Carlyle Trips Chasing Blackstone in Diversification Push

By Devin Banerjee

Thirty miles south of London, residents of Tunbridge Wells are disgusted.
Their ire is directed at Carlyle Group LP (CG), which with Bellhouse Joseph Ltd. bought a dilapidated movie theater in 2011 and then failed to develop the site. Ben Chapelard, a member of the local government, described it as the area’s greatest “grot spot,” and more than a fifth of the town demanded the theater be torn down. Two months after demolition, the lot sits empty, surrounded by blue construction boards.
“It just looks awful,” Chapelard said in a telephone interview. “If you stand on the street asking people to pressure Carlyle to do something, you collect a signature every 20 seconds.”
The Washington-based firm’s investors are also frustrated with Carlyle’s international real estate efforts. One European property fund started before the financial crisis has lost 80 percent in value after ill-timed deals in the U.K and Italy, and another is barely breaking even. Carlyle’s real estate operation, started in 1997, manages about $13 billion, a fraction of the $80 billion currently overseen by
Blackstone Group LP. (BX)
“I didn’t even know they were in the real estate business,” Tony James, Blackstone’s 63-year-old president, said on a July call with analysts after buying London office buildings from its competitor.

Expansion Stumbles

Carlyle’s property stumbles reflect broader difficulties at the $203 billion firm in diversifying earnings beyond leveraged buyouts, an ambition of 65-year-old co-founder David Rubenstein since the 1990s. In October, Carlyle took another hit when hedge fund unit Claren Road Asset Management lost about 10 percent in its main fund. Assets fell more than $1.1 billion to $7.3 billion in weeks and investors have demanded it return about a quarter of the remaining capital.
“Carlyle is not seeing some of the growth in assets that the other guys are, Blackstone most notably,” said Stephen Ellis, an analyst at Morningstar Inc. “Private equity is a highly cyclical business, and shareholders have put tremendous pressure on them and on the industry to diversify away from it in order to have a more stable, reliable income stream.”
Blackstone is 40 percent bigger by assets than Carlyle, even though each managed less than $30 billion in 2003. Blackstone is also more diversified. Its credit arm, GSO Capital Partners, oversees $70 billion, compared with Carlyle’s $17.6 billion in credit assets.

Blackstone Giant

Stephen Schwarzman, the 67-year-old billionaire head of Blackstone who expanded assets to $284 billion, isn’t the only one expanding his firm. Leon Black, 63, has spent the past decade growing the debt group at Apollo Global Management LLC (APO), Carlyle’s next biggest rival, to be twice the size of its private equity unit. And Henry Kravis, 70, is modeling KKR & Co. (KKR) after Warren Buffett’s Berkshire Hathaway Inc., plowing more of the firm’s own money into investments ranging from buyouts to lending.
In the 12 months ended Sept. 30, 85 percent of Carlyle’s economic net income, a measure of profit that includes unrealized gains, came from private equity. That compared with 32 percent of economic income at New York-based Blackstone and 48 percent of earnings at Apollo. At KKR, 79 percent of profit was generated in private market investments, which include private equity, energy, infrastructure and real estate.

Buyout Success

The firms have been rewarded by shareholders for diversifying. Blackstone has returned 194 percent including reinvested dividends since May 2, 2012, when Carlyle’s stock began trading. New York-based Apollo has generated 154 percent and KKR, also based in New York, has produced 99 percent. Carlyle has returned 42 percent.
Carlyle’s continued reliance on buyouts in part reflects its success in private equity. The business has produced 19 percent annual returns after fees since 1994, among the best in the industry. Blackstone’s private equity funds have returned 16 percent, and the industry average over 25 years is about 14 percent, according to research firm Cambridge Associates LLC.
“Carlyle’s intellectual capital is housed in the private equity business, which is world-class,” said Chris Kotowski, an analyst at Oppenheimer & Co. “That said, Blackstone is legitimately more diversified. I’d say Blackstone got a jump on a strategy to innovate beyond buyouts.”
That didn’t have to be the case. About a decade after Rubenstein, Bill Conway and Dan D’Aniello founded Carlyle in 1987 with $5 million, they expanded into venture capital and U.S. real estate. A year later they created a high-yield group, opened an office in Asia and started a firm to invest in troubled companies.

Poor Timing

Blackstone, founded by Schwarzman and Peter G. Peterson in 1985 as a buyout and advisory firm with a $400,000 balance sheet, was first to diversify, with a unit allocating money to hedge funds in 1990 and a real estate group two years later. They didn’t start a debt investment operation until 1999.
While Carlyle has grown to manage 129 funds and 141 fund-of-funds vehicles from 40 offices, it’s often shown poor timing or been unable to retain new hires.
In 2001, the firm hired Afsaneh Beschloss, the World Bank’s chief investment officer, to build Carlyle Asset Management. Two years later, the 15-person group, which invested in hedge funds, left. In 2004, the head of Carlyle’s turnaround business, B. Edward Ewing, also departed with another 15 employees to start his own firm.
“David Rubenstein’s mantra is find the opportunities and keep working them until you make them work,” spokesman Christopher Ullman said at the time.

Losing Money

Rubenstein stuck to his guns. In 2007, just as the U.S. housing market was about to crack, Carlyle gave hedge funds another go with Blue Wave. Within 16 months, the group was a casualty of the unfolding turmoil and shut down. Carlyle Capital Corp., a publicly traded credit fund, also collapsed in 2008 after defaulting on $16.6 billion in debt. While many investment firms, including KKR’s asset-management unit, also had losses, the setbacks stunted Carlyle’s expansion.
Carlyle’s biggest shortfall relative to Blackstone has been in real estate. Carlyle started its first property fund in 1997 with $470 million and an initial focus on North American investments. After the firm expanded to include a European vehicle in 2001 and an Asian pool in 2005, investments outside of the U.S. began to struggle.
Carlyle Europe Real Estate Partners II, raised in 2005 with 763 million euros ($939 million), has lost 80 percent of its value. Its successor fund, a 2.2 billion-euro vehicle that invested in the ill-fated Tunbridge Wells site, has produced a negative 5 percent annual return after fees as of Sept. 30.

Europe Woes

The funds were mainly casualties of timing. Much of the money was invested in development projects in Western Europe, a person with knowledge of the deals said, with a thesis that the economy was bottoming. The recession persisted longer than Carlyle expected and the funds came under pressure because several holdings in countries such as Italy, Portugal and the U.K. were still under development and not producing revenue, said the person, who requested anonymity to discuss private investments.
With holdings struggling, the European group’s co-heads, Robert Hodges and Eric Sasson, left in 2013 after 12 years at the firm. Carlyle turned to Adam Metz, a real estate veteran and adviser to TPG Capital, to revive investments outside the U.S.

Potential Acquisition

Carlyle has also discussed a potential acquisition of a European real estate team with at least two investment firms, said another person, who requested anonymity because the conversations are private.
Randall Whitestone, a spokesman for Carlyle, declined to comment on the European property group.
As Carlyle’s real estate fortunes soured, its biggest competitor set records.
Blackstone began growing a property unit in the early 1990s, a time when an analyst named Jonathan Gray joined the firm from the University of Pennsylvania. Gray, 44, now leads the group, which is preparing to raise its eighth global real estate fund, following an industry-record $13.3 billion vehicle that closed in 2012.
“They have a massive, massive advantage in real estate,” Morningstar’s Ellis said of Blackstone. “That makes it much easier for them to do truly different types of deals that smaller-bucket funds just can’t do.”

New Urgency

Carlyle’s efforts to build its non-buyout businesses took on added urgency in the past five years, according to the people, as clients increasingly asked for more offerings. It’s also been driven by the firm’s 2012 IPO, as stockholders value a stable, diverse stream of fee-related earnings more than payouts produced by leveraged buyouts in unpredictable cycles.
“Part of the new paradigm, especially over the last five years, is that clients are looking to do more with fewer relationships,” Glenn Youngkin, Carlyle’s co-president, said in an interview. “The largest firms, including ourselves, have extended our product lines and have been able to receive commitments across them.”
Carlyle’s recent expansion has primarily centered on energy -- now its fastest-growing business -- as well as credit and funds-of-funds. Since 2010, the firm has added $95 billion in assets through new strategies, according to a presentation Youngkin gave last month in New York.
Expansion comes with costs, and spending on fundraising and hiring has hurt Carlyle’s margins. This may persist longer than the initial expenses, according to Meghan Neenan, an analyst at Fitch Ratings.

Outside Hires

“Carlyle continues to report below-average margins given its higher operating expense base,” Neenan said. “It has more people, offices and funds than its peers.”
Acquisitions since 2010 have included hedge fund firms Claren Road and Emerging Sovereign Group, commodities firm Vermillion Asset Management, two funds-of-funds groups and a stake in NGP Energy Capital Management, which became the nucleus of Carlyle’s energy platform after ending a partnership with Riverstone Holdings LLC in 2011.
To set the strategy into motion, Carlyle relied on big hires from the outside, a contrast to Blackstone’s development of internal dealmakers to lead its largest business units.
In 2010, Carlyle hired Morgan Stanley’s Mitch Petrick to expand the Global Market Strategies unit beyond its role as issuer of collateralized loan obligations. The firm last year organized its funds-of-funds under one roof and named Morgan Stanley’s Jacques Chappuis head of the business, called Solutions.

Youngkin, Cavanagh

“If you stand still, if you’re not thinking about new things to offer investors to give them an edge, then somebody else is going to do it,” said Youngkin, who joined Carlyle in 1995. “This is the competitive landscape we all live in. If you’re not running, you’re standing still.”
The highest-profile addition came this year, when Carlyle’s founders asked Mike Cavanagh, a top lieutenant to JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon, to be co-president with Youngkin. Cavanagh, 48, has been tasked with developing new business alongside Youngkin, a 48-year-old father of four and former college basketball star.
“Cavanagh’s success will be measured based on the firm’s ability to grow in new directions,” said Brennan Hawken, an analyst at UBS Group AG. “Cavanagh’s experience and connections across the financial services waterfront should be a significant advantage.”

Higher Earnings

The strategy has started propelling earnings higher, with Global Markets Strategies and Solutions now claiming $70 billion in assets producing recurring management fees, or half of the total.
The firm is also experiencing some familiar hurdles.
When Carlyle bought a 55 percent stake in Claren Road four years ago, the firm oversaw $4.5 billion. That grew to more than $8.5 billion this year as it delivered steady returns. Then, in the first half of October, investments in Fannie Mae (FNMA) and Freddie Mac securities, as well as investments in energy, plunged. Claren Road’s clients have asked to withdraw $1.9 billion, said two people familiar with the redemption requests, who requested anonymity because the information isn’t public.
Vermillion has also struggled. Assets fell to $1.4 billion as of July from $2.2 billion in October 2012, when Carlyle bought a 55 percent stake, according to a copy of an investor letter obtained by Bloomberg News. Viridian, its main fund, slid 15 percent this year through September.

‘Sluggish Performance’

“In the near term, we see moderating private equity exit activity and sluggish performance in the Global Market Strategies and Solutions businesses keeping us sidelined on Carlyle’s shares,” said Marc Irizarry, an analyst at Goldman Sachs Group Inc.
Carlyle is also facing pressure in its growing energy business after oil prices tumbled to the lowest in five years, a result of slower growth in global demand and surging production in North America. Oil and gas producers in NGP’s portfolio, including Memorial Production Partners LP, Rice Energy Inc. (RICE) and RSP Permian Inc. (RSPP), have all declined since June, as have energy producers owned by Apollo and KKR.
“We certainly anticipate on the upstream side of oil and gas -- equipment and oil services -- that there will be some softness,” Brian Bernasek, who focuses on industrial and transportation investments for Carlyle’s U.S. buyout fund, said on a conference call with investors, a recording of which was published yesterday on the firm’s website. “There are implications all around the board.”

Growth Phase

Kotowski of Oppenheimer said he’s optimistic about Carlyle’s chances of moving into a new phase of growth because its partners are putting their own money into new funds and alternative-asset firms are increasingly replacing institutions such as banks in areas from lending to underwriting stocks and bonds. Carlyle has also positioned leaders to take over from the founders, Kotowski said.
Rubenstein, who is writing a book about his life called “Sprinting to the Finish Line,” has said he doesn’t plan to retire. D’Aniello, 68, and Conway, 65, have said the same.
In Tunbridge Wells, the residents have more immediate concerns. While Carlyle paid about 14 million pounds ($22 million) for the movie-theater site in the center of town, the city now estimates its value at half that amount, said Chapelard, the council member. The stalled development remains a work in progress for Carlyle, similar to its larger expansion efforts.
“The walls are 8-feet-high and you can’t see anything past them,” Chapelard said of the site, which was close to attracting a supermarket before negotiations with Carlyle fell apart. “Would it be better if Carlyle were to get rid of it and move on? Maybe. Right now it’s a toxic asset.”