By Jason Kelly
April 23 (Bloomberg) — It’s been a rough few months for David Rubenstein, co-founder and managing director of Carlyle Group.
As the subprime crisis sent dealmaking into a tailspin last August, Carlyle barely saved its buyout of Home Depot Inc.’s contractor supply unit. When banks balked at lending, Carlyle increased the amount of cash it put in and got Home Depot to slash the price 18 percent to $8.5 billion.
In December, unions petitioned regulators to block Carlyle’s $6.3 billion purchase of nursing home chain Manor Care Inc., accusing the firm of focusing on profits to the detriment of patients. Though their effort was unsuccessful, the unions continued to hound Rubenstein, demonstrating in January at the University of Pennsylvania, where he gave a speech at a private equity conference held at the Wharton School.
“For the next year or so, we will be in purgatory,” Rubenstein told the conference. “We will have to atone for our sins a little bit.”
A few weeks later, Carlyle’s mortgage bond fund paid for the transgression of overleveraging. Carlyle Capital Corp. defaulted on $16.6 billion of debt, after borrowing 32 times its $670 million of equity capital nine months earlier to invest mainly in AAA-rated mortgage securities.
Carlyle, which has 60 funds owning $81.1 billion in assets, can withstand the $150 million loss from the Carlyle Capital failure. More severe was the damage to its reputation for giving investors stellar returns — an average of more than 30 percent annually since its founding in 1987, according to the company.
“They tripped, and they tripped in public,” says Paul Schaye, managing director of New York-based Chestnut Hill Partners LLC, which helps private equity firms find investments. “That hurts the brand.”
Carlyle’s woes reflect those of the whole private equity industry. After low interest rates and a booming stock market fueled record deal volume in 2006 and ’07, the pace of buyouts has screeched to a halt. The subprime crisis, rising interest rates and a shrinking appetite for stock offerings have choked off the industry’s main sources of profit.
As banks balked at extending credit, announced buyouts globally plummeted 63 percent in the second half of 2007 to $200.8 billion from $542.0 billion in the first half, according to data compiled by Bloomberg.
Model `Is Broken’
“You don’t see the banks interested in getting into the syndicates,” says Susanne Forsingdal, a partner at Copenhagen- based ATP Private Equity Partners, which manages about 3 billion euros ($4.75 billion). “That model is broken.”
The slump worsened in the first quarter, when $60.7 billion of deals were announced globally — down 70 percent from $200 billion a year earlier. Carlyle’s total plummeted to just $568.6 million in the first quarter, an 86 percent drop from $4 billion a year earlier.
“The Greek gods reminded us that Golden Ages end, and not always happily,” Rubenstein, a slender 58-year-old with silver hair and glasses, said in a talk at a private-equity conference in December in Dubai, where Carlyle set up an office in 2007.
Buyout firms are also finding that the traditional exits for their investments — stock offerings — have slammed shut. In the first quarter of 2008, initial public offerings and stock sales fell 38 percent to $73.3 billion, according to Bloomberg data.
While private equity investors typically have a time horizon of as much as seven years before they reap their profits, they may have to wait even longer, says Forsingdal, whose firm doesn’t have any money in Carlyle funds.
“In some cases, funds are saying it will take a year longer than they were expecting to sell an investment,” she says. “They’re not in a position to make the very fast returns we’ve seen in the past couple of years.”
Carlyle is counting on its head start in international markets to help it weather the turbulence in private equity. Rubenstein predicts that within five years, about two-thirds of the firm’s investments will be in non-U.S. companies. Currently, 64 percent is in North America, 26 percent in Europe, and 10 percent in Asia.
Rubenstein, whom Colin Blaydon, director of Dartmouth College’s Tuck Center for Private Equity and Entrepreneurship, calls “the secretary of state of private equity,” spends 250- 270 days traveling from Carlyle’s Washington headquarters each year, according to a company official.
Abu Dhabi Buys Stake
Carlyle itself has been hit by the markets’ edginess. Last year, it postponed plans to sell shares in itself via an IPO. Instead, the firm worked its long-standing connections in the Middle East: Mubadala Development Co., an arm of the Abu Dhabi government, bought 7.5 percent of Carlyle for $1.35 billion in September, valuing Carlyle at about $20 billion.
That made it the buyout firm’s second-largest owner, behind the founders, who refuse to disclose their stakes, and ahead of the California Public Employees’ Retirement System, or Calpers, which owns 5 percent.
Mubadala is just one of the sovereign wealth funds — government-owned pools of capital — that have bought into private equity firms recently. In May 2007, China Investment Corp. bought a 9 percent stake in Blackstone Group LP, the private equity firm that manages more than $100 billion in buyout, real estate and hedge fund assets. Blackstone closed yesterday at $18.62, 40 percent below its $31 offering price last June 21.
Last July, Apollo Management LP sold a $1.2 billion stake to the Abu Dhabi Investment Authority and Calpers. It also sold an undisclosed amount of shares through a private exchange run by Goldman Sachs Group Inc. In April, New York-based Apollo said it would apply to list those shares on the New York Stock Exchange.
Higher Taxes Loom
More trouble could be brewing for private equity if a Democrat wins the U.S. presidential election. Candidates Barack Obama and Hillary Clinton have both said they favor treating carried interest, the profits private equity partners take when they sell an investment, as ordinary income rather than capital gains. That means it would be taxed at a 35 percent rate rather than 15 percent.
Private equity companies hold enormous sway over the economy. Carlyle says companies it has investments in employ more than 286,000 workers and have combined annual revenue of $87 billion, more than Microsoft Corp. or Procter & Gamble Co.
“It’s a giant institution,” Rick Rickertsen, managing partner of Washington-based Pine Creek Partners, says of rival private equity firm Carlyle. “They’ve built Goldman Sachs in 20 years.” (The Wall Street powerhouse was founded in 1869.)
Andy Stern, the Washington-based president of the Service Employees International Union, which opposed Carlyle’s takeover of Manor Care, says, “We’re seeing companies more than countries making the rules of global economy.”
Rubenstein says the backlash by unions and politicians means private equity firms have to be more open. “We have to be more forthcoming about how private equity works, who our investors are, how we add value,” he says. Not that forthcoming: Carlyle declines to disclose the names of investors in its funds or to give returns on individual funds.
To continue attracting investors, Carlyle needs new markets. Last year, Carlyle began raising a $750 million Middle East fund — its first — that aims at taking stakes in local family-owned companies or doing buyouts.
“We were early in Europe, early in Asia and hopefully early here,” Rubenstein said in an interview in December in Dubai. “Now we have to prove we can do the deals.” So far, Carlyle hasn’t announced any.
Osama bin Laden
In 1997, Carlyle became the first U.S. private equity firm to set up in Europe. The firm bought Andritz AG, an Austrian machine maker, in 1999, and more than doubled its investment of 48 million euros when it sold its stake four years later.
The Middle East is where Carlyle got some of its first investors, including the Saudi royal family and owners of the Saudi Binladin Group, the Jeddah-based construction company founded by Osama bin Laden‘s father, Mohammed. Carlyle returned the bin Laden family’s money after the Sept. 11, 2001, terrorist attacks.
Now, with oil trading at about $100 a barrel and Dubai trying to transform itself into a tourism and financial hub for the region, Rubenstein is hoping to evolve from a fly-in fundraiser to an on-the-ground investor.
In November 2006, Rubenstein hired Paul Bagatelas, 45, formerly a director at Credit Suisse Group in Dubai, as a managing director to run the Dubai office, adding to regional outposts in Cairo and Istanbul. The same month, Rubenstein tapped Beirut-based Walid Musallam, formerly chief executive officer of Abu Dhabi Investment Co., the state-owned fund created in 1977, to head the Middle East and North Africa fund.
Seeking Deals in Dubai
Carlyle’s 10 Dubai employees include Jordanian Firas Nasir, 38, a former mergers and acquisitions banker at UBS AG in San Francisco. Nasir is scouting for transactions in countries such as Qatar and Saudi Arabia.
He’s based in offices on the seventh floor of a building in the Dubai International Financial Centre complex, which Dubai created to cater to foreign firms. Investment banks including Citigroup Inc. and Credit Suisse are neighbors.
“Private equity in this part of the world is a book that’s being written right now,” says Gary Long, chief operating officer of Investcorp Bank BSC, a Bahrain-based private equity firm. “Success is going to be all about contacts and whether they trust you.”
Investcorp has historically invested Middle Eastern money outside the region in deals such as the buyout of Gucci Group NV and Tiffany & Co. Last year, it started a $1 billion fund to invest in Gulf companies.
Woody Allen’s Rule
Rubenstein agrees that contacts lead to deals. “Woody Allen said that 80 percent of success is showing up,” he says in an interview in his Washington office. “The fact that I’m showing up and showing my respect may make it easier to do business.”
One recent stop for Rubenstein’s Gulfstream jet was Abu Dhabi, where he met with executives of Mubadala, including Waleed al-Muhairi, the fund’s dishdasha-clad chief operating officer. “This part of the world has been developing extremely rapidly,” al-Muhairi said in a December interview in his Abu Dhabi office. “They’ve taken notice of that.”
Earlier that same week, al-Muhairi and his staff had hosted a dinner for Rubenstein and other Carlyle executives at a Lebanese restaurant in the Emirates Palace Hotel, overlooking the deep blue waters of the Persian Gulf. They talked about U.S. credit markets and potential deals, says William Conway, a co- founder of Carlyle who attended the dinner. “There are a few of them that are deal junkies,” he says of the Mubadala executives.
`Hair on These Deals’
Abu Dhabi first began investing with Carlyle as a limited partner in various funds in the 1990s. Mubadala plans to invest a further $500 million in the region with Carlyle, the firm said in September. The companies are looking for investments in the energy, aerospace and construction and real estate sectors, al- Muhairi says.
Even when they find a transaction, completing it will take time. “There will be hair on these deals,” predicts Peter Baumbusch, a partner with the law firm of Gibson Dunn & Crutcher LLP in Dubai. “It won’t be the simple deals that happen in the U.S.”
Compared with the U.S., the Middle Eastern market is tiny. Last year, $12 billion of deals were announced in the Middle East and Africa. That represented a 55 percent increase from $7.79 billion in 2006, according to Bloomberg data. In the first quarter of 2008, deals announced in the region totaled $479.2 million, down from $6.27 billion a year earlier.
Rubenstein started Carlyle in 1987 with Conway, a former chief financial officer at MCI Communications Corp., and Daniel D’Aniello, a former vice president at hotelier Marriott Corp. They named the firm after New York’s Carlyle Hotel, where the three held early meetings.
Rubenstein is a former corporate lawyer who’d worked as a domestic policy adviser to President Jimmy Carter, counseling him on the federal budget and other subjects.
Drawing on Rubenstein’s Washington connections, the firm brought on advisers from the world of government, including former President George H.W. Bush, former Secretary of State James Baker, former Defense Secretary Frank Carlucci and John Major, the former British prime minister, who helped open doors. “Carlucci could call CEOs whom we didn’t have access to,” Rubenstein says.
Carlyle initially focused on the defense industry. It bought BDM International Inc., a defense technology consultant, in 1990 for $125 million, eventually making a profit of $411 million. In 1993, the firm bought Magnavox Electronic Systems, maker of equipment that analyzed radar signals, and sold it four years later for almost twice that amount.
In 2003, Rubenstein and his partners hired Louis Gerstner, former CEO of International Business Machines Corp., as chairman. After George W. Bush was elected president and amid publicity including Michael Moore’s 2004 documentary Fahrenheit 9/11, which criticized Carlyle for its defense industry background and ties to Middle Eastern investors, Carlyle pared the ranks of its political advisers. “We concluded that though the criticism was unfair, it was a distraction,” Rubenstein says.
Under Gerstner, who replaced Carlucci, Carlyle has been doing buyouts of consumer companies such as Dunkin’ Brands Inc., owner of the U.S. doughnut chain, which Carlyle acquired in March 2006 for $2.4 billion and still owns.
It bought France’s Zodiac Marine, a maker of inflatable boats, last September for 1.4 billion euros.
Gerstner, 66, is forcing Carlyle’s founders to think about succession. All Carlyle investment managers now meet annually in Washington — a way of identifying rising talent. “He’s a master of strategy and organizational restructuring,” D’Aniello, 61, says of Gerstner. “He’s helping us build an institution while opening up the firm.”
Gerstner, who worked at RJR Nabisco Inc. and American Express Co. before his decade at IBM, also serves as door opener, using his connections to recruit executives for portfolio companies.
“The high-profile celebrity adviser is no longer part of the Carlyle culture,” says Arthur Levitt, chairman of the U.S. Securities and Exchange Commission from 1993 to 2001. Levitt, who joined Carlyle in ’01, is also on the board of Bloomberg LP, parent of Bloomberg News.
Other current advisers include Norman Pearlstine, former editor-in-chief of Time Inc., the magazine-publishing division of Time Warner Inc., and Sandy Warner, a former chairman of JPMorgan Chase & Co.
While Carlyle broadened to areas besides defense, it also made deals overseas. The firm set up its first foreign fund in Paris in 1997, when Rubenstein hired Jean-Pierre Millet, a Frenchman who’d run his own investment firm.
One company Millet, 50, set his sights on was Avio Holding SpA, the aviation and aerospace unit of Italian carmaker Fiat SpA. His Milan-based Italian buyout team visited the company during a period of several years before Fiat agreed to consider a sale. Carlyle’s European staff had no aerospace expertise at the time, so Millet turned to Washington for help.
The U.S.-based aerospace group sent a team to vet Avio, with some members spending a month at a time at the company’s headquarters in Turin. “Whenever we have someone who’s facing something new, it’s very unusual if we don’t have someone they can almost immediately bring in to help,” Millet says of the help he got with Avio.
Carlyle’s U.S. and European buyout funds split the equity commitment for the deal, acquiring Avio with Italy’s Finmeccanica SpA for 1.5 billion euros in 2003. Three years later, the firm sold Avio to Cinven Ltd., a London-based private equity firm, for 2.57 billion euros.
Carlyle has opened offices in France, Germany, Italy, Spain, Sweden and the U.K. Carlyle Europe Partners II LP, a 1.8 billion euros fund started in 2003, has an internal rate of return of 53.4 percent, according to data compiled by Calpers, an investor.
Last year, the company added a central and eastern European office in Warsaw, headed by Ryszard Wojtkowski, a Polish national who previously worked at Novartis AG and served as a chief of staff in the Polish government.
Growth in Asia has been bumpier. Carlyle opened its first Asia buyout fund in Hong Kong in 1999, raising $750 million. Carlyle Asia Partners has posted returns of 16.6 percent — about half of Carlyle’s average, according to Calpers.
A second fund that was started in 2001, focused on smaller deals across Asia, including venture capital, has had returns of 35 percent since then, according to Calpers.
In Japan, Carlyle spent years before getting the formula right, says Tamotsu Adachi, head of Carlyle’s Japan fund in Tokyo. Since opening the office in 2000, the firm has hired three different heads of its Japan fund, most recently bringing on Adachi, who joined Carlyle in 2003 following six years at GE Capital and almost a decade at McKinsey & Co.
Adachi says he declined Rubenstein’s advances at first because he didn’t think Japanese businesses were ready to entertain private equity offers. “The concept of the buyout was not well understood by the Japanese,” he says.
Some tenets of buyouts were anathema to Japanese culture, Adachi says, including a tendency to fire management in acquired companies. “Replacing the existing managers is not usually accepted positively,” he says. “We have to treat existing managers well.”
Adachi pointed to Carlyle’s purchase and subsequent IPO of manufacturer Kito Corp., which the fund acquired in a management buyout for 13.4 billion yen (about $111.8 million). To keep the family engaged, Carlyle promoted Yoshio Kito, grandson of the founder, to president and eventually CEO.
Adachi tapped Carlyle colleagues overseas to help expand Kito into the Chinese market and the U.S., quadrupling profits in four years. The company went public in Tokyo last year, raising 19.1 billion yen.
At Adachi’s urging, Carlyle made sure that the majority of investors in the Tokyo-based fund were Japanese, so that the benefits of any deal would go mostly back into their own economy. “He made us be more Japanese,” Conway says of Adachi. “It has given us an edge in that country.”
Carlyle Japan Partners I, launched in 2001, has delivered a 47.8 percent IRR, according to the Calpers data.
Carlyle may have to wait years before it can reap that kind of return from Dubai. Mubadala’s al-Muhairi says he isn’t worried. “Carlyle’s an institution whose track record speaks for itself,” he says. “They have friends in every nook and cranny of the world.”
The friends may be fewer after Rubenstein’s remark that Carlyle Capital was its only fund to go bust out of a total of 60, says David Currie, CEO of SL Capital Partners LLP, a unit of Edinburgh-based insurer Standard Life Plc.
“All of us certainly raised our eyebrows,” Currie says. “I don’t think you want to have that flippant an attitude to one of your funds getting into that kind of difficulty.” SL Capital, which oversees about 5.9 billion euros of investments in private equity funds, doesn’t have any money in Carlyle funds.
Rubenstein, meanwhile, is betting that he can find a way to turn a profit even while his industry is in purgatory. On Monday, Carlyle said it was raising a $500 million collateralized loan obligation to buy high-risk, high-yield debt that banks are selling at discounted prices, people with knowledge of the plan said. And in April, Carlyle finished raising $1.35 billion — nearly three times its goal of $500 million — for a new U.S.-based distressed debt fund. Carlyle Strategic Partners II is buying up loans and equities from troubled leveraged buyouts.