A lack of appreciation for the lengths of cycles is a key risk for private-equity investors, who can miss the upside if they are too conservative, says Jason Thomas, managing director and director of research at The Carlyle Group.
“If interest rates remain low, there will be demand for higher-yielding assets, which supports higher asset prices. Be wary of calling a top,” he says. “My guidance is not to say you shouldn’t be concerned about the end of expansion. But it can’t be so front and centre that you can’t think of other risks and you pass on otherwise attractive investments. If you were in cash two years ago, you would regret it.”
In 2013, Leon Black, the chief executive of Apollo, one of Carlyle’s biggest competitors, said, “We’re going to sell everything that’s not nailed down,” and prices have risen dramatically since then. Similarly, Alan Greenspan’s warning of irrational exuberance was in 1996, and the market doubled after that, Thomas says.
“Eight years into an expansion, there’s a temptation not to be invested, or to pass on attractive companies,” he says. “But not realising how long cycles can go for is a concern. You need a balanced approach to thinking about the cycle because risks can be more symmetric than they appear.”
He says Carlyle, a global manager of alternatives with $170 billion in assets under management, typically takes a conservative position, preferring to sell earlier and get liquid earlier, but part of his job is to query decisions constantly, mostly through analysis of data.
Thomas acts as economic adviser to the investment committees at Carlyle. He uses economic data, proprietary and official, to examine the difference between what was expected to happen in the portfolio, and what did happened.
The trick, he says, is managing the tension between over-reacting to monthly data and using inflexion points, month-ahead forecasts, to make decisions.
“We want to step back and see what the idiosyncratic versus systematic portion of the portfolio is,” he explains. “We look at how different our portfolio data is to what we were expecting, plus the prior month’s official data. How our portfolio changed relative to our own volatility and the official data, gives a sense of systemic shifts in economic conditions.
“In private equity, everything depends on the perspective. You can have a compelling case but not have a deal. My role has to be additive and can inform at the outset of the fund; we can look at industries then assess deals as they come in. It helps to contextualise.”
It can also accelerate the sales process, and inform the disposal of assets if there is a belief that a deterioration is not totally priced in.
Against the conventional wisdom
At the moment, Thomas’s view is contrary to conventional wisdom that the current cycle is coming to an end.
“This is not quite right,” he says. “Many economies experienced a pronounced slowdown or full-blown recession in 2015-16, which allows for a sustained recovery today. Everything is going strongly simultaneously; we are seeing recovery from slowdown, it was a dip and we are bouncing back.”
In particular, he says, if the US dollar is not going up – and he doesn’t think it is – then the perceptions of risks in emerging markets may be overstated and Carlyle is more willing to deploy capital there. It has a weighting of about 25 per cent to emerging markets.
Thomas says there is a potential downward adjustment, a real adjustment, to the US dollar, which could be 8 per cent to 15 per cent in a five-year period.
“At the start of the year, the dollar may have been 20 per cent overvalued,” he says. “Investors need to be prepared for a US dollar recalibration down, which is good for the US economy.
“Accumulate foreign assets. The rest of the world is on sale. Buy high-quality companies at reasonable prices elsewhere. There will be a 2 per cent to 3 per cent annual gain over a five-year window, from currency.”
He says part of the reason is the US Federal Reserve has always been so far ahead in its tightening and easing cycles, which has had an effect on the US dollar when it is counter to the rest of the world. In addition, the US is less competitive because the dollar is relatively high, which acts as a constraint on investment and wage growth.
Trump changes not so dramatic
The past nine months, since Trump’s election, has been a test for those wanting to deploy capital.
There was a period of insecurity after the US election last November based on the potential scale of changes in U.S. public policy.
“There was a temptation in the weeks after the election to try and predict policy to an extent that was not practical. Then reality set in, and the scale of the policy changes appears likely to be much less dramatic than people anticipated. Now we are back in a situation where perceptions of the economy and fiscal and monetary policy environment are closer to where they were in November,” he says, pointing out that the Fed may raise rates again in December.
“But they won’t do it for no reason and the impetus is not there now.”
Immediately after the election, Thomas spent much time trying to get his head around the portfolio implications of Trump’s policy promises. For example, the implications of Mexico exposure, mostly through supply chains, and China exposure, along with the implications of tax reforms and potential infrastructure spending, which are ongoing.
“People had a lot of questions; for example, a border tax could affect a lot of different deals,” he explains.
Hypothetically, he offered the example of a textile manufacturer in China that got most of its retail sales from the US. If a 30 per cent border tax were introduced, it would wipe out the company’s operating profit. But it would also wipe out the operating profit of all its competitors.
“It is unrealistic to think that Americans would no longer have access to low-cost apparel made in China, so it’s a complicated question to consider,” he says. “The good news is that such developments force you to consider the processes in place to assess these types of unconventional risks.”
Back to fundamentals
Thomas says there is much less focus on government policy in his discussions with investment professionals.
“To some extent, the policy focus feels, in retrospect, to have been a bit of a detour,” he says. “Carlyle deployed capital aggressively this year, but on those that had severe policy implications there was a hesitance.”
The discussions are now back to fundamentals, where most of the value is coming from, he says, and Carlyle is deploying capital at a healthy rate – more in 2017 than in 2016 – because of the strength of the underlying economy. The US is rebounding because of energy and industrials, and Thomas can see that in the portfolio data.
“Energy spending/orders for equipment are up 20 per cent in our portfolio. Last year, that was still contracting,” he says.