Carlyle Group LP (CG), in a transaction nine months before it filed to go public, saddled itself with debt to pay owners including William Conway, Daniel D’Aniello and David Rubenstein a $398.5 million tax-deferred dividend.
The private equity firm borrowed $500 million from Abu Dhabi’s Mubadala Development Co. in December 2010, saying it would use part of that to expand investment products. Instead, it paid out almost 80 percent of the money to existing owners, according to regulatory filings. Separately, the Washington- based firm negotiated bank credit giving it the option to distribute an additional $400 million prior to its initial public offering, lending agreements filed last month show.
The deals, which echo the dividend recapitalization private equity managers use to extract cash from the companies they acquire, leave Carlyle’s future shareholders with the cost of servicing the debt. Assuming Carlyle holds its IPO by the end of June, Mubadala will have earned a return in excess of 50 percent, including a $200 million equity stake the owners gave away to obtain a loan that lasted about a year and a half.
“It begs the question, ‘Why would you do that?’ ” said Matthew Pieniazek, the president of Darling Consulting Group, an adviser to banks in Newburyport, Massachusetts. “IPOs are not guaranteed. They were willing to give up some of the upside for the certainty of” a distribution.
Chris Ullman, a spokesman for Carlyle, declined to comment.
By financing the dividends with debt, Carlyle’s founders can receive the full amount without facing an immediate tax bill, and without having to sell shares in the IPO. Under Internal Revenue Code regulations for partnerships, the owners can defer paying taxes on the distribution until the debt is retired, said Allan Weiner, a partner in the Washington office of the law firm Kelley Drye & Warren LLP.
“They are essentially creating a distribution without paying taxes,” Weiner said. “Presumably, because it is debt, they are burdening the existing entity.”
Carlyle has taken advantage of borrowed money in the past to pay its fund investors dividends before taking holdings public. So-called dividend recaps were used when Dunkin’ Brands Group Inc. borrowed $1.25 billion in 2010 to pay $500 million to owners Carlyle, Bain Capital LLC and Thomas H. Lee Partners LP. Dunkin’ went public last year in a $486 million share sale.
Six months after the buyout of Hertz Corp. in 2005, the car rental company used a $1 billion loan to pay a dividend to its new owners, Carlyle and Clayton Dubilier & Rice LLC.
Carlyle, founded in 1987, is the second-biggest private equity firm, with $148 billion in assets as of Sept. 30, including stakes in companies such as Dunkin’ Brands and Nielsen Holdings N.V. Its three founders received a combined $413 million last year, mostly from distributions. Apart from the founders and Mubadala, its owners include the California Public Employees’ Retirement System, or Calpers.
The firm found some of its first investors in the Middle East, including the Saudi royal family and owners of the Saudi Binladin Group, the Jeddah-based construction company founded by Osama bin Laden’s father, Mohammed. Carlyle returned the family’s money after the Sept. 11, 2001, terrorist attacks.
The firm has weighed an IPO since at least 2007 when larger competitor Blackstone (BX) Group LP went public. As financial markets started to collapse, Carlyle instead agreed to sell a 7.5 percent stake to Mubadala, an investment vehicle owned by the Abu Dhabi government, for $1.35 billion in September 2007. Mubadala got a 10 percent discount and received protection against a drop in the value of its holdings.
Mubadala made the second investment in Carlyle in December 2010, buying $500 million in debt convertible into Carlyle stock at a 7.5 percent discount to the IPO price. Carlyle agreed to pay an interest rate of 7.25 percent and give Mubadala a 2 percent equity stake valued at about $200 million, an expense booked as an “upfront cost” to secure the debt financing, according to the firm’s registration statement with the U.S. Securities and Exchange Commission.
Carlyle refinanced half of that debt in October, a month after filing to go public and securing a bigger credit line from its banks. Carlyle borrowed $265.5 million under the expanded credit agreement to retire $250 million face amount of the notes. Carlyle paid Mubadala a $10 million premium, a fee that is often assessed when bonds are retired ahead of time, and $5.5 million of accrued interest.
The private equity firm may repay the balance of Mubadala’s debt before the IPO, according to a person familiar with Carlyle’s plans who asked not to be identified because the matter is private. If it doesn’t, Mubadala would be entitled to convert the debt into Carlyle stock at a 7.5 percent discount to the IPO price.
Private companies typically pay interest rates of about 13 percent to 14 percent when taking out so-called mezzanine loans that rank behind senior debt, such as bank loans, when it comes time to being repaid, according to James Hill, who heads the private equity practice of the law firm Benesch LLP in Cleveland.
While the interest Carlyle is paying is low in comparison, the equity stake makes it expensive for current owners. Carlyle has about 100 partners who own a piece of the company. The three founders own more than half.
“As long as Carlyle goes public, it is a pretty big win for” Mubadala, Hill said in an interview. “If they hadn’t gone public, it wouldn’t have been as big a win because you own two percent of a privately owned management company and who knows what that is worth over time.”
The sale was subject to Calpers waiving pre-emptive rights that it received under a February 2001 agreement to invest in Carlyle, according to a Feb. 14 SEC filing. Calpers also had to consent to the deal between Carlyle and Mubadala, the filing shows.
Carlyle’s previous IPO plans had been set back in 2007 when a publicly traded credit fund sponsored by the firm fell victim to the housing crisis. Carlyle, which unsuccessfully tried to rescue the fund, had obtained an $875 million credit line at that time from a banking consortium led by Citigroup.
Carlyle has agreed to pledge 70 percent of the firm’s quarterly management fees, along with the carried interest of its partners, as collateral, according to the most recent version of the loan agreement, filed with the SEC last month.
Carlyle entered into additional collateral agreements in December 2008, involving U.S. and U.K. bank accounts under the name of Carlyle Investment Management LLC. The firm reported a net loss of $514 million that year, according to the IPO filing.
After Carlyle filed to go public in September of last year, its lenders -- Citigroup Inc., Credit Suisse Group AG and JPMorgan Chase & Co. -- agreed to increase the revolving credit line to $750 million from a prior limit of $150 million. According to a copy of the borrowing agreement, revised again in December, the banks will no longer require the management and carried interest fees that Carlyle and its partners pledged as collateral once the IPO is completed and Mubadala is repaid.
All three banks were awarded top roles managing Carlyle’s share sale. Officials for the banks declined to comment.
The Mubadala financing in 2010 helped Carlyle distribute $787.8 million in cash to its top executives that year, up from $215.6 million in 2009 and $253.9 million in 2008, according to regulatory filings.
Carlyle didn’t give a reason for the dividend payout. Its founders were among senior professionals who had committed to contributing $1.2 billion to the firm’s buyout and other funds as of Sept. 30, according to the IPO documents. Such commitments can sometimes prove burdensome for private equity executives, said David Miller, a tax attorney at Cadwalader, Wickersham & Taft LLP in New York.
“It was not infrequent during the recession that private equity managers had to draw on credit lines because they had commitments,” Miller said.
In addition, when Carlyle’s buyout funds sell portfolio companies, either through direct sales to another suitor or through IPOs, the firm’s partners must recognize income for tax purposes, even though they may not get any of the actual cash. Instead they must wait until outside investors in Carlyle funds have gotten all of their capital back plus a preferred return of 8 to 9 percent, according to the firm’s IPO filing.
“Managing the cash in a private equity arrangement is a little more of a challenge than in a typical hedge fund that has liquid assets,” said Jim Browne, a partner at Strasburger & Price LLP, a Dallas-based law firm that specializes in general tax planning.
The stock grant that Mubadala received when it bought subordinated notes from Carlyle in 2010 raised its holdings to 9.5 percent. Carlyle’s valuation of the 2 percent equity stake assumed that the buyout company was worth $10 billion, according to the filing. The purchase price Mubadala paid for its initial investment in 2007 implied a valuation of about $20 billion for Carlyle at the time.
The terms for Mubadala’s 2010 investment “could simply be a way of giving them a little kicker for what both parties knew was an overvalued equity infusion three years earlier,” said Pieniazek.
Shares of Blackstone, which is based in New York, have lost half of their value since they were first sold in the 2007 initial offering at $31 each.
Following Carlyle’s offering, Mubadala will be restricted from selling parts of its stake for 12 to 24 months, according to Carlyle’s registration statement. The Abu Dhabi company, the second-largest Carlyle owner after the founders, is also restricted from holding a stake bigger than 19.9 percent.
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