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Grasping 'Radical' Economic Change

Interviewee: David M. Rubenstein, founder and managing director, Carlyle Group
Interviewer: Lee Hudson Teslik, Associate Editor, CFR.org
October 10, 2008

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After eight consecutive days of stock market declines in the United States, and cascading losses in other major markets around the world, many analysts said the financial crisis of 2008 had devolved into a full-fledged panic. David M. Rubenstein, the cofounder and managing director of the Carlyle Group, a leading private equity firm, discusses what must be done to mitigate the fear he says has "overtaken everything." Rubenstein, who sits on CFR's board of directors, says the present stock declines and credit crunch "are just the tip of the iceberg." He envisions a broad overhaul of the financial economic motors that had driven the global economy in recent decades and says major coordination between business and government leaders in the United States-and between the United States and other countries-will be necessary to prevent further pain. Rubenstein also discusses how the current turmoil will affect the private equity business. He says new limits on leverage could pose significant challenges for private equity firms, and goes on to discuss how these firms-many of which are flush with cash but cannot get loans and thus cannot pursue their former strategy of buying companies through leveraged buyouts-can alter their business model to keep afloat. Eventually, Rubenstein says, he suspects "once in a lifetime" buying opportunities will come of this crisis.

President Bush just spoke on the economic crisis. He didn't introduce any new policy and basically said that the U.S. government would continue with the steps it has already taken to counter the crisis. Are those steps enough?

Clearly more needs to be done if the market is going to have enough confidence to find a bottom. The leaders in our government today, and the leaders of the business world today, do not really have a clear understanding of what needs to be done. I'm not sure anybody does. Everything that has been thought of has been tried and it hasn't yet worked. I do think that at some point we will hit a bottom and people will say this is as far down as the markets should go. The problem is that by the time we hit that bottom, it may well be that many companies do not survive, that unemployment has gone up much higher than people can tolerate, that the credit system is not fatally but near-fatally wounded, and the entire economic construct under which the globe has conducted itself has to be radically changed. Nobody has ever anticipated something like this, nobody has ever seen anything like this, and it's therefore taxing everybody's abilities to find out what the solution is.

I'm hesitant to be a bearer of bad news, but I'm afraid that some of the things we're talking about today-stock declines, credit crunches, things like that-are just the tip of the iceberg. We haven't yet seen the declines in commercial real estate, the rising unemployment, the credit card defaults, the student loan defaults or inability to fund student loans, and the general decline in business sales and consumer activity. All of those things combined will have a very devastating impact, not only on our economy but also [on] the global economy. It's clear now that the concept that some had proposed, that there is a decoupling of the U.S. economy from the rest of the world's, is just not the case. It's clear that the U.S. economy drives the world economy, and we're going to see downturns essentially all around the world.

Private equity firms are in an interesting place right now. Many of them have a fair amount of cash on hand, but they can't do leveraged buyouts because they can't get loans. Is there anything the government could say right now that would give you more confidence to invest?

Private equity firms are in an enviable position because most of us are privately held. We have a fair amount of capital available to us, and therefore we have the ability to invest at probably what will be historically low prices. On the other hand, all of us own companies that are probably worth less today, and all of us have to make sure that the existing companies, many of which have leverage, can survive this downturn as well. So all of us have a lot to do to just make sure that what we own is in good shape and can get through this. I would say that the main economic engines that you've seen over the last couple years in the U.S. economy and the rest of the world are going to change dramatically in ways that we won't recognize them. For example, the commercial banks are going to be dramatically different in what activities they can undertake. The investment banks are all but gone as stand-alone entities. Hedge funds are going to be decimated in their number and the capital available to them. Private equity firms will reshape the way they do business. They'll have to rely much less on leverage and use other means to make investments that will get the kind of returns their investors want. And governments themselves will have limited ability to stimulate their economies or to do the kind of things they often do to prod business forward. So it's a completely different world in which we're living.

One of the things that the world hasn't yet focused on, but it will shortly, is that in addition to the economic pain for business organizations that's in the newspapers every day, there's going to be an enormous impairment that's going to be felt by the nonprofit world, the philanthropic world. Universities, foundations, all kinds of hospitals, and other charitable organizations will have three problems that they're going to have to deal with. Number one, they will have fewer contributions coming in, no doubt. Number two, the values of their endowments will go down, probably, because they are all invested in things that are going down. And three, the cash that they generate off their endowment, or equivalent of an endowment, will be less, and therefore they'll have less cash. In other words, not only will the endowment be smaller in size, but it will produce less income. So there's going to be a real tightening at some of the nonprofits as well.

I wish I could say I saw the bottom. We're closer to the bottom than we've been in the past. But I think before we actually hit the bottom there will be some major bankruptcies and some enormous further losses of money. On the other hand, on the optimistic side, I do think that we will see money coming in at some point to make investments, to shore up companies, and to take advantage of the opportunities that will be once in a lifetime. I recognize that not everybody has the kind of money to make these kinds of investments, but those that do will benefit their investors and ultimately benefit the overall economy by making the kinds of investments that will give people some confidence. Regrettably, there are very few people in the country and in the world whose views on what the economy should do, and what government should do, are taken that seriously. There are very few people who can say, "We're at the bottom," and have those words inspire enough confidence for people to follow them. Greed has completely fallen by the wayside and fear has completely taken over. Normally there's some kind of balance between greed and fear, but greed has so disappeared and fear has so overtaken everything that we're really not in a rational situation right now.

In the short term, is there something concrete that the Treasury or the Fed should do to mitigate that fear?

A couple things: One, I think the Treasury has done everything it knows to do, but they will have to use the authority given to them by Congress to make investments in companies, rather than buying assets from companies. They will have to invest in preferred shares of many companies that now seem weak. Second, they will have to extend that purchase and that investment activity to companies beyond just the financial sector, but to some industrial companies and other companies whose importance to the U.S. economy is very significant, and therefore would not be helpful if they went bankrupt.

Third, it is of paramount importance that the next president of the United States announce his Treasury secretary and his economic team the day after the election, and have that team work immediately with the current Treasury secretary and economic team so we don't have the normal two-and-a-half month hiatus, which I don't think the global economy can afford. Given this situation, I don't think we can afford to not know what the new president's Treasury secretary and economic team want to do on some of these issues. We can't afford to have one secretary doing something that's diametrically opposite of what the next secretary wants to do, and have this uncertainty in a transition.

I also believe that the more times we can get the congressional leadership and the president meeting together and agreeing on things would be helpful. And the more we can get business leaders meeting with governmental leaders and agreeing what should be done and coming out and giving the country a sense that the leadership of the country-business and government-have a common view on what should be done, would be helpful.

I also think there needs to be much more coordination between the governments around the world of what to do. The IMF meetings that will be occurring over this weekend in Washington are going to be very important, and at that time I hope the financial leaders of the major economies of the world will come up with a coordinated approach to what they will do.

To a degree, the volatility we've seen has been driven by institutional trading and hedge funds, first pouring money into equities and commodities and now unwinding their positions. Is there a systemic problem here?

You have three things that were going on. One is enormous unsustainable and unprecedented leverage. Two, you have the global interconnection of this leverage. The leverage was being utilized all over the world, so everything was linked. And because of the way trading now works, and the 24/7 nature of society, the velocity at which changes can occur-at which trading can be done and opinions can be expressed-has produced a very rapid global and therefore interconnected deleveraging. Deleveraging is far more painful than anyone realized. We've never had a massive global and instantaneous deleveraging of this type, and therefore there's no precedent for it. People often ask,"Are you better off with deflation or inflation?" We don't have much experience with deflation in this country, but those who have experienced it in other countries actually say it's in many ways far worse than inflation. We have tools in our economic kit to deal with inflation, typically. We don't have as many tools to deal with deflation. So the government needs to take steps-which it's trying to do-to combat the prospect of serious deflation.

Last, given likely limitations on leverage in the future, possibly through new government regulation, how will private equity have to change to address the problems presented by that?

Private equity is a two-word phrase that has come to mean different things to different people. To me, the phrase private equity means intelligent people investing their own money alongside their investors' money to do things, typically in the private sector, to make their investments worth more. One part of private equity has been buyouts. The buyout part of private equity has utilized leverage-three, four times leverage-to make the transactions occur. However, if you buy something cheap enough, you don't need any leverage. In other words, if I can buy something at eight times [the company's] cash flow, I may need leverage to get the return that I want. But if I can buy something at one time or two times cash flow, I probably don't need any leverage. So what you'll see is private equity firms buying things at much, much reduced prices, in which case they'll need less leverage to get the returns they want. Secondly, they'll be taking a lot of minority investments, where there's no leverage involved-they'll take a stake in a company but not employ leverage to try to get control of the company. †And third, they'll invest much more outside the United States in emerging markets. While those countries have problems as well, the prices are still much cheaper there than they are in the United States. The private equity people will be okay. Nobody is immune from the laws of gravity, and private equity will have its problems as well, but by and large the private equity firms are probably going to emerge from this far stronger than many of the other kinds of economic engines of our society.

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