Carlyle Group

We started a new position in Carlyle Group (“Carlyle”) during Q4. Carlyle is a name-brand private equity firm. We like the private equity business because 1) the sector is taking market share with investor portfolios, 2) the business results of private equity firms are asymmetrical in bull markets versus bear markets, and 3) the locked-up client capital is more durable than traditional investment managers.

Carlyle’s stock had a tough 2022. Private equity firms had very strong years in 2020 and 2021 as investors recognized the attractiveness of the business model. They bid up multiples to unattractive levels. Then as the bear market of 2022 unfolded, investors pulled away from the stocks of private equity firms due to the firm’s equity exposure. The high market valuations made it unattractive for private equity firms to make new investments, and, at the same time, the declining stock market made it difficult to monetize existing investments.

Carlyle underperformed the other private equity firms for a couple of reasons: 1) the company botched the CEO transition from the three company founders to the next generation, and 2) fund raising slowed after raising several large funds in 2021. Investors are understandably concerned about the botched CEO transition from several angles: 1) the firm will have trouble attracting and retaining talent, or 2) large investors will be reluctant to commit to new funds. We believe Carlyle’s founders will resolve the CEO issue in the 1st half of 2023. Once a new CEO is in place, investors should feel more comfortable buying the stock.

At its current valuation, we are buying Carlyle at about 10x fee-related earnings (“FRE”). FRE measures all costs of the company against the management fees to estimate earnings without regard to incentive or performance fees. So, even if Carlyle never earned a performance fee in the future, we’d be paying a reasonable multiple for the FRE income stream. Of course, this is simplistic because if Carlyle never earned a performance fee in the future, then the firm would never raise another fund, and the management fee stream would melt away. We fully expect Carlyle to earn performance fees in the future, but we view them as free options.

Another potential upside to Carlyle is improved operating margins. When Carlyle was privately owned, the firm’s operating model was to run the business at break-even on a management fee basis, and the partners would get paid on performance fees. As Carlyle and other private equity firms became publicly traded, it became obvious that the other PE firms were profitable on a management fee basis versus Carlyle’s model of break-even. We have two thoughts about Carlyle’s practice of running the firm breakeven on a management fee basis:

1.  Carlyle probably has a bloated cost structure as the managers thought of the management fee line item as their potential budget because they did not have to show a profit margin on that revenue, and
2. Carlyle’s valuation was handicapped when sell-side analysts began using sum-of-the-parts analysis to value the PE firms. Carlyle has moved away from operating at break-even on a management fee basis, but their operating margins are still significantly lower than their peers.

If Carlyle were to bring in an outside CEO, we believe there is an opportunity for them to improve Carlyle’s operating margin and improve its valuation. Carlyle is unique amongst its peers with its opportunity for margin expansion.