and retirees of CalSTRS may feel better about their pension plan because it is being cleansed of  guns, Remington and Bushmaster, Freedom Groups top brands, continue to pump out weapons.

The financial press has engaged in all sorts of speculation about why the business wasn’t sold.  Some pundits wonder if Cerberus is seeking too high a price.  Others conjecture that Freedom Group has become too large to be acquired by a competitor or another private equity firm.  Still others wonder if Cerberus was truly intent on selling the business in the first place.  I think we’ll get the answers some time next year.  Cerberus should be liquidating the existing fund in the not-to-distant future, so it will undoubtedly continue to pursue the sale of the business.

If the equity markets remain strong, Cerberus might be able to dust-off the S-1 it withdrew in 2010 and take the company public.  Both Sturm, Rueger & Co (NYSE: RGR) and Smith & Wesson (OTC: SWHC) have performed well in 2013, so Cerberus might attempt an IPO.   I can see where the sale of the company to another private equity firm could be problematic.  The combined debt and equity of any such deal would probably require the wherewithal of large banks and PE firms.  Those institutions might be reluctant to upset their public pension plan investors.  Moreover, potential PE firms might fret about how they would exit the business in four or five year’s time.

Offering CalSTRS an early exit from a particular investment sets a bad precedent.  When investors sign up for a private equity partnership, they sign up as limited partners.  They don’t get to pick and chose their investments.  In this instance, CALSTRS was content to own a piece of Freedom Group for six years before finally objecting after the Newtown shootings.  Cerberus has decided to accommodate one of its most important clients.  If CalSTRS didn’t want its capital invested in guns, it should have made that a condition of its investment in the first place.

If I were an LP in Cerberus’s fund, I would be pretty upset about this special arrangement.   It’s one thing for a large investor to get a break on the management fee.  It’s quite another thing for a large investor to pressure the GP to allow it to exit ahead of the other investors.  Having bent Cerberus to its will, what’s to prevent CalSTRS or other large funds from pressuring their private equity managers to  let them exit an investment because they don’t like its business practices or merely because they want their money back.

A year after Newtown, it’s depressing to see this shameless game.  Cerberus is bending over backwards to accommodate a major client.  The client will soon get to write a press release extolling its morality for divesting Freedom Group.  Meanwhile the assault rifles, silencers, and heavy ammunition will continue to flow unabated.   




[2] http://www.calstrs.com/sites/main/files/file-attachments/pe_portfolio_performance_q1_2013.pdf
[3] http://www.freedom-group.com/Q3_2013_Report.pdf

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