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The Iron Triangle: Inside the secret world of the Carlyle Group

Jossey-Bass

Chapter One

It was a great scam.
-Stephen Norris, co-founder
Carlyle Group, May 20, 2002

Cast of Characters

Stephen Norris Co-founder Carlyle Group.

David Rubentstein Co-founder Carlyle Group.

Dan D'Aniello Co-founder Carlyle Group.

William Conway Co-founder Carlyle Group.

Frederic Malek Former Nixon aide, close friend of George Bush Sr.,
and current CEO of Thayer Capital.

Jimmy Carter Former president of the United States.

William Barr Former attorney general and law partner of David
Rubenstein.

Stephen Norris is getting excited now. Even today, recalling the events that led to the formation of the Carlyle Group, the company that would eventually come to represent Norris' legacy, gives the 53-year-old Washington dealmaker a thrill. Though they didn't know it at the time, co-founders Norris and David Rubenstein, a young staffer from the Carter administration, were embarking on the ride of a lifetime.

With a nose for the big deal, the cocksure Norris is, by his own admission, a difficult man to get along with. His time with the Carlyle Group, ending abruptly in January 1995, was marked by tension, competition, and conflicting egos. He is a man with casual disregard of those with whom he is conversing. His eyes flit around the room. He looks at everything but you. He talks freely, with no fear of consequence, and rarely pauses for a retort. He talks over you. Athletic, fit, handsome, and with a healthy taste for the good life, Norris speaks longingly, even boastfully, of his time with the Carlyle Group, fondly recalling his blockbuster deals with rich Saudi princes and Fortune 500 companies. He is, and always has been, a man that swings for the fences.

In late 1986, Norris, then an executive with Marriott's mergers and acquisitions group and a tax whiz, got wind of a little-known tax loophole that allowed Eskimo-owned companies in Alaska to sell their losses to profitable companies. The origin of the loop-hole dated back to 1971, when Alaskan natives arrived at a unique settlement with the federal government over ownership claims of Alaskan land. Typically, when Native Americans sued the U.S. government over the atrocities committed during the nation's "manifest destiny" era, the settlements revolved around land, otherwise known as reservations. The logic went that if the government could return some portion of the land they stole in claiming America for themselves, the irreparable cultural damage done to Native Americans in the process would somehow be forgotten. But the Eskimos weren't buying it. Unlike Native Americans in the lower 48 states, Alaska's natives eschewed the traditional award of land reservations. Instead, the Alaskans chose cash. Under a unique settlement, Alaskan natives were allowed to set up native-run corporations to invest and manage the money they had been awarded. In the end, the Eskimos and other native Alaskans ended up with $962 million to manage as they saw fit. They also managed to negotiate for 44 million acres of land on which to run their businesses. It was the price paid to them for decades of oppression, and they took it.

Because of some bureaucratic foot-dragging and truly unfortunate timing, the newly formed corporations missed out on Alaska's boom time in the mid-1970s. Fishing, timber, and oil, three of the local industries most companies were set up around, experienced major downturns. Many of the companies fell prey to mismanagement, investing in foolish pursuits like tire manufacturers, concrete plants, and hotels. Even though they had chosen their own fate, the owners of the companies felt they had been set up to fail. More than 180 companies had been formed out of the settlement. Only one managed to consistently turn a profit. It was a total disaster.

The companies soon found themselves facing huge losses, and limited options for turning things around. In 1983, Alaskan Senator Ted Stevens worked to save his floundering constituency by incorporating a clause in the 1984 tax bill that allowed the Alaskan-owned companies to leverage their losses by selling them to profitable companies looking for a break on their taxes. Essentially, if an Alaskan company lost $10 million in a fiscal year, they would sell the losses for $7 million in much-needed cash. The buyer would then write the losses off against its profits, getting a $10 million tax credit for just $7 million. Everyone's happy, except, of course, the government. Norris smelled money. But he needed help from someone. Someone with exceptional connections. Someone that knew everybody, including some Alaskan Eskimos.

Someone like David Rubenstein.

Rubenstein: Carlyle's Beating Heart

Ask enough people about David Rubenstein, and you start to hear the same descriptors over and over: brilliant, driven, tireless. Norris still maintains an objective respect for Rubenstein, with whom he joined forces in 1986. Rubenstein had been toiling as a Washington, DC, lawyer for six years with the mergers and acquisitions groups at Shaw, Pittman, Potts & Trowbridge and G. William Miller & Co. when Norris came calling. Norris, who often transitions seamlessly between utterly eloquent and outright crude, calls Rubenstein "indefatigable," "indomitable," and "f**king brilliant." Rubenstein would go on to become the very heart and soul of Carlyle, driving the company forward through clashing egos and countless near-scandals.

After graduating from the University of Chicago Law School in 1973, Rubenstein worked his way up the political ranks with blazing speed. At the tender age of 27, he became the deputy domestic policy assistant to President Jimmy Carter. He was the first person in the office in the morning, and the last to leave. One of the most widely circulated stories about Rubenstein is that he survived solely on vending machine fare during his time at the White House, a claim he does not refute. He strongly believed in the nobility of being a public servant. He was young, idealistic, and most of all, innocent.

In the spring of 1980, Rubenstein filed a memo to the president late one night. Before he left to go home-some thought that he was actually living in the White House due to his late hours-he remembered something he had intended to add to the memo, and went into the president's office to fetch the document. After shuffling through some papers in the president's inbox, he found the memo, amended it, and returned it to the stack. The next morning, President Carter questioned Rubenstein about his late-night foray into his office, asking him pointedly and repeatedly what he had seen while he was there. Rubenstein truthfully told the president that he simply got his memo, and then returned it, seeing nothing in the process. As it turns out, atop the stack of papers on Carter's desk, were the plans for the ill-fated rescue attempt of America's Iranian hostages in April 1980. The story, related to me by Norris, demonstrates Rubenstein's early naiveté. It also foreshadows the paranoia that some say has grown inside him over the past 20 years in Washington, DC. "He sees conspiracies," says Norris.

After Carter lost to Reagan in 1981, Rubenstein was released into the world of high-priced beltway lobbyists. It was a business that insulted Rubenstein's renowned intelligence and underutilized his many talents. His distaste for the work was captured in a 1993 article in New Republic, where he was quoted as saying, "I found it demeaning, it was legalized bribery." His opinion of lobbying would change later in his career.

Rubenstein would soon be delivered from the tedium of Washington influence peddling, when Norris, while still working for Marriott, contacted him, looking for a way to cash in on what would come to be known within Carlyle as the Great Eskimo Tax Scam.

Norris' entire job at the time was to scour tax law and find ways to save Marriott millions. He hired Rubenstein and William Barr, the man who would go on to become attorney general from 1991 to 1993, from Shaw, Pittman, Potts & Trowbridge, a Washington law firm that had represented Marriott on the Hill in the past. Along with his relentless work ethic, Rubenstein had also garnered a reputation for his extensive Rolodex. When Norris asked him if he knew any native Alaskans, Rubenstein had no problem coming up with some names.

Marriott ended up paying Rubenstein and Barr a seven-figure fee for their help in saving them a bundle on their taxes in 1986. Norris, after reading the tax bill closely, decided there was a much greater opportunity here than just this one-shot deal. He figured if Rubenstein and Barr could make out so handsomely for their limited role in facilitating Marriott's tax relief, he could, too. Norris left Marriott and set up shop in Seattle to pursue the deals, all the while talking to investors about opening up a little business of his own.

Before long, Norris and Rubenstein were flying Eskimos into Washington, DC, buttering them up, and brokering deals between them and profitable American companies. Finding the loss-making Eskimos was easier than either of them had imagined, and the profitable counterparts couldn't get enough of the free money. Norris and Rubenstein took a 1 percent cut of the transactions and sent an estimated $1 billion through the loop-hole. A cottage industry had been born. After clearing close to $10 million, Norris and Rubenstein recognized the ongoing potential of the business, and decided to incorporate. For corporate representation, the two hired none other than Ron Astin of the venerable Houston law firm Vinson & Elkins. (Astin would later find himself testifying before Congress about offshore partnerships he had helped set up for Enron.) With the crew in place, liabilities limited, and money coming in the door, the boys were ready to make something of themselves. All they needed now was a name.

During this time, Norris and Rubenstein frequented the Carlyle Hotel in New York. Norris loved the place. It was the kind of over-the-top lavishness he couldn't get enough of. It had a high-roller feel to it. His hero, Andre Meyer, the legendary head of investment bank Lazard Freres, had lived there for years. Norris felt the name lent the company a silk-stocking air. After selling Rubenstein on the idea, the Carlyle Group was born.

That the Carlyle Group was formed out of a temporary tax loophole, which was eliminated a year later, is utterly appropriate. David Rubenstein, as dedicated a public servant as there ever was, saw fit to found his company on a scheme that denied the federal government close to $1 billion in taxes. It was the first of many ironies that would compromise Rubenstein's political roots as his career with Carlyle progressed. As with many of the Carlyle Group's future deals, the Great Eskimo Tax Scam was entirely legal. Whether it was ethical, is another question.

The tax loophole unwittingly encouraged Eskimo companies to overstate their losses, and the IRS was called in to investigate. A discrepancy between "hard" and "soft" losses arose. Corporate appraisers took liberties in estimating the loss in value of certain goods, like timber and oil. Suddenly everyone in Alaska had losses for sale. It was a bonanza for accountants. Though no charges were ever filed, the case portends the current corporate malfeasance in America, in which companies inf late revenues and earnings through marginally legal accounting.

It bears mentioning that in certain cases, the tax loophole actually did what it was intended to do. Some Alaskan companies took the capital they received and reinvested, saving themselves from certain bankruptcy. Finally, however, just before Carlyle could complete a $500 million deal with a company called Cook Inlet, the government had seen enough of its money wasted, and sewed up the hole. It was the end of a great scheme for Carlyle, and it would be the last easy money the company saw for half a decade.

Goin' Legit

After the tax loophole closed, Norris and Rubenstein briskly went about building an empire. They brought Dan D'Aniello over from Marriott, whose salary Norris personally guaranteed. They also signed up William Conway, a former chief financial officer at MCI Communications. Funding for what Rubenstein was pitching as a leveraged buy-out firm came mainly from Pittsburgh's wealthy Richard K. Mellon family and Ed Mathias at T. Rowe Price, the Baltimore-based investment bank. It only took $5 million to get them on their way.

It was the go-go 1980s, and big business was flying high. Leveraged buyouts were the name of the game. This particular brand of cut-throat business consisted of big banks borrowing billions, acquiring huge positions in struggling companies, snatching them up on the cheap, and selling them off for parts or turning them around. Everyone was getting rich and Rubenstein was itching to get a piece of the action. He would later confess to a reporter that "I thought I had a pretty good IQ myself, and people were making a lot more money than me who I thought maybe weren't so smart."

The most important thing for buyout firms, otherwise known as private equity firms, is raising capital. The more money a given firm can raise, the more successful it can be. Like a mutual fund, a buyout fund collects money from a number of sources-wealthy individuals, institutional investors, pension funds-then invests it on their behalf. But instead of investing in stocks, buyout funds buy companies, with the intention of turning them around and selling them for a profit. Typically, the companies are bought with a mix of capital and debt, somewhat mitigating the risk of the buyer. Hence, the leveraged buyout, or LBO, nickname. The companies are then held in a portfolio, or fund, which usually has a target market or theme. It can be a dangerous form of investing, open only to the extremely wealthy. Minimum investments in a given fund are usually no less than $1 million, and returns are generally expected to be more than 25 percent, usually within 10 years, sometimes less. Downside can be that much and more. LBOs are not for the faint of heart.

The Carlyle Group based themselves in Washington, DC, instead of the more traditional buy-out firm haunts of New York or Chicago, a move that surprised many in the business. Arthur Miltenberger, then chief investment officer of the Mellon Foundation, would tell Forbes at the time, "I was intrigued by a merchant bank based in Washington, DC, because foreigners have to come to Washington." Upon incorporation, Carlyle hardly registered a blip on the radar of older, more established buyout firms like Kohlberg Kravis & Roberts and Fortsmann Little.

Continues...

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Excerpted from The Iron Triangle: Inside the secret world of the Carlyle Group by Dan Briody
Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.

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