For Major Investor, Wall Street's Crisis Raises Questions and Opportunities

By Thomas Heath
Monday, September 29, 2008

It was just a few months ago when I was eating a hamburger with Carlyle Group co-founder Bill Conway and he was predicting that the mayhem on Wall Street would get worse and last at least a year.

Credit cards, auto loans, small-business loans, home equity loans -- every form of credit would be affected, he had said. He had added that the best time to invest would be when the economy and headlines were most gloomy.

After one of the scariest weeks in Wall Street history, I checked back with Conway. Carlyle Group is one of the richest and most successful private-equity firms in the world, with around $80 billion under management, $40 billion of which is cash that is ready to be deployed. As chairman of its investment committees, Conway has the final word on where Carlyle places investors' money.

I wanted to know whether the economy had bottomed out and what he thought of the bailout plan proposed by Treasury Secretary Henry M. Paulson Jr. and Federal Reserve Chairman Ben S. Bernanke.

First, the economy: "I knew it would be bad, but the current situation is much worse," he said.

He said the bailout's success may ride on whether Paulson gets the flexibility he needs.

"For example," Conway said, Paulson "should be able to buy auto loans, buy loans in packages or directly from homeowners or from commercial property owners. He should be able to buy equity in banks."

Conway said Warren Buffett's decision to take a $5 billion stake in Goldman Sachs "can serve as a template for certain institutions and certain situations." Buffett is a director of The Washington Post Co.

Conway says there's a possibility the bailout will cost taxpayers little or nothing, depending on how deeply the government enters the credit and banking crisis. For example, if the government buys toxic assets from banks at fair market value just to take those assets off their hands, it will cost less.

If, on the other hand, the purpose is to recapitalize the banks and make them healthy, the government would purchase the impaired assets for more than they are worth. In that case, Conway said the United States should receive an equity stake in some banks in return for saving them.

"I fear that the package is being 'sold' as the former (liquidity), but is in reality the latter (equity recapitalization)," he said by e-mail.

Conway likes Paulson, calling him "the right man for the job."

"First, although I have only had very limited business dealings with him personally (when he was at Goldman), in those dealings, he was tough, but A MAN OF HIS WORD," Conway wrote in the e-mail. "Second, his background at Goldman prepared him (to the extent anyone could be!!) for the tumultuous MARKET CHAOS that we have and will face. Frankly, his market instinct for action may be the right counterbalance to Fed Chairman Bernanke's academic training. Finally, I believe that he is seen as someone who can work in the POLITICAL MIDDLE."

But Conway said an oversight board "is essential."

"Even the right man needs some oversight," Conway said.

Conway and his co-founder at Carlyle, David M. Rubenstein, said they were concerned about conflicts of interest. In particular, financial institutions should not be able to sell bad assets to the Treasury and then turn around and use that capital to buy other bad assets -- and perhaps eventually making a profit from those assets.

"The conflicts ought to be worked out," Conway wrote. "Whoever advises the Treasury in the asset purchase process, should NOT be a participant in the buying and selling (too many conflicts). Frankly, they also ought to let others other than the U.S. Government be buyers in the process (e.g., sovereign wealth, foreign banks, pension funds, etc.) -- better prices, more transparency, more firepower focused on the process."

Both Conway and Rubenstein say there is a role for private equity in the bailout, and that there's money to be made.

"Private equity has a lot of experience buying assets at distressed prices and we expect to see a lot of attractively priced assets," Rubenstein said, adding that with $40 billion in dry powder, Carlyle is ready to do some deals. "It's likely that private equity will be a big investor in this area. It's good that private-equity firms are in good shape and have the resources to buy some of these assets and help the system."

Carlyle is 7.5 percent owned by Mubadala Development, which is owned by the government of Abu Dhabi. Carlyle takes investments from several overseas sovereign wealth funds, as well as from big U.S. pension funds, universities, foundations and wealthy people. The California Public Employees' Retirement System (CalPERS) owns a 5.5 percent stake in the firm.

Conway enjoys near-mythical status as an investor, mostly among current and former Carlyle employees but also among others in private equity. He isn't perfect. Remember the costly implosion earlier this year of Carlyle Capital, an offshore public company that invested in mortgage-related securities?

The firm is looking to hire Wall Street specialists who have been orphaned by the shake-up to pursue opportunities both with the bailout and with other distressed financial properties. They will be on the hunt for the next 18 months, Rubenstein said. "Right now Wall Street is shrinking, a lot of people are leaving their current jobs," he said. "So we might have something for people in this area."

It's difficult to argue with Carlyle's results: 26 percent annual net rates of return for investors. Conway has a novelist's eye for detail when it comes to investing, from the growth of food lines at downscale sandwich shops to the nuances of the home rehabilitation industry.

Prior to Carlyle's annual investor conference, held earlier this month in Washington, Conway sent a memo to the heads of his investment funds and to the firm's top executives, including co-founders Rubenstein and Daniel A. D'Aniello, chairman Louis V. Gerstner Jr., senior adviser James H. Hance Jr., and managing directors Edward J. Mathias and Glenn A. Youngkin.

Here's what he said:

"As you know, our annual Investor Conference commences this weekend in Washington. I want to be certain that you continue to understand my views and that we have consistent communications with our limited partners.

"In January, 2008, I sent each of you a brief note (attached) about my view of the global economy and the actions I wanted us to take. Generally, these actions were to intensely manage our portfolio and to invest in a few wonderful deals. These guiding principles remain in effect. If anything, I have grown even more pessimistic about the near-term future. My pessimism is a function of the housing crisis, problems with financial institutions, energy prices and an over-stretched consumer. These problems are not confined to the United States. And, I expect the troubles to persist at least through 2009. Hopefully, we are ready."

It's worth noting that Conway began his January note this way: "If you are not in a panic by now, it is too late . . . "

He signed off by saying: "P.S. If you are in a state of panic, now is the time to return to calm, and take good care of our investors, portfolio companies and employees."

Thomas Heath's "Value Added" column focuses on Washington's entrepreneurial set and runs weekly on the WashBiz Blog.

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