NEW YORK--(BUSINESS WIRE)--Fitch Ratings has downgraded the Long-Term Issuer Default Ratings (IDRs) of The Carlyle Group L.P. and its related entities (collectively, Carlyle) to 'BBB+' from 'A-'. The Rating Outlook has been revised to Stable from Negative. See the complete list of ratings at the end of this release.
Today's rating actions have been taken as part of a periodic peer review of the Alternative Investment Manager (IM) industry, which comprises seven 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 increased 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 alternative IMs with strong franchises such as those included in Fitch's peer review.
Fee-earning AUM (FAUM) growth has slowed considerably for the rated peer group, as numerous strategies have record levels of uncalled capital to invest. Overall fundraising is expected to moderate to some extent, although there will be variability among firms, but management fees are expected to retain their resiliency, as capital not yet earning management fees (shadow AUM) remains elevated and realizations of legacy investments have declined. While an increase in market dislocations would impact the valuations and realization of existing investments, it could also result in stronger management fee growth, as uncalled capital would be invested at a faster pace. That said, Fitch does not expect a widespread distress cycle to emerge over the near term.
The variable cost structure of the alternative IMs has contributed to relatively steady cash flows through cycles. Fee-related earnings before interest, taxes, depreciation, and amortization (FEBITDA) margins rebounded modestly in 2015 and 2016 as many alternative IMs have begun to realize the scale benefits of follow-on funds and adjacent strategies. The FEBITDA margin for 'A' category alternative IMs averaged 41.6% for the trailing 12 months (TTM) ended Sept. 30, 2016, which compared to a 35.6% average for 2015 and Fitch's quantitative benchmark range of 30%-50% for 'A' category alternative IMs. Still, dispersion in the group is significant, with a more than 25 percentage point differential between the highest and lowest performer, driven by differences in strategy and product mix. Fitch believes higher margins provide enhanced operating flexibility through cycles.
Gross realized incentive income has steadily declined since peaking in 2014, driven by the length of time valuations have been at elevated levels, a less supportive IPO environment, and a reduction in the average age of fund investments. Overall exit activity has declined in 2016 and is likely to moderate further, which points to likely reductions in distributable earnings. That said, incentive income accruals remain strong and Fitch believes realized incentive income may be less volatile than pre-crisis experience given the increased diversity of product platforms.
Leverage levels have increased across the industry, as issuers have taken advantage of the low interest rate environment to issue long-duration funding for the purpose of funding balance sheet co-investments, acquisitions, and, in some instances, to pre-fund maturities. Average leverage, defined as debt divided by FEBITDA, was 3.16x for 'A' category firms for the TTM ending Sept. 30, 2016, which compares to Fitch's quantitative benchmark range of 0.5x-2.5x for 'A' category alternative IMs. Fitch believes the issuances have been largely opportunistic and views the reduction in refinancing risk favorably. Over time, Fitch expects leverage levels to generally decline to the benchmark range, as FEBITDA growth is driven by cost controls, increased scale, continued fundraising, and the gradual deployment of FAUM that earns fees on invested capital.
Counterbalancing the up-tick in leverage is the maintenance of strong liquidity profiles. Several firms remain in a negative net debt position and 2016 saw the introduction of perpetual preferred issuances by two issuers in the sector, with proceeds to date used to improve operating flexibility and liquidity. Debt maturities are negligible for the sector in 2016-2018. Payout ratios remain relatively high, but Fitch believes alternative IMs retain the ability to reduce shareholder distributions as necessary to meet obligations. While several share repurchase programs were announced over the last 12 months, execution of the programs is expected to remain opportunistic and is not expected to impair the sector's overall liquidity.
KEY RATING DRIVERS
IDRs AND SENIOR DEBT
The downgrades reflect Fitch's belief that Carlyle will not be able to generate sufficient FEBITDA momentum over the next 12 months to address the firm's elevated leverage ratio. Fitch believes the delay in FEBITDA expansion is being driven by outflows in the Claren Road funds, the sale of Emerging Sovereign Group (ESG), the run-off of Diversified Global Asset Management, and, to a lesser extent, elevated costs associated with product development for the Global Market Strategies (GMS) segment. While the next private equity fundraising cycle could begin in the latter part of 2017, with one or more of the firm's buyout strategies likely to begin raising its next flagship fund, the beginning of a cycle often results in reduced FEBITDA generation, as fundraising costs rise before management fees begin to be collected. As a result, Fitch believes leverage could increase meaningfully in 2017 before, improving, potentially, in 2018 and 2019.
Ratings remain supported by Carlyle's position as a leading global alternative IM, its experienced management team, strong corporate culture, institutional investor base, large base of FAUM, a lower payout ratio relative to peers and the subordination of general partner (GP) interests to outstanding indebtedness. The ratings are further supported by a generally successful track record in terms of underlying fund performance in corporate private equity and U.S. real estate, 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 co-investment commitments to the funds. Rating constraints for the alternative IM industry as a whole 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.
Fitch believes Carlyle retains one of the strongest and most profitable private equity franchises globally, but attempts to diversify beyond this business have been met with mixed results, as the corporate private equity segment continues to account for the vast majority of the firm's cash earnings (79.7% of distributable earnings for the TTM ended Sept. 30, 2016). Traction and scalability in other operating segments, which then contribute to greater earnings diversity, higher FEBITDA and lower leverage, would be important determinants in generating positive ratings momentum over time.
FAUM amounted to $123.8 billion at Sept. 30, 2016, down 3.4% year-over-year, as fund realizations, meaningful hedge fund redemptions, and market depreciation, surpassed fundraising activity. Fitch expects fundraising to remain active in coming quarters, although FAUM is not expected to grow meaningfully until 2018 when the next-generation buyout funds are more likely to begin their investment periods.
Carlyle's FEBITDA margin has been consistently lower than peers given the firm's higher cost structure, the impact of higher fundraising costs and, more recently, outflows from its hedge funds and elevated product development costs in GMS. Management fees were down about 10.8% in the first nine months of 2016, as compared to the same period in 2015, given declines in catch-up management fees, lower FAUM from hedge funds, and changes in the fee basis where the investment period has expired. The FEBITDA margin was 20.7% for the TTM ended Sept. 30, 2016, which is well below the peer average, and at the low end of the 'BBB' category quantitative benchmark for alternative IMs of 20%-30%. Fitch has expected margin expansion for several years, with the launch of step-out strategies and follow-on funds, but operating leverage has yet to materialize.
Carlyle also set aside $100 million in reserves for ongoing litigation and contingencies in 3Q16, related to a variety of previously disclosed contingent matters in various stages of resolution. While the reserve has been excluded from FEBITDA calculations, it will impact cash when and if a financial settlement is reached.
Counter to the relative management fee weakness, income generated from realized performance fees remains at the higher-end of the peer group as exit activity has been strong. Still, net realized performance fees, were down 30.2% for the TTM ended Sept. 30, 2016, compared to the prior TTM period, as the industry appears to have moved beyond the cycle peak in terms of exit activity. Still, accrued performance fees, net of associated compensation, remain strong, amounting to about $1.2 billion at the end of third quarter 2016 (3Q16). 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 5.39x for the TTM ended Sept. 30, 2016, which is well above Fitch's 'BBB' category quantitative benchmark for alternative IMs of 2.5x-4.0x. Fitch believes leverage is likely to increase further in 2017 as FEBITDA is pressured by the continued decline in the hedge fund business, , and higher fundraising costs as the firm gears up for the next fundraising cycle, and to a lesser extent, elevated expenses associated with product development in GMS. Fitch believes the firm's leverage will be maintained within the 'BBB' benchmark range over the longer term, but an ability develop a more consistent leverage profile, particularly at the lower end of the range, could support positive rating momentum over time.
Fitch believes Carlyle's liquidity profile is adequate, although weaker than peers, as the firm does not operate in a negative net debt position. Carlyle also has more demands on its cash than many peers given sizeable co-investment commitments to its funds (a large portion of which is expected to be funded by employees), and several non-recurring cash payments of late, including the potential $45 million of funding requirements for portfolio company, Urbplan Desenvolvimento Urbano S.A, as of June 30, 2016.
At Sept. 30, 2016, balance sheet cash and liquid investments amounted to $1.1 billion, although operating cash was lower, adjusting for amounts allocated to specific requirements. This compared to balance sheet debt of $1.28 billion at Sept. 30, 2016 and unfunded investment commitments of about $375 million at June 30, 2016 (assuming $2.6 billion of commitments are funded by employees). Additionally, based on a probability-weighted estimate by Carlyle, the firm expected to fund $153.2 million of cash consideration related to acquisitions as of 2Q16; approximately $76.3 million of which would be funded through the end of 2017. However, potential cash consideration has declined year-over-year given the underperformance, exit and/or sale of certain hedge funds.
Carlyle's distribution target of approximately 75% of distributable earnings 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.
In February 2016, Carlyle's board authorized the repurchase of up to $200 million of units. In the first three quarters of 2016, Carlyle spent $54 million on share repurchases. Several peers have established repurchase programs over the past year given relative unit price underperformance. While Fitch recognizes the potential accretion provided by the program, we would view cash used for the reduction of debt more positively, given Carlyle's elevated leverage and relatively weaker liquidity position.
The Stable Outlook reflects Fitch's expectations that management will continue to generate relatively stable management fees on core products, grow/retain FAUM through the raising of new and expansion of existing funds, sustain operating margins, reduce leverage to the 'BBB' benchmark range over the medium term, and appropriately manage its liquidity profile to meet debt service requirements, and co-investment commitments to funds.
IDRs AND SENIOR DEBT
Declines in investment performance, a key-man event and/or legislative risk which negatively impact the company's ability to raise FAUM and generate fees, material declines in FEBITDA margins, failure to maintain leverage within Fitch's 'BBB' benchmark range longer term, and/or impairment of the liquidity profile could result in negative rating action.
Longer term, positive rating momentum could be driven by stronger cash earnings diversity, a sustained reduction in leverage to under 4.0x, 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 IM specializing in private equity, real estate, energy, credit funds, and fund of funds. As of Sept. 30, 2016, FAUM amounted to $123.8 billion and total AUM was $169.1 billion. The company's stock is listed on the NASDAQ under the ticker 'CG'.
Fitch has taken the following rating actions:
The Carlyle Group L.P.
Carlyle Holdings I, II, and III L.P.
TC Group LLC
-- Long-Term IDR downgraded to 'BBB+' from '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 downgraded to 'BBB+' from 'A-'; and
-- Unsecured debt downgraded to 'BBB+' from 'A-'.
The Rating Outlook has been revised to Stable from Negative.
Additional information is available on www.fitchratings.com
Global Non-Bank Financial Institutions Rating Criteria (pub. 15 Jul 2016)
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