The darker side of buyout firms

NEW YORK (Fortune) -- Buyout firms like to present themselves as a can't-fail combination of operational genius and financial support that can heal sick businesses and create thriving companies. But sometimes, as in the case of Aegis Mortgage, genius fails and bankruptcy is declared. The private investment firm Cerberus bought a controlling stake in the Houston-based mortgage lender in 1998, but despite an infusion of cash and talent, Aegis ceased operations on Monday, August 6. Now hundreds of employees have been laid off - all without health insurance. It's a reminder that risky turnarounds can mean real pain for more than just investors raising questions about how Cerberus will treat other ailing companies it has purchased, notably Chrysler.

Aegis, which was founded in 1993, closed its mortgage production operations on August 6. Two days later, employees were warned that there would be layoffs within 60 days and that benefits would be terminated effective midnight August 10, according to Aegis employees. They were also told that earned paid-time off would not be paid out and that there would be no severance. When the layoffs came on Monday, August 13, 782 people out of 1,302 employees were fired. Those let go were shocked to find that they were not eligible for COBRA. While Federal law requires businesses with more than 20 employees to offer departing workers the chance to buy an extra 18 months of health insurance, it is only required for companies with an active benefit plan, and Aegis had terminated its plan days before. Moreover, Aegis admitted in its bankruptcy filing that it didn't have the money to pay employee benefits anyway.

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Those actions have some up in arms. Richard Thompson, who co-founded Aegis in 1993, is asking Cerberus and Aegis to take care of its employees. "As a founder of Aegis, one of our stated corporate values was to always do the right thing," says Thompson, who was CEO until October 2006, when Cerberus ousted him. "The right thing is to reinstate the company's health insurance policy for the thousands of families affected by their actions last week."

Thompson, of course, has reason to dislike Cerberus. Not only was he fired, he is suing Cerberus for mismanaging the company and destroying its chance to go public. Other observers note that many companies that go bankrupt leave their employees stranded. John Challenger, head of executive outplacement firm Challenger Gray Christmas, says: "Creditors will line up, so the company is taking these harsh actions to save what they can. You're going to see lots of fighting over the company assets." In its bankruptcy filing, Aegis said it had $625 million in debt and owed banks including Goldman Sachs, Deutsche Bank, Merrill Lynch and Morgan Stanley. Madeleine LLP, a subsidiary of Cerberus, is also in line for money.

Cerberus declined to comment; an Aegis spokesman said that the company is doing what it can to help its remaining 500 or so employees, including providing health care and job training.

What happened to Aegis? The company managed to survive the mortgage meltdown and S&L problems of the '90s, but it had been wounded. Plans in 1997 to hold an IPO for its REIT business were scrapped when the REIT sector began to exhibit problems. The conditions were perfect for a company like Cerberus, which regularly scoops up distressed businesses it believes will be winners in the future. The mortgage business was suffering in the late 1990s, but the industry is cyclical and Cerberus was betting on returns during the upswing. (Indeed, even as the subprime business began to melt down this spring, Cerberus agreed to buy sub-prime lender Option One Mortgage from H&R Block this April.)

So in 1998, Cerberus agreed to buy a controlling stake in Aegis, which had $2.5 million in equity. Following a familiar pattern, Cerberus immediately injected a huge amount of money into the company ($47 million), placed its own people on the board and kept the management team, including Thompson, in place. It rolled pieces of other dying lenders into Aegis and built a thriving mortgage lending operation.

In late 2006, the company had grown its capital in reserves to $361 million, and like all other lenders it couldn't issue mortgages fast enough for the Wall Street machine that used them to create high-risk, very profitable bonds. At the height of the mortgage origination boom, Aegis employed about 3,500 people, mostly in the Houston area. But Aegis lost it all in just nine months when the market for mortgage loans tanked.

The failure calls into question the management and health of Cerberus's other loan plays. Cerberus owns a majority stake in GMAC and its mortgage subsidiary ResCap. Thanks to the credit crunch, the ratings agencies have downgraded ResCap, thus making it more expensive for the company to operate. The rising cost of capital may hurt Chrysler Financial, too, the healthy operation within Chrysler that should have been able to help fund the ailing automaker's turnaround. At a minimum, Cerberus will take a financial hit because of Aegis and the bankruptcy is an embarrassment amid the firm's recent spate of high-profile acquisitions.

"Cerberus has become a major player in the global economy. Its many constituents rightly will expect a higher standard of behavior than was exhibited last week with Aegis," says Thompson. It's a sober reminder that even the vaunted geniuses of private equity can't save every company, and that employees - more than investors - are the real victims when they go under.

Do you think this is a sign of what would happen if more private equity deals go bust? Tell us what you think.