Private Equity

An interview with David Rubenstein, Co-Founder of The Carlyle Group.

By Michael Connor

The deals have been getting larger and more high-profile: Spanish language broadcaster Univision ($12.3 billion), casino operator Harrah’s ($17.1 billion), hospital operator HCA ($21.2 billion) and commercial building owner Equity Office Properties ($23 billion). And these figures do not include billions of dollars in debt assumed by the buyers. Finance insiders say more and bigger transactions are coming, with a $50 billion deal possible soon and a $100 billion deal maybe only a matter of time.

What distinguishes these sales from routine mergers and acquisitions is that they involve publicly held companies being bought—and taken private—by private equity firms. With global markets awash in capital, and interest rates low, private equity firms executed $664 billion in buyouts in 2006, according to Thomson Financial. That number was nearly twice as much as the year before and accounted for approximately 18 percent of global merger and acquisition volume.

Private equity firms raise money from large institutional investors—many of them pension funds—to buy companies that they think are undervalued, with the acquired company frequently taking on substantial debt to help finance the deal. Private equity firms work with existing management, or bring in new management, to operate the companies. Their goal is to eventually cash out through a stock offering or outright sale.

As private equity booms, it confronts issues of corporate responsibility. Corporate governance—a key measure of accountability at publicly held companies—becomes far less transparent when a business is privately owned. In fact, many think the rush to go private reflects a corporate and executive weariness with the reporting demands of the Sarbanes-Oxley Act of 2002. While private equity firms argue that they “build value” with a longer-term business perspective, free from quarter-to-quarter earnings pressures, critics accuse them of sometimes “stripping” acquired companies of assets before “flipping” them. Shareholder activists who organize around social and environmental issues lose a powerful weapon when there are no publicly held shares.

One of the largest private equity firms in the world is The Carlyle Group, based in Washington, D.C. Founded in 1987, the firm now manages more than $46 billion from 27 offices around the world. Originally known as an acquirer of defense companies, last year Carlyle joined with other private equity firms in successful bids for information company VNU, energy giant Kinder Morgan and Freescale Semiconductor, among other deals.

Carlyle executives bristle at frequent media descriptions of the firm as “secretive” (a Google search combining the words “Carlyle” and “secretive” returns more than 65,000 results) and, along with other private equity firms, have recently stepped up efforts to make the industry’s case.

David Rubenstein, one of three co-founders of The Carlyle Group, is a lawyer by training. He spoke recently with CRO Editor Michael Connor about governance, corporate social responsibility, and the evolving role of private equity.

Michael Connor: 2006 was a banner year for private equity. What role do you think the private equity industry plays in the American economy and, on a broader scale, the global economy?

David Rubenstein: Well, clearly in 2006, private equity played an increasingly important role in the U.S. economy. In fact, in my view, it probably became the face of the American economy. In 2006, people tended to probably read more about Carlyle, Blackstone, Texas Pacific Group and KKR than they did about General Motors, Ford or IBM. In the old days, the latter companies would have gotten more attention; today, private equity companies tend to get the attention. I think it’s been a good thing for the U.S. economy, because as private equity has been in the ascendancy, I think it’s had the effect of making the U.S. economy more efficient, more productive, in focusing people on things like shareholder value and also greater efficiency.

It’s not yet the case that private equity is as dominant in Europe or in Asia as it is in the United States, though increasingly it’s very important in Europe. Asia is a little bit behind Europe and the United States. I think increasingly people in Europe and Asia, as well as Latin America, are beginning to say that perhaps the techniques of private equity can add value to their economy. I think they’re increasingly welcoming this type of investment technique.

Why private equity? What does a private equity firm do that can’t be done by a typical publicly held company?

Well it’s not as if the private equity people are geniuses and the people running public companies are not similarly intelligent. Private equity, though, tends to operate in private and, as a result, private equity firms do not have to account for their company’s performance on a quarterly basis, or on a monthly basis, or on a daily basis, or on an hourly basis. Very often, public companies are subject to these quarterly, monthly, daily and hourly pressures and, as a result, the private equity firms can focus more on longer term value, worrying about not short-term profits but longer term value creation—and that is something that the public companies, unfortunately in our system, do not have the ability to do as much as they used to be able to do. In other words, today the public companies are under such pressure from their shareholders, from their stock analysts, from their board members, from their employees and others, to get the stock price up every day, that it’s hard to worry about longer term value creation. Private equity has the advantage of being able to do that.

The private equity industry has gotten a lot more criticism lately. BusinessWeek suggested that instead of being “turn around pros,” private equity firms are often more like “fast buck artists” who take over a public company with an attitude of, “Buy it, strip it, then flip it”. Carlyle’s participation in the Hertz buyout is cited as an example. How do you react to that?

Well first, I think that that type of criticism is both unfair and not really that knowledgeable. On the whole, private equity firms think that it takes three to five years, or four to six years, or maybe even longer, to effectuate the value creation that you’re trying to bring about and therefore when people see that in some cases, a company like Hertz was taken public relatively quickly after it was purchased, you have to actually look at what happened. In that case, yes, Carlyle with two other firms purchased Hertz from Ford, we made enormous changes in the company, we created a lot of value, and the economy was good and the travel industry was good. So there was a lot of value created in just a year.

However, when we took that company public, we sold a relatively small percentage of the company and the owners of the company who bought it originally still own about 80 percent of the company. So it’s not fair to say that we have bought it, sold it, stripped it and just milked it for profits because, in truth, we own 80 percent of it and we expect to own a large percentage of it for quite some time.

In addition, I think it should be noted that many people do not distinguish between private equity funds and hedge funds. While hedge funds have a lot of virtue to them and we have a hedge fund as well, they tend to be the organizations that are trading more and that are flipping assets more readily or at least shares of assets.

Final point to be made is this, when it is said that Carlyle made a great deal of money or Blackstone made a great deal of money and we flipped an asset quickly or we made outside profits, it has to be recognized who is actually making those profits. Carlyle is really a representative of the people who we invest on behalf of and those people tend to be public pension funds. Large private equity firms in the United States and around the world get most of their money from public pension funds. So in our case, approximately 80 percent of the profits that we earn are going to our investors and probably 80 percent of those profits are going to public pension funds, which means the people who work in state governments, for example. So policemen, or firemen, or teachers, or state government employees—they are the beneficiaries of much of what we do and we think that that’s a real important thing for our industry to emphasize, that we are working on behalf of many people who would not otherwise be able to realize these kind of profits if they were just investing their money on their own.

Debt levels have mushroomed at a number of companies acquired in recent private equity deals. Some analysts believe that if interest rates rise or the economy turns sour, these businesses may be hard pressed to manage their debt without major restructuring and major substantial layoffs. How concerned are you about debt levels?

Well, of course the leveraged buyout is, by definition, a vehicle where leverage is employed and leverage does help make the profits greater for the investors if the transaction works out. The key is to make sure that the transaction works out and you do not have too much debt. In the early days of the buyout industry I think the buyout professionals probably weren’t as experienced in what is the acceptable level of debt, and when the economy went down, in some cases, many buyouts did not work.

Today, the situation is completely different. First, the amount of debt being put on these companies is actually less than before. In the late 80s, an average of about 7 percent equity was put into a buyout of about $200 million or more in size. Today, the average is between 32 percent and 35 percent equity. So there’s much more equity underpinning these deals. Second, the debt that is provided today tends to be debt that is less expensive than debt of 10 or 15 years ago and it tends to have covenants that are much more difficult to violate and, as a result, if the economy should slow down, these deals would not likely go under or likely have covenant problems as they might have 10 or 15 years ago.

A third factor is that the buyout organizations today are large organizations. In our case, we have approximately 800 people. I think KKR, Blackstone and Texas Pacific Group are probably similarly sized in many ways and, as a result, we have an enormous number of investment professionals. So it’s not a question of just buying a company hoping that leverage works out well and you sell it in a few years. Now we are, from day one, trying to add value and I think, therefore, if something were to go wrong, we have the people in our organizations that can really try to make these companies work even in a bad economic environment.

By and large, I think these deals are much safer than they were 10 or 15 years ago and I don’t think that the concerns that some of the critics have are really that well-founded.

Publicly held companies are heavily regulated and require significant disclosure, and that’s not true for private equity firms or the portfolio companies they acquire. How do you reassure those who might be concerned about less transparency in corporate governance and reduced financial disclosure?

A couple of points: First, while we are technically a private company, many of the things that we do are very public. Our investors, as I mentioned, are public pension funds and so what they are invested in and what their investments are doing is very often available through their own websites or through the information they distribute to their pensioners.

Secondly, very often a private equity firm has public debt even though it might be a privately owned company. The public debt requirements are such that we make filings with the SEC.

Third, many of the deals that are done today are so large and have so many people following them that I think they really are quite transparent in what is happening. I don’t think there are a lot of secrets about how these companies are operating.

Another point is that private equity people are very concerned about the appropriate alignment of interests. We believe that good corporate governance will make better companies and so we try very hard to align interests throughout our economic structure when we buy a company to make sure that the managers and the employees and the investors are properly aligned. Once we take these companies public, if we do, we try to keep these same types of good corporate governance practices.

A lot of the corporate governance changes that have come about, particularly at the board level in recent years, have resulted from shareholder activism, pressure brought by individual institutional investors. When companies go private, what happens to that dynamic of shareholder pressure?

Shareholder pressure is often designed to get the highest price in a relatively short term. So very often when you have activists, they are seeking very short-term profits and they’d like the stock price to get higher. In the private setting, of course, we all want the value to be created and to be higher, but we have the luxury of waiting months or years to effectuate this value.

I don’t think that the CEO who’s running a company that’s private feels, all of a sudden, he can take a day at the beach and not really worry about creating value. I think these CEOs are under a reasonable amount of pressure to perform, but they don’t have to worry about the kind of hourly or daily pressure that you might have with a public company. But still, in time, there will be a need to show value creation and I think that the CEOs of these private companies recognize that.

In the field of corporate social responsibility, advocates say a successful business needs to be accountable to multiple stakeholders including employees, the communities in which a company operates—as well as investors. The argument is that a successful business benefits from addressing financial, social and environmental impacts. What’s your view of that?

I think that’s accurate. There was, I think, in the 1980s, a great deal of pressure on companies to worry only about their shareholders and the price of their stock. The law of the United States very often has been that companies that are public need to sell to the highest offerer—and maybe in many cases that’s not a really attractive thing.

In some cases, the best offer for a company will not necessarily be the one that has the highest price. It would probably be a good thing if our laws were to be changed a bit to allow boards of directors to consider things like whether somebody has been a responsible owner in the past, whether they’ve actually created value in the past, whether they have had good labor relations in the past, whether they’ve been good in community support and charitable endeavors in the past. Unfortunately our laws now, particularly the laws of Delaware, really require that a corporation, a public company, when it’s up for sale almost always is going to have to consider the higher price that’s being offered and the other factors that I mentioned are not often being considered.

I think it would be good and better—for our country and for corporate governance—if actually boards of directors could consider more than price. Now, technically, they might be able to, but the reality is that another dollar in share price is almost certainly going to win over another buyer who might be at a lower price but has a track record that might be much more attractive as an operator of a company.

The private equity industry recently announced a formation of a trade association, The Private Equity Council, based in Washington, D.C. What prompted that?

I think it was a recognition by people in the private equity industry that we have done a less-than-desirable job of explaining to people who we are, what we do and who we represent. Many people think we’re mysterious financiers, that we really don’t care about good corporate governance, that we don’t care about good labor relations, we don’t care about good community relations, and all we care about is flipping a company and making a quick profit. The truth is just the opposite. So I think we need to do a better job of explaining what we do, who we are, and who we represent. I think the Private Equity Council will not only be able to let members of Congress and the administration, but also foreign governments, know what it is that private equity is doing and what the benefits of private equity can bring to an economy.

What does the future look like? Are we likely to see more private equity deals in the next 12 months, bigger private equity deals in the next 12 months?

I think there are several things for the future. One, I think private equity will increasingly be recognized as not being an alternative investment mechanism but a mainstream investment mechanism. In other words, one that everyone who has an investment portfolio should participate in. Secondly, I think you’ll see deals getting a bit larger than they have been, though they are quite large now. Third, I think you’ll see much more money being invested in emerging market private equity opportunities, because I think, increasingly, people see emerging market opportunities being quite attractive. Fourth, I think you’ll see many more opportunities, or many more situations, where hedge funds will be competing with private equity firms. In some cases, I think you’ll see hedge funds and private equity firms working together to buy companies and to create value.
On the whole, I would say the private equity industry’s future is probably stronger in the future than it has been in the past. In other words, we’ve had a very good several years in private equity, but I think the best is really ahead of us.

Note: This transcript was edited for style and clarity.

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