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Anatomy of a Carlyle Collapse
Pressure on Banks Left an Ailing Fund Exposed

By Thomas Heath
Washington Post Staff Writer
Friday, March 14, 2008

It was around noon on Wednesday, and the founders of the Carlyle Group, the District-based private-equity powerhouse, thought they had a $500 million deal to salvage their troubled European affiliate along with their firm's reputation.

The three co-founders, David M. Rubenstein, William E. Conway Jr. and Daniel D'Aniello, took a collective deep breath in their Pennsylvania Avenue offices after days spent fending off a handful of hungry banks. The banks, under enormous pressure from regulators to put their balance sheets in order, had been pressing Carlyle to put more money into the ailing, highly leveraged hedge fund known as Carlyle Capital.

"I thought we were going to come to a restructuring arrangement where we would invest $400 or $500 million to make it work," Rubenstein said in an interview yesterday. "We had asked them to freeze . . . for a year, giving us a breathing period, and we would put up a lot of money."

Then the phones started ringing again.

"From noon to about 4, it cycled downward," Rubenstein said. "I was in the office. Dan and Bill were in the office. We were all working. The banks asked for even more money. . . . We were prepared to put up a lot of money, but in the end, we didn't see a bottom. We had a sense late in the afternoon that it wasn't going to work."

By early evening, Carlyle Capital, a publicly traded affiliate of Carlyle that is incorporated on Guernsey, an island in the English Channel, was preparing an announcement that it could not meet the banks' demands. Carlyle Capital would collapse, and its investors would lose $900 million -- including Carlyle Group executives who owned 15 percent of the company.

The demise of the fund is a shock to the private-equity giant, long proud of its record of returning an average of 26 percent, net of fees, to investors of nearly 60 funds. Carlyle Group manages $81 billion in assets for unions, pensions, endowments, individuals and foreign governments. In the past two years, it returned $18 billion in profits and equity to its clients.

Carlyle Capital is now a blot on that record. The company's business was to borrow money to buy mortgage-backed securities, and to make money on the difference between the firm's borrowing costs and what it earned on the interest paid on the bonds.

Its stock closed at 35 cents a share yesterday after the fund defaulted on more than $16 billion in assets. The shares have dropped 93 percent since Tuesday.

A contrite Rubenstein yesterday worked to put the best light on the situation.

"I don't think that today the reputation of the Carlyle Group will be enhanced," Rubenstein said. "However, we have a 20-year reputation and track record of yielding probably the highest rate of return of any private-equity firm that has invested as much money as we have."

Going forward, he said, "the way we hope to handle this is to be honest, forthright and recognize mistakes were made and reassure people around the world about Carlyle. It's important that people say that Carlyle are people who stand behind what they do. That they are honest, reputable people. And they are the kind of people who we think are appropriate custodians of our money. Unfortunately, in this case it did not work."

Rubenstein said the firm planned to talk with investors in Carlyle Capital to explain what happened; it would also try to do something to soften the loss, though Rubenstein did not specify what the firm would do.

"I'm angry with myself," Rubenstein said. "We conceived the product. We are responsible." But, he added, "you can't say this is an isolated thing. Every fund of this type is under enormous stress right now."

Many investors think Carlyle Capital is only the tip of the iceberg. Drake Management's three hedge funds, with nearly $5 billion under management, recently suspended investor redemptions as it considers liquidating its assets. Nuveen Investments, purchased last year by Chicago private-equity firm Madison Dearborn Partners, faces lower profits and slower growth because of higher borrowing costs brought on by the credit crunch.

Peloton Partners, a hedge fund based in London, was forced to liquidate its funds recently, and Thornburg Mortgage, a big U.S. lender, failed to meet margin calls by lenders last week. Citigroup is committing $1 billion to shore up its hedge funds.

Analysts said the fear is that the banks will move more aggressively to seize assets from troubled funds, triggering a cycle that will make it difficult for funds to meet margin calls.

At Carlyle, that squeeze began late in the afternoon March 4, when executives at Carlyle Capital informed Conway and Rubenstein that Deutsche Bank, J.P. Morgan Chase and others were demanding the company boost its cash reserves, in what is known as a margin call.

Rubenstein, who had bought a $21 million copy of the Magna Carta and donated it to the National Archives the day before, was optimistic, based on past experience, that an agreement could be reached.

But this time was different.

The bankers kept raising their demands, setting off a week of furious negotiations in Manhattan, where Carlyle keeps a midtown office. Some even began seizing Carlyle Capital's collateral -- and its chief asset, its AAA-rated, mortgage-backed securities -- and selling them. Meetings went on last weekend, and by Monday, Carlyle Group thought it could meet the margin calls.

But it wanted the banks to agree to not make further demands -- freezing future seizures -- to give the company's securities a chance to rise in value.

Rubenstein said the securities from Fannie Mae, Freddie Mac and Ginny Mae had a historic record as safe investments that were unlikely to decline in value.

"But now we have a [credit] crisis that is deeper than anything we have seen since the Depression," Rubenstein said.

In the aftermath, the Carlyle co-founder said he would seek to assure investors that the Carlyle Group remains healthy. It has "enormous profits embedded in its current funds," he said.

Then he sounded a Churchillian note:

"When you look back at things, we hope people will say this was not Carlyle's darkest hour. We hope people will look back and say this is a very strong hour for Carlyle. We will help investors. We will be transparent about our mistakes and will be careful to recognize what we can do to improve our performance in the future."

Staff writer Tomoeh Murakami Tse contributed to this report.

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