David Rubenstein: Private Equity’s ‘Purgatory’ Phase and the ‘Combat Sport’ of Capitalism

Private Equity has passed through a Golden Age, but will now spend a year or so in “purgatory” before entering an even greater period of expansion, or “Platinum Age,” according to David Rubenstein, co-founder and managing director of The Carlyle Group, the Washington, D.C.-based private equity firm with more than $70 billion in assets.


In a keynote address at the 14th annual Wharton Private Equity and Venture Capital Conference titled, “Harnessing the Winds of Change,” Rubenstein said the credit crisis triggered by subprime lending has brought the growth of private equity investment to an abrupt halt. The industry’s new realities are in sharp contrast to its high-flying period from 2002 to mid-2007, when top private equity firms were doing deals worth billions and generating returns of 30% for their partners.


As Rubenstein began his talk, he was interrupted by union members protesting Carlyle’s $6.3 billion acquisition of Manor Care, the nation’s largest nursing home chain. Chanting “patients, not profits,” the protesters unfurled banners and questioned whether Carlyle would provide job security and quality patient care at the chain’s facilities. Carlyle had only taken control of Manor Care two weeks earlier, Rubenstein responded, but it hoped to make the company perform better. “[Capitalism] is sometimes a combat sport,” Rubenstein remarked after security led the protesters out of the ballroom of the Philadelphia hotel where the conference was held.


Later in his speech, he stressed that private equity professionals frequently come under that type of public scrutiny because of the high pay-outs they earn. “The private equity world needs to spend much more time letting people know what [we] do to create value,” he said. “I think we’ve seen an indication of that this morning.”


‘The Music Stopped’


Rubenstein said that during the most recent private equity boom, he had imagined many ways the good times would come to an end. A spike in energy prices, Federal Reserve tightening or an act of terrorism like the one that occurred on September 11, 2001, were among his most likely scenarios.


He never foresaw what actually did happen — a credit crisis spurred by subprime lending. The industry’s undoing goes back to the period he now calls the “Golden Age” of private equity, when the business of lending itself became an important part of the industry as large banks earned high fees for making loans to private equity firms to do deals. The banks then syndicated those loans to collateralized debt funds that were also investing in subprime loans. Rubenstein noted that “subprime” is a somewhat misleading description for the widespread loans banks made during this period; instead, they should have been labeled “not credit worthy,” because they were actually six times more risky than prime-rate loans, he said.


When the subprime loans began to go bad, the syndicates were unable to take on new debt to finance private equity transactions. “All of a sudden, in mid-2007 — around July — the music stopped,” said Rubenstein.


When credit markets dried up, large banks had already committed to $300 billion in private equity deals, Rubenstein noted. About a third of that value stayed on bank balance sheets, although much of it has already been written down, he said. Another third was renegotiated with tougher terms for private equity sponsors. For the final third, the deals were never completed and are now the subject of litigation or break-up fees. “For the next year or so, we will be in purgatory,” he said. “We will have to atone for our sins a little bit.”


According to Rubenstein, the 1970s and 1980s were the “Bronze Age” of private equity, when early buyout deals emerged, culminating in 1989 with Kohlberg Kravis Roberts’ leveraged buyout of RJR Nabisco and then the collapse of the proposed buyout of United Airlines. After the recessionary period of 1991 to 1992, private equity entered what Rubenstein calls the industry’s “Silver Age.” During this time, buyout deals grew larger, sellers turned to private equity as a way to liquidate holdings and sponsors were able to prove their ability to transform companies and earn handsome returns. That era, he said, ended when the technology bubble burst in 2000.


After a two-year break, private equity then entered what Rubenstein calls its “Golden Age,” as deals grew to enormous size and private equity firms teamed together in so-called “club” deals to take over ever-larger companies.


With the current credit crisis, private equity deals have slowed dramatically. Rubenstein told the audience that in order to revive the industry, private equity sponsors will need to scale back the size of deals, reduce leverage and look overseas for opportunities in countries such as India and China.


“Once a period of time is over, once the debt on the banks’ books is sold and new lending begins in six to nine months, I think you will see private equity coming back in a Platinum Age, better than ever before,” he predicted.


Handing over Money Happily


Before that can happen, Rubenstein said, private equity managers need to do a better job of explaining how they can improve companies and deliver strong returns that lead to increased employment and economic expansion overall. Throughout most of the business’s history there was little reason to offer explanation, he noted. Investors looked at private equity funds’ returns and were happy to hand over money to sponsors.


“Nobody asked any questions about how many jobs were created or how many facilities were going to be built,” he said. “We didn’t have that information. Now we recognize that if we are going to be able to function in the way we want, we have to be much more aware of the organizations that deal with our industry — labor, consumers, Congress and the media.”


As lenders digest the current credit overhang, private equity professionals should use this period to explain how the industry works and why it is able to generate strong returns, “and why we deserve to get compensated the way we get compensated,” he said.


Rubenstein predicted that private equity will continue to attract investors, because it provides returns that are “better than anything you can legally do with your money.” Returns will remain strong, he said, because the techniques used by sponsors to improve companies have been proven to work, including giving management a stake in the companies they run.


The current economic slump might be a good time to make private equity investments, he added, although the typical 10-year lifespan of a private equity fund cushions investors from wild swings in value. Meanwhile, the industry may remain stalled for another six to nine months as it wrestles through a “denial stage” and sellers come to terms with valuations for businesses that are lower than they might have been at the peak of the buyout boom. Many private equity firms will grow so large that they will go public, he added. “I don’t think the private equity work is going away.”


During his talk, Rubenstein noted that he had had several other careers before co-founding Carlyle in 1987. He had worked as a lawyer and had been an official in the Carter White House assigned to fight inflation. At the time, inflation was 19% and mortgage rates were 22%, he said.


When he and his partners founded Carlyle, the firm was different than other buyout companies in business because it offered multiple types of funds, rather than specializing in venture capital or real estate, according to Rubenstein. Today, the firm has 60 funds. Carlyle also pioneered the idea of taking private equity funds global.


Addressing concerns that private equity sponsors had become modern “Robber Barons,” amassing riches beyond what they provide in economic value, he argued that the wealth private equity can deliver to sponsors allows them to give back to society. “One beauty of private equity is that if you are successful, you will have the means to give wealth away and see it being used while you’re alive … to improve society,” said Rubenstein, who serves on the boards of several non-profit organizations including Lincoln Center, Memorial Sloan-Kettering Cancer Center and the Council on Foreign Relations.


Rubenstein told the conference that the wealth he had amassed through Carlyle had allowed him to purchase the only copy of the Magna Carta in the United States — for $21 million — and arrange for it to be on permanent display at the National Archives in Washington, D.C. “That’s the kind of thing private equity people need to do more of, giving money back to the society that made it possible to make that kind of money in the first place,” he said. “All of us who have been financially successful have this kind of responsibility.”

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