OREANDA-NEWS. Fitch Ratings has affirmed the long-term Issuer Default Ratings (IDRs) of The Carlyle Group L.P. and its related entities (collectively Carlyle) at 'A-'. The Rating Outlook has been revised to Negative from Stable. Approximately $1.1 billion of unsecured debt is affected by these actions. A complete list of ratings is detailed at the end of this release.

Today's rating actions have been taken as part of a periodic peer review of the Alternative Investment Manager (IM) industry, which comprises seven publicly rated global firms. Fitch's outlook for the sector is stable; reflecting the relative stability of core operating fundamentals, given the locked-in nature of a large portion of fee revenue, modest but increased leverage levels, manageable near term obligations relative to available liquidity resources, increasing asset under management (AUM) diversity and investors' increasing allocation to alternative investments, particularly those managed by alternative IMs with strong franchises such as those included in Fitch's peer review. While fund realization activity has increased significantly over the last three years, leading to the amortization of existing AUM, managers have continued to replace capital, and therefore fees, with follow-on funds and expansion into other product categories through step-out strategies, seed investments, and/or acquisitions.

The variable cost structure of the alternative IMs has contributed to relatively steady cash flows through cycles. Fee-related earnings before interest, taxes, depreciation, and amortization (FEBITDA) margins had been trending down in recent years, given lower fee rates on new product categories, higher fundraising costs, and because the cost of doing business has risen with increased regulation and administrative costs associated with operating as public companies. However, FEBITDA margins have turned a corner more recently as many alternative IMs have begun to raise follow-on funds for newer strategies, which adds scale to the platform. The FEBITDA margin for 'A' category alternative IMs averaged 35.5% for the trailing 12 months (TTM) ended Sept. 30, 2015, which compared to a 34.9% average for 2012.

Leverage levels have increased across the industry, as issuers have taken advantage of the low interest rate environment to issue long duration funding and have also used debt financing for acquisition purposes. Average leverage, defined as debt divided by FEBITDA, was 3.54 times (x) for 'A' category firms for the TTM ending Sept. 30, 2015, which compared to an average of 2.55x at year-end 2012. Fitch believes the issuances have been largely opportunistic and views the reduction in refinancing risk favorably. Over time, Fitch expects leverage levels to migrate toward historical averages, as cash proceeds are deployed into FEBITDA-generating opportunities and recent acquisitions begin to contribute to consolidated results.

While core issuer fundamentals remain solid, alternative IMs continue to have record levels of capital to invest at a time when conditions are increasingly challenging. Therefore, there is more capital chasing fewer deals, which could lead to significant fund underperformance if competition bids prices up further. Outsized vintage concentration could potentially exacerbate this issue. While most of the large managers have operated through a variety of market cycles, and have demonstrated investment restraint, pressure for returns from limited partners remains high, given the length of time that interest rates have been at low absolute levels. That said, a meaningful portion of the industry's uncalled capital is not-yet-earning fees, often referred to as shadow AUM, which could provide some material upside to alternative IM FEBITDA as the capital is deployed.

KEY RATING DRIVERS

IDRs AND SENIOR DEBT

The rating affirmations for Carlyle reflects its position as a leading global alternative investment manager, its experienced management team, strong corporate culture, institutional investor base, large base of fee-earning assets under management (FAUM), and the subordination of general partner (GP) interests to outstanding indebtedness. The ratings are further supported by a generally successful track record in terms of underlying fund performance, which has garnered significant incentive income for the firm and supported continued fundraising.

Rating constraints include higher-than-peer leverage levels and a weaker liquidity profile, given lower FEBITDA margins and the demands on the firm's cash related to acquisition earn-out payments and co-investment commitments to the funds. Rating constraints for the industry as a whole include 'key man' risk, which is institutionalized throughout many limited partnership agreements, reputational risk, which can impact the company's ability to raise future funds, and legal and regulatory risk, which could alter the alternative asset space.

The revision of Carlyle's Rating Outlook to Negative from Stable reflects a lack of progress on core FEBITDA growth due to a variety of factors, including a continuation of relatively high fundraising costs, temporarily elevated catch-up management fees and recent underperformance of two hedge fund acquisitions (Claren Road and Vermillion). The lower FEBITDA generation further increases the firm's already high leverage, and the expected 2016 funding of a $120 million promissory note related to the NGP Energy Capital Management (NGP) acquisition, will further weaken Carlyle's leverage profile on a relative basis.

Furthermore, Carlyle has encountered a variety of challenges in recent quarters, which although non-recurring in nature, in aggregate, heighten the potential for reputational damage to the firm. These events include the consolidation of Brazilian land development company Urbplan Desenvolvimento Urbano S.A. (Urbplan) out of Carlyle's real estate funds and the injection of approximately $270.2 million of capital into the company from Carlyle and senior professionals; the funding by Carlyle of a French tax assessment associated with a European real estate fund investment, amounting to approximately EUR74 million; significant redemptions in the Claren Road hedge funds; the organizational and strategic restructuring of the Vermillion hedge funds; underperformance of the European real estate business and legacy energy partnership, and the departure of Co-Chief Operating Officer, Michael Cavanagh just 10 months after his hiring.

Fitch believes Carlyle retains one of the strongest and most profitable private equity franchises globally, but attempts to diversify beyond this business have been met with mixed results, as the corporate private equity segment continues to account for the vast majority of the firm's cash earnings (90.1% of distributable earnings for the TTM ended Sept. 30, 2015). Traction and scalability in other operating segments, which then contribute to higher FEBITDA and lower leverage, will be an important determinant in resolving the Negative Rating Outlook.

FAUM amounted to $128.1 billion at Sept. 30, 2015, down 8.6% year-over-year, as fund realizations, meaningful hedge fund redemptions, market depreciation, and a negative foreign exchange impact, particularly in investment solutions, offset strong fundraising activity. Fitch expects fundraising to remain active in coming quarters and FAUM will benefit from several funds starting their investment periods in early 2016, but FAUM growth will be highly dependent upon the pace of realization activity.

Carlyle's core operating performance has been consistently weaker than peers given the firm's higher cost structure, the impact of higher fundraising costs and, more recently, outflows from its hedge funds. Management fees were down about 0.6% through the first three quarters of 2015, as compared to the same period in 2014, as declines in global market strategies and investment solutions segments outpaced growth in private equity and real assets, although both of these segments continued to benefit from catch-up fees, which have been elevated for some time. The FEBITDA margin was 22.7% on a TTM basis through Sept. 30, 2015, which was well-below the peer average as of the same date. Fitch has expected margin expansion for several years, with the launch of step-out strategies and follow-on funds, but operating leverage has yet to materialize.

Counter to the relative management fee weakness, income generated from realized performance fees remain at the higher-end of the peer group as exit activity has been strong. Realized performance fees, net of associated compensation were $688.3 million year-to-date (up 45.8% from the comparable 2014 period) and $951.9 million for the TTM ended Sept. 30, 2015. Furthermore, accrued performance fees, net of associated compensation, were nearly $1.3 billion at the end of the third quarter of 2015 (3Q15). While Fitch does not consider the accrual a liquid asset, it does point to the potential for future income and cash flow generation, which could be used to support debt service.

Firm leverage remained elevated at 4.01x at Sept. 30, 2015 on a TTM basis, which is above the peer average. FEBITDA generation in 2015 trended below that of 2014, and there is the potential for further deterioration in 4Q15, given redemption activity in hedge funds. Additionally, Carlyle is expected to add a $120 million promissory note related to the NGP acquisition sometime in 1Q16, which would add about 0.4x to the leverage ratio, all else equal. The pace of, and degree to which Carlyle is able to gain momentum on FEBITDA expansion over the coming 24 months, will also be an important determinant in resolving the Negative Rating Outlook.

Fitch believes Carlyle's liquidity profile is adequate, although weaker than peers, as the firm does not operate in a negative net debt position. Carlyle also has more demands on its cash than many peers given sizeable co-investment commitments to its funds (a large portion of which is expected to be funded by employees), earn-out provisions associated with acquisition activity, and several non-recurring cash payments of late, including the aforementioned Urbplan and the French tax assessment. At Sept. 30, 2015, balance sheet cash amounted to $1.3 billion, although operating cash is lower, adjusting for amounts allocated to specific requirements. This compared to balance sheet debt of $1.14 billion at Sept. 30, 2015 and unfunded investment commitments of $400 million at June 30, 2015 (assuming $2.8 billion of commitments are funded by employees). Additionally, based on a probability-weighted estimate by Carlyle, the firm expected to fund $463.6 million of cash consideration, related to recent acquisitions as of 2Q15; approximately $140.5 million of which would be funded through the end of 2017. However, potential cash consideration declined in 3Q15 given the underperformance of certain hedge funds.

Beginning in 2015, Carlyle's distribution policy was changed, such that quarterly distributions are approximately 75% of distributable earnings, which is at the low-end of the peer group. Fitch believes the company has the flexibility to reduce distributions, if necessary, to bolster liquidity in any given quarter. Fitch views the alteration of the distribution policy favorably and believes enhanced balance sheet liquidity will provide the firm with more operating flexibility as it relates to growth and expansion opportunities.

RATING SENSITIVITIES

IDRs AND SENIOR DEBT

Carlyle's ratings remain particularly sensitive to currently high leverage levels, stemming from a combination of increased debt issuance and reduced FEBITDA generation. Failure to gain momentum on FEBITDA expansion over the coming 24 months, through incremental management fees and enhanced operating leverage in non-private equity segments, in order to support an eventual decline in the firm's leverage ratio, could lead to a rating downgrade. Negative rating actions could also be driven by declines in investment performance which adversely impact the firm's ability to fundraise and generate incentive income, reduced product line diversity, and/or excessive distributions or non-recurring cash charges which impair the liquidity profile as it relates to operating needs, debt maturities, earn-out provisions, and co-investment commitments.

Resolution of the Negative Rating Outlook is likely to extend to the outer end of Fitch's 12-24 month Outlook horizon, reflecting Carlyle's very strong franchise, lack of near-term debt maturities, available balance sheet resources and the locked-in nature of the majority of its AUM which enhances earnings reliability. These ratings strengths mitigate the risk of near-term rating migration, and limit the magnitude of a potential downgrade thereafter to likely no more than one notch (i.e. to 'BBB+' from 'A-').

Carlyle's Rating Outlook could be revised to Stable should Fitch observe enhanced consistency in the operating performance of the non-private equity segments, which signal the potential for improved FEBITDA generation, operating margins, liquidity, and lower leverage over the next 24 months. More specifically with respect to leverage, in order to revise the Outlook to Stable from Negative, Fitch would expect Carlyle's leverage to begin to decline within the Outlook horizon, with increased clarity with respect to the path to sustained leverage of less than 4.0x thereafter.

Longer term, positive rating momentum could be driven by stronger cash earnings diversity, meaningful reductions in leverage to levels that are commensurate with Fitch's 'A' category tolerance levels, and improvements in balance sheet liquidity which provide the firm with more operating flexibility as it relates to growth and expansion opportunities.

Carlyle is a leading global alternative investment manager specializing in private equity, real estate, energy, credit funds, and fund of funds. As of Sept. 30, 2015, FAUM amounted to $128.1 billion and total AUM was $187.7 billion. The company's stock is listed on the NASDAQ under the ticker 'CG'.

Fitch has affirmed the following ratings:

The Carlyle Group L.P.
Carlyle Holdings I, II, and III L.P.
TC Group LLC
--Long-term Issuer Default Rating (IDR) at 'A-'.

Carlyle Investment Management LLC
TC Group Investment Holdings LP
TC Group Cayman Investment Holdings LP
TC Group Cayman LP
Carlyle Holdings Finance L.L.C
Carlyle Holdings II Finance L.L.C
--Long-term IDR at 'A-';
--Unsecured debt at 'A-'.

The Rating Outlook is revised to Negative from Stable.