Such a Deal

By Steven Pearlstein
Friday, May 23, 2008

It is a cause for celebration that two of the Washington area's most successful companies -- Carlyle Group and Booz Allen Hamilton -- have decided to join forces.

Carlyle, of course, is one of the world's top private-equity firms, having grown over the past 20 years from a politically connected Washington investment boutique into a global financial powerhouse with 1,000 employees, offices in 21 countries and more than $80 billion under management.

Now, with its $2.54 billion purchase of Booz's government contracting division, announced late last week, Carlyle is coming home. Many of Carlyle's earliest deals involved aerospace and defense companies, among them BDM -- at the time the quintessential Beltway contractor, which Carlyle took public and later sold to TRW at a handsome profit. In Booz, Carlyle has picked up a jewel of a company that offers proven management, steady cash flow and a valuable brand name.

This was a complicated deal that took months longer to nail down than anyone expected.

Just as things began to come together last fall, conditions began to deteriorate in financial markets, as many banks decided they were no longer interested in lending money for private-equity deals. The two banks that were still willing to participate, Bank of America and Credit Suisse, made clear that they'd finance only half the purchase price rather than the two-thirds that had been standard just months before -- and that came with higher interest rates and more strings attached.

Also complicating the deal was the fact that Booz would be required to split itself into two companies -- one a government contractor based in McLean that would be majority-owned by Carlyle, the other a commercial consulting firm headquartered in London.

In fact, it was a decision two years ago to split Booz into two firms that eventually led its chief executive, Ralph Shrader, to approach Carlyle about a deal.

Although Booz claims to have founded the management consulting business in 1914, when University of Chicago economist and psychologist Ed Booz began peddling strategic advice and statistical analysis to a number of leading corporations, it is its government contracting division that has become the growth engine over the past two decades. The shift in its center of gravity has caused strains within the firm.

The basic model of a commercial management-consulting business revolves around a highly paid partner who specializes in one industry and works with a team of half a dozen MBAs hired right out of business school. These consultants work in small teams, travel constantly, are billed out at high hourly rates, earn big salaries and either work their way up the partnership ladder or are asked to leave. The culture tends to be entrepreneurial.

The model for Booz's government business, by contrast, starts with a highly paid partner who may be very knowledgeable about one discipline or one government agency, and who oversees a hundred or more employees with various skills and backgrounds, many of them former federal employees. The project teams are larger, work is more collaborative, the average pay and billing rates are lower and there is no up-or-out quality to career advancement. And because of government contracting rules -- particularly those affecting Booz's classified work for the Pentagon, Homeland Security and the intelligence agencies -- the culture tends to be bureaucratic.

Two years ago, Shrader concluded that the compromises required to maintain these two models, and two cultures, within a single firm had become too much of a burden to both businesses. At the same time, there were growing financial tensions between the 200 partners in the slower-growing commercial-consulting business and the 100 partners in the government business now generating two-thirds of Booz's revenue and a majority of the profits. So Shrader quietly began looking for ways to split the company by spinning off the commercial business into a separate partnership and selling the more marketable and more valuable government contracting business.

One option -- the one that would have brought the highest price -- was to sell the government business to another big government contractor such as Northrop Grumman or Lockheed Martin. But Shrader and his team concluded that in trying to incorporate Booz into a larger organization, such a strategic buyer would undermine the unique culture that has been the source of Booz's competitive strength.

In Carlyle, however, Shrader found a buyer familiar with the industry that would allow Booz to operate largely as it had been and that was willing to pay off the commercial consulting partners and provide the capital needed to continue expanding the business by 15 percent a year.

For Booz's 300 partners, it will be a sweet payday when the deal closes-- on average, more than $8 million apiece. The commercial partners will use a portion of their payouts to capitalize their new firm, Booz & Co. Those on the government side will have to invest at least 40 percent back in the company, with the prospect of an even bigger payday when Carlyle cashes out, sometime over the next decade.

Between now and then, look for Carlyle to push Booz to cut costs and become even more aggressive in winning new business -- whatever it takes to generate the cash and pay off that $1.25 billion in debt as fast as possible. And look for other private-equity firms -- flush with cash and eager for recession-proof acquisitions -- to come calling on local contracting firms that have been unwilling or unable to go public as valuations declined from their 2006 peaks.

Steven Pearlstein can be reached

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