David Rubenstein's Interview with WSJ

'How Could Buyers Resist Taking Those Terms?'
Carlyle Founder on Cheap Debt, Credit Crunch and the New Buyout Landscape
By HENNY SENDER
August 25, 2007

The buyout boom that saw a handful of investment firms snap up ever larger public companies seems to be fizzling as the debt market used to fuel these takeovers seizes up.

Carlyle Group's David Rubenstein says private equity is no longer too 'private.'

David Rubenstein, who co-founded Carlyle Group in 1987, has seen his share of deal cycles. With deals harder to finance, private-equity firms will have to live with their companies for longer now. In an interview with The Wall Street Journal, Mr. Rubenstein struck an optimistic tone despite the challenges facing the industry.

WSJ: How serious a setback for private equity is the turmoil in the debt markets?

Mr. Rubenstein: Cheap debt fooled people. Because financing was so cheap relatively in the past few years, many people think all we do is buy companies with cheap debt, wait a short while and then sell them. But most private-equity firms are about hard work, not just financial engineering.

In the near future, we won't see buyout deals of the size we saw 60 days ago due to the debt-market uncertainty. And available debt will be more expensive. The sellers will have to adjust to lower prices. This is not a calamity. What we have now is just a temporary imbalance of credit. When the debt market returns to equilibrium, a lot of companies will be available and there will be clear bargains. Private-equity firms will continue to buy companies with a bit more expensive debt but also a bit more pricing discipline.

WSJ: But isn't it true that in recent years, financial engineering was a big part of what drove deals? Your partner Bill Conway himself described cheap debt as the "rocket fuel" of this cycle.

Mr. Rubenstein: We got labeled with the financial engineering label because in the early days, the deals were done with only 5% to 7% equity and the companies were highly levered. Today, the average equity is between 32% and 35%. Deals aren't as heavily engineered or have as levered structures.

WSJ: How dramatic is the change in the debt market today?

Mr. Rubenstein: The banks found that providing financing to private-equity firms was very attractive and profitable, so the banks made it easier and easier to accept their financing. They offered us relatively low interest loans. They later said they didn't need "mac" clauses (which give the banks an out if circumstances change). Then they offered us covenant-lite loans and pik toggles (which give borrowers much more flexibility). And then they offered to bridge some of our equity. How could buyers resist taking those terms, knowing the result would be better returns for their investors.

And because of this favorable financing, we could pay a bit more for companies. For the last five years, there was almost no penalty for overpaying by 5-10%, for we were emboldened by these attractive loan features. Now these things are probably a relic of the past, or at least for the next few years. We won't see many covenant-lite or pik toggles. That will no doubt mean more discipline in assessing deals. But private equity can do quite well in this changed environment, as it has in previous times of retrenchment. Prices will return to more normal levels. And that will be quite helpful to the industry.

WSJ: Can you describe the dialogue between the banks and the private-equity firms now?

Mr. Rubenstein: Now there is a Kabuki dance going on among the buyer, the seller and the lenders. Everyone is assessing what to do. Some deals announced in the past 60 days will close as negotiated and some will be renegotiated and some will never close.
Our attitude has been we live with the banks every day. They help us get our deals done. We are not in the business of saying we win and you lose. You create more animosity and you don't live to play the next day. Our attitude is we want everyone to make a profit and we are willing to have discussions to get deals done on sensible terms. You make more friends when you help when there are problems.

WSJ: Are there other sources of capital to tap?

Mr. Rubenstein: Five years ago, a lot of buyers, including [managers of collateralized loan obligations] and hedge funds realized the debt financing buyouts is a good investment. They liked the higher fees and the higher interest rates on [leveraged-buyout] debt. As a result, a great deal of debt money came into the market so there were many sources of capital for debt deals. But at some point, you will see pension funds and sovereign wealth funds, especially those with fixed-income investment departments, come in as sources of debt. It won't happen overnight or dramatically but it will happen.

WSJ: How will private-equity firms evolve in coming years?

Mr. Rubenstein: Private equity is in the process of becoming bifurcated. There are eight to 10 brand names and thousands of other private-equity firms. Most make investments in small firms and do so profitably, but they don't get publicity and they should still be able to raise money. However, the better known private-equity firms will benefit from a flight to quality, for many investors will want to invest in brand-name firms, assuming their returns stay consistent.

You will also see more mergers and acquisitions, especially after some of the private equity go public and have currencies in the form of stock. When investment banks went public, they bought niche firms. Large private-equity firms might do the same, especially when expanding abroad.

WSJ: How is Carlyle itself changing?
Mr. Rubenstein: We are a deeper, more global organization today. We have 425 investment professionals, operating in all continents and in many different investment disciplines. We can clearly add more value than we did in our early years. We also have dozens of individuals who have been CEOs and CFOs at other companies, and they can now add real value through their experience to our portfolio companies. Twenty years ago, we couldn't say that. If the economy slows, our companies and all companies will feel the effects. It will delay returns and slow down exits. We are not magicians. But we are not as vulnerable to downturns as in earlier years.

WSJ: How do you feel about the limelight into which private-equity firms have been thrust?

Mr. Rubenstein: In the current environment, private equity is not so private. We need to deal with Congress, regulators, environmental groups, trade unions, the media and community organizations. It is a complicated shift. Now we recognize that we must explain to other constituencies -- and to the public -- how we add value and why we are productive forces in the national economy and contributors to local communities.

WSJ: Was Blackstone Group's going public a mistake in that it brought attention to the industry and its big profits? What are Carlyle's plans to go public?

Mr. Rubenstein: The private-equity industry was attracting attention for its considerable success and growth in size long before that offering. If we feel it is necessary to be public to be competitive and to maintain our track record, we would look at it. But we are comfortable now with our posture of the last 20 years -- privately owned.

WSJ: What's your prognosis on the Grassley-Baucus bid to raise taxes on private-equity firms?

Mr. Rubenstein: Treating private equity differently will likely bring back the Law of Unintended Consequences -- the same law which gave us the [alternative minimum tax], an earlier effort to produce a tax "fix" on a few. It now covers 50 million Americans.