The following discussion analyzes the financial condition and results of
We conduct our operations through four reportable segments: Corporate Private Equity, Global Market Strategies, Real Assets and Solutions.
• Corporate Private Equity - Our Corporate Private Equity segment advises our
23 buyout and 9 growth capital funds, which seek a wide variety of
investments of different sizes and growth potentials. As of
our Corporate Private Equity segment had approximately
$43 billionin Fee-earning AUM.
• Global Market Strategies - Our Global Market Strategies segment advises a
group of 65 funds that pursue investment opportunities across structured
credit, distressed debt, corporate and energy mezzanine debt, middle-market
and senior debt, as well as credit, emerging markets and commodities-focused
hedge funds. As of
• Real Assets - Our Real Assets segment advises our 10 U.S. and internationally
focused real estate funds, our infrastructure fund, our two power funds, our
international energy fund, as well as our five Legacy Energy funds (funds
that we jointly advise with Riverstone). The segment also includes eight NGP
management fee funds and two NGP carry funds advised by NGP. As of
2014, our Real Assets segment had approximately
$28 billionin Fee-earning AUM.
• Solutions - Our Solutions segment advises a global private equity fund of
funds program and related co-investment and secondary activities across 99
fund of funds vehicles. On
investments in global real estate, which manages 26 fund of funds vehicles.
vehicles, which manages 14 fund of funds vehicles. As of
Solutions segment had approximately
billion in Fee-earning AUM.
We earn management fees pursuant to contractual arrangements with the investment funds that we manage and fees for transaction advisory and oversight services provided to portfolio companies of these funds. We also typically receive a performance fee from an investment fund, which may be either an incentive fee or a special residual allocation of income, which we refer to as a carried interest, in the event that specified investment returns are achieved by the fund. Under U.S. generally accepted accounting principles ("U.S. GAAP"), we are required to consolidate some of the investment funds that we advise. However, for segment reporting purposes, we present revenues and expenses on a basis that deconsolidates these investment funds. Accordingly, our segment revenues primarily consist of fund management and related advisory fees, performance fees (consisting of incentive fees and carried interest allocations), investment income, including realized and unrealized gains on our investments in our funds and other trading securities, as well as interest and other income. Our segment expenses primarily consist of compensation and benefits expenses, including salaries, bonuses, performance payment arrangements, and equity-based compensation excluding awards granted in our initial public offering or in connection with acquisitions and strategic investments, and general and administrative expenses. Refer to Note 18 to the unaudited condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for more information on the differences between our financial results reported pursuant to U.S. GAAP and our financial results for segment reporting purposes. 81
Our Family of Funds
The following chart presents the name (acronym), total capital commitments (in the case of our carry funds, structured credit funds, certain fund of funds vehicles, NGP management fee funds, and the NGP carry funds), assets under management (in the case of our hedge funds, fund of hedge funds vehicles and other structured products), gross assets (in the case of our business development companies), and vintage year of the active funds in each of our segments, as of
June 30, 2014. We present total capital commitments (as opposed to assets under management) for our closed-end investment funds because we believe this metric provides the most useful information regarding the relative size and scale of such funds. In the case of our hedge funds and fund of hedge funds vehicles, which are open-ended and accordingly do not have permanent committed capital, we believe the most useful metric regarding relative size and scale is assets under management. 82 -------------------------------------------------------------------------------- [[Image Removed: LOGO]] Note: All funds are closed-end and amounts shown represent total capital commitments as of June 30, 2014, unless otherwise noted. Certain of our recent vintage funds are currently in fundraising and total capital commitments are subject to change.
(1) Open-ended hedge funds and other pooled vehicles. Amounts represent AUM
across all products as of
(2) Amounts represent gross assets as of
(3) Includes NGPC, NGP ETP I, NGP M&R, NGP ETP II, NGP VII, NGP VIII and NGP IX.
Trends Affecting our Business
Risk asset prices again strengthened during the second quarter of 2014, bringing valuation ratios above historic averages. Between
March 31, 2014and mid-July 2014, the S&P 500 rose 5.7% to set a new record high. During the same period, stock markets in other advanced economies rose by 4.1%, on average, as measured by the MSCI World Index. During the second quarter, emerging markets also continued their rebound from the first quarter of 2014, with the MSCI Worldup 6.9% and credit spreads on emerging market corporate debt falling to 5.5% by mid-July 2014. Domestic financing conditions remained robust in the second quarter, with average spreads on speculative grade corporate credit remaining close to cyclical lows. The Federal Reserve Open Market Committee ("FOMC") continued to "taper" asset purchases during the second quarter and announced that it would reduce the pace of monthly purchases to $35 billionper month starting in July 2014. FOMC also signaled in its June 2014meeting minutes, which it released in July 2014, that it anticipates phasing out asset purchases entirely in October 2014and signaled in Congressional testimony in July 2014that the first increase in the federal funds interest rate is likely to occur in the second quarter of 2015 or earlier if the labor market improves at a faster rate than expected. Despite the signaling of the anticipated further tapering of asset purchases and potential increase in policy rates, the 10 year Treasury yield declined by 20 basis points to end the second quarter at 2.5%, which reflects a decrease of 50 basis points from the beginning of January 2014. Strong financial market performance occurred during the quarter despite the release of worse-than-expected U.S. economic data. In June 2014, the U.S. Commerce Departmentannounced that it estimated that the U.S. economy contracted at a 2.9% annual rate in the first quarter of 2014, which was substantially worse than the original estimate of 0.1% growth. This news was mitigated by strong growth in U.S. industrial production and payroll employment during the second quarter, as well as survey data from Bloombergannounced in June 2014, which suggested that professional forecasters expected U.S. GDP to accelerate in the second half of 2014. However, the large decline in first quarter U.S. GDP growth caused the International Monetary Fund, in July 2014, to cut its estimate for global growth in 2014 to 3.6%, which is down from the 3.7% forecasted for 2014 in January 2014and the 4.1% forecasted for 2014 in January 2013. Despite certain unfavorable U.S. economic data that was announced during the second quarter, the continuing strong performance in the financial markets during the second quarter fostered the appreciation of our carry fund portfolio by 5% overall, with a 5% increase in our Corporate Private Equity segment, a 12% increase in our Global Market Strategies segment and a 3% increase in our Real Assets segment. Our public portfolio, which accounted for approximately 26% of our overall carry fund portfolio fair value at June 30, 2014, appreciated by 5% in the second quarter. Given the signals from the FOMC, during the second quarter we continued to take advantage of low rates to finance new investments and refinance existing investments in advance of a potential rate increase. The increase in asset prices, relatively low volatility, and abundant financing continued to create a challenging environment in which to find attractive new investments during the quarter. Despite these challenges, the generally favorable economic environment and the continuing efforts of our investment professionals resulted in increased investment activity during the quarter as we invested $3.4 billionin new and existing investments in our carry funds that met our investment criteria and strategic objectives. We also capitalized on continuing high asset values during the quarter and, as an opportunistic seller, realized proceeds of $6.5 billionin 142 investments and 36 funds during the quarter. While there can be no assurance that these exit and investment trends will continue, we remain focused on maximizing the value of our portfolio for our fund investors and our business.
July 2014, we exercised our option to acquire additional interests in the general partner of the NGP Natural Resources X, L.P.fund ("NGP X"), which entitles us to an allocation of income equal to 40% of the carried interest received by the fund's general partner. The exercise price for this option was approximately $61.3 million. We additionally acquired certain general partner investments in this fund, for which we paid $16.6 million. In July 2014, the Board of Directors of our general partner declared a quarterly distribution of $0.16per common unit to common unit holders of record at the close of business on August 11, 2014, payable on August 22, 2014. 84
Consolidation of Certain Carlyle Funds and Variable Interest Entities
Pursuant to U.S. GAAP, we consolidate certain Carlyle sponsored funds, related co-investment entities and CLOs that we advise, which we refer to collectively as the Consolidated Funds, in our consolidated financial statements. These funds represent approximately 16% of our AUM as of
June 30, 2014; 13% and 14% of our fund management fees for the three months and six months ended June 30, 2014, respectively; and approximately 3% of our performance fees for the three months and six months ended June 30, 2014. We are not required under U.S. GAAP to consolidate in our financial statements most of the investment funds we advise because such funds provide their limited partners with the right to dissolve the fund without cause by a simple majority vote of the non-Carlyle affiliated limited partners, which overcomes the presumption of control by Carlyle. However, we consolidate certain CLOs that we advise as a result of the application of the accounting standards governing consolidations. As of June 30, 2014, our consolidated CLOs held approximately $18 billionof total assets and comprised 59% of the assets of the Consolidated Funds and 100% of the loans payable of the Consolidated Funds. As of June 30, 2014, our consolidated AlpInvestfund of funds vehicles had approximately $7 billionof total assets and comprised 23% of the assets of the Consolidated Funds. The remainder of the assets of the Consolidated Funds as of June 30, 2014relate to our consolidated hedge funds and other consolidated funds. The assets and liabilities of the Consolidated Funds are generally held within separate legal entities and, as a result, the liabilities of the Consolidated Funds are non-recourse to us. For further information on consolidation of certain funds, see Note 2 to the unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q. Generally, the consolidation of the Consolidated Funds has a gross-up effect on our assets, liabilities and cash flows but has no net effect on the net income attributable to the Partnership and partners' capital. The majority of the net economic ownership interests of the Consolidated Funds are reflected as non-controlling interests in consolidated entities, redeemable non-controlling interests in consolidated entities, and partners' capital appropriated for Consolidated Funds in the consolidated financial statements. For further information, see Note 2 to the unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q. Because only a small portion of our funds are consolidated, the performance of the Consolidated Funds is not necessarily consistent with or representative of the combined performance trends of all of our funds. In addition, as described in Note 17 to the unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q, as of September 30, 2013, we began consolidating Urbplan, a Brazilian real estate portfolio company held by certain of our real estate investment funds. Due to the timing and availability of financial information of Urbplan, we consolidate the financial position and results of operations of Urbplan on a financial reporting lag of 90 days. As of June 30, 2014, our unaudited condensed consolidated financial statements included approximately $254 millionof assets related to Urbplan, representing less than 1% of our consolidated total assets.
Key Financial Measures
Our key financial measures are discussed in the following pages.
Revenues primarily consist of fund management fees, performance fees, investment income, including realized and unrealized gains of our investments in our funds and other trading securities, as well as interest and other income. See Note 2 to the unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for additional information regarding the manner in which management fees and performance fees are generated. Fund Management Fees. Fund management fees include (i) management fees and (ii) transaction and portfolio advisory fees. Management fees are fees we earn for advisory services we provide to funds in which we hold a general partner interest or with which we have an investment advisory or investment management agreement. Management fees are based on (a) third parties' capital commitments to our investment funds, (b) third parties' 85 -------------------------------------------------------------------------------- remaining capital invested in our investment funds at cost or at the lower of cost or aggregate remaining fair value, (c) gross assets, excluding cash and cash equivalents, (d) for the private equity and real estate fund of funds vehicles following the expiration of the commitment period or weighted-average investment period of such vehicles, the lower of cost or fair value of the capital invested, the net asset value for unrealized investments, or the contributions for unrealized investments, (e) the total par amount of assets for our CLOs and other structured products, or (f) the net asset value ("NAV") of certain of our investment funds, as described in our unaudited condensed consolidated financial statements. Additionally, management fees include "catch-up management fees", which are episodic in nature and represent management fees charged to fund investors in subsequent closings of a fund which apply to the time period between the fee initiation date and the subsequent closing date. Management fees for funds in our corporate private equity funds, closed-end carry funds in the global market strategies segment and real assets funds generally range from 1% to 2% of commitments during the investment period of the relevant fund. Large funds tend to have lower effective management fee rates, while smaller funds tend to have effective management fee rates approaching 2.0%. Following the expiration or termination of the investment period of such funds, the management fees generally step-down to between 0.6% and 2.0% of contributions for unrealized investments. Depending upon the contracted terms of investment advisory or investment management and related agreements, these fees are called semiannually in advance and are recognized as earned over the subsequent six month period. As a result, cash on hand and deferred revenue will generally be higher at or around January and July, which are the semiannual due dates for management fees. The management fees for our private equity and real estate fund of funds vehicles generally range from 0.3% to 1.0% on the vehicle's capital commitments during the commitment fee period of the relevant fund or the weighted-average investment period of the underlying funds. Following the expiration of the commitment fee period or weighted-average investment period of such funds, the management fees generally range from 0.3% to 1.0% on the lower of cost or fair value of the capital invested, the net asset value for unrealized investments, or the contributions for unrealized investments. The management fees for our fund of hedge funds vehicles generally range 0.2% to 1.5% of NAV. Management fees for our Solutions segment are generally due quarterly and recognized over the related quarter. Our hedge funds generally pay management fees quarterly that range from 1.5% to 2.0% of NAV per year. Management fees for our business development companies are due quarterly in arrears at annual rates that range from 0.25% to 1.0% of gross assets, excluding cash and cash equivalents. Management fees for our CLOs and other structured products typically range from 0.15% to 1.00% on the total par amount of assets or the aggregate principal amount of the notes in the fund and are due quarterly or semiannually based on the terms and recognized over the relevant period. Our management fees for our CLOs/structured products and credit opportunities funds are governed by indentures and collateral management agreements. With respect to
Claren Road, ESG, and Vermillion, we retain a specified percentage of the management fees of the businesses based on our economic ownership in the management companies of 55%. Through the second quarter of 2013, we retained 60% of the management fees of AlpInvestbased on our 60% equity interest in AlpInvest. During the third quarter of 2013, we acquired the remaining 40% equity interest in AlpInvest, and therefore we are entitled to 100% of the management fees of AlpInvestsubsequent to that acquisition. Management fees are not subject to repayment but may be offset to the extent that other fees are earned as described below under "-Transaction and Portfolio Advisory Fee." Management fees attributable to Carlyle Partners VI, L.P.("CP VI"), our sixth U.S. buyout fund with approximately $12.0 billionof Fee-earning AUM as of June 30, 2014, were approximately 13% and 14% of total management fees recognized during the three months and six months ended June 30, 2014, respectively. Management fees attributable to Carlyle Partners V, L.P.("CP V"), our fifth U.S. buyout fund with approximately $9.2 billionof Fee-earning AUM as of June 30, 2014, were approximately 13% and 16% of total management fees recognized during the three months and six months ended June 30, 2013, respectively. No other fund generated over 10% of total management fees in the periods presented. Transaction and Portfolio Advisory Fees. Transaction and portfolio advisory fees are fees we receive for the transaction and portfolio advisory services we provide to our portfolio companies. When covered by separate contractual agreements, we recognize transaction and portfolio advisory fees for these services when the service has been provided and collection is reasonably assured. We are required to offset our fund management fees earned by a percentage of the transaction and advisory fees earned, which we refer to as the "rebate offsets." Such rebate offset percentages generally approximate 80% of the transaction and advisory fees earned. The recognition of portfolio advisory fees and transactions fees can be volatile as they are primarily generated by investment activity within our funds, and therefore are impacted by our investment pace. We have received and expect to continue to receive 86
requests from a variety of investors and groups representing investors to increase the percentage of transaction and advisory fees we share with our investors in future funds; to the extent that we accommodate such requests on future funds, the rebate offset percentages would increase relative to historical levels.
Performance Fees. Performance fees consist principally of the special residual allocation of profits to which we are entitled, commonly referred to as carried interest, from certain of our investment funds, which we refer to as the "carry funds." We are generally entitled to a 20% allocation (or 10% to 20% on external coinvestment vehicles, with some earning no carried interest, or approximately 2% to 10% in the case of most of our fund of funds vehicles) of the net realized income or gain as a carried interest after returning the invested capital, the allocation of preferred returns of generally 8% to 9% and the return of certain fund costs (subject to catch-up provisions as set forth in the fund limited partnership agreement). Carried interest revenue, which is a component of performance fees in our consolidated financial statements, is recognized by Carlyle upon appreciation of the valuation of our funds' investments above certain return hurdles as set forth in each respective partnership agreement and is based on the amount that would be due to us pursuant to the fund partnership agreement at each period end as if the funds were liquidated at such date. Accordingly, the amount of carried interest recognized as performance fees reflects our share of the fair value gains and losses of the associated funds' underlying investments measured at their then-current fair values. As a result, the performance fees earned in an applicable reporting period are not indicative of any future period. Carried interest is ultimately realized and distributed when: (i) an underlying investment is profitably disposed of, (ii) certain costs borne by the limited partner investors have been reimbursed, (iii) the investment fund's cumulative returns are in excess of the preferred return and (iv) we have decided to collect carry rather than return additional capital to limited partner investors. Our decision to realize carry considers such factors as the level of embedded valuation gains, the portion of the fund invested, the portion of the fund returned to limited partner investors, and the length of time the fund has been in carry, as well as other qualitative measures. The portion of performance fees that are realized and unrealized in each period are separately reported in our statement of operations. Under our arrangements with the historical owners and management team of
AlpInvest, we generally do not retain any carried interest in respect of the historical investments and commitments to our fund of funds vehicles that existed as of July 1, 2011(including any options to increase any such commitments exercised after such date). We are entitled to 15% of the carried interest in respect of commitments from the historical owners of AlpInvestfor the period between 2011 and 2020 and 40% of the carried interest in respect of all other commitments (including all future commitments from third parties). In certain instances, carried interest associated with the fund of funds vehicles is subject to entity level income taxes in the Netherlands.
Our performance fees are generated by a diverse set of funds with different vintages, geographic concentration, investment strategies and industry specialties. For an explanation of the fund acronyms used throughout this Management's Discussion and Analysis of Financial Condition and Results of Operations section, refer to "- Our Family of Funds."
Performance fees from
Carlyle Europe Partners III, L.P.("CEP III"), our third Europebuyout fund, CP V, and Carlyle Asia Partners II, L.P., our second Asiabuyout fund, (with total AUM of approximately $7.5 billion, $15.8 billion, and $1.3 billion, respectively, as of June 30, 2014) were $179.0 million, $90.3 million, and $(57.5) million, respectively, for the three months ended June 30, 2014. Additionally, performance fees from AlpInvest's Main FundIII-Coinvestments (2006) and Main Fund III-Secondary Investments (2006) fund of funds vehicles (with total AUM of approximately $3.7 billionas of June 30, 2014) together represented $83.4 millionof performance fees for the three months ended June 30, 2014. Performance fees from CEP III and CP V were $343.0 millionand $339.4 million, respectively, for the six months ended June 30, 2014. No other fund generated over 10% of performance fees during those periods. Performance fees from CP Vand Carlyle Partners IV, L.P.("CP IV"), our fourth U.S. buyout fund, were $186.3 millionand $27.2 million, respectively, for the three months ended June 30, 2013. Performance fees from CP V and CP IV were $345.9 millionand $206.1 million, respectively, for the six months ended June 30, 2013. No other fund generated over 10% of performance fees during those periods. Realized carried interest may be clawed-back or given back to the fund if the fund's investment values decline below certain return hurdles, which vary from fund to fund. When the fair value of a fund's investments 87 -------------------------------------------------------------------------------- remains constant or falls below certain return hurdles, previously recognized performance fees are reversed. In all cases, each investment fund is considered separately in evaluating carried interest and potential giveback obligations. For any given period, carried interest income could thus be negative; however, cumulative performance fees can never be negative over the life of a fund. In addition, we are not obligated to pay guaranteed returns or hurdles. If upon a hypothetical liquidation of a fund's investments at the then-current fair values, previously recognized and distributed carried interest would be required to be returned, a liability is established in our financial statements for the potential giveback obligation. As discussed below, each individual recipient of realized carried interest typically signs a guarantee agreement or partnership agreement that personally obligates such person to return his/her pro rata share of any amounts of realized carried interest previously distributed that are later clawed back. Accordingly, carried interest as performance fee compensation is subject to return to the Partnership in the event a giveback obligation is funded. Generally, the actual giveback liability, if any, does not become due until the end of a fund's life. In addition to the carried interest from our carry funds, we are also entitled to receive incentive fees or allocations from certain of our Global Market Strategies funds when the return on AUM exceeds previous calendar-year ending or date-of-investment high-water marks. Our hedge funds generally pay annual incentive fees or allocations equal to 20% of the fund's profits for the year, subject to a high-water mark. The high-water mark is the highest historical NAV attributable to a fund investor's account on which incentive fees were paid and means that we will not earn incentive fees with respect to such fund investor for a year if the NAV of such investor's account at the end of the year is lower that year than any prior year-end NAV or the NAV at the date of such fund investor's investment, generally excluding any contributions and redemptions for purposes of calculating NAV. In these arrangements, incentive fees are recognized when the performance benchmark has been achieved based on the hedge funds' then-current fair value and are included in performance fees in our consolidated statements of operations. These incentive fees are a component of performance fees in our consolidated financial statements and are treated as accrued until paid to us. For any given period, performance fee revenue on our statement of operations may include reversals of previously recognized performance fees due to a decrease in the value of a particular fund that results in a decrease of cumulative performance fees earned to date. Since fund return hurdles are cumulative, previously recognized performance fees also may be reversed in a period of appreciation that is lower than the particular fund's hurdle rate. For the three months ended June 30, 2014and 2013, the reversals of performance fees were $77.9 millionand $74.3 million, respectively. For the six months ended June 30, 2014and 2013, the reversals of performance fees were $123.4 millionand $18.4 million, respectively. As of June 30, 2014, accrued performance fees and accrued giveback obligations were approximately $3.8 billionand $32.3 million, respectively, after amounts eliminated related to the Consolidated Funds. Each balance assumes a hypothetical liquidation of the funds' investments at June 30, 2014at their then current fair values. These assets and liabilities will continue to fluctuate in accordance with the fair values of the fund investments until they are realized. In addition, realized performance fees may be reversed in future periods to the extent that such amounts become subject to a giveback obligation. If at June 30, 2014, all investments held by our carry funds were deemed worthless, the amount of realized and previously distributed performance fees subject to potential giveback would be $1.1 billion. See the related discussion of "Contingent Obligations (Giveback)" within "- Liquidity and Capital Resources." As described above, each investment fund is considered separately in evaluating carried interest and potential giveback obligations. As a result, performance fees within funds will continue to fluctuate primarily due to certain investments within each fund constituting a material portion of the carry in that fund. Additionally, the fair value of investments in our funds may have substantial fluctuations from period to period. In addition, we use the term "net performance fees" to refer to the performance fees from our funds net of the portion allocated to our investment professionals which is reflected as performance fee related compensation expense. We use the term "realized net performance fees" to refer to realized performance fees from our funds, net of the portion allocated to our investment professionals which is reflected as realized performance fee related compensation expense. See "- Non-GAAP Financial Measures" for the amount of realized and unrealized performance fees recognized each period. See "- Segment Analysis" for the realized and unrealized performance fees by segment and related discussion for each period. 88
-------------------------------------------------------------------------------- Fair Value Measurement. U.S. GAAP establishes a hierarchal disclosure framework which ranks the observability of market price inputs used in measuring financial instruments at fair value. The observability of inputs is impacted by a number of factors, including the type of financial instrument, the characteristics specific to the financial instrument and the state of the marketplace, including the existence and transparency of transactions between market participants. Financial instruments with readily available quoted prices, or for which fair value can be measured from quoted prices in active markets, will generally have a higher degree of market price observability and a lesser degree of judgment applied in determining fair value. Financial instruments measured and reported at fair value are classified and disclosed based on the observability of inputs used in the determination of fair values, as follows: Level I - inputs to the valuation methodology are quoted prices available in active markets for identical instruments as of the reporting date. The type of financial instruments included in Level I include unrestricted securities, including equities and derivatives, listed in active markets. The Partnership does not adjust the quoted price for these instruments, even in situations where the Partnership holds a large position and a sale could reasonably impact the quoted price. Level II - inputs to the valuation methodology are other than quoted prices in active markets, which are either directly or indirectly observable as of the reporting date. The type of financial instruments in this category includes less liquid and restricted securities listed in active markets, securities traded in other than active markets, government and agency securities, and certain over-the-counter derivatives where the fair value is based on observable inputs. Investments in hedge funds are classified in this category when their net asset value is redeemable without significant restriction. Level III - inputs to the valuation methodology are unobservable and significant to overall fair value measurement. The inputs into the determination of fair value require significant management judgment or estimation. Financial instruments that are included in this category include investments in privately-held entities, non-investment grade residual interests in securitizations, collateralized loan obligations, and certain over-the-counter derivatives where the fair value is based on unobservable inputs. Investments in fund of funds are generally included in this category. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the determination of which category within the fair value hierarchy is appropriate for any given financial instrument is based on the lowest level of input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the financial instrument. 89
The table below summarizes the valuation of investments and other financial instruments included within our AUM, by segment and fair value hierarchy levels, as of
As of June 30, 2014 Corporate Global Private Market Equity Strategies Real Assets Solutions Total
Consolidated Results Level I
$ 10,613 $ 8,199 $ 6,772 $ 527 $ 26,111Level II 615 3,130 1,081 1,180 6,006 Level III 29,383 21,498 23,995 35,621 110,497 Total Fair Value 40,611 32,827 31,848 37,328 142,614 Other Net Asset Value 587 3,994 (862 ) 98 3,817 Total AUM, Excluding Available Capital Commitments 41,198 36,821 30,986 37,426 146,431 Available Capital Commitments 23,284 1,418 12,310 19,302 56,314 Total AUM $ 64,482 $ 38,239 $ 43,296 $ 56,728 $ 202,745In certain cases, debt and equity securities are valued on the basis of prices from an orderly transaction between market participants provided by reputable dealers or pricing services. In determining the value of a particular investment, pricing services may use certain information with respect to transactions in such investments, quotations from dealers, pricing matrices, market transactions in comparable investments and various relationships between investments. Investment professionals with responsibility for the underlying investments are responsible for preparing the investment valuations pursuant to the policies, methodologies and templates prepared by our valuation group, which is a team made up of individuals with previous valuation experience reporting to our chief financial officer. The valuation group is responsible for maintaining our valuation policy and related guidance, templates and systems that are designed to be consistent with the guidance found in U.S. GAAP. These valuations, inputs and preliminary conclusions are reviewed by the fund accounting teams. The valuations are then reviewed and approved by the respective fund valuation sub-committees which are comprised of the respective fund head, segment head, chief financial and chief accounting officers, as well as members from the valuation group. The valuation group compiles the aggregate results and significant matters and presents them for review and approval by the global valuation committee, which is comprised of our co-chief executive officers, chief operating officer, chief risk officer, chief financial officer, chief accounting officer, deputy chief investment officer, the business segment heads, and is observed by the chief compliance officer and director of internal audit. Additionally, each quarter a sample of valuations is reviewed by external valuation firms. In the absence of observable market prices, we value our investments using valuation methodologies applied on a consistent basis. For some investments little market activity may exist. Management's determination of fair value is then based on the best information available in the circumstances and may incorporate management's own assumptions and involves a significant degree of judgment, taking into consideration a combination of internal and external factors, including the appropriate risk adjustments for non-performance and liquidity risks. Investments for which market prices are not observable include private investments in the equity of operating companies and real estate properties, and certain debt positions. The valuation technique for each of these investments is described in Note 4 of our unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q. Investment Income and Interest and Other Income. Investment income and interest and other income represent the unrealized and realized gains and losses on our principal investments, including our investments in Carlyle funds that are not consolidated, our equity method investments and other principal investments, as well as any interest and other income. Investment income (loss) also includes the related amortization of the basis difference between the carrying value of our investment and our share of the underlying net assets of the investee, as well as the compensation expense associated with compensatory arrangements provided by us to employees of our equity 90 -------------------------------------------------------------------------------- method investee. Realized investment income (loss) is recorded when we redeem all or a portion of our investment or when we receive or are due cash income, such as dividends or distributions. A realized investment loss is also recorded when an investment is deemed to be worthless. Unrealized investment income (loss) results from changes in the fair value of the underlying investment, as well as the reversal of previously recognized unrealized gains (losses) at the time an investment is realized. Interest and Other Income of Consolidated Funds. Interest and other income of Consolidated Funds primarily represents the interest earned on CLO assets. However, the Consolidated Funds are not the same entities in all periods presented and may change in future periods due to changes in U.S. GAAP, changes in fund terms and terminations of funds. Revenue of a Consolidated Real Estate VIE. Revenue of a consolidated real estate VIE consists of revenue generated by Urbplan, which primarily is revenue earned for land development services using the completed contract method and investment income earned on Urbplan's investments. Under the completed contract method of revenue recognition, revenue is not recognized until the period in which the land development services contract is completed. Net Investment Gains (Losses) of Consolidated Funds. Net investment gains (losses) of Consolidated Funds measures the change in the difference in fair value between the assets and the liabilities of the Consolidated Funds. A gain (loss) indicates that the fair value of the assets of the Consolidated Funds appreciated more (less), or depreciated less (more), than the fair value of the liabilities of the Consolidated Funds. A gain or loss is not necessarily indicative of the investment performance of the Consolidated Funds and does not impact the management or incentive fees received by Carlyle for its management of the Consolidated Funds. The portion of the net investment gains (losses) of Consolidated Funds attributable to the limited partner investors is allocated to non-controlling interests. Therefore a gain or loss is not expected to have a material impact on the revenues or profitability of the Partnership. Moreover, although the assets of the Consolidated Funds are consolidated onto our balance sheet pursuant to U.S. GAAP, ultimately we do not have recourse to such assets and such liabilities are generally non-recourse to us. Therefore, a gain or loss from the Consolidated Funds generally does not impact the assets available to our equity holders. Expenses Compensation and Benefits. Compensation includes salaries, bonuses, equity-based compensation, and performance payment arrangements. Bonuses are accrued over the service period to which they relate. We recognize as compensation expense the portion of performance fees that are due to our employees, senior Carlyle professionals, and operating executives in a manner consistent with how we recognize the performance fee revenue. These amounts are accounted for as compensation expense in conjunction with the related performance fee revenue and, until paid, are recognized as a component of the accrued compensation and benefits liability. Compensation in respect of performance fees is paid when the related performance fees are realized, and not when such performance fees are accrued. The funds do not have a uniform allocation of performance fees to our employees, senior Carlyle professionals and operating executives. Therefore, for any given period, the ratio of performance fee compensation to performance fee revenue may vary based on the funds generating the performance fee revenue for that period and their particular allocation percentages. In addition, we have implemented various equity-based compensation arrangements that require senior Carlyle professionals and other employees to vest ownership of a portion of their equity interests over a service period of up to six years, which under U.S. GAAP will result in compensation charges over current and future periods. Further, in order to recruit and retain existing and future senior Carlyle professionals and other employees, we have implemented additional equity-based compensation programs that have resulted in increases to our equity-based compensation expenses, which is a trend that is expected to continue in the future as we increase the use of deferred restricted common units. For example, in February 2014, we granted approximately 5.6 million deferred restricted common units across a significant number of our employees for a total estimated grant-date fair value of approximately $172 million; these awards vest over a period up to six years. Compensation charges associated with the equity-based compensation grants issued in our initial public offering in May 2012or grants issued in acquisitions or strategic investments are excluded from our calculation of Economic Net Income. Compensation charges associated with all equity-based compensation grants are excluded from Fee Related Earnings and Distributable Earnings. 91
-------------------------------------------------------------------------------- We expect that we will hire additional individuals and that overall compensation levels will correspondingly increase, which will result in an increase in compensation and benefits expense. As a result of recent acquisitions, we have charges associated with contingent consideration taking the form of earn-outs and profit participation, some of which are reflected as compensation expense. Our fundraising has increased in recent periods and, as a result, our compensation expense increased in periods in which we closed on increased levels of new capital commitments. Amounts due to employees related to such fundraising will be expensed when earned even though the benefit of the new capital and related fees will be reflected in operations over the life of the related fund. General, Administrative and Other Expenses. General, administrative, and other expenses include occupancy and equipment expenses and other expenses, which consist principally of professional fees, external costs of fundraising, travel and related expenses, communications and information services, depreciation and amortization and foreign currency transactions. We expect that general, administrative and other expenses will vary due to infrequently occurring or unusual items. Also, our utilization of third parties to assist in fundraising will cause general, administrative and other expenses to increase in periods of significant fundraising. We also expect to incur greater expenses in the future related to our recent acquisitions including amortization of acquired intangibles, earn-outs to equity holders and fair value adjustments on contingent consideration issued. Additionally, we anticipate that general, administrative and other expenses will fluctuate from period to period due to the impact of foreign exchange transactions.
Interest and Other Expenses of Consolidated Funds. The interest and other expenses of Consolidated Funds consist primarily of interest expenses related primarily to our CLO loans, professional fees and other third-party expenses.
Interest and Other Expenses of a Consolidated Real Estate VIE. Interest and other expenses of a consolidated real estate VIE reflect expenses incurred by Urbplan, consisting primarily of interest expense, general and administrative expenses, compensation and benefits, and costs associated with land development services. Also included in this caption is the change in our estimate of the fair value of Urbplan's loans payable during the period. Income Taxes.
The Carlyle Holdingspartnerships and their subsidiaries operate as pass-through entities for U.S. income tax purposes and record a provision for state and local income taxes for certain entities based on applicable laws and a provision for foreign income taxes for certain foreign entities. In addition, Carlyle Holdings I GP Inc.is subject to additional entity-level taxes that are reflected in our consolidated financial statements. Prior to our initial public offering in May 2012, we operated as a group of pass-through entities for U.S. income tax purposes and our profits and losses were allocated to the individual senior Carlyle professionals, who were individually responsible for reporting such amounts. We recorded a provision for state and local income taxes for certain entities based on applicable laws and a provision for foreign income taxes for certain foreign entities. Income taxes for foreign entities are accounted for using the liability method of accounting. Under this method, deferred tax assets and liabilities are recognized for the expected future tax consequences of differences between the carrying amounts of assets and liabilities and their respective tax basis, using currently enacted tax rates. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period in which the change is enacted. Deferred tax assets are reduced by a valuation allowance when it is more likely than not that some or all of the deferred tax assets will not be realized. In the normal course of business, we are subject to examination by federal and certain state, local and foreign tax regulators. As of June 30, 2014, our U.S. federal income tax returns for the years 2010 through 2012 are open under the normal three-year statute of limitations and therefore subject to examination. State and local tax returns are generally subject to audit from 2009 to 2013. Foreign tax returns are generally subject to audit from 2007 to 2013. Certain of our foreign subsidiaries are currently under audit by foreign tax authorities. 92
-------------------------------------------------------------------------------- Non-controlling Interests in Consolidated Entities. Non-controlling interests in consolidated entities represent the component of equity in consolidated entities not held by us. These interests are adjusted for general partner allocations and by subscriptions and redemptions in hedge funds which occur during the reporting period. Non-controlling interests related to hedge funds are subject to quarterly or monthly redemption by investors in these funds following the expiration of a specified period of time or may be withdrawn subject to a redemption fee in the hedge funds during the period when capital may not be withdrawn. As limited partners in these types of funds have been granted redemption rights, amounts relating to third-party interests in such consolidated funds are presented as redeemable non-controlling interests in consolidated entities within the consolidated balance sheets. When redeemable amounts become legally payable to investors, they are classified as a liability and included in other liabilities of Consolidated Funds in the consolidated balance sheets. We record significant non-controlling interests in
Carlyle Holdingsrelating to the ownership interests of the limited partners of the Carlyle Holdingspartnerships. The Partnership, through wholly owned subsidiaries, is the sole general partner of Carlyle Holdings. Accordingly, the Partnership consolidates the financial position and results of operations of Carlyle Holdingsinto its financial statements, and the other ownership interests in Carlyle Holdingsare reflected as a non-controlling interest in the Partnership's financial statements.
Non-GAAP Financial Measures
Economic Net Income. Economic net income or "ENI," is a key performance benchmark used in our industry. ENI represents segment net income which excludes the impact of income taxes, acquisition-related items including amortization of acquired intangibles and contingent consideration taking the form of earn-outs, charges associated with equity-based compensation grants issued in
May 2012upon completion of the initial public offering or grants issued in acquisitions or strategic investments, corporate actions and infrequently occurring or unusual events. We believe the exclusion of these items provides investors with a meaningful indication of our core operating performance. For segment reporting purposes, revenues and expenses, and, accordingly, segment net income, are presented on a basis that deconsolidates the Consolidated Funds. Total Segment ENI equals the aggregate of ENI for all segments. ENI is evaluated regularly by management in making resource deployment decisions and in assessing performance of our four segments and for compensation. We believe that reporting ENI is helpful to understanding our business and that investors should review the same supplemental financial measure that management uses to analyze our segment performance. This measure supplements and should be considered in addition to, and not in lieu of, the results of operations discussed further under "Consolidated Results of Operations" prepared in accordance with U.S. GAAP. Distributable Earnings. Distributable Earnings is derived from our segment reported results and is an additional measure to assess performance and amounts potentially available for distribution from Carlyle Holdingsto its equity holders. Distributable Earnings, which is a non-GAAP measure, is intended to show the amount of net realized earnings without the effects of consolidation of the Consolidated Funds. Distributable Earnings is total ENI less net performance fees and investment income plus realized net performance fees, realized investment income, and equity-based compensation expense. Fee Related Earnings. Fee Related Earnings is a component of Distributable Earnings and is used to measure our operating profitability exclusive of performance fees, investment income from investments in our funds, performance fee-related compensation, and equity-based compensation expense. Accordingly, Fee Related Earnings reflect the ability of the business to cover direct base compensation and operating expenses from fee revenues other than performance fees. Fee Related Earnings are reported as part of our segment results. We use Fee Related Earnings from operations to measure our profitability from fund management fees. 93
We monitor certain operating metrics that are common to the alternative asset management industry.
Fee-earning Assets under Management
Fee-earning assets under management or Fee-earning AUM refers to the assets we manage or advise from which we derive recurring fund management fees. Our Fee-earning AUM generally equals the sum of:
(a) for carry funds and certain co-investment vehicles where the investment
period has not expired and for Metropolitan fund of funds
the weighted-average investment period of the underlying funds, the amount of limited partner capital commitments, for
AlpInvestfund of funds vehicles, the amount of external investor capital
during the commitment fee period, and for the NGP management fee funds and NGP carry funds, the amount of investor capital commitments before the first investment realization (see "Fee-earning AUM based on capital commitments" in the table below for the amount of this component at each period); (b) for substantially all carry funds and certain co-investment vehicles where the investment period has expired and for Metropolitan fund of funds vehicles after the expiration of the weighted-average
period of the underlying funds, the remaining amount of limited partner invested capital, and for the NGP management fee funds and NGP carry funds where the first investment has been realized, the amount
commitments less realized and written-off investments (see
AUM based on invested capital" in the table below for the amount of this component at each period); (c) the amount of aggregate Fee-earning collateral balance at par of our CLOs, as defined in the fund indentures (typically exclusive of equities and defaulted positions) as of the quarterly cut-off date for each CLO and the aggregate principal amount of the notes of our other
products (see "Fee-earning AUM based on collateral balances, at par" in the table below for the amount of this component at each period);
(d) the external investor portion of the net asset value (pre-redemptions and
subscriptions) of our long/short credit funds, emerging markets, multi-product macroeconomic fund of hedge funds vehicles and
funds (see "Fee-earning AUM based on net asset value" in the
for the amount of this component at each period);
(e) the gross assets (including assets acquired with leverage), excluding
cash and cash equivalents of our business development companies and certain carry funds; and
expired, and certain carry funds where the investment period has
the lower of cost or fair value of invested capital (see
based on lower of cost or fair value and other" in the table
the amount of this component at each period). The table below details Fee-earning AUM by its respective components at each period. As of June 30, 2014 2013 Consolidated Results (Dollars in millions) Components of Fee-earning AUM Fee-earning AUM based on capital commitments (1)
$ 42,075 $ 34,834Fee-earning AUM based on invested capital (2) 42,957
Fee-earning AUM based on collateral balances, at par (3) 17,789
Fee-earning AUM based on net asset value (4) 17,278
Fee-earning AUM based on lower of cost or fair value and other (5) 25,550 22,738 Balance, End of Period
$ 145,649 $ 132,024
(1) Reflects limited partner capital commitments where the investment period,
weighted-average investment period, or commitment fee period has not expired.
(2) Reflects limited partner invested capital and includes amounts committed to
or reserved for investments for certain Real Assets and Solutions funds.
(3) Represents the amount of aggregate Fee-earning collateral balances and
principal balances, at par, for our CLOs/structured products.
(4) Reflects the net asset value (pre-redemptions and subscriptions) of our hedge
funds and fund of hedge funds vehicles.
(5) Includes funds with fees based on gross asset value.
The table below provides the period to period rollforward of Fee-earning AUM.