The Carlyle Group, one of the world’s largest private equity firms, has been in China for nearly a decade and has contributed to the fast growing private equity industry in China. Why is private equity so important in China now? What are its major challenges? China Knowledge at Wharton recently interviewed David Rubenstein, co-founder and managing director of the Carlyle Group, which was established in 1987 and today manages more than $75 billion in 33 offices around the world.
China Knowledge at Wharton: Many private equity firms have their eye on China. What are the opportunities and dangers there?
Rubenstein: We are very large investors in China. We operate in Shanghai and Beijing with very large teams, all of them PRC [People’s Republic of China] natives. I think the single most exciting place to invest over the next five or 10 years is China, both in buyouts and in venture capital. Venture capital is already booming. Every major venture capital firm has a China strategy. We have a very good firm in China to do these kinds of transactions. Buyouts are more complicated in China because the government doesn’t want large companies being sold to foreign interests. We own a lot of companies in China but we have minority stakes in those large companies. And they have done quite well.
It takes a long time to make the investments work. The rules are different from those in the United States. You have to understand that. You have to be very patient. I’ve told people, if you want to invest in China, which is a very good thing to do, be patient. Don’t expect profits overnight. People in China don’t wake up every morning and say, “How can I make American investors richer?” They don’t do that. They want to build the best economy they can in China.
For 15 of the last 18 centuries, China was the biggest economy in the world. It probably only went down in the 1700s. Now China is regaining its momentum as a dominant economy. If you want to invest, you have to understand the Chinese rules and Chinese terms. That’s why we have all the PRC natives investing there. Given its economic growth rate and its population, it will be the best place to invest in the next five to 10 years. It is not risk-free, but it is a very attractive place.
China Knowledge at Wharton: The Shanghai Composite Index has risen past 6,000 points. Is it anywhere close to a bubble?
Rubenstein: Well, you don’t know you are in a bubble until the bubble bursts. Let me put it this way: Markets fluctuate. They go up and down. But China has the largest population in the world, and it has had economic growth in the last nine or 10 years of at least 9%, 10% or 11%. If the bubble bursts, maybe the economy grows at 7% a year. That’s still greater than other economies in the world. China has had double-digit growth in the last 10 years, and if it is growing at 7%, it is not a calamity. I think the major difference between now and five or 10 years ago is that in countries like China, when the market went down previously, people ran away and said, “I’ve had enough of emerging markets, I’ve had enough of China, I’ve had enough of Thailand.” Now people say it is a buying opportunity. If the market went down, money would race in. China is too large an economy and people won’t say, “No, I’m not going here because it went down a little bit.”
China Knowledge at Wharton: What about real estate in China? Some economists say the low interest rate in the United States is a driving force in the huge amount of U.S. dollars flowing to China. What accounts for such huge amounts of capital in China’s real estate?
Rubenstein: China is trying to do in five, 10, 15 years what a normal economy does in 50 or 60 years, which is to build an infrastructure, housing, commercial office space for a very large population. So there is an enormous amount of opportunity for real estate and there is enormous need. I don’t think China is in a real estate bubble. There may be fluctuations from time to time. You have 1.3 billion people and some of them live in urban areas. China has 170 cities with more than one million people — very large urban areas. They need infrastructure, roads, bridges, airports, office buildings. There is so much demand. I don’t think there is a bubble that’s bursting anytime soon.
China Knowledge at Wharton: How are you structured in China?
Rubenstein: Carlyle has three funds operating in China: a real estate fund, a buyout fund and a growth-capital fund. Each has separate teams and all of them are headed by people who are PRC natives. They operate offices in Shanghai, Beijing and Hong Kong. Many investments now we think are very attractive. We recognize that some industries are more attractive than others, but you can’t be that picky because there are so many opportunities coming along and there is increasingly more competition. We got in early, but now everybody is coming to China. Still, it is a great place to invest because it is growing at such a large rate.
China Knowledge at Wharton: Talk about the issue of control of Chinese companies, of how difficult it is for private equity to gain a majority of shares or seats on a board.
Rubenstein: In the growth-capital businesses, Chinese entrepreneurs are happy to take capital from other people. They want to retain control but they are happy to give a board seat or some representation. I don’t think anybody in China is against having minority stakes owned by foreigners or outside investors. I think there is a concern in China about letting large [state-owned enterprises] or publicly traded companies be under control of foreigners. I think China recognizes that in order to attract capital, it has to adapt to international standards. On the other hand, I think foreign capital is willing to adapt to Chinese standards as well.
China Knowledge at Wharton: You are an entrepreneur and a smart investor. Do you think the skill sets required for the entrepreneur and investment professional are very different?
Rubenstein: You are going to succeed in life if you are smart, hardworking, willing to put in the hours to learn the business, if you know how to get along with people, if you are incented to make money, if you recognize that patience is a virtue. A lot of those qualities are true of a good investor, and also true for good entrepreneurs. Entrepreneurs are great risk takers. There are people who would like to bet their ideas would work. The entrepreneur style of Silicon Valley in the United States has inspired people around the world to start new companies and try to build something great. You see that a lot in China now.
The center of the venture capital world has shifted from Silicon Valley to China in the last few years or so. That’s a major change because Silicon Valley was dominating the venture capital world. It is still a major presence. But I think more and more exciting things are happening in China now. It is very interesting to watch.
China Knowledge at Wharton: You have described the private equity industry as the face of American capitalism. Why?
Rubenstein: Traditionally, when you talk about American capitalism, you talk about IBM, Ford, Microsoft, but now the names Blackstone, TPG, KKR, Carlyle are as well-known as the names of the companies that I have mentioned. Every day when you pick up the newspaper, you read in the business pages about what the private equity firms are doing, as opposed to what Ford is doing, because these private equity companies have become so large and own so many companies. That’s what I meant.
China Knowledge at Wharton: Many people have a certain perception of private equity. They think private equity will cause many listed companies to exit the stock markets, and as a result damage the capital market. They say private equity will lead to layoffs. How can private equity improve its public image?
Rubenstein: For most of private equity’s history, our focus has been convincing our investors that we get good returns that deserve their money. Now we recognize that we have to appeal to other people. We have constituencies in Congress and in the press, labor unions, environmental groups. We have to explain to them what we are doing. The truth is that we haven’t done a good job in explaining that. We have created jobs. We make money by building better companies, not by destroying value. If you look at job losses in the United States over the last five or 10 years, those are large public companies. You never hear of private equity. The biggest job losses were at Ford or General Motors or U.S. Steel. They weren’t in private equity firms. So it is an unfortunate perception that we are laying people off.
China Knowledge at Wharton: How do private equity firms make companies better?
Rubenstein: Private equity firms can operate in private settings. They don’t have to worry about quarterly numbers, increasing stock prices. They can make longer-term investments. They can make companies operate more efficiently. Studies have been done which show that private equity-operated firms increase employment, make companies more profitable. So I think it is unfair and unfortunate that our image isn’t as good as the reality. But in truth, if you have a five-year period of time that you can operate in the private setting, you can make companies much more valuable by doing things you are afraid to do and wouldn’t be incented to do in the public setting.
China Knowledge at Wharton: Currently, private equity firms pay 15% capital-gains tax on their carried interests. There is a debate on whether they should be taxed at a 35% ordinary-income-tax rate. If you were asked to testify before the Senate, how would you justify the lower rate?
Rubenstein: The reason that most countries, including the United States, distinguish between capital gains and ordinary income in terms of tax rates is that they try to incent people to build business and create jobs. That’s what you do when you invest capital.
What we are doing is creating jobs. We are investing capital. Most of the capital is the capital of our investors, and we invested alongside. What we do takes a great deal of risk. If we don’t succeed in our jobs, we don’t make any money and we will lose our own money that we have invested. So we have to convince members of Congress that, in fact, we do create jobs, and we take the capital risks with our money and other people’s money that deserve capital-money treatment.
Treating private equity with the carried interest of 15% — that’s the same thing that has been done in the oil and gas business, the venture-capital business and the real estate business for generations. So all we are doing is being treated in the same way as other businesses in the United States. We are not asking for favorable treatment. We are doing the same thing as other entrepreneurial industries are doing.
China Knowledge at Wharton: Some experts consider private equity to be one of the most expensive forms of financing. Why is that?
Rubenstein: Private equity is seeking to get a 25% to 30% rate of return. So it is much more expensive than the capital where publicly traded firms might seek a return of only 6% 7%. But why do people hate private equity capital? It’s not as if I go to people, hit them over the head with a hammer and force them to take my money. They consider that private equity people can bear risk, can add value, make the firm more efficient. That’s why the business operates. It operates very well because we are creating jobs, we are making a lot of money for investors. It is not operating because of government demanding or requiring people to take our money. I think we have done a very good job and get a good rate of return for our investors. In fact, if you have money to invest, probably the best thing you can legally do is to put it into a buyout fund. Because in the past five or 10 years, if you had put money into a buyout fund, you would have had a very high rate of return.
China Knowledge at Wharton: A few technical questions. Early-stage companies will go to private equity, but why do some late-stage companies need private equity?
Rubenstein: You say early and late stage, do you mean venture capital or buyout?
China Knowledge at Wharton: Venture capital.
Rubenstein: The phrase private equity is used differently in different parts of the world. In the United States, private equity really means two things: buyout and venture capital. In some parts of the world, the phrase private equity only means buyout. Venture capital is very useful in helping new companies get off the ground. Very often when you want to start a company, you need somebody to give you the money. You can’t borrow money because you have no assets that people will lend against. So you need either first-round or angel financing. Then the company might get a second round of financing. That’s a very difficult business compared with buyout. I would say 19 out of 20, maybe 24 out of 25 buyouts work, whereas with early-stage venture capital, only 30% of the deals work. It is a much more risky business. It potentially has a great rate of return. If you were an early investor in Google, you would be very happy. But good deals come along infrequently.
China Knowledge at Wharton: Another hallmark of private equity is the widespread adoption of limited partnerships. Could you talk about their importance?
Rubenstein: The concept of limited partnerships is relatively traditional in the investing world. When you form a partnership, investors put their money in, but they are limited to how much money they can lose. They can only lose the money they put in. They are not responsible for the debt or things beyond the money they invested. The advantage of the limited partners is that you have the general partner to take all the risks. He or she has the liability. Limited partners don’t have additional liability. But you also get the tax benefits. Tax benefits can be passed directly to the partners at the federal level of taxation. So the conventional way that you