NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed the long-term Issuer Default Ratings (IDR) of The Carlyle Group L.P. and its related entities (collectively Carlyle) at 'A-'. The Rating Outlook is Stable. Approximately $1.1 billion of unsecured debt is affected by these actions. A complete list of ratings is detailed at the end of this release.
Today's rating actions have been taken as part of a periodic peer review of the Alternative Asset Manager (AAM) industry, which comprises six publicly rated global firms. Fitch's outlook for the sector is stable; reflecting the relative stability of core operating fundamentals, given the locked-in nature of a large portion of fee revenue, modest but moderately increasing leverage levels, manageable near term obligations relative to available liquidity resources, increasing asset under management (AUM) diversity and investors' increasing allocation to alternative investments, particularly those managed by AAMs with strong franchises such as those included in Fitch's peer review. While fund realization activity has increased significantly over the last two-to-three years, leading to the amortization of existing AUM, managers have continued to replace capital, and therefore fees, with follow-on funds and expansion into other product categories through step-out strategies, seed investments, and/or acquisitions.
The variable cost structure of the AAMs has contributed to relatively steady cash flows through cycles, but fee-related earnings before interest, taxes, depreciation, and amortization (FEBITDA) margins have trended down in recent years, given lower fee rates on new product categories, higher fundraising costs, and because the cost of doing business has risen with increased regulation and administrative costs associated with operating as public companies. Still, Fitch believes margins are beginning to stabilize to some extent. The FEBITDA margin for 'A' category AAMs averaged 35.4% for the trailing 12 months (TTM) ended Sept. 30, 2014, which compared to a 34.9% average for 2012.
Leverage levels have increased across the industry, as issuers have taken advantage of the low interest rate environment to issue long duration funding. Average leverage, defined as debt divided by FEBITDA, was 3.07 times (x) for 'A' category firms for the TTM ending Sept. 30, 2014, which compared to an average of 2.55x at year-end 2012. Fitch believes the issuances have been largely opportunistic and views the reduction in refinancing risk favorably. Over time, Fitch expects leverage levels to migrate toward historical averages, as cash proceeds are deployed into FEBITDA-generating opportunities.
While core issuer fundamentals remain solid, AAMs have a significant amount of capital to invest at a time when credit markets are frothy and valuations are high. Therefore, there is more capital chasing fewer deals, which could lead to significant fund underperformance if competition bids prices up further. Outsized vintage concentration could potentially exacerbate this issue. While most of the large managers have operated through a variety of market cycles, and have demonstrated investment restraint, pressure for returns from limited partners remains high, given the length of time that interest rates have been at low absolute levels.
KEY RATING DRIVERS
The ratings affirmation for Carlyle reflects its position as a leading global alternative investment manager, its experienced management team, strong corporate culture, institutional investor base, large base of fee-earning assets under management (FAUM), which has demonstrated consistent growth, and the subordination of general partner (GP) interests to outstanding indebtedness. The ratings are further supported by a successful track record in terms of underlying fund performance, which has garnered significant incentive income for the firm and supported continued fundraising.
Rating constraints include higher-than-peer leverage levels and a weaker liquidity profile, given lower FEBITDA margins and the demands on the firm's cash related to acquisition earnout payments and co-investment commitments to the funds. Other risks to the ratings include 'key man' risk, which is institutionalized throughout many limited partnership agreements, reputational risk, which can impact the company's ability to raise future funds, and legal and regulatory risk, which could alter the alternative asset space.
FAUM amounted to $140.2 billion at Sept. 30, 2014, up 1.7% year-over-year, given strong fundraising, particularly in private equity and solutions, and the acquisition of Metropolitan Real Estate Equity Management, LLC, a real estate fund of funds business, which added about $2.1 billion of FAUM in the fourth quarter of 2013 (4Q'13) and the acquisition of Diversified Global Asset Manager, a fund of hedge funds business, which added about $2.9 billion of FAUM in 1Q'14.
The increase in FAUM, while modest, is noteworthy given the offsetting impact of a strong exit environment. Carlyle distributed approximately $30 billion of capital over the last 12 months (on an AUM basis), as the firm took advantage of strong market valuations to exit legacy positions. Fundraising is expected to remain solid, given the diversity of Carlyle's product offerings, but Fitch expects FAUM growth to moderate over the near term given a continuation of elevated realization activity and because the firm's large U.S. buyout fund ($13 billion of committed capital) is in the early stages of its investment period.
Carlyle's core operating performance has been consistently weaker than peers given the firm's higher cost structure. Management fees have been on the rise; increasing at an 8.7% compound annual rate from 2009-2013, but non-carry compensation has grown 15.4% over the same period and Carlyle has faced higher costs associated with being a public company and from increased fundraising activity. FEBITDA margins did expand modestly for the nine months ended Sept. 30, 2014, as fundraising costs declined; however, management fees included larger-than-average catch-up fees from subsequent fund closings and elevated transaction fees. Carlyle's FEBITDA margin was 21.2% on a TTM basis through Sept. 30, 2014 compared to 18.7% in 2013.
Conversely, income generated from realized performance fees has been at the higher-end of the peer group as exit activity has been strong. Realized performance fees, net of associated compensation were $472.1 million in the first nine months of 2014 (up 47.3% from the comparable 2013 period) and $828.8 million for the TTM ended Sept. 30, 2014. Furthermore, accrued performance fees, net of associated compensation, were nearly $2 billion at the end of 3Q'14. While Fitch does not consider the accrual a liquid asset, it does point to the potential for future income and cash flow generation, which could be used to support debt service.
Firm leverage remained elevated at 4.21x at Sept. 30, 2014 on a TTM basis, which compares to 4.55x at Dec. 31, 2013. Carlyle added $200 million of long-term debt to the balance sheet in March 2014, after re-opening its 30-year bond deal, but that increase was more than offset by higher FEBITDA to date in 2014. Still, TTM FEBITDA and leverage has benefited from some management catch-up fees and non-recurring transaction fees in 2014.
Fitch believes proceeds from the March debt issuance have and will likely be used to fund a variety of initiatives, including the exercise of Carlyle's option rights to acquire certain carry proceeds from funds managed by NGP Energy, balance sheet co-investment commitments to funds, and the potential for future acquisitions. The incremental debt is viewed negatively by Fitch, as proceeds are expected to be used to generate investment income and for activities that are likely to favor incentive income over fee income. Both investment and incentive income are less predictable relative to base management fees, and even when earned, the majority of proceeds are typically distributed to shareholders. That said; Fitch expects Carlyle's FEBITDA levels to benefit from recent acquisitions and strong fundraising trends, adding some potential stability to leverage levels over the near term. However, should FEBITDA generation fall short of expectations, leading to sustainably higher leverage, negative rating action would likely result.
Helping to offset Carlyle's higher leverage, on a relative basis, is the firm's product and fund diversity, its track record of generating significant incentive income during strong realization cycles, and the expectation for incremental FEBITDA from recent acquisitions.
Fitch believes Carlyle's liquidity profile is adequate, although weaker than peers, given the relatively small size of the balance sheet and the meaningful earnout provisions coming due. At Sept. 30, 2014, balance sheet cash amounted to $1.4 billion, although management estimates that operating cash is closer to $880 million, adjusting for net performance and investment income realized to date but not yet distributed, in addition to several other items. This compared to balance sheet debt of $1.1 billion and unfunded investment commitments of about $300 million at Sept, 30, 2014 (assuming $2.7 billion of commitments are funded by employees). Additionally, as of Sept, 30, 2014, based on a probability-weighted estimate, Carlyle would expect to fund $158.4 million of contingent cash consideration, related to recent acquisitions, through the end of 2016.
Carlyle's distribution policy is to pay a flat $0.16 per share quarterly dividend for the first three quarters of the year and a year-end true-up dividend based on realized performance fees and investment income earned throughout the year. The actual payout in 2013 was about 75%, which is at the low-end of the peer group. Fitch believes the company has the flexibility to reduce distributions, if necessary, to bolster liquidity in any given quarter. Fitch believes enhanced balance sheet liquidity would provide the firm with more operating flexibility as it relates to growth and expansion opportunities.
RATING SENSITIVITIES
The Stable Rating Outlook reflects Fitch's belief that core fundamentals will remain solid and that the firm will continue to produce consistent investment performance to support future fundraising and FAUM expansion, and retain a sufficient liquidity profile in order to cover operating expenses and meet co-investment commitments to funds.
Carlyle's ratings are particularly sensitive to currently high leverage levels. The issuance of additional debt, excluding debt associated with performance-related earn-out provisions, which does not result in sufficient FEBITDA generation to maintain leverage at or below current levels would be expected to yield negative rating action.
Negative rating actions could also be driven by material changes in the operating strategy or leverage tolerance resulting from changes in senior management or declines in investment performance which adversely impact the business franchise, meaningful FAUM and margin contraction which impairs FEBITDA, reduced product line diversity, and/or excessive distributions which impair the liquidity profile as it relates to operating needs, debt maturities, and co-investment commitments.
Positive rating momentum is viewed as limited over the near term, but could be driven over the longer term by reductions in leverage to levels that are more in line with peer averages and improvements in balance sheet liquidity which provide the firm with more operating flexibility as it relates to growth and expansion opportunities.
Carlyle is a leading global alternative investment manager specializing in private equity, real estate, energy, credit funds, and fund of funds. As of Sept. 30, 2014, FAUM amounted to $140.2 billion and total AUM was $202.6 billion. The company's stock is listed on the NASDAQ under the ticker 'CG'.
Fitch has affirmed the following ratings with a Stable Outlook:
The Carlyle Group L.P.
Carlyle Holdings I, II, and III L.P.
TC Group LLC
--Long-term IDR 'A-'.
Carlyle Investment Management LLC
TC Group Investment Holdings LP
TC Group Cayman Investment Holdings LP
TC Group Cayman LP
Carlyle Holdings Finance L.L.C
Carlyle Holdings II Finance L.L.C
--Long-term IDR 'A-'; and
--Unsecured debt 'A-'.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
-- Global Financial Institutions Rating Criteria' (January 2014);
-- 'Investment Manager and Alternative Funds Criteria' (December 2013).
Applicable Criteria and Related Research:
Global Financial Institutions Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=732397
Investment Manager and Alternative Funds Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=725057
Additional Disclosure
Solicitation Status
http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=918436
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