The secretive private equity firm risked the ire of investors, which include some of the largest U.S. public pension funds, after its investment in Freedom Group Inc, owner of Bushmaster Firearms International that makes the rifle, came under public scrutiny.
The pressure on Cerberus to sell the firearms maker comes as it seeks up to $3.5 billion from investors for its latest buyout fund.
Late on Monday, California Treasurer Bill Lockyer asked CalPERS and CalSTRS, the state's public pension funds and the largest in the United States, to account for their investments in gun manufacturers, and proposed that they sell their interest in any company that makes guns that are illegal under California's assault weapons ban.
California's ban includes the Bushmaster rifle.
"The Treasurer's view is that neither fund should be invested in any company that makes guns that are illegal in this state, especially ones that were used to kill 20 innocent children and six innocent adults," Tom Dresslar, a spokesman for Lockyer said.
CalSTRS, the California State Teachers' Retirement System, said on Monday it was reviewing its investment with Cerberus in the wake of Friday's shooting at Sandy Hook Elementary School in Newtown.
"It's an unusual move by Cerberus but it was a terrible event, so they are responding to some of their investors who are teachers' funds. I'm sure they will be selling it at a low price because now would not be a good time to sell the business," said Steven Kaplan, a University of Chicago finance professor.
Cerberus filed for an initial public offering of Freedom Group in October 2009 but withdrew the registration in April 2011, without offering a reason.
In addition to Cerberus, some gun retailers also took steps.
Dick's Sporting Goods pulled all guns from its store closest to the site of the massacre in Newtown, Connecticut, and suspended the sale of certain kinds of semi-automatic rifles from its chains nationwide.
Wal-Mart Stores Inc took down an informational website about semi-automatic Bushmaster rifles.
Cabela's Inc continued to advertise AR-15 type Bushmaster rifles on its website, though it said the weapons were not available for sale online or at its Connecticut store location.
Cerberus Institutional Partners V, Cerberus' latest buyout fund, was seeking between $3 billion and $3.5 billion from investors, CalPERS, the California Public Employees' Retirement System, that has committed $400 million to the fund, said in a report earlier this year.
Cerberus is also raising a real estate fund, Cerberus Institutional Real Estate Partners III, according to a filing last month with the Securities and Exchange Commission.
Founded in 1992 by Stephen Feinberg and William Richter, New York-based Cerberus has more than $20 billion under management and shares its name with a mythical three-headed dog which in Greek mythology guards the entrance to the underworld.
Feinberg's father, Martin Feinberg, is a resident of Newtown, Bloomberg reported on Tuesday, citing an interview with him. Public records show a Martin Feinberg residing in a retirement facility in Newtown.
Cerberus said on Tuesday it would hire a financial adviser to sell its interests in Freedom Group and return the proceeds to investors.
The private equity firm expressed shock and grief at the killings in Newtown but added that Freedom Group was not responsible.
"We do not believe that Freedom Group or any single company or individual can prevent senseless violence or the illegal use or procurement of firearms and ammunition," it said.
Cerberus bought firearms maker Bushmaster in 2006 and later merged it with other gun companies to create Freedom Group, which reported net sales of $677 million for the nine months ended September, up from $565 million a year earlier.
Besides Cerberus, a few other private equity firms also have stakes in firearms companies. Sciens Capital Management, for example, jointly owns small arms maker Colt Defense.
In an opinion piece published on Monday in Slate magazine, prior to the announcement by Cerberus, former New York Governor Eliot Spitzer said pressure should be stepped up on the owners of gun companies, like Cerberus, to change the way they operate.
"It is time to determine pension fund by pension fund who has invested in Cerberus and bring pressure on those investors either to get out of Cerberus or have Cerberus change the way it runs the gun industry," Spitzer wrote. (http://link.reuters.com/vuf74t)
GUN CONTROL DEBATE
Cerberus said the Newtown tragedy was a "watershed event" that has raised the national debate on gun control "to an unprecedented level."
However, it added the firm was responsible for only investment decisions it makes on behalf of its clients and does not play the role of "statesmen or policy makers."
"It is not our role to take positions, or attempt to shape or influence the gun control policy debate. That is the job of our federal and state legislators," it said.
U.S. lawmakers have not approved a major new federal gun law since 1994, and a ban on certain semi-automatic rifles known as assault weapons expired in 2004.
The Newtown massacre has led President Barack Obama and some congressional leaders to reconsider what has been a largely hands-off approach to gun control in recent years.
The percentage of Americans favoring tough gun regulations rose significantly after the killings at the Connecticut school, a Reuters/Ipsos poll showed on Monday.
(Additional reporting by Martine Geller in New York, Lisa Baertlein in Los Angeles and Dan Burns in Newtown, Connecticut; Editing by Hans-Juergen Peters, Mark Potter, John Wallace and Andrew Hay)