Carlos Velásquez · Medium · 6 min read · Image by Alex Wong from Zibio.com

David Rubenstein is the billionaire co-founder and co-chairman of private equity firm The Carlyle Group, chairman of several civic and cultural institutions, and host of The David Rubenstein Show, a popular podcast that explores “successful leadership”.

Given Rubenstein’s deep business and leadership understanding, one might assume The Carlyle Group’s portfolio companies have always been staffed with competent managers adept at co-opting disruptive business models. Or that their investment errors are invariably rectified once Rubenstein gets involved, enabling his private equity firm to reap exponential returns. While these assumptions may generally hold, at least two glaring exceptions blemish The Carlyle Group’s and Rubenstein’s track record.

This article recounts errors of omission and selling too early, costing The Carlyle Group billions of dollars in forgone profits. Errors that investors seeking asymmetric risk-reward returns should heed next time they consider bypassing an investment opportunity or exiting one.

Error Of Omission: The Carlyle Group’s $260B Mistake

In the 1990s, Baker & Taylor was the second-largest book distributor in the United States. At the time, it was also an underperforming portfolio company of The Carlyle Group, the private equity firm Rubenstein co-founded in 1987.

In the early days of Amazon, Jeff Bezos projected his company could sell 20 times the number of books that a typical brick-and-mortar bookstore sold annually. He contacted Baker & Taylor, hoping to strike a deal to sell Baker & Taylor’s book catalogue online. The cash-strapped Bezos offered a 20% equity stake in Amazon to obtain this right.

Failing to recognize the asymmetric risk-reward potential embedded in Bezos’ offer, Baker & Taylor negotiated a five-year $500k contract with Bezos instead.

Had Baker & Taylor’s management team considered the online bookselling business model more carefully and accepted Bezos’ equity offer, The Carlyle Group could have reaped a profit of upwards of $260 billion [20% of Amazon’s 1.3 Trillion market cap, as of 9/3/22].

Selling Too Early: Rubenstein Leaving An Additional $13B On The Table

Upon realizing his portfolio company’s enormous error two years into the deal, Rubenstein met with Bezos and offered seed money for Bezos’ still fledgling but growing online bookseller. Bezos rejected Rubenstein’s offer but made a counteroffer: if Baker & Taylor tore up the existing five-year contract, Rubenstein’s private equity firm could have a 1% equity stake in Amazon.

Rubenstein agreed.

The 1% equity deal Bezos renegotiated — down from the 20% equity stake Baker & Taylor initially dismissed — is evidence that the 20 times brick-and-mortar book sales Bezos projected a few years earlier were materializing. In light of Rubenstein’s growing familiarity with “successful leadership”, his direct negotiations with Bezos (today considered one of the best business operators) should have compelled Rubenstein to savour his firm’s second bite of the apple much longer in the form of a long-term investment holding.

Instead, Rubenstein sold its firm’s 1% stake in Amazon at its initial public offering, resulting in a $13 billion mistake [1% of Amazon’s 1.3 Trillion market cap, as of 9/3/22].

Hindsight Reveals Our Ignorance

One can speculate why Baker & Taylor turned down Bezos’s initial 20% equity offer. Perhaps the deal was difficult to execute due to contractual obligations with other booksellers. Perhaps Baker & Taylor calculated it could lead to lower margins. Regardless, Rubenstein’s seed money overtures two years after Baker & Taylor turned down Bezos’ 20% equity offer is telling: The Carlyle Group had failed to capitalize on an asymmetric risk-reward investment opportunity.

While Baker & Taylor’s lack of business foresight is shocking, Rubenstein’s error of selling his firm’s 1% Amazon equity stake highlights a lack of vision even the most sophisticated investor can have regarding the potentially long runway of a new business model. By Rubenstein’s admission, selling too early was a “stupid” decision.

“It was stupid, but we did.” ~ Rubenstein, on selling Amazon shares at its IPO, Invest Like the Best with Patrick O’Shaughnessy (discussion at 27:35 to 28:38 minute mark)

Ultimately, The Carlyle Group failed to fully benefit from its not one but two bites at the proverbial apple — an apple that, upon ripening, would evolve into a conglomerate that revolutionized the manner and speed in which global commerce is conducted — making the wealth destruction magnitude of these errors that much more noteworthy.

Takeaway: Don’t Be “Stupid”

The chances of reaping exponential returns increase when investors limit their mistakes. Namely, those involving errors of omission and selling too early. Below are a few additional takeaways.

1. Adopt an investment strategy that limits errors of omission. Even the most sophisticated investors can fail to recognize asymmetric risk-reward opportunities; you will fail too. Counter this inherent shortcoming by making small allocations to many investments with asymmetric risk-reward. Reduce risk through proper position-sizing, not by the outright omission of investments that appear to be speculative.
2. Errors of omission are more costly than errors of commission. Errors of commission (investments one makes that fail) have a known downside — i.e., the 100% loss of deployed capital. Errors of omission (investments not made) can result in unbound losses — i.e., the potential of forgone exponential returns. Making many small asymmetric risk-reward bets mitigates the downside risk of any one position while exposing one’s portfolio to the benefits of unbound investment upside.
3. Fear giving back profits? Trim your position; hold the remainder indefinitely. Investors often exit profitable positions prematurely out of fear of giving back profits. Counter this fear by automating a 50% exit strategy after one business cycle (~7 years) and retaining the rest of the position indefinitely. You will be 50% right and 50% wrong regardless of the subsequent price action. The Carlyle Group could still have a 10% stake in Amazon, worth $130 billion today, had they adopted this heuristic.
4. Temper your conviction— exponential returns are a function of time. In 2001, Rubenstein must have felt like a genius for selling his firm’s 1% stake in Amazon (AMZN’s price fell 95% from 1999 to 2001). Years later, Rubenstein feels “stupid” for selling AMZN. The best companies accrue over 90% of their value after their IPO; the best investment ideas accrue value similarly. Develop patience.
5. Black Swan events can drive your investment returns. Black Swan events (unpredictable events with outsized consequences) will impact your portfolio. Whatever your beliefs about tech, biotech, crypto, Web 3.0, blockchain, commodities etc., Black Swan events will bend the trajectory of these industries/sectors unpredictably. Become comfortable with the uncomfortable; invest a portion of your portfolio in seemingly speculative opportunities to be better situated to benefit from rare but consequential events.
6. The Power Law applies to your portfolio. A modest percentage of one’s portfolio holdings can drive long-term returns. Habitually selling “winners” leads to exiting positions whose returns will continue to compound, causing a portfolio to underperform the broader market (the Power Law effect of outliers naturally benefits the broader market). Exponential returns entail taking risks and staying invested. Build the mental fortitude to exploit the Power Law dynamics of your portfolio.

Postscript

Don’t feel too sorry for David Rubenstein. Despite whiffing on two “once-in-a-lifetime” investment opportunities, The Carlyle Group’s defense industry investments and Rubenstein’s Washington D.C. contacts (Rubenstein worked in the Carter Administration) have helped The Carlyle Group become the world’s second-largest private equity fund. Sometimes it’s not only what you know about business and leadership but who you know in business and leadership positions that aid one’s long-term investment returns. As of September 2022, Rubenstein’s net worth is $3.3 Billion.

Author also wrote: Wargames Investment Strategy | Fooled By Randomness | Our Airbnb Experiment | Wealth Transfers | 5 Stocks: S&P’s YTD | Inflation Hedges | An 80-Year Life | 13 Rules | N. Taleb’s Minority Rule | Your Inner Voice | Bitcoin’s Volatility | Blockchain Stocks | 50 Investment Lessons | Flywheel Effect | Bitcoin: Mental Framework | Crypto Moonshots | 4 Crypto Stocks | Bitcoin: Insurance | Brief History: Money | Spontaneous Order | Ackman’s $2.6B Moonshot | Fragility Inducing Events | Antifragile: Definition | 1% Bitcoin: 99% Cash | COVID-19: Market

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Disclaimer: Topics covered herein are for informational purposes. Before acting on investment information, consult with a financial professional.