Carlyle Group Candid: A Q&A with David Rubenstein –

Earlier this month, Buyouts’ Editor Danielle Fugazy and Associate Editor Ari Nathanson sat down with David Rubenstein, a co-founder of The Carlyle Group, to talk about the past, present and future of The Carlyle Group and the buyout industry as a whole. The following is an excerpted version on the conversation.

Buyouts: Many people feel that the market is overcapitalized and, with multiples going up, that returns are on the way down. Do you share that concern?

Rubenstein: For about 20 years it has been said by outsiders that there is too much capital chasing too few deals in the buyout world. And for about 20 years that comment has proven not to be the case. In my view, it is not the case today. I truly do not think that today there is too much money chasing too few deals. Of course, there clearly is a good deal of money in the buyout area, and some buyout investors have made mistakes in the recent past by paying too much or in over-levering their companies. But it’s equally clear from the results achieved by many experienced firms over the last couple of years that buyouts can be as profitable today as they have ever been. For that reason, I believe the future of the buyout industry is brighter than ever. Buyouts have obviously proven themselves to be a consistent way to earn attractive returns, when the sin of undisciplined bidding is avoided.

And with the amount of deals going to auction, do you feel that prices are rising too high?

If there is a good deal of equity capital available, that does not mean the capital will be invested unwisely. It really means there will probably be more deals done some perhaps unwisely priced but the vast majority, if history is a guide, will be wisely priced and exited. Remember, 25 years ago it wasn’t common for people to think of disposing their assets to private equity buyers. They were not considered a viable, meaningful and, in some cases, respected source for a disposition. Today, it is commonly accepted that a private equity solution is a good solution for a seller, for employees, for managers and for investors. So because it’s more commonly accepted today, there are many more deals that people are willing to do with private equity buyers.

You now see that same phenomenon in Europe. It wasn’t socially acceptable 10 years ago to sell assets in Europe to private equity buyers. It’s now very socially and professionally acceptable. In Asia, you see that acceptability gaining a bit in China, India and Japan. And I think in five years it will be the same as it is in Europe and, in 10 years, the same as it is in the United States today.

The point is that having a good deal of capital doesn’t mean that deals will get done that are poor; it just means that there may be more deals done. Now, in some cases-at the height of a bubble-it is possible that some people can get carried away and pay too much, but I think that is generally not the biggest problem with there being a good deal of available buyout equity.

There are, of course, a good many auctions today. Anything above $1 billion in purchase price, today, is almost certainly going to be auctioned in the United States, Europe, Latin America, Asia and Japan. Auctions aren’t necessarily a terrible thing. I think if you’re disciplined and you don’t pay ridiculous prices, you can still get a reasonably good deal in what I’ll call a modest auction.

And the definition of an “auction” has certainly varied. Some people say they don’t participate in auctions and by that they mean, “We don’t participate in transactions in which 25 firms are invited in.” I understand that. But it’s very difficult to credibly say you don’t participate in limited or modest auctions in which three or four potential buyers are competing. I think almost everybody has to compete in those transactions to get deals done today. You cannot be a real player in the private equity world today and not participate in modest auctions. Most importantly, though, the returns from auctioned deals modest or full auction appear to be as good as those from non-auctioned deals.

Asia, specifically China, is an area that’s been getting a lot of private equity attention lately. What opportunities are you seeing there?

From time to time the emerging markets have appealed to investors. All of North America was an emerging market several hundred years ago, and Europeans came in search of the presumed riches and greater opportunities thought to exist here. Now, Asia, Central Europe, Russia, parts of Latin America, and of course India are considered emerging markets, and Americans, among others, are chasing the presumed riches. And in fact, in my view at least, all of these areas offer extraordinary opportunities to get much greater rates of return than you might get in mature markets like the United States or Europe.

But, you have to remember that when you compete in these markets, the rules are somewhat different. The rules in the United States or in Western Europe for doing transactions are just not going to apply in all cases in these markets they are still relatively young. The classic type of Western buyout just may not be possible in India or China, for some time, and you thus have to adapt to the local situation if you are going to succeed.

In India, for example, there has never been a true leveraged buyout. In China there has also never been a true leveraged buyout. In other words, there has never been a deal in which equity is invested and 75% of the capital structure is debt led by local banks. Those deals have simply not yet occurred in India or China. We’re working on a transaction which would be the first true leveraged buyout in China, but it could well not happen. Therefore, if you’re going to invest in these countries, you have to recognize that, to date, you’ll probably have to take a non-control and non-leveraged position in any company of size.

The deals that have been done in India, with almost no exceptions, have been deals in which private equity firms have invested in publicly traded companies. And even if they get to control the board at some point, which happens in a few cases, the company is still public. So the classic leveraged buyout is not something that has come to India, or to China. It will come, no doubt, but it hasn’t yet. In short, an investor cannot take Western business models and expect to transplant them overnight.

Emerging markets have an infinite capacity to disappoint. In other words, they always look terrific in the peak years. They always look like a place where you can get greater returns than you can get in mature markets. But because these areas often have boom-or-bust phases, you have to be prepared for the bust. If you’re not prepared for this phase of an emerging market, you shouldn’t be investing there in the first place. You just do not have the stomach for emerging market investing.

I think a change that has happened in emerging-market investing over the last five years or so is that when the inevitable bust- perhaps more politely called a correction-does occur, the Western investors who are putting money in these areas are not as likely to flee the market as they once did. Today, they are likely to see this inevitable correction as a buying opportunity and will put even more capital into these markets than they would in the good times. That is a clear change from before.

What about Europe? Has that market become overcapitalized as well, or are there still opportunities for good returns?

Europe is an attractive place to invest, for two principal reasons. In the United States, in the early 1980s, we began to say that Japan was a preferred economic model, and we were beginning to think that we could not compete with Japan. Ultimately, as you know, the Japan model proved not to be perfect and the United States, in order to compete with what it saw as the Japan threat, began to shape up its companies. We reduced the size of our conglomerates, we worried about shareholder value. Private equity played a major role in bringing about this change in the then \-standard corporate values and mindset. That phenomenon took place in the mid-1980s and mid-1990s in the United States, but it really didn’t occur simultaneously in Europe.

From the mid-1990s on to today-roughly a 10-year period-Europe has begun to worry about whether it’s competitive with the United States. And in thinking about that, Europeans have done many of the same things that we did 10-plus years earlier in response to the Japanese. Europeans forced their big conglomerates to sell off subsidiaries; they’ve allowed private equity to become an important part of the economy; more money has been invested by European pension funds into private equity; buyouts are now more socially and professionally acceptable; and as a result, the European economy and European businesses are much better performers than they had been. But that trend has not yet been completed, and there are still many improvements that will happen over the next several years in Europe. And as these improvements occur, Europe will be filled with a great many solid and attractive buyout opportunities.

In the past 18 months, Carlyle has returned about $6.6 billion to its investors. Do you feel that that answers the doubts concerning mega funds and their ability to generate upper quartile returns?

Over the last two or three years, what you’ve seen is a sea change in the way some investors have looked at the buyout market. Four or five years ago, it was the conventional wisdom among many in the investment community that the best buyouts to be done were in the medium-sized range, the second best were in the small range and the third best were in the large range.

Much of the investing community now feels that the attractive deals to be done are in the large-sized range. Here are the reasons: One, many people rushed into the middle-sized range, making it much more competitive. When we sell a company that’s mid-sized, we see 35 to 40 mid-sized players trying to bid. When we are involved in a large company transaction, there are the usual six to eight suspects who show up, but not many more. In short, it is less competitive in the larger arena.

Second, the larger-sized transactions get more attention from the big Wall Street investment banks. And they seem to be prepared to provide much more attractive financing terms than you might get with mid-sized deals.

Third, you can recruit much better managers, given the size of the companies, for some of the larger-sized transactions. And as a result you really have world-class talent managing some of these companies.

Fourth, one of the reasons that returns have been good for everybody in the large-sized space has been that the recapitalization phenomenon has been very evident there. The recaps have occurred on probably half, if not more, of significant buyouts done in the last two years. And recaps tend to be easier for larger companies to do, given the greater willingness of the banks to recap companies in this size range.

For all of these reasons, many investors now recognize that the funds which have delivered what are probably the most consistent returns over the last three, four or five years in the private equity space-and I mean all parts of private equity: venture capital, buyout, Europe, United States, exteria-have probably been the large buyout funds in the United States and the large funds in Europe. There is no guarantee that the big funds can continue to deliver superior returns, but the skepticism about large-sized funds seems to have abated considerably over the past couple of years.

Buyouts: Club deals were certainly a popular topic in 2004. What are your thoughts on pursuing private equity deals with other firms?

Rubenstein: There has also been an enormous change in the way those in our business now look at these types of transactions. Ten years ago, firms tried to do deals by themselves. KKR, in 1989, did the RJR [Nabisco] transaction by itself. KKR ultimately put in $3.2 billion of equity without partners. Today, I suspect the firm would not do that transaction by itself. Today, most buyout firms would probably feel uncomfortable putting in more than $500 million themselves in any one transaction, and as a result more club deals are happening.

In our case, we are quite willing to do them under the right circumstances. And we have recently done a number of them-one with KKR in PanAmSat that’s worked out very well, another one with Bain in Loews that’s also working out quite well. We do them, though, under these conditions: First, we have to be involved in the due diligence from the beginning-we don’t just invest in someone else’s deal. Second, we have to have equal corporate governance rights as the other partners. Third, we have to have essentially equal exit rights as the other partners. Fourth, we have to be teaming with a group with whom we feel completely compatible.

The issue with these deals is not whether teaming with two or three other parties can buy something on attractive terms; it’s evident that this can be accomplished. But what happens when the economy isn’t so good, when the deal doesn’t work out so well? We don’t yet have a long case history of private equity firms that have invested considerable sums together in a deal that is heading south. Who then decides whether the CEO is to be replaced? Who then decides whether the company is to be sold or liquefied? These answers may be written in legal documents, but the reality may turn out to be much different. There will clearly be some long arguments in these situations.

Are you seeing any pushback from LPs due to the club deal strategy?

I don’t think limited partners are opposed to the theory of the club deal. They don’t seem too concerned about whether you can get attractive priced deals through consortiums. I think their concerns are whether they are investing in funds that are just tagging along on somebody else’s transactions. In other words, they worry about the fact that they might be investing with somebody who is getting a 20% carried interest while all that firm is doing is using somebody else’s due diligence and just piling on somebody else’s deal.

The second concern is that if three or four buyout firms team together, the deal might be well priced and conceived, but limited partners who have invested in all three or four of these funds will get far more exposure to that deal than prudence and appropriate diversification strategies might warrant.

And third, there is the just-discussed concern about who is really in charge when things go downhill.

At the Yale Private Equity Conference in November, you had mentioned that The Carlyle Group had perhaps become too politically affiliated without really considering the repercussions. Can you talk a little bit about that?

When we brought some people in who had served in government we didn’t think it was that unusual, because people who had served in government had worked in investment banks and even some private equity firms before. Pete Peterson, a former Secretary of Commerce, was a founder of Blackstone, for example. But because we had more than a few well-known people who had served in government, we got more attention than we deserved. For example, today somebody might think we have an enormous number of former government people in this firm. We actually have 300 deal people who have never been in government and seven or eight who have actually served in senior government positions.

Nonetheless, what I said at Yale was that I personally didn’t pay enough attention to the fact that we were getting so much press for this and that I, personally, was at fault for not responding to press inquiries adequately about this. In part to deal with that, Chris Ullman has joined us [as director of global communications]. He has done a much better job than I was doing in terms of explaining to the press that we really are a private equity firm, not a former government officials reservoir.

In truth, many of the former government officials, while they’ve provided very useful services to us, have left the firm or have retired. And I think that is all reflective in the fact that our new chairman, Lou Gerstner, is a very serious, senior business executive who projects the kind of tone that we like to set for people: specifically that we are a very serious business organization, not an organization of former government people. The former government people, in their day and in their time, were helpful in getting us some credibility. Now, given how established we’ve become, the credibility that we seek is really obtained by our track record. And as I mentioned, I think the track record is a match for anyone’s in the buyout world.

We were never really involved in politics in the sense that we were never in the business of lobbying governments or holding fundraisers for politicians. Many of the private equity firms, and they’re certainly free to do so, are much more actively involved in political contributions, fundraising or lobbying, than we have ever chosen to be. Perhaps because we have had a fair amount of attention to our “political” image, we have actually bent over backwards to avoid that kind of activity. We think our track record is as good as anybody’s in the private equity world. Of the $11 billion that we have invested over the past 17 years, we’ve earned a gross internal rate of return of 28 percent. That track record is what we look to as our testament of what we stand for and who we are, not some people in the firm who may have served in government.

Can you talk about succession and what will happen in the next decade when some of the people who started this industry move on?

The founders of Carlyle are in their mid-fifties. When my father turned that age I thought he was ready for a nursing home. I now realize mid-50s is the prime of life, and my father was 30 years too young for a nursing home. Seriously, time moves on, and so what we have decided to do at Carlyle is to recognize that we have built an institution that will more than readily survive its founders.

To begin the transition, we’ve established, for the first time ever, a management committee of 10 individuals, all of whom could well lead the firm in the future. Of the 10, two or three will probably emerge as the future leaders of the firm and they will, over a period of time, be given more management and investing responsibility and authority. Today the firm is essentially run by a variety of people. We have many different committees that make determinations on compensation, promotions and related matters. The founders are not really making day-to-day decisions on the firm’s operations as we once were. So we have begun a transition and inevitably in a few years we’ll probably do more transitioning.

Over the next 10 years, all of the founders of the best-known private equity firms will probably be transitioning away from the leadership of those firms, and that’s probably a very good thing for the industry. It shows that the private equity firms are not just an extension of their founders, that serious institutions have been built over the years, that these institutions will be good custodians for investors’ money for quite some time, and that they are not dependent on the founders to get good rates of return.

You see this transition as relatively seamless?

We’re going to do our best to ensure that a transition is smooth, and perhaps barely noticed by our investors. For that to occur, we want to make certain that the people are prepared for the leadership roles that they’re likely to take. We are undertaking that process now.

Remember, for many years private equity firms were essentially a bunch of mom-and-pop shops-a cottage industry at best. What’s happened over the last 10 years is that a number of organizations-Carlyle, Blackstone, Texas Pacific Group, Bain, Warburg Pincus, among others-have shown that they can create on-going institutions and brands which are strong enough to survive leadership changes. Indeed, these firms are likely to prosper quite well after the founders are gone. In our case, the firm will do even better without the three co-founders. At least I hope so.

Looking into the crystal ball, what do you see happening in the year, or years, to come for the buyout industry?

One, the buyout industry will grow in terms of people who are working in it, people who are investing in it and companies that are owned by it. Second, the buyout world will be an increasingly important part of the U.S. economy and ultimately of the European and Asian economies. What private equity has done in the United States has improved the U.S. economy in many significant ways. It is already beginning to do so in Europe and it is certain to do the same in Asia, Japan and India. Buyouts have turned out to be a very important part of the transformation of the U.S. economic model, and that’s been a healthy thing for everyone associated with the economy here. The same benefits will be derived ultimately by emerging market economies where buyouts are allowed to play a major role.

There will be ups and downs, for sure. Some deals won’t work, and there will be people saying that the buyout industry is not as vibrant as I’m now saying it is. But over a period of time I think you’ll see more capital devoted to the buyout industry, and a greater recognition of its contribution to economic wellbeing.

What do you see happening with the convergence of hedge funds and the private equity world?

Right now, hedge funds are getting into the private equity space. And they have a number of advantages, including the fact that they can move more quickly because they don’t have to secure debt for each transaction. Buyout firms, in response, have begun to add hedge fund and hedge fund-of-fund adjuncts to their private equity business.

Ultimately, what you’re going to see in 10 years is not “private equity funds” and not “hedge funds,” but “alternative investment funds,” which will give investors the best features of private equity funds and the best features of hedge funds. The general partners who manage them will have a lot more flexibility than they might have today.

With the convergence of these two asset classes, will we see fewer traditional private equity firms in about 10 years?

There are thousands of hedge funds, and thousands of private equity funds. I don’t think there will be a noticeable diminution in these funds as long as they provide incentive fees of 20% or more. If you were to go to the best colleges in the United States and ask the smartest people what they wanted to do 35 years ago, people would say, “I want to go to medical school,” or “I want to go to law school.” Today, for better or worse, a lot of the most talented young people want to go into private equity or hedge funds, and that’s because the economic rewards are fairly significant, the challenges are good, the intellectual appeal is there. You’ll see that trend continuing, as the economic rewards elsewhere decline. So I don’t think there will be a diminution in private equity or hedge funds-there will probably even be more of them. I just hope we still train enough doctors to take care of the private equity and hedge investors as they reach old age.

OK, lighening round. What was the best deal that Carlyle has done in the past three years?

Dex Media with Welsh, Carson, Anderson & Stowe. We paid $7 billion for the yellow pages of Qwest and of the $1.5 billion of equity that was invested, we will probably at least triple that. We have had higher multiples, but that is the largest quantitative profit.

What was Carlyle’s worst deal ever?

Not actually investing in the Citicorp deal that we advised Prince Alaweed bin Talal on in the mid-90s. We served as an advisor on the deal. We could not convince our then-investor base (which was admittedly quite smaller than today) that the deal was a once-in-a-lifetime opportunity. It turned out to be a 10-bagger. Not investing in Netscape at the outset was another missed opportunity.

If you were starting your career over again and you had to choose between buyouts and venture capital, which would you choose?

I think buyouts are a more predictable endeavor. So today if I had to choose, I probably would choose the buyout business but would try and find a way to do some venture capital investing to provide my professional life with a bit more daring, spice, and a sense of possibly helping to change the world for the better.

Who won the Connecticut v. Forstmann Little case?

The lawyers.

Better President: George H. W. Bush or George W. Bush?

I don’t think you can judge a President’s term until it’s fully over. So it’s not possible to say until 43rd’s second term is over.

If you weren’t involved in private equity, what would you be doing?

Rubenstein: My goal would probably be to be the publisher and editor of Buyouts. [Ed.We did not put him up to that answer.]

Is your firm really named after a hotel?

The Carlyle Hotel, itself, is named after Thomas Carlyle who is a famous British philosopher and economist. So while we may have stolen their name, they have stolen his name.