In a Too-Close Tango, Carlyle Trips Over Age-Old Missteps

The Carlyle Group isn't accustomed to failure. Over the past 15 years, it has built itself into one of the world's biggest and most successful private-equity funds by seeing value where others didn't. For most of that time, its risks have been carefully calculated, its timing nearly impeccable.

Which makes it all the more noteworthy that, over the past month, Carlyle has been forced to lend $200 million of its own money, and take back some of its own loans, to rescue Carlyle Capital, a recently launched offshore investment subsidiary that got badly squeezed by the recent credit-market turmoil. It was a rare public humiliation for Carlyle. And it presented a sufficient risk to its reputation that its founding partners felt they had no choice but to use their own funds to shore it up.

Carlyle Capital was launched just about a year ago as an investment vehicle for Carlyle insiders interested in using extensive leverage to generate above-average yields from fixed-income securities. In common parlance, it was a hedge fund.

There was never any doubt this would be a Carlyle operation. Members of Carlyle's staff would raise the capital, make all of Carlyle Capital's investments and handle all the administrative details. And in addition to investing in mortgage-backed securities, Carlyle Capital would also invest in leveraged loans and junk bonds used to finance the Carlyle Group's private-equity deals.

Although its operations were to be primarily in the United States, Carlyle Capital was incorporated offshore, on the island of Guernsey in the English Channel, which offers the advantages of low corporate taxes, lax regulation and legal protection from unhappy investors.

It was not until February that Carlyle finished raising the initial money for Carlyle Capital from large institutions and wealthy individuals. But the ink was barely dry on that $600 million private placement when the fund announced that it would also tap the public markets for what turned out to be an additional $345 million by listing its shares on Amsterdam's Euronext exchange. The foreign listing allowed Carlyle Capital to avoid some of the tighter rules on disclosure, corporate governance and investor protection that govern stocks on U.S. exchanges. But it could not shield Carlyle Capital from the turmoil of U.S. markets when the credit bubble burst.

In many ways, Carlyle Capital is a metaphor for that has gone wrong in the world of finance.

At the time it was launched, most of the big private-equity firms had concluded they had no choice but to get into the hedge fund business, if not for the lucrative fees, then because hedge funds had begun to move into their territory. Nobody seemed to care that the two were very different businesses, requiring very different skills, cultures and time horizons.

Around the same time, Carlyle's partners were also hearing the siren call of the public equity markets. For years, they had gone around the country declaring how much better and easier it was to run companies when they were private. But suddenly, with arch-rival Blackstone Group announcing its intention to go public, and Kohlberg Kravis Roberts not far behind, Carlyle's founders convinced themselves that they too had to take at least a tentative step toward a public offering.

Suddenly, instead of scouring the world for promising but undiscovered companies to buy and retool -- its core business -- Carlyle found itself scouring the world for tax and regulatory havens, trying to keep up with rivals in offering all things to all investors. It was the same mistake Wall Street banks and investment houses had made again and again over the years, to their investors' dismay. Now, Carlyle looked as if it were about to fall into the same trap.

Ah, but this was going to be different, they explained. Carlyle Capital was going to be a sure bet because of how conservatively it was managed. The money was to be invested mostly in triple-A securities, many of them with an implicit government guarantee. Leverage would be aggressive but not excessive, with a generous "equity cushion" to provide that margin of safety in case of market turmoil. And the bets would be hedged to withstand the financial equivalent of a 50-year storm.

Only, of course, it didn't. Somehow, with all the fancy models, it never occurred that maybe the housing market would crash and the price of mortgage-backed securities might move in a different direction than the price of U.S. Treasury bonds. Or that investment banks might get so nervous that they might actually demand an increase in collateral for buying derivatives contracts.