The Carlyle Group is about to go public. The founders of the second-largest private equity group wish to create a vehicle that will allow them to cash out gradually. It is perfectly understandable that they would want to sell some of their holdings. What is much less obvious is why anybody would want to buy.
Whenever we buy a stock, we ought to worry about the motivation of the seller from whom we buy. Is she just a passive investor who is rebalancing her portfolio or is she someone who is much better informed about the company and its prospects than we are? One would obviously much rather buy from an index fund manager than from an insider. The price at which an insider is willing to sell will usually turn out to be a bad price for the buyer. In the case of Carlyle, it is glaringly obvious that the sellers know a lot more than most of the potential buyers so the old adage about “buyer beware” certainly applies.
What is on offer are partnership interests in a limited partnership, not common stock. As a result, the buyers will not have any voice in the management of the entity, which will continue to be managed by a general partner, controlled by the sellers. Given the byzantine structure of the group – typical for the private equity industry – outsiders will find it difficult to ascertain where the bulk of future profits is likely to accrue in the future. Of course, there is a prospectus, which presumably covers all the relevant legal aspects of the deal. But it runs to hundreds of pages plus dozens of supporting documents and is written in the usual legal jargon that is essentially impenetrable for non-specialists. Also, as usual, the main purpose of the prospectus is not meaningful information but rather the protection of the sellers against any foreseeable legal problems in the future.
Private equity firms have been indefatigable in touting the advantages of private ownership and their ability to take a long-term view, unencumbered by concerns about the next quarterly results. But starting now, Carlyle will be distracted by such short-term concerns, particularly since the principals will want to sell further tranches of their holdings in the months and years to come. So instead of that long-term focus that they used to preach about, they will need to manage short-term expectations and the share price. Also, some opportunities that they might have considered attractive in their old configuration might suddenly appeal less because of their potential negative impact on short-term results.
The very fact that the IPO is obviously part of the principal’s succession planning adds another concern. What exactly is one buying? The principals – whose experience built Carlyle – will fade away at some point, and in the meantime, they will be distracted by the need to be more transparent. Asset management is a people business where success can typically be attributed to a small group of key individuals. Perhaps the next generation is ready but succession management in asset management businesses is notoriously difficult. Large egos tend to get in the way of effective mentoring.
Carlyle started to diversify some years ago into hedge fund management. Some may consider this an advantage but, again, it is more likely to prove to be a distraction. It will dilute the focus of top management and may well create even more conflicts of interest than exist already in the group. As investors, we can provide our own diversification; we want the managers of our portfolio holdings to focus on what they do best. It may be in their interest to buy “insurance” by diversifying their activities; it is not in ours – financial conglomerates have had their day.
Finally, precedents offer little encouragement. Many asset managers that have gone public in the past have ultimately disappointed. Public ownership is not a natural habitat for performance driven asset managers. Thus, their IPO usually marks the beginning of the end, not a new beginning.
Of course, my views may be all wrong and the Carlyle Group may reward its new limited partners with spectacular performance. But for my taste, the combination of insiders selling, the lack of an effective governance structure, the uncertain succession, the distraction of public ownership and the previous experience of such IPOs adds up to a rather unattractive cocktail. So if you are a buyer, good luck – you may need it.