Carlyle Group Inc. quarterly report, Q3 FY2017

Business Context and Reporting Period

The filing is The Carlyle Group L.P.’s unaudited Form 10-Q for the quarter and nine months ended September 30, 2017. Carlyle is a global alternative asset manager operating through Corporate Private Equity, Real Assets, Global Market Strategies and Investment Solutions. The filing consolidates certain funds and variable-interest entities, which materially increases reported assets, liabilities and cash flows but generally has limited effect on income attributable to Carlyle.

At September 30, 2017, total AUM was $174.4 billion and fee-earning AUM was $121.8 billion. Carlyle reported 97.8 million common units outstanding and issued 16.0 million 5.875% Series A Preferred Units during the quarter.

Financial Performance and Key Metrics

Metric	Q3 2017	Q3 2016	9M 2017	9M 2016
Total revenue	$639.9 million	$607.3 million	$2,668.4 million	$1,698.4 million
Fund management fees	$262.5 million	$255.1 million	$747.6 million	$817.1 million
Total performance fees	$285.6 million	$214.7 million	$1,510.8 million	$570.8 million
Income before taxes	$165.9 million	$(49.7) million	$737.3 million	$33.4 million
Net income attributable to Carlyle	$44.6 million	$0.8 million	$185.2 million	$15.3 million
Basic earnings per common unit	$0.47	$0.01	$2.06	$0.19
Distributable Earnings	$259.9 million	$228.2 million	$514.2 million	$644.3 million
Fee Related Earnings	$96.4 million	$30.8 million	$128.1 million	$126.7 million

GAAP income before taxes represented approximately 25.9% of quarterly revenue and 27.6% of nine-month revenue. Net income attributable to Carlyle represented approximately 7.0% of quarterly revenue and 6.9% of nine-month revenue. These ratios are affected by performance-fee volatility, non-controlling interests, consolidation effects and unusual items.

Quarterly revenue increased 5%, while nine-month revenue increased 57%, primarily because of higher performance fees.
Quarterly performance fees increased $70.9 million year over year. Nine-month performance fees increased $940.0 million, including $658.1 million of unrealized performance fees compared with a $334.3 million unrealized performance-fee reversal in the prior-year period.
Quarterly total expenses fell $169.2 million because of lower litigation and contingency costs, insurance recoveries and lower general and administrative expenses. Nine-month expenses increased $339.4 million, primarily from higher performance-fee-related compensation and consolidated-fund expenses.
Operating cash flow was $571.8 million for the nine months, compared with $127.5 million in the prior-year period. Cash and cash equivalents increased to $1,355.7 million from $670.9 million at December 31, 2016.
Cash used in investing activities was $22.4 million. Financing activities provided $73.7 million, including $387.6 million of net preferred-unit proceeds and $202.6 million of debt proceeds, partially offset by distributions and other financing payments.

Balance Sheet, Debt and Liquidity

Total assets were $11.7 billion, including $3.5 billion of accrued performance fees, $1.5 billion of investments and $4.2 billion of investments held by consolidated funds.
Total liabilities were $8.9 billion. Carlyle’s debt obligations were $1.5 billion, compared with $1.3 billion at December 31, 2016. Consolidated-fund loans payable were $3.8 billion and are generally non-recourse to Carlyle.
The senior credit facility consisted of a $25.0 million term loan and a $750.0 million revolving facility, with no revolving balance outstanding at September 30, 2017. The facility matures May 5, 2020.
Management stated that cash, operating cash flows and the available credit facility should be sufficient to fund capital needs for at least the next twelve months. Cash and corporate treasury investments totaled approximately $1.5 billion, of which management estimated approximately $1.3 billion remained after amounts allocated to specific requirements.
Carlyle was in compliance with its debt covenants at September 30, 2017. The senior credit facility requires minimum management fee-earning assets of $65.3 billion and a total leverage ratio below 3.0 to 1.0.
Unfunded commitments totaled $2.8 billion, of which approximately $2.5 billion was subscribed individually by senior Carlyle professionals, advisors and other professionals. Carlyle’s operating entities had contractual obligations of $3.7 billion excluding consolidated-fund obligations and most externally funded commitments.

Material Changes Versus the Prior Comparable Period

Corporate Private Equity drove the nine-month performance-fee increase, with segment performance fees of $1.1 billion versus $279.0 million in the prior-year period. Nine-month Corporate Private Equity Economic Net Income rose to $647.3 million from $153.4 million.
Global Market Strategies improved substantially as the business exited hedge-fund and commodities-advisory activities and focused on global credit. Nine-month segment Fee Related Earnings rose to $76.0 million from $(4.9) million, aided by insurance recoveries and lower expenses.
Real Assets nine-month Distributable Earnings fell to $(25.5) million from $68.8 million, primarily because of a $65.0 million realized loss associated with the disposal and deconsolidation of Urbplan.
Fee-earning AUM increased to $121.8 billion from $114.0 billion at December 31, 2016, but remained below $123.8 billion at September 30, 2016. Growth from capital commitments and foreign exchange was partly offset by distributions, outflows and the wind-down of former hedge-fund activities.
Accrued performance fees increased to $3.5 billion from $2.5 billion at December 31, 2016. Accrued performance-fee-related compensation also increased to $1.8 billion from $1.3 billion.
Carlyle issued preferred units for $387.6 million of net proceeds. Preferred distributions are discretionary and non-cumulative, with a stated rate of 5.875%.
Senior Carlyle professionals exchanged approximately 4.6 million Carlyle Holdings partnership units for common units during the first nine months, increasing common units outstanding and reducing non-controlling interests in Carlyle Holdings.

Guidance, Outlook, Commentary and Risks

Management expected fundraising activity to accelerate during the remainder of 2017 and into 2018, supported by flagship buyout funds. Carlyle targeted $100 billion of gross new capital raised over the four-year period beginning in 2016 and had raised $22.1 billion during the preceding twelve months.
Management expected fundraising costs to increase in the fourth quarter of 2017 and into 2018 before related management fees are activated. Two large buyout funds were expected to activate fees around the middle of 2018. Pending fee-earning AUM was $5.5 billion at September 30, 2017.
Carlyle anticipated elevated expenses as it expanded its global credit business, hired additional employees and compensated personnel for current and expected performance.
Management reported favorable global growth, tight credit spreads, low defaults and strong fundraising conditions, but cautioned that higher asset valuations could pressure returns on new investments.
Effective January 1, 2018, Kewsong Lee and Glenn Youngkin were scheduled to succeed Bill Conway and David Rubenstein as co-chief executive officers. Management did not anticipate changes to the investment process or teams.
Performance fees depend on unrealized investment valuations and can reverse. Giveback obligations were $67.6 million at September 30, 2017; management estimated that potential after-tax givebacks could reach approximately $0.8 billion if all carry-fund investments became worthless, a scenario it considered remote.
The filing identifies risks from private-investment valuation uncertainty, market and foreign-exchange movements, leverage and credit risk, fundraising and fee-basis changes, regulatory investigations, litigation, tax audits, capital commitments and potential changes in distribution capacity.
Carlyle paid $265 million to resolve claims related to petroleum commodities investments managed by Vermillion, issued approximately $54 million of promissory notes, and recognized $177 million of net insurance proceeds during the nine months. Approximately $35 million of liabilities were accrued for litigation, regulatory and other contingencies.
The SEC was seeking information regarding historical acceleration of monitoring fees and Carlyle’s relationship with a third-party adviser. Carlyle stated it was cooperating and did not believe existing matters were probable to have a material effect, while noting that adverse outcomes could materially affect individual periods.
The company planned to adopt the new revenue standard on January 1, 2018, with a full retrospective presentation. The filing expected a reclassification of certain carried-interest amounts from performance-fee revenue to investment income.

Most Important Facts for Investors to Verify

Whether the substantial increase in 2017 performance fees, particularly unrealized fees, converts into sustainable realized cash earnings.
The composition, valuation assumptions and concentration of the $3.5 billion accrued performance-fee balance and the $1.5 billion net accrued performance fees attributable to Carlyle Holdings.
The effect of fundraising costs, new credit-business hiring and future fee activation on Fee Related Earnings and Distributable Earnings.
The liquidity impact of $2.8 billion of unfunded commitments, expected CLO risk-retention funding of approximately $750 million over five years, debt maturities and tax-receivable-agreement payments.
The potential financial exposure from givebacks, Vermillion-related recoveries, regulatory inquiries, litigation and tax audits.
The impact of preferred-unit distributions, common-unit exchanges and the significant non-controlling ownership in Carlyle Holdings on earnings and distributions available to common unitholders.
Reconciliations between GAAP results and management’s non-GAAP Economic Net Income, Fee Related Earnings and Distributable Earnings, which exclude or reclassify significant items.