Carlyle Fund in Free Fall
As Its Banks Get Nervous

By PETER LATTMAN, RANDALL SMITH and JENNY STRASBURG

Carlyle Group, the powerful Washington-based buyout firm, has long been known for its gold-plated connections. Its chairman is Louis Gerstner, the legendary former IBM chief, and it once employed both former British Prime Minister John Major and former President George H.W. Bush.

But connections don't mean much in today's credit crunch.

Yesterday, a publicly traded investment fund affiliated with Carlyle Group that had ballooned to $22.7 billion back in the era of easy borrowing all but collapsed as banks rushed to sell assets backing the mortgage fund. Shares of Carlyle Capital Corp., which trades in Europe, are down 97% for the year, closing yesterday at 35 cents.

Across Wall Street, banks that once lent freely and engaged in all sorts of complex transactions are now scrambling to protect their balance sheets. Some that once fought to lend to private-equity firms are now suing their erstwhile clients.

For Carlyle Group, whose partners own 15% of the fund, events came to a head just a week ago at a conference at the tony Deer Valley, Utah, ski resort. There, James B. Lee Jr., a vice chairman of J.P. Morgan Chase & Co., warned Carlyle Group's David Rubenstein that, short of a massive bailout, lenders would seize the fund's assets.

Even though Mr. Lee is "one of my better friends in the investment world," the silver-haired Mr. Rubenstein said yesterday, "they had to do what they felt they had to do."

Because banks are worried about their own stability, he said, "they can't do things that they would normally do for their clients, as much as they would like to."

The Carlyle Group itself isn't expected to suffer much of a financial blow from the collapse. It owns a wide array of strong companies, from AMC movie theaters to Dunkin' Donuts, and runs some 60 separate funds.

The trouble at Carlyle Capital is the latest sign of a remarkable reversal of fortune hitting Wall Street. The Carlyle Group-affiliated fund went public less than a year ago, when buyout firms were at the peak of their financial power and looking to cash in. Rival Blackstone Group had just gone public in a $4.1 billion offering, enabling co-founder Steve Schwarzman to extract some $680 million.

The Carlyle fund's problem was simple: As part of its strategy, it invested an immense amount of borrowed money. In recent weeks, as its lenders got nervous about the fund's mortgage-related holdings, they began demanding more collateral.

Myriad other funds use similar investment strategies. If Carlyle Group -- which paid out $330 million in Wall Street banking fees last year -- can't catch a break, that doesn't bode well for other shops. For reasons like these, the woes at Carlyle have been shaking the broader market, contributing to yesterday's gyrations in the Dow Jones Industrial Average.

"This is the brave new world of the credit crunch," says a top executive at one of Carlyle's lenders -- a group that included Citigroup, Deutsche Bank, Merrill Lynch and Bear Stearns. "It doesn't matter who the client is or how long you've known them."

Losing Ground

Carlyle Capital isn't the firm's only vehicle to lose ground in the credit crunch. A year ago it launched Carlyle-Blue Wave, a multistrategy hedge fund with almost $700 million in assets as of October. Blue Wave lost 17.2% last year in just 10 months of operation, mainly on bad bets in the debt markets, according to investor documents reviewed by The Wall Street Journal.

Carlyle Capital's shareholders are at risk of losing their entire investment in the fund, although Mr. Rubenstein, one of Carlyle Group's co-founders, said the firm is considering steps that could soften the blow. "We recognize that investors suffered losses, and we're not happy about that," he said. "We will try to make this experience ultimately feel better than it does today."

It's unclear what losses, if any, Carlyle Capital's lenders will incur. Some of its dozen or so lenders are currently in the process of seizing the fund's assets. They have a choice of either selling them or retaining them in hopes that the market for them improves later.

While Carlyle Group isn't likely to feel a significant financial impact from the fund's troubles, its demise deals a blow to the reputation of a firm that has built itself as one of the world's premiere asset-management companies. Over the past three years, Carlyle Group has participated in some of the largest buyouts in history, including purchase of car-rental giant Hertz Corp.

The concept behind Carlyle Capital was fairly simple. It would be a separate investment fund primarily holding highly rated mortgage investments, owned 15% by Carlyle executives, with the rest sold to outside investors.

In 2006, Carlyle hired John Stomber to run the fund. Mr. Stomber was an executive at Deutsche Bank AG in the 1990s before becoming treasurer of Merrill Lynch & Co. Previously, he worked at private-equity firm Cerberus Capital Management.

Unveiled in August 2006, Carlyle Capital would invest borrowed money, and then pocket the difference between the interest earned on its investments and the interest rate paid on the borrowings. That difference was small, so the secret to making money was borrowing massive sums. Carlyle Capital managed only $940 million in client money, but used borrowings to boost its portfolio of bonds to $22.7 billion -- meaning it was about 24 times "leveraged," a level that can quickly prove deadly in a volatile market.

Carlyle Group defended the strategy in a letter Thursday intended to reassure its investors. Carlyle Capital "believed this to be a creative and thoughtful approach and one that was time-tested in the market for these types of assets," that letter said. It was signed by top Carlyle Group executives William Conway, Daniel D'Aniello and Mr. Rubenstein.

Carlyle Capital had been struggling since summer. The fund had to postpone an initial public offering of stock in June, just as the credit crunch was first taking hold. Then, when it did go public in early July, it was forced to sell its shares at a discount. In August, only a month after the IPO on the Euronext exchange, Carlyle Group put up $200 million to bolster the fund.

Investors' Fears

In August 2007, Mr. Stomber wrote a letter to calm investors' fears. "We designed [Carlyle Capital's] business model to withstand a liquidity event equal to the events of Oct. 1998 when the demise of Long Term Capital Management threatened the financial markets," said Mr. Stomber, referring to the collapse of the large hedge fund.

But he also issued a warning: "We believe that the recent liquidity disruption" -- a reference to the debt-market turmoil then just getting started -- "is significantly worse than the events of 1998."

The fund's precarious position came as little shock to bankers, who had already been warning the fund it was too overloaded with debt. "They made the decision to reduce the leverage somewhat, but not to the extent that we thought appropriate," said one banker.

In recent months Carlyle Group tried to shore up the fund by selling about $1 billion of nonmortgage assets and suspending its dividend.

Speaking at World Economic Forum in Davos earlier this year, Mr. Rubenstein said that "the golden age of private equity" was over. The industry had now entered its "purgatory age," he said. "We have to atone for our sins a bit."

In recent weeks, Carlyle Group increased a credit facility to $150 million, one of several steps the firm described in a letter as "extraordinary measures" to keep the fund out of trouble.

However, the prices on the fund's underlying securities -- backed by government-sponsored Freddie Mac and Fannie Mae -- have in recent weeks dropped to levels not seen in more than 20 years.

On March 3, just two days before Carlyle Capital's problems became public, the fund held an earnings call reviewing its 2007 results. The executives' overall tone was cautious. "It's the worst fixed-income market I've ever seen in my career," said Mr. Stomber on the call.

With their balance sheets under extreme pressure, banks have tightened their purse strings and are now requiring more collateral for loans. Because the Carlyle Capital securities were somewhat obscure and thinly traded, as soon as there was selling in the market it drove prices as much as 10% to 15% below face value -- there were simply too few buyers. That triggered a spiral of "margin calls," or requests for collateral by lenders, that in turn forced more selling.

Working the Phones

Mr. Rubenstein worked the phones, calling his contacts in the banking world. In addition to contacting J.P. Morgan executives, he also placed a call to Josef Ackerman, chief executive of Deutsche Bank, to help stave off the crisis.

Mr. Ackerman was traveling in Brazil and the two never connected.

The situation intensified after Carlyle Capital disclosed that its lenders last week had issued margin calls on more than $400 million of loans and had started issuing default notices. The banks urged Carlyle Group to infuse a significant amount of capital -- as much as $1 billion -- into the fund to prevent a meltdown.

As late as Wednesday afternoon, executives at the Carlyle Group thought the firm had reached a deal that would have had the firm inject as much as $700 million to rescue Carlyle Capital. But even that might be wiped out if asset values continued to decline, its advisers said.

Instead, Carlyle Group will have to absorb the hit to its reputation. Throughout the past week, its switchboard has been flooded with calls as confused investors worried that Carlyle Group was the one at risk. Carlyle Group was forced to issue public statements over the past week explaining the distinction between Carlyle Group and Carlyle Capital.