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Los Angeles Times January 10, 2002

Arms Buildup Enriches Firm Staffed by Big Guns

By MARK FINEMAN, Times Staff Writer

WASHINGTON -- Even by Washington standards, the Carlyle Group has some serious clout.

President George W. Bush's father works for Carlyle; so does former Defense Secretary Frank C. Carlucci, whose close friend Donald H. Rumsfeld now runs the Pentagon; and so does a stellar cast of retired generals and Cabinet secretaries, including former Secretary of State James A. Baker III.

And even by Wall Street standards, the Carlyle Group has some serious money: $12.5 billion in investments at last count. The Washington-based private equity firm, which advises and invests for wealthy clients and institutions, has shown returns of more than 34% through the last decade, particularly through timely defense and aerospace investments.

So when President Bush declared war on terrorism in September, few were better poised than Carlyle to know how and when to make money.

On a single day last month, Carlyle earned $237 million selling shares in United Defense Industries, the Army's fifth-largest contractor. The stock offering was well timed: Carlyle officials say they decided to take the company public only after the Sept. 11 attacks. The stock sale cashed in on increased congressional support for hefty defense spending, including one of United Defense's cornerstone weapon programs.

Carlyle's windfall is a result of astute business decisions, excellent connections, strategic lobbying, good timing and a bit of luck. It is also a prime example of how defense contractors got well in a hurry after the Sept. 11 attacks, in a year when the Bush administration already was planning steep hikes in defense spending.

For several years in the late 1990s, United Defense's Crusader Advanced Field Artillery System--a massive high-tech cannon that could fire faster and with more impact than any before it--was in trouble at the Pentagon. The system clashed with the vision many military planners and analysts have for a lighter, more mobile Army. And its high price tag--originally $20 billion--endangered it in times of tight defense budgets.

But the suicide attacks on the Pentagon and the World Trade Center freed up tens of billions of dollars in new defense spending. United Defense already had modified the Crusader, making it 20 tons lighter. And the Army had cut its order by more than half to make it more palatable to budget cutters.

On Sept. 26, the Army signed a $665-million modified contract with United Defense through April 2003 to complete the Crusader's development phase. In October, the company listed the Crusader, and the attacks themselves, as selling points for its stock offering.

Then Congress fully funded the system in the defense authorization bill that passed the House and Senate on Dec. 13, the day before Carlyle's stock sale. And President Bush is scheduled to open the funding spigot today, when he signs a defense appropriation bill that includes $487.3 million for the Crusader in 2002.

The ties that bind the president's family and close advisors to Carlyle have helped draw the confidence of its investors--and the criticism of outsiders.

"It's the first time the president of the United States' father is on the payroll of one of the largest U.S. defense contractors," said Charles Lewis, director of the Center for Public Policy and one of Carlyle's most ardent critics.

"Between Baker and Carlucci, not to mention dear old dad, the relationship of the president with this particular company is as tight and close as, well, anyone can imagine."

Carlyle officials bristle at such talk. They described their recent stock sale as just plain good business that benefited a wide array of investors, including pension funds like those of California's state employees.

Carlyle spokesman Chris Ullman said that neither the company nor its managers, directors and advisors have ever personally lobbied for the Crusader or other government contracts now in the hands of United Defense and other Carlyle subsidiaries and investments.

Of Carlucci, Carlyle's board chairman, and his friendship with the current Defense secretary, Ullman said: "I assure you he doesn't lobby. That's the last thing he'd do. You'd have to know Carlucci to know he'd never do that, and you'd have to know Rumsfeld to know it wouldn't matter."

But even if Carlyle and Carlucci don't lobby, their subsidiaries and majority-owned companies do. And documents on file with the Securities and Exchange Commission, the Federal Election Commission, the Defense Department and Congress show that they do so heavily, strategically and persistently.

Midway Between White House, Congress

By any standard, the Carlyle Group has the right address. Its suite of offices are on Pennsylvania Avenue midway between the White House and Congress--a 15-minute walk to each.

It was founded as a small private-equity firm in 1987 by David M. Rubenstein, a young lawyer who had worked as an aide in Jimmy Carter's White House, and two investment specialists. They named the company after their favorite hotel in New York and started out with a modest portfolio of $100 million.

In 1989, Carlucci retired as Ronald Reagan's Defense secretary and joined Carlyle. Soon after, the company aggressively went after defense and aerospace investments, a specialty for Carlucci and the other former government officials who followed him into Carlyle.

Their investment strategies paid off, not only in defense acquisitions and sales but also in a wide array of corporations. Carlyle's portfolio quickly grew into the billions of dollars as pension funds and wealthy businessmen and families, including royal sheiks in the Persian Gulf, invested with the firm.

As its reputation grew, so did the group's star-studded management roster. It added former Joint Chiefs of Staff Chairman Gen. John M. Shalikashvili; Arthur Levitt, the long-serving former chairman of the Securities and Exchange Commission; former British Prime Minister John Major; former Secretary of State Baker; and former President Bush (Carlyle officers say the elder Bush's principal role is as "a draw": delivering speeches at Carlyle-sponsored events).

Last February, the California Public Employees' Retirement System announced it was investing $425 million in "a strategic partnership" with Carlyle. Even the company owned by Osama bin Laden's estranged billionaire family in Saudi Arabia was among Carlyle's clients--a mere $2-million investment that Carlyle said it bought out after Sept. 11 "for image reasons," Ullman said. He declined to say whether the Bin Ladens made a profit.

Ullman downplayed Carlyle's defense connections, saying that today less than 10% of its $12.5-billion portfolio is in defense, an additional 15% percent in commercial aerospace, and the rest in real estate, health care, telecommunications and consumer industries.

Only 15 of Carlyle's 500 employees are former government officials, Ullman said. Most of the rest are investment professionals working in 24 offices scattered across the globe.

Carlyle bought Arlington, Va.-based United Defense LP in October of 1997 for $850 million.

At the time, the company had contracts for the Army's main fleet of armored infantry vehicles, an automated naval gun system and a Navy missile-launching system. Among its potentially most lucrative contracts was the one for the next generation of high-tech Army battlefield artillery.

Still, the company was losing money. The year after Carlyle bought it, United Defense lost $122 million on $1.2 billion in revenue. But under Carlyle's ownership, United Defense turned around; last year, it reported a net profit of $18.8 million.

Critical to that turnaround was the future of the Crusader artillery system.

United Defense had started work on the Crusader in 1994. It is a self-propelled 155-millimeter howitzer that fires ammunition the size of scuba tanks farther, faster and more accurately than ever imagined, with the killing power of 10 rounds per minute.

The Crusader reloads automatically from an armored sister vehicle, and it uses millions of lines of computer code and battlefield intelligence to pinpoint and strike enemy positions as far as 25 miles away.

The system was, and is, considered the most advanced and lethal artillery on the globe.

It's also the heaviest. At 110 tons, the Crusader was deemed far too heavy for the rapidly deployable Army that will be needed to fight the sudden and remote conflicts America will face, according to a Pentagon-appointed National Defense Panel that sharply criticized the Crusader in December 1997.

That report fed into what is now the lead edge in post-Cold War Pentagon planning: To transform the U.S. armed forces into a slim, trim fighting force that can move halfway around the globe in a matter of hours and fight in conditions like the Afghan campaign.

And the Crusader, the panel concluded, was anything but mobile.

"Crusader was the gleam in somebody's eye in the later years of the Cold War," said Andrew Krepinevich, executive director of the Center for Strategic and Budgetary Assessments in Washington and a member of the 1997 Defense Panel.

But Krepinevich, who has testified against the Crusader on Capitol Hill in the years since that report, added: "For something so heavy and hard to move as Crusader, it certainly has been a hard target to hit on the Hill. They've done a remarkable job in keeping it alive."

Here's how:

About the time the Carlyle Group bought United Defense, the United Defense LP Employees Political Action Committee registered with the Federal Election Commission. Since then, that committee has contributed more than $300,000 to several dozen legislators who have been key supporters of the Crusader and other Pentagon weapon systems that United Defense supplies.

In many cases, the legislators who received the money have other interests in pushing United Defense's agenda: jobs and commerce in their home states or districts.

Oklahoma Republican Rep. J.C. Watts Jr., for example, has been one of the Crusader's staunchest supporters. Watts' district includes the Crusader's Comanche County assembly and testing facility. Watts also has received $7,000 in contributions from the United Defense PAC.

Sen. Rick Santorum (R-Pa.) has received $10,000 from the same PAC. Pennsylvania is home to a United Defense plant in York. In October, he praised the Senate's passage of an early version of the defense authorization bill because it included $487 million for Crusader in 2002.

And Rodney P. Frelinghuysen, a GOP member of the House Appropriations Committee, was among the Crusader's pioneering proponents, dating back to the system's early development at the Picatinny Arsenal in Frelinghuysen's New Jersey district. The company's PAC has contributed $4,500 to his campaigns.

Such contributions are business as usual in the industry; larger defense contractors lavish even greater sums on their congressional supporters, FEC records show. Carlyle denies it played any role in creating United Defense's PAC.

United Defense spokesman Doug Coffey said the contributions are "not anything that would be out of the norm." The PAC's creation, he said, was timed not to the Crusader project but to the fact that United Defense became an independent corporation allowed to make such contributions only after Carlyle bought it.

"The contributions are primarily made to congressional members in areas where we have facilities," Coffey said. "And the total amount is nothing very extraordinary in the defense industry."

In addition to making its case on Capitol Hill, United Defense sought to answer Pentagon worries. The company redesigned the Crusader--and in record time. Its engineers took 20 tons off the system's weight, making it light enough to rapidly deploy two of them on a C-17 transport aircraft.

The Army also cut its order to 480 from more than 1,100 Crusader systems, reducing the program's overall cost to a projected $11 billion. And ever since, a succession of Army chiefs of staff have argued passionately for the program as an essential, leading-edge tool for its battlefield readiness in the 21st century.

Some independent analysts are impressed. John Pike, who runs the defense watchdog group GlobalSecurity.org, said he believes the Army will need an advanced artillery system, which he called "the king of battle, the thing that kills half the enemy."

But Krepinevich and others remain unconvinced. Given that future conflicts more likely will resemble Afghanistan than the Gulf War, he said: "over time, Crusader becomes less and less attractive. . . . Nobody wants to fight the American military out in the open anyway."

Krepinevich concluded that the system nonetheless has survived because "there's a high level of support by United Defense, No. 1; No. 2, by the [congressional] members whose constituents are affected by the health of United Defense. Then, you've got the Army. This kind of artillery system pacifies the traditional culture of the Army while it is transitioning to a lighter, more modern force.

"And there simply isn't the same kind of intensity on Capitol Hill to cancel projects like Crusader, especially in times of bigger defense budgets."

Carlyle Officials Seek to Sell United Defense

Carlyle officials say their strategy is to keep companies for three to five years and then sell them. Defense industry sources said Carlyle was trying to market United Defense as early as a year ago but had no takers. Carlyle officials confirm they were looking for an "exit strategy" from their ownership of United Defense.

"They basically didn't have options," said Stuart McCutchan, who edits the Virginia-based Defense Mergers & Acquisitions newsletter. "What has happened in the last two or three months has given them an option. The public becomes the buyer."

And Carlyle's timing was impeccable.

First came the Bush administration's proposed 2002 defense budget. The document landed in Congress in June 2001, and it included an 11% hike in defense spending, including full funding for the Crusader.

Bolstered by the good news and the prospects for the company, Carlyle took its first dividends from United Defense on Aug. 13: $289.7 million.

Twenty-nine days later, the two hijacked airliners slammed into the World Trade Center towers, while another hit the Pentagon. President Bush declared war on terrorism, defense industry stocks were suddenly hot and, just five weeks later, Carlyle was ready to take United Defense Industries public.

On Oct. 22, United Defense filed its stock-offering prospectus with the SEC.

"The terrorist attacks of September 11, 2001, have generated strong Congressional support for increased defense spending," the prospectus declared. "We believe that domestic and international defense spending will grow over the next several years as a result of an increased focus on national security by the U.S. government and its allies."

A month later, Carlyle took $92 million more in dividends out of United Defense.

Then, on Dec. 13, the Defense Authorization Bill passed both the House and Senate, with full funding for the Crusader, just one day before United Defense went public. United Defense's president and chief executive, Thomas Rabaut, even got invited to ring the opening bell at the New York Stock Exchange that day.

Carlyle Managing Director Allan Holt explained: "The decision to take United Defense public was a function of the performance of the company, the outlook for its programs in the defense budget and the receptiveness of the market to defense equity offerings.

"We have an obligation to try to achieve the best returns for our investors."

And they did.

By the closing bell, Carlyle, which still controls 54% of United Defense, had sold more than 11 million of its shares in the company for a total of $237 million. United Defense raised an additional $163 million from the sale of about 9 million new shares.

On Wednesday, the company's stock, which Carlyle and United Defense opened at $19 a share Dec. 14, was trading for nearly $21.

Copyright 2001 Los Angeles Times