WASHINGTON, May 31 (UPI) -- David Rubenstein, chief executive of the Carlyle Group, outlined Tuesday at an Economic Club of Washington dinner the history and current operations of Carlyle, claimed by Rubenstein to be the United States' largest private equity company, with $18 billion in asset value under management. Carlyle's history brings closely into focus a disturbing trend in the United States: the growth of crony capitalism.
Crony capitalism, a term often used pejoratively when referring to such imperfect examples of the free market as Boris Yeltsin's Russia, can be defined as a nominally free-market system in which business decisions are made to benefit a small group of insiders, and government resources are diverted to those insiders' private profit.
Within the pure private sector, crony capitalism is closely related to the "oligarchic markets" which I praised in a column some time ago. If two private sector individuals want to do business with each other, and the agency relationship with the shareholders is properly set up in both companies, there is no reason why they should not do so. In such a case, the information, speed and certainty benefits from the two individuals knowing and trusting each other may legitimately outweigh the theoretical price benefits from a costly and time-consuming "sealed bid" open transaction process.
The position is different, however, when one of the entities is the government, or a company doing business closely with the government, and the cronies are politically powerful. Here non-market factors come into play that may distort the decision making process. Notoriously, the agency relationship between a government functionary and the taxpayer is very loose, not to say non-existent, so the pressure on the functionary to save money for the taxpayer may be extremely weak. Equally the pressure that can be brought to bear on the functionary through the crony's political connections may be very strong indeed, even overwhelming, perhaps equivalent to a Mafia kidnapping of the functionary's wife and children.
Crony capitalism, therefore, while practiced by London merchant banks and Russian oligarchs alike, is not a threat to the economic system when practiced by London merchant banks (if there is no public sector involvement) but may be a terminal threat to the system if practiced by Russian oligarchs.
In Carlyle's case, suspicions are aroused by the number of former high government officials involved in its management. Rubenstein himself was formerly second to Stuart Eisenstat in President Jimmy Carter's domestic policy White House team (if he's made it so big now, why was some of this expertise not available to formulate Carter's singularly disastrous economic policy?) As he proudly proclaimed, Carlyle has made it a policy to recruit former high government officials; first Frank Carlucci, President Ronald Reagan's last Secretary of Defense, then President George H.W. Bush's Secretary of State James Baker and his Budget Director Richard Darman (as well as Bush himself, who gives speeches for the group.) Most recently former Senator George Mitchell (D.-Maine) has joined Carlyle (gee, do you think Carlyle believes Kerry's going to win in November?)
It has to be said, these are not inspiring choices. We're not talking former Secretary of State George Schultz, former Defense Secretary Caspar Weinberger or former Treasury Secretary Robert Rubin here -- any of who's advice would be worth having on any subject. The abilities of Carlyle's luminaries may be illustrated by one question -- why in the world would you pay money to listen to a speech by President George H.W. Bush? Rubenstein claimed that Carlyle was unfairly thought to be a refuge for out-of-office Republicans. Actually it seems to be to be a combination of liberal Democrats who actually run the place, working with the kind of Republican ex-office-holders the better Presidents regret having hired.
Of course, the London merchant banks used to hire former government officials, but they were used primarily for decorative purposes, to impress the simpler minded clients with the bank's prestige and connections. At Hill Samuel in the 1970s, I used to invite to client lunches whenever possible Sir John Colville, Winston Churchill's former private secretary and later author of the immortal memoir "The fringes of power." Colville, a wonderful old boy, would wait for the short silence after the meal had been served, and then begin "When Winston and I were at Casablanca..." Worked every time!
Carlyle's purpose in recruiting its luminaries appears to be somewhat different. It is surely for his current power and influence with the George W. Bush administration and the congressional Republicans, and not for his charming fund of historical anecdotes, that one might wish to lunch with James Baker. To see why this might be useful it is worth examining the economics of the private equity business.
Successful private equity businesses center on three functions: raising money, buying companies, and selling them on at a profit. Actually running the companies is a subsidiary function, generally undertaken only to maximize their eventual sale price. Anyone whose company has bought a subsidiary from a private equity company, or who has invested in an Initial Public Offering for a company largely controlled by private equity interests will tell you that there is generally a day of reckoning shortly after the acquisition or issue, in which necessary but previously avoided expenses are incurred, and cosmetic changes to the income statement and balance sheet are reversed. To a private equity investor trying to sell a company, appearance is everything, long term sustainability is irrelevant.
Private equity companies will tell you that a long term investment track record is the key to acquiring new funding, which begs the question of how they ever get started. In practice, a long term investment track record is important only when attracting investment from the open market, or from wealthy individuals. Carlyle's track record on its first fund is a very impressive return of 35 percent per annum (before deducting management's remuneration and other costs, which bring it down to 27 percent per annum, and counting only from the date at which money is actually drawn down, and not from when the investor commits to the funding, tying up resources.) On later funds, its track record is somewhat less impressive, around 25 percent per annum before expenses in a period of a generally expanding economy, which would reduce to well under 20 percent per annum after management and other costs (as is well known, private equity managers take a return of 20 or even 25 percent of the profits on a fund's investments before shareholders see a penny of gain.)
Even this is excellent by the standards of the private equity industry. Rubenstein gave a carefully modulated sales pitch to those in the room (not including me!) who might have qualified under the Securities and Exchange Commission's rule of $1 million net worth, to invest in private equity, complete with a chart showing returns on private equity investments over the last 20 years. However, those returns, for the average private equity fund as distinct from the "top quartile" funds that private equity fund salesmen like to highlight, are less than stellar: 9 percent per annum over the decade 1993-2003, and 11 percent per annum over the 20 year period 1983-2003. Since a private equity investor is tying up money for years, and generally paying huge fees and costs to its manager, it may be thought that a 20 year private equity return from 1983 that was about equivalent to the yield on a 20 year government bond at that time is distinctly unimpressive. The tendency for private equity returns to decline over time, even before taking account of a possible economic downturn, is also disquieting, but to be expected given the enormous amounts of money -- over $300 billion in 2000 alone -- that have gone into private equity in recent years.
Superannuated politicians are extremely useful in raising money before you have a track record, particularly from countries such as those in the Middle East where elites want favors from the United States. While one cannot blame Carlyle for having accepted a $2 million investment from the bin Laden family, the bin Laden family are typical of the kind of Middle Eastern investor for whom a meeting with James Baker could be exceptionally attractive.
Former government officials are also useful both in finding companies in which to invest, and in arranging purchase transactions that may not be entirely at arms length. Only 5 percent of Carlyle's investments are in defense related sectors, we are told, but there are innumerable businesses far outside the defense sector for which the relationship with the federal government, either as buyer of their products or as regulator of their activities is of primary importance. For any such business a big "name" would make Carlyle's acquisition of all or part of its operations very much simpler. Of course, having acquired a government related business, senior government connections can also be used to build it up.
Finally, in the disposal of businesses, particularly those with a government relationship, a senior ex-politician can also be exceptionally useful. For an initial public offering, sold through Wall Street, or for a sale to a private sector venture capitalist, such people will be beneficial only in assuring Carlyle's bona fides. However, for an acquirer which itself is a major government contractor, establishing a relationship with such a person may well be an extremely valuable facilitator of other business.
There are many ways in which a senior former politician can make himself useful in the private sector. For a lobbyist, he can lobby Congressmen and Cabinet officials to ensure that his client's needs are met. For a government contractor, he can add value to a bid proposal, thereby pushing his employer to the top of the bid selector's rankings.
However, in both these cases, a top government official's contribution is limited by the profit on an individual contact, or by a certain number of highly billed hours. For a private equity investor, his contribution can be very much greater. By assisting in fund raising, company acquisition, operating relationships with government and disposal he can multiply his contribution many-fold, leveraging it to maximize the company's capital gains income both from managing funds and from the investments themselves. Carlyle, a unique institution, appears to have been the first to discover this exceptional benefit.
As I said, crony capitalism. Former Yukos chairman Mikhail Khodorkovsky should have operated in the United States -- he might have got just as rich, and avoided jail!
(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, June 2004) -- details can be found on the Web site greatconservatives.com.