Gerstner's Surprise

As Carlyle Group's chairman, he'll help the firm shed its image as a defense dealmaker

To the small universe that knows about it, Carlyle Group has an image right out of a John Grisham novel--a secretive firm of bigwigs that buys up lucrative defense businesses, wins hush-hush military contracts, and manipulates governments around the world to wring private profit out of public policy. It doesn't help that Washington-based Carlyle's payroll includes such formers as President George H.W. Bush, Secretary of State James A. Baker III, British Prime Minister John Major, and Securities & Exchange Commission Chairman Arthur Levitt Jr.

Now Carlyle is about to scramble the conspiracy theories. On Nov. 21, it was expected to announce that Louis V. Gerstner Jr., the former CEO of IBM (IBM ), will join Carlyle as chairman in January. In the real world, Gerstner's appointment has little to do with geopolitical intrigue. Instead, it's the clearest signal yet that the firm has outgrown its old shell.

From its roots in defense, Carlyle has expanded rapidly into the world's largest private-equity manager. Drawn by its 36% annual returns, wealthy individuals and big institutions have committed $13.9 billion for the firm to manage. Carlyle has always been more than a defense boutique, but now it is scooping up companies in a wider range of businesses--from the world's largest maker of artificial Christmas trees to semiconductors. And it's in the midst of closing the biggest buyout deal since RJR Nabisco Inc. in 1989--Qwest Communications' $7.05 billion spin-off of its QwestDex Yellow Pages business.

Besides outgrowing its better-known Wall Street rivals--firms like Kohlberg Kravis Roberts & Co. and Blackstone Group LP--Carlyle is hoping to outmaneuver them. It's pushing to become the first full-service private-equity manager, with 23 buyout, venture, real estate, and asset-management funds in North America, Europe, and Asia. If this unproven model can outperform the small deal shops that now dominate, Carlyle can become the Fidelity Investments of private equity, with one-stop shopping for institutions and individuals willing to invest at least $5 million.

Gerstner will replace Frank C. Carlucci, Defense Secretary during the Reagan Administration, who has been with Carlyle since 1989 and becomes chairman emeritus. The former IBM chief hopes to provide strategic input on Carlyle's global activities and help guide the managers of companies that Carlyle buys to renew and rejuvenate. "I plan to advise the firm on what it does best--buying and managing companies--while helping Carlyle grow as an institution," Gerstner told BusinessWeek. The part-time advisory job--Gerstner is also committed to fostering education reform and studying Chinese history--will call on the same strategic and culture-building skills that helped him rescue IBM, albeit at a robust organization.

Gerstner won't be changing the basic direction set by Carlyle's co-founders: David M. Rubenstein, a lawyer and domestic policy adviser to President Jimmy Carter; William E. Conway Jr., once the CFO of MCI; and former Marriott executive Daniel A. D'Aniello. This triumvirate doesn't win much recognition. But they, and not the famous ex-politicos they've recruited, actually run the firm, heading a deep bench of 280 dealmakers in 21 offices worldwide.

The trio, known internally as DBD for their first initials, figures that Carlyle's diversified approach will build a private-equity firm that can outlast its founders. "Every pension or institution now invests in private equity," says Rubenstein. "To stay on top of their investment lists, firms like ours are going to have to become major institutions."

To make its strategy work, Carlyle will have to find advantages in its size for two constituencies: investors and dealmakers. The firm's brand name--and hefty returns in buyout funds--has indeed rubbed off on its other funds, appealing especially to foreign investors and families with, say, $50 million to put into private equity. "Their franchise gives them a real boost in raising funds, which is the key to this business," says Erik R. Hirsch, chief investment officer for Hamilton Lane, a private-equity investment consultant in Philadelphia.

But one-stop shopping doesn't necessarily enhance the firm's appeal to the huge U.S. pensions and endowments that provide the bulk of buyout and venture funding. "There's no particular advantage to us to have several fund options at one organization," says Robert Boldt, president of the $13.2 billion University of Texas Investment Management Co., which has bought into Carlyle's domestic buyout funds but not its overseas or venture funds. "If you have a blow-up in one area, it will affect the whole organization."

Other analysts note that although Carlyle's funds multiplied during the stock market's boom years, its venture funds, in particular, have struggled to find good investments in the technology downturn. "You'll be seeing some of those funds merge," predicts one adviser, who has limited his pension clients to Carlyle's buyout funds. Carlyle says it has no plans to consolidate its funds.

Carlyle's diversity, however, is proving its value on the dealmaking side. When semiconductor maker Conexant Systems Inc. approached Carlyle's San Francisco office to fund a spin-off of Conexant's wafer foundry, the venture-fund managers realized the deal was better suited for a buyout approach. They bounced it over to Claudius E. "Bud" Watts IV, a Charlotte (N.C.) info-tech buyout director, who structured a $50 million deal for 55% of the foundry. Watts, for his part, leaned heavily on Carlyle's Asian offices for their semiconductor expertise. The new plant will use innovative processes to make chips for the next generation of cell phones and wireless networks--and serve as a base for more chip deals.

Carlyle also can draw on its financial strength. It has more than $6 billion in cash because it cut back sharply on acquisitions when stock prices were high. But now that prices are back to earth, hard-hit public companies are scrambling to sell off units to bolster their balance sheets. The key to the QwestDex purchase, for example, was Qwest's urgent need for cash. While other bidders sought to break up the directory business, Carlyle and its partner, New York-based buyout firm Welsh, Carson, Anderson & Stowe, offered the only fully financed bid for the whole operation. They paid only 7.9 times the unit's cash flow, vs. multiples of 8.7 to 9 in similar recent deals.

To help maintain deal discipline, Carlyle's partners put their own money into every investment. "Investors love it--we're taking the same risks they are," says D'Aniello. Moreover, the firm avoids auctions where price alone determines the outcome. "A business that's clean, simple, easy to understand, ethical--you might as well sell that on eBay," quips co-founder Conway, the firm's chief deal maven. Carlyle's expertise shows when it ends up the second- or third-highest bidder in an auction--and later prevails when more optimistic bidders drop out.

The co-founders joke that Carlyle's initial focus on defense was an accident of location: What credibility would a Washington-based firm have bidding on, say, a retailer? But the firm has long since proved its expertise in a wide range of endeavors. The arrival of business superstar Gerstner is just a reminder that at Carlyle success has not been accidental, but a matter of design.

By Mike McNamee in Washington

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