Dr. P.V. Viswanath

pviswanath@pace.edu

Carlyle: The Best Deal in Private Equity

Barron's, vol. 97, issue 37, Sep 11, 2017

CARLYLE GROUP IS ONE OF THE WORLD'S largest private-equity managers, with $170 billion in assets under management spread over six continents. For many years the Washington, D.C.-based firm was as well known for the company it kept as for the companies it bought. Carlyle's marquee roster of partners and advisors has included President George H.W. Bush and RJR Nabisco and IBM chief Lou Gerstner. It has owned household corporate names like Hertz Global and Dunkin' Brands. The firm's global connections have made it the target of antiglobalism protests and the subject of a controversial Michael Moore film, Fahrenheit 9/11.

It has had a much lower profile with investors: Carlyle's units (ticker: CG) have fallen 24% over the past five years, a period of record stock returns. Investors generally are wary of private-equity firms because of their complicated long-term partnership structure, the opaque nature of their investments, the illiquidity of their holdings, and volatile quarterly earnings that ebb and flow with the mergers-andacquisitions and initial-public-offering markets. Worries about whether huge privateequity funds can find good opportunities have also undercut the stocks.

In Carlyle's case, these problems have been compounded by an ill-starred move into hedge funds, where, among other issues, one fund lost $400 million as a result of an investment in an oil refinery that allegedly was a victim of fraud in Morocco. That dragged on earnings, including $235 million in hedge fund charges since 2015.

The troubles have leftCarlyle shares looking extremely cheap. They trade at 7.2 times estimated 2017 earnings, a big discount to peers like Blackstone Group (BX), which trades at 11 times earnings (see nearby table). Only KKR (KKR) has a comparably low price/earnings ratio of seven times. The 12-month yield on the units is 5.8%.

The cheap price doesn't do justice to Carlyle's prospects, insists President and Chief Operating Officer Glenn Youngkin. "We buy companies, not stocks and bonds," he says. "We believe the private-equity approach has the best chance of delivering strong returns in times of high stock-market valuations. We have a better chance of creating value when we drive the change, rather than sitting back and hoping a management team does its job."

In fact, Carlyle has gotten out of the hedge fund business, and is in the midst of an ambitious $100 billion fund-raising effort that could boost fee-related earnings for the next few years. Morgan Stanley analyst Michael J. Cyprys estimates that Carlyle's existing investments are worth $55 billion today and could produce cash of about $19.25 a share, nearly equaling the recent price of $20.25. It still has $35 billion to put to work in new deals. His most bullish scenario puts the units at $40, almost twice last week's price.

Now in its 30th year, the firm has broadened its original concentration on heavily regulated industries such as telecom, aerospace, and defense to include real estate, infrastructure, and energy properties. It owns everything from common stock to distressed debt. Hedge funds aside, Carlyle has posted reasonably strong long-term returns: Its flagship Carlyle Partners V fund, with assets of $13 billion, is now worth 2.1 times invested capital, giving it an annual net internal rate of return of 14%.

While buying or selling well-known companies brings attention, much of Carlyle's focus is on the nitty-gritty of acquiring lesser lights or misunderstood units of big companies, installing new management, and pushing new strategies. One example, Axalta Coating Systems (AXTA), is a former unit of DuPont that produces autopaint coatings. Carlyle assembled a new executive team, accelerated a plan to expand in emerging markets, simplified the company's structure, and took it public. By one estimate, Carlyle generated a $4.5 billion profit on the company's rejuvenation. Berkshire Hathaway (BRK.A) later bought a nearly 10% stake in Axalta.

Cyprys estimates that Carlyle's feerelated earnings will grow to $261 million by 2019, up from $39 million in 2017. This growth, plus margin expansion, will be a key catalyst, writes the Morgan Stanley analyst. Carlyle's new funds are bigger on average than the ones they're replacing, potentially generating more fees.

Wall Street analysts expect Carlyle to post earnings of $941 million, or $2.81 per unit, on revenue of $3 billion this year, up sharply from adjusted net income of $249 million on almost $2 billion in revenue in 2016, in part because of the hedge fund divestitures and liabilities. Next year, Carlyle should post earnings of $850 million, or $2.51 a unit, on revenue of $2.9 billion, and $958 million, or $2.84 a unit, on estimated revenue of $3 billion in 2019.

Right now, Youngkin likes health care and energy. He sees "great opportunities" in the hard-hit energy sector, where Carlyle has partnerships with Houston-based Hilcorp Energy-one of the country's largest privately owned oil-and-gas explorers. It has also made two recent health-care deals, purchasing Albany Molecular Research and privately held prescription manager WellDyneRx.

There are legitimate worries about how much longer private equity-which at yearend had $4.6 trillion in assets versus $707 billion in 2000, according to data provider Preqin-can deliver top returns. But today's firms have advantages because banks are more heavily regulated. Carlyle, for instance, has launched a publicly traded business-development company that works with deep-pocketed partners to offer secured loans to medium-size businesses.

Bill Miller IV, portfolio manager of the Miller Income fund (LMCLX), is a Carlyle shareholder who likes to invest with the well-heeled. The son of the famed value investor says he loves "investing alongside billionaire capitalists willing to tie up their liquidity in the stock itself. Private equity offers the best value of any of the financial-service offerings." And Carlyle offers the group's best value.

The Nordstrom family has suspended efforts to take Nordstrom Inc. private after struggling to raise enough financing for the leveraged buyout, in the latest sign of how much investors have soured on the retail industry.

The founding family, including the co-presidents, Blake, Erik and Peter Nordstrom, notified the special committee of the board that it would resume its efforts to explore a go-private deal after the holiday shopping season.

The department-store operator disclosed in June that the family, which owns nearly one-third of the shares and runs the business, was exploring the possibility of going private . The family subsequently teamed with the private-equity firm Leonard Green & Partners in what could have been a $10 billion deal. But the transaction faltered in recent weeks as the partners had trouble raising enough debt at reasonable rates, people familiar with the situation said.

Nordstrom declined to make its executives available for comment.

The deal's unraveling shows that even a chain like Nordstrom--which gets more than a quarter of its sales online and has a growing off-price Nordstrom Rack business--is struggling to attract investors, while lending to highly indebted companies outside the retail sector remains robust . The retail industry is suffering from a record number of bankruptcies and chains are on track to close more stores in 2017 than during the recession amid weak sales and profits.

Nordstrom, with its smaller footprint and stores mainly located in high-end malls, is considered a bright spot among department stores.

The company's investment-grade debt rating is higher than that of Macy's Inc., Kohl's Corp., J.C. Penney Co. and numerous other retailers tracked by Fitch Ratings.

But it isn't immune to the changes reshaping the industry. Net profit for its most recent fiscal year fell 35% to $354 million on asset-impairment charges and higher technology and fulfillment costs. Sales rose nearly 3% to $14.5 billion.

Bankers were concerned they wouldn't be able to sell the buyout debt before the holiday shopping season and would have to hold it until next year, exposing them to the risk that Nordstrom's business, or the broader market, would deteriorate in the interim, the people said.

"There is nothing that would make anyone put leverage on a specialty apparel retailer or department store right now," said Paul Lejuez, a Citi analyst. "These businesses have been under a lot of pressure--and that's with strong consumer spending."

The debt markets have been far from closed to retail companies in recent months: Retailers issued $5.3 billion of junk-rated bonds through the first three quarters of 2017, up from $4.1 billion over the same period last year, according to LCD, a unit of S&P Global Market Intelligence. But the chapter 11 bankruptcy filing in September of Toys "R" Us Inc., which was felled by $5 billion in debt from a 2005 leveraged buyout , served as a reminder to debt investors of the vulnerability of retailers.

Conditions for retailers have worsened in recent weeks, and the size and timing of the Nordstrom deal made it unattractive for lenders. Bonds issued at par by PetSmart Inc. in May recently traded at 80 cents on the dollar and have fallen this month as low as 78.625 cents, according to MarketAxess.

As of early October, the Nordstrom family was scrambling to save the deal , possibly by adding more equity, though it was unclear where that equity would come from, the people said. One problem: additional equity would dilute the family's stake, which stands at roughly 31%.

If Nordstrom has a good holiday season, it could find it easier to raise debt, but the price of its equity could also go up, changing the calculus for potential partners. A bad season could put a deal even more out of reach.

Analysts are expecting department stores to report another round of disappointing quarterly earnings in November given the unusually warm fall weather, which would be a gloomy harbinger for the important end-of-year selling season.

Nordstrom shares declined 5.3% Monday to $40.40, helping to drag down the shares of other department-store chains, including Macy's, Penney and Dillard's Inc.

Since the Toys "R" Us bankruptcy filing, bankers have been wary about adding debt to retailers--as siphoning cash flow to interest payments means the companies would have less money to spend on improving their businesses at a time when investing in new technologies and store upgrades is seen as a crucial way to stay competitive.

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