Carlyle Group Inc. quarterly report, Q2 FY2019

Carlyle Group L.P. 10-Q Summary

Business context and reporting period

The filing covers the unaudited quarter and six months ended June 30, 2019. Carlyle is a global investment manager operating through Corporate Private Equity, Real Assets, Global Credit, and Investment Solutions. Total AUM was $222.7 billion and fee-earning AUM was $158.4 billion at quarter-end. The filing was submitted by The Carlyle Group L.P.; the company announced on July 31, 2019 that it intends to convert to The Carlyle Group Inc., effective January 1, 2020.

Key financial metrics

Metric	Q2 2019	Q2 2018	H1 2019	H1 2018
Total revenue	$1,061.1 million	$893.6 million	$2,148.1 million	$1,596.4 million
Income before tax	$542.0 million	$252.8 million	$1,012.3 million	$378.3 million
Net income	$526.5 million	$241.2 million	$972.8 million	$358.9 million
Net income attributable to common unitholders	$148.2 million	$63.5 million	$285.2 million	$97.3 million
Diluted earnings per common unit	$1.23	$0.56	$2.41	$0.87
Distributable Earnings	$213.4 million	$114.5 million	$314.2 million	$253.4 million
Fee Related Earnings	$132.7 million	$57.8 million	$236.0 million	$86.0 million

GAAP income-before-tax margins were approximately 51.1% in Q2 and 47.1% for H1 2019, compared with 28.3% and 23.7% in the comparable 2018 periods. Net-income margins were approximately 49.6% and 45.3%, respectively. The margin improvement was primarily driven by higher principal investment income, including Fortitude Re earnings, and lower compensation-related expenses relative to revenue.

Fund management fees increased 30% year over year in Q2 and 32% in H1, primarily from newly fee-paying funds, catch-up fees, and higher advisory and transaction fees.
Performance allocations declined to $247.6 million in Q2 from $425.1 million, and to $596.7 million in H1 from $733.2 million.
Principal investment income increased to $342.0 million in Q2 from $78.2 million and to $643.8 million in H1 from $132.3 million. Fortitude Re contributed $271.0 million in Q2 and $527.3 million in H1, including substantial unrealized gains.
Total expenses declined 19% in Q2 and 8% in H1. Compensation and benefits declined to $370.2 million in Q2 and $802.1 million in H1, despite higher cash compensation, because equity-based and performance-related compensation decreased.
Operating cash flow was $269.0 million in H1 2019 versus $(538.2) million in H1 2018. Investing cash flow was $(23.7) million, and financing cash flow was $(202.3) million. Cash, cash equivalents, and restricted cash ended at $683.6 million.
Cash and cash equivalents were $669.2 million, including approximately $601 million that management identified as remaining after amounts allocated for specific business purposes.
Debt obligations were $1.532 billion, including $1.200 billion of senior notes and $329.9 million of CLO borrowings. The $775 million senior revolving facility had no borrowings outstanding. The company reported compliance with all debt covenants.
Consolidated CLO liabilities of $4.506 billion are generally non-recourse to Carlyle and supported by CLO assets.

Material changes versus the prior comparable period

Revenue increased 19% in Q2 and 35% in H1, while common-unit net income increased 134% in Q2 and 193% in H1.
Distributable Earnings increased 86% in Q2 but increased only 24% in H1 because the prior-year period benefited from higher realized performance revenues.
Fee Related Earnings increased 130% in Q2 and 174% in H1, reflecting higher recurring fee revenue, lower external fundraising costs, and lower equity-based compensation.
Fee-earning AUM increased 8% year over year to $158.4 billion, but declined from $160.0 billion at March 31, 2019 because of outflows. Total AUM increased from $216.5 billion at December 31, 2018.
Investments, including accrued performance allocations, increased to $6.707 billion from $5.698 billion at December 31, 2018. Accrued performance allocations increased to $3.907 billion from $3.480 billion.
Accrued compensation and benefits increased to $2.413 billion from $2.222 billion, including $2.034 billion of accrued performance-allocation and incentive-fee compensation.
The company adopted lease accounting in 2019, recognizing $231.3 million of lease right-of-use assets and $307.9 million of lease liabilities without a material impact on operating results.

Guidance, outlook, commentary, risks, and unusual items

Management expects global growth, M&A activity, syndicated lending, and exit activity to remain challenging. Trade tensions, slowing growth, high industry dry powder, tighter leveraged-loan liquidity, and volatile markets could reduce investment pace and realizations.
Management expects net realized performance revenues to remain at lower levels during the second half of 2019, although it believes the maturing fund portfolio can generate significant realizations in future years.
Carlyle raised $3.5 billion of new capital in Q2, surpassed its multi-year $100 billion fundraising target, and invested $7.3 billion in new or follow-on transactions. Management expects fundraising to continue but at a slower pace.
Carry funds appreciated 2% in Q2. Real estate appreciated 6%, Corporate Private Equity 1%, Global Credit 1%, and Investment Solutions 4%; natural-resources funds declined 4%, and the public portfolio declined 5%.
Fortitude Re produced a material but volatile earnings contribution. Of its $271.0 million Q2 contribution, $230.9 million represented unrealized gains related to embedded derivatives; management cautions that these marks may not reflect underlying operating performance.
A French tax dispute settlement generated $71.5 million of principal investment income in Q2.
Potential giveback obligations were $63.2 million. The filing states that previously realized and distributed carried interest subject to potential giveback could be approximately $0.4 billion on an after-tax basis under an extreme scenario.
Unfunded commitments totaled $4.013 billion, of which approximately $3.4 billion was subscribed by senior professionals and other professionals and the balance funded directly by Carlyle.
Legal and regulatory contingencies were accrued at approximately $35 million. Management did not believe pending matters were likely to be material beyond recorded accruals, but acknowledged that adverse outcomes could materially affect a particular period.
The planned conversion to a corporation is expected to eliminate future tax receivable agreement obligations other than approximately $1.50 per exchanged Carlyle Holdings unit, payable over five annual installments. Based on June 30 holdings, aggregate payments would be approximately $346 million, subject to reduction from pre-conversion exchanges.
Following conversion, management anticipates an initial common dividend of $0.25 per share per quarter, or $1.00 annually, subject to board discretion. The company also expects to pay more corporate income taxes, with an estimated effective tax rate on Distributable Earnings in the mid-to-high teens initially and low twenties over the long term.

Most important facts for investors to verify

Whether the January 1, 2020 corporate conversion occurs as planned and the final terms of the tax receivable agreement termination.
The sustainability of earnings excluding Fortitude Re unrealized marks, the French tax settlement, and other unusual items.
The timing and amount of future realizations, carried interest, distributions, and potential givebacks.
The effect of higher corporate taxes and the proposed $1.00 annual dividend on post-conversion cash generation and distributable earnings per share.
Progress in fundraising, fee-earning AUM retention, and Global Credit expansion relative to the stated market and liquidity challenges.
Funding requirements for the $4.0 billion of unfunded commitments, contingent consideration, leases, debt maturities, and other contractual obligations.
Valuation sensitivity of Level III investments and CLO assets to default rates, recovery rates, discount rates, discount margins, and indicative pricing.