Carlyle Tries To Weather Rare Setbacks
Failed Finds Tarnish Equity Giant's Image

By Thomas Heath
Washington Post Staff Writer
Monday, August 18, 2008; D01

Carlyle Group over the past two decades has built a sterling reputation as one of the most successful private-equity firms in the world, with a stable of advisers that has included former presidents and prime ministers, investment returns that have earned billions for clients, and a trio of founders who became fabulously wealthy -- all with nary a hint of losses.

But the near-mythic reputation that started in 1987 has been bruised over the past several months as the District company has endured some high-profile financial troubles.

It started in March with the $700 million implosion of Carlyle Capital, an offshore public company that invested in mortgage-related securities. The company's business was to borrow money to buy the 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. But when the value of those securities dropped, lenders asked for more cash; they foreclosed when Carlyle refused.

Carlyle suffered another hit last month when it announced it would liquidate Carlyle-Blue Wave Partners Management, a vehicle that made similar bets in mortgage-related securities. Blue Wave, begun in spring 2007, failed to earn enough fees to cover its overhead, and Carlyle decided to shut it down.

In the midst of those setbacks, Carlyle's expected gain in SemGroup, an oil marketing company based in Tulsa, may be wiped out because of the company's recent filing for bankruptcy reorganization. And China last month announced that it had declined to sell Carlyle a minority share in an industrial company there after a three-year courtship by the firm.

Like many other large private-equity firms, Carlyle pursued a rapid-growth strategy in the era of easy credit. In 2007, a hugely active period for buyout firms, Carlyle spent billions acquiring a number of U.S. companies, including Home Depot Supply, Manor Care nursing homes and Freescale. A spokesman said the companies, while facing headwinds, are on track to earn Carlyle a profit because the firm factored economic downturns into the business plans.

The most closely watched deal has been the one for Freescale, a supplier of semiconductors to big manufacturers such as Motorola and auto companies, which Carlyle and others bought in December 2006 for about $17 billion. Freescale has been slowed by the downturn, but Carlyle said the company has strong cash flow and nimble financing and will eventually sell for a big profit.

Home Depot Supply could be hurt if the economic slowdown continues to hammer the housing and home-building industries. Carlyle bought the supply arm of the home-improvement chain for $8.5 billion last year, negotiating it down from an original offer of $10.3 billion.

"We are going through one of the most uncertain and difficult periods in the world of finance that we've seen in recent history," said Frederic V. Malek, a former Carlyle senior adviser who now runs his own private-equity funds. "Any firm, especially one as widespread as Carlyle, is going to have some stumbles. But what is more germane is to judge a firm by its long-term record of returns to investors, and it seems to me that they have done a darn good job in that category."

Carlyle spokesman Chris Ullman said in a statement: "With innovation comes the occasional setback. However, over 20 years, product and geographic expansion has served our investors well, generating firm-wide 26 percent annual net rates of return.

"Our portfolio is solid and performing on plan. We bought strong companies, financed them conservatively and are working hard to create additional value."

Carlyle investors said the firm hasn't lost its touch.

"Carlyle continues to be one of our leading, top-quartile-performing investment managers," said Jon Carlo Mark, senior portfolio manager for private-equity investments at the California Public Employee Retirement System (Calpers), which owns a stake in the firm and gives Carlyle money to invest on its behalf. He added, "Blue Wave and Triple C [Carlyle Capital] are two small pieces of their overall investment activity and do not materially impact their performance as a Calpers partner or our confidence in them."

Even the local pension plans of the Service Employees International Union, which has criticized private equity, saying firms like Carlyle don't do enough for employees at companies they own, have no intention of pulling their money from the funds because of Carlyle's setbacks.

Carlyle owns 224 companies, from Hertz to Dunkin' Donuts; employs 950 professionals; and manages $82.7 billion from clients in 68 countries. Its list of directors and advisers includes many influential figures crossing political, corporate and philanthropic spheres.

Private equity's conventional model involves buying companies, taking them private, making them more profitable and selling them years later for a much higher price. The profits are then distributed to investors. Forty-one percent of Carlyle's investors are pension funds, and 32 percent are financial institutions, according to its annual report. Most of the rest are wealthy individuals.

Because private-equity firms earn fees based on the amount of money they manage for investors, the bigger they get, the more income they generate.

Carlyle built its reputation by buying mid-size defense businesses, worth a few hundred million dollars each, and turning them into more profitable enterprises over several years. That's a different skill set than overseeing highly complex credit products that are bought and sold by the minute, which is what Carlyle ventured into with Blue Wave and Carlyle Capital.

"Owning a business and having outright control is vastly different than trying to operate in an industry or asset class where you are making decisions in hours and minutes instead of years," said Erik R. Hirsch, chief investment officer with Hamilton Lane, which advises clients on investing in private equity.

Carlyle set out to open Blue Wave with more than $1 billion in assets but fell short of the minimum target by about $100 million. Losses and redemptions further eroded those assets to about $600 million before the company announced the fund's liquidation.

It wasn't the first time Carlyle has tried to master the art of hedge funds. The company in 2001 formed a high-profile fund of hedge funds called Carlyle Asset Management, which it eventually sold without remarkable success.

In Carlyle Capital, Blue Wave and Carlyle Asset Management, "Carlyle was trying to do something very, very different, and it's something they don't have experience doing," said Dan Primack, who writes a private-equity blog for Thomson Reuters. "Carlyle is still very successful in terms of private equity and has a very successful venture capital practice. Nevertheless, it hasn't done a good job expanding outside of private equity."

Carlyle was founded by Daniel D'Aniello, William Conway Jr. and David Rubenstein. Forbes estimates that all three are billionaires. The company last year returned $8.9 billion in equity and profit to investors, its second richest year, after 2006, when it gave back $10.2 billion, according to its annual report.

Mark A. Frantz, general partner with the Arlington venture capital firm RedShift Ventures and a Carlyle alumnus, said the recent setbacks are not a sign that Carlyle is on the rocks.

"These are just foul tips compared to the strikeouts that other private-equity firms are experiencing," Frantz said. "Overall, Carlyle is actually thriving, from everything I hear. The firm is an aircraft carrier, and it will sail through this storm in the market."