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THE CARLYLE GROUP | 1001 PENNSYLVANIA AVENUE, NW | WASHINGTON, DC 20004-2505 | 202-729-5626 | WWW.CARLYLE.COM

CARLYLE PERSPECTIVES: Thinking Beyond the Cycle

MAY 2019

GLOBAL INS IGHTS

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THINKING BEYOND THE CYCLEBy Jason M. Thomas

After a decade of robust returns, uninterrupted global econom-ic growth (despite some regional stumbles), and a seemingly inexorable rise in valuations across virtually all asset classes, investors have become focused on the endgame. Questions regarding the timing of this cycle’s inevitable turn for the worse are certainly worth pondering, but they are hardly the only ones worth asking, nor are they likely to prove to be the most consequential to portfolio performance. Instead, it is the secular decline in expected returns – rooted in the rise of global savings relative to investment demand – that poses the greatest risk to investors.

Financial capital is no longer the finite resource it once was. Modern businesses generate more cash than they can rein-vest. The rise of “hyperscalers,” “virtual companies,” and asset-light business models has resulted in a structural surplus of liquidity that bids up the price of existing assets and pushes real financing costs to zero. High returns over the past decade partly reflect asset prices’ one-time adjustment to this shift. Now that this process has run its course, those returns are largely in the rearview mirror.

If investors are to avoid the looming diminution in returns, they will need to adopt a secular, rather than cyclical, orien-tation to their thinking and investment strategy. This means that rather than assume a defensive posture in anticipation of a downturn, investors should think beyond the cycle and in-crease their exposure to the scarce resources, demand drivers, and investment strategies most likely to generate persistent returns over the next decade or more.

Today, human capital is the finite resource that constrains the growth of businesses: managerial talent, creativity, profession-al networks, and the capacity to manage complex situations and execute in circumstances that others cannot. Human capital not only offers the prospect of faster growth, but also uncorrelated returns from the specific actions undertaken to unlock value. Only by identifying businesses and partners rich in human capital can investors hope to generate the incremen-tal returns necessary to offset the decline in the equilibrium return on savings.

Investors seeking persistent returns through the next down-turn should also weight portfolio exposures towards sectors that exhibit less dependence on global GDP growth and strat-egies that offer uncorrelated risk profiles. This means focusing on assets whose cash flows depend more on demographics and structural changes in the economy than aggregate de-mand growth, and investment strategies with countercyclical properties and longer holding periods.

The decline in expected returns has made life difficult for sav-ers, but this is not due to a conspiracy among central banks or temporary forces likely to dissipate in the next few years. Instead, it reflects a structural change in the global economy that has increased the amount of cash chasing investment op-portunities of all types. Investors shouldn’t delude themselves into thinking a downturn won’t come, but obsessive focus on

its timing distracts attention from the steps necessary to en-sure recent returns persist through the next cycle and beyond.

Calm But Not Complacent – Contextualizing the Next DownturnTiming recessions is notoriously difficult. Downturns almost necessarily involve some unforeseen shock that destabilizes the system. This unpredictability makes market-timing strat-egies unprofitable.1 Increased cash holdings introduce a drag on returns that can only be offset if investors are right about the timing and magnitude of the market correction and even-tual rebound. Even worse, obsessive focus on “getting out” at the top to beat these long odds often leads to indiscriminant selling of the sort that boosts returns for other investors by allowing them to deploy additional capital at more advanta-geous prices during market hiccups.

While cyclical fears tend to increase with the length of the expansion, the magnitude of the eventual downturn does not. The depth and duration of recessions instead depend on the size of the capacity overhang that develops during the expan-sion (Figure 1). Large imbalances can manifest themselves in a relatively short period, as between 2002 and 2007 in the U.S. when the stock of commercial mortgages doubled, builders constructed five million more single-family homes than were necessary to meet household demand, and the average loan-to-value ratio on mortgaged properties rose by 20 percentage points.2 Timing the spark that ended that cycle was much less important than recognizing the potential scale of the inferno that could result.

FIGURE 1

GDP Growth Over the Next Two Years is Inversely Related to Measures of Excess Capacity in Credit, Real Estate & Corporate Capex3

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1 C.f. Lo, A. W. and A. C. MacKinlay. (1990), “Data-snooping biases in tests of financial asset pricing models.” Review of Financial Studies. Andreas Neuhierl, A. and B. Schlusche. (2011), “Data Snoop-ing and Market-Timing Performance,” Journal of Financial Econometrics.2 Carlyle analysis; Federal Reserve Flow of Funds Accounts, B. 103 and L. 217.3 Carlyle Analysis of BEA Data, April 2019.

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FIGURE 2

Few Signs of Excess Capacity in Advanced Economies Due to Weak Cumulative Fixed Investment & Credit Growth4

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Despite the lengthy expansion, there are few obvious signs today of excess capacity on a comparable scale (Figure 2). The modest GDP growth in advanced economies over the past decade can be traced directly to weakness in capital spend-ing and credit growth. Construction activity has remained near recession levels in the U.S. and Europe, while household indebtedness has declined well below pre-crisis levels.5 Real estate developers have been remarkably circumspect, with commercial development spending failing to rise with valua-tions for the first time on record (Figure 3). After a decade of conservatism, CEOs today invoke “late-cycle” concerns to rationalize even more risk aversion (Figure 4).

FIGURE 3

High Real Estate Valuations have not Spurred New Development Spending6

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4 Carlyle; Federal Reserve Flow of Funds, March 2019. 5 Bank for International Settlements, Credit Statistics, May 2019.6 Carlyle Analysis of Federal Reserve Data, March 2019.

FIGURE 4

Corporate Management’s Use of “Late-Cycle” to De-scribe Economic Environment in 10-Qs and 8-Ks Rises Exponentially7

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The Bigger Risk is the Decline in Expected Returns...While the available evidence counsels against a defensive posture, both because of an inability to time the downturn and the absence of obvious excesses that would merit a high degree of caution, this is hardly the time for complacency. Ex-pected returns have declined significantly over the past several years, introducing the risk that portfolio balances in five and ten years’ time will fall well short of targets.

FIGURE 5

At Current Growth Rates, Mean Reversion in Multiples and Margins Would Result in Stock Returns of <5%, Including Dividends8

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The cyclical recovery from the Global Financial Crisis combined with the secular decline in interest rates to produce a decade of strong returns on the back of rising valuations (+40%) and

7 Carlyle Analysis. SEC EDGAR Database, Google. April 1, 2019.8 Carlyle Analysis of S&P Capital IQ Data, April 2019.

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expanding operating margins (+3 percentage points).9 This process has largely run its course. If we assume that sales continue at their current pace (i.e. no recession) but margins, interest rates, and multiples slowly revert to their pre-crisis averages, the expected return on stocks would be close to 4% in nominal constant-currency terms (including dividends) over the next five years (Figure 5). Perhaps high valuations, low financing costs, and wide operating margins may prove to be a more enduring feature of the investment environment, but it is hard to imagine future returns from further improvements across any of these dimensions.

…Originating from the Rise of Corporate Savings and Asset-Light Business ModelsWhile unconventional monetary policy has been blamed for the drop in bond yields and corresponding rise in valuations across asset classes, it is important to disentangle cause and effect. Central banks have simply responded to fundamentals. Expected returns are low because financial capital is no longer the finite resource it once was.

For a large and growing share of businesses, internally-gen-erated cash flow is more than sufficient to cover all desired capital spending. In fact, these corporate cash flow surpluses have grown so large that the (nonfinancial) corporate sector has not only become self-financing, on the whole, but has actually shifted from being a net borrower from the rest of the economy to a net lender (Table 1).

TABLE 1

Nonfinancial Corporate Sector Net Borrowing (-) or Lending (+) from the Rest of the Economy10

OperatingCash Flow

(Net of R&D)

GrossInvestment

(Capex)Borrowing (-)or Lending (+)

As a %of Sales

2018 2,216.00 2,094.10 $121.90 1.2%

2008 1,348.50 1,433.30 -$84.80 -1.2%

1999 914.30 1,020.60 -$106.30 -2.0%

1990 491.30 530.90 -$39.60 -1.2%

1980 274.60 310.60 -$36.00 -2.2%

1974 126.40 146.00 -$19.60 -2.3%

(in USD in billions)

This turns our traditional understanding of the economy’s capital development on its head. Forty years ago, the largest companies were industrial businesses—GM, Exxon, Ford, GE, IBM, Chevron, Westinghouse, among others—that could not scale production without external capital. When current output consumed existing capacity, these businesses would tap the savings of households, pensions, trusts, insurers, and other pools of capital to build the new factories, buy the new

9 Carlyle Analysis, S&P Capital IQ data, May 2019.10 Carlyle, Bureau of Economic Analysis Integrated Macroeconomic Accounts, April 2019.

equipment, and hire the new workers necessary to increase production. These investments increased the economy-wide stock of assets, and the income they generated became the coupons, dividends, and capital gains that constituted inves-tors’ returns.

Today, intangible assets—ideas, content, design platforms, software, proprietary technology, brand, business methods, etc.—account for over 80% of economy-wide enterprise value, up from just 20% forty years ago (Figure 6). These assets introduce a scalability that allows virtually infinite rev-enue growth without much, if any, incremental investment. For many of today’s largest and most profitable businesses, the old resource constraints not only no longer apply but are not even intelligible as concepts. What is the capacity utiliza-tion of Facebook? What is the physical depreciation rate of WeChat? What is the inventory turnover ratio of Windows 10?

As shown in Table 2, the ten largest (by market cap) U.S.-list-ed businesses today generate roughly 2.5x as much operat-ing income (Ebit) as they reinvest in the business. Only two of the companies are net borrowers: ExxonMobil, an “old economy” company whose cash flow relations provide a guide to how things worked in the past; and Amazon, whose aggressive expansion strategy necessitated significant capital outlays that should decline in relation to income in the future. The other eight companies—including two based in China —generated 3.5x as much internal cash from operations as they reinvested in the business over the past five years, after accounting for all R&D spending and related intellectual property production.

TABLE 2

Net Cash Flow Position of Largest U.S.-Listed Businesses11

Weighted Average 2.4x

OperatingIncome

(USD Thousands)*

CapitalExpenditures

(USD Thousands)*

InternalCash/CapexCoverage

Ratio

*Four-Year Average

Apple 65,874,000 12,436,250 5.30x

Microsoft 30,510,000 8,512,000 3.58x

Berkshire Hathaway 27,427,750 13,820,250 1.98x

Alphabet (Google) 25,837,500 14,621,250 1.77x

Johnson & Johnson 20,141,000 3,409,500 5.91x

Facebook 15,942,000 6,915,500 2.31x

Exxon Mobil 13,646,000 19,407,250 0.70x

Tencent 8,954,771 1,690,452 5.30x

Alibaba 6,638,383 2,542,691 2.61x

Amazon 5,736,500 9,643,250 0.59x

11 Carlyle, Company financial data obtained through Yahoo! Finance, April 17, 2019

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FIGURE 6

Ideas, Platforms, Proprietary Tech, Software, Brand, Business Methods, Distribution Networks Now Repre-sent Bulk of Corporate Value12

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Net Equity Issuance by the U.S. Nonfinancial Corporate Sector (IPOs and SEOs Minus Share Repurchases)13

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With no need for external capital and more internal cash than they could plausibly spend, the corporate sector builds larger and larger cash positions, repurchases stock, boosts dividends, and even lends to other businesses through asset management subsidiaries. Since the Global Financial Crisis, share repurchases have exceeded new equity issuance by roughly $4 trillion in the U.S. alone (Figure 7), while Apple has become one of the largest market-based lenders in the world, with an asset management subsidiary with more than $250 billion under management.14

By no means is this phenomenon restricted to megacap com-panies or the technology and health care sectors. Over the past decade, a new generation of “asset-light” or “virtual” busi-nesses has emerged that has redefined the boundaries of the firm by focusing on core competencies and outsourcing much

12 Bloomberg, Ocean Tomo, April 2018.13 Carlyle Analysis; BEA; Integrated Macroeconomic Accounts of the U.S.14 Braeburn Capital, “Apple should shrink its finance arm before it goes bananas,” The Economist. The AUM is estimated based on the cash position of Apple as of 12/31/2018.

else, including productive capacity (plant, equipment, staffing) through contract manufacturing. Rather than a cost arbitrage, this new generation of outsourcing reflects the greater degree of specialization made possible by digitization, globalization in services, and longer and more competitive value chains. The most profitable and fastest growing “manufacturers” have be-come sophisticated, lightly-staffed design platforms capable of orchestrating complex, cross-border production processes for precision equipment, apparel, electronics, and other goods.15

Today’s Relevant Constraint is Human Rather than Financial CapitalWhile businesses may not need money from financial interme-diaries, they still need their help. Today, human capital is the finite resource that binds the growth of businesses and com-mands high returns, and this is as true for “virtual” companies as it is for large industrial firms with billions of dollars’ worth of physical assets. While the structural excess of corporate savings over investment has depressed equilibrium return on passive saving,16 the return on human capital has never been higher.

Human capital refers to managerial talent, creativity, profes-sional networks, and, perhaps most importantly, the experien-tial knowledge gained from years devoted to building better businesses. The great business managers are not infinitely replicable; neither are the creative geniuses that invent prod-ucts that we didn’t know we need or thought technically possible; but neither is the practical knowledge of product market dynamics and operations that has been accumulated over decades inside of certain businesses and investment firms. In each case, there is a finiteness, a binding constraint. Some have it, others do not, and returns have come to depend on its accumulation and deployment.

Human capital, like human intelligence, can take many forms and should not be misconstrued as a single general ability.17 Returns often depend as much on the degree of complemen-tarity between types of human capital as its raw accumulation.

For instance, businesses with the human capital necessary to develop innovative products may lack the skills necessary to successfully commercialize them, which generally requires experience in the industry, customer and market knowledge, branding and communication, distribution, and close relation-ships with key actors.18 Likewise, businesses with products dominant in a given market may lack the skills and relationships necessary to expand globally, which often requires linguistic, cultural, and social capital.19 There is also a transformational form of human capital often used to reorient and reposition large, incumbent businesses that possess a strong brand and customer base but have fallen on difficult times; in these cases, the genius of the manager or financial sponsor is to prove that elephants can, in fact, dance.20

15 C.f. Haskel, J. and S. Westlake, (2017). Capitalism without Capital: The Rise of the Intangi-ble Economy. Princeton University Press.16 Summers, L. (2014), “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound,” Business Economics.17 Gardner, H. (1993). Multiple intelligences: The theory in practice. New York: BasicBooks.18 Aarikka-Stenroos, L. and B. Sandberg. (2012), “From new-product development to commercializa-tion through networks,” Journal of Business Research.19 Konara, P. and Y. Wei. (2019), “The complementarity of human capital and language capital in foreign direct investment,” International Business Review.20 Gerstner, L. (2002). Who Says Elephants Can’t Dance?. New York: Harper Collins.

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The Ascendance of Private Capital Dovetails with this Structural ShiftIn many ways, these structural changes have made it the best and worst time for private capital. On the one hand, few businesses are looking for capital underwritten to 20% annual returns, and those who do likely have something wrong with them. The simple act of finding deals no longer commands the returns it once did. But, on the other hand, current conditions are especially propitious for those private capital firms with the replicable growth strategies, CEO networks, and global plat-forms that can help companies accelerate growth or change directions.

When financial capital was the binding constraint, businesses pursued public listings to obtain the lowest-cost capital avail-able to scale their business. Today, entrepreneurs, founders, and management teams increasingly prefer to partner with global private investment firms in pursuit of human capital. Identifying deficiencies is not always easy; possessing the professional network, market knowledge, and resources nec-essary to remedy them is even harder. Just as certain types of human capital accumulate more quickly in areas with more skilled workers and a common focus,21 other types grow most efficiently inside of global investment firms with integrated networks of professionals that have devoted their lifetimes to building better businesses.

Investors have responded by dramatically increasing their allocations to private capital to participate in this process. Over the past decade, “active management” has come to be synonymous with private equity, as ETFs and passive strategies account for a larger share of sophisticated investors’ stock portfolios and “stock picking” has been replaced by direct ownership and control through private markets.

Ironically, some have labeled the exponential growth in the private equity industry’s assets under management (AUM) and dry powder as a “bubble.”22 These observers see massive capital flows into the industry but fail to perceive the profound structural changes that have led to a more-than-proportion-al increase in companies seeking private capital. In fact, the number of public companies in the U.S. has dropped by 53% from its peak, a decline similar to that observed in many other economies (Table 3) and the mirror image of the rise of private equity-backed companies (Figure 8). When controlling for company size and financial market development, overall listing propensity has declined by roughly two-thirds over the past 40 years.23

The universe of public companies is not just smaller in number; its composition has shifted towards businesses that tend to be substantially older, larger, and more mature than was the case 10-to-20 years ago. Delistings due to mergers, buyouts, and bankruptcies have not been offset by new Initial Public Offer-ings (IPOs), which have declined by 75% in the U.S. since the

21 Glaeser, E. and M. Resseger, (2009). “The Complementarity between Cities and Skills,” NBER Working Paper No. 15103.22 “The private equity bubble is bound to burst,” Financial Times, April 12, 2019.23 Carlyle Analysis. While listings in some Asian economies continue to grow due to faster new firm formation, the pace has slowed dramatically and the number of listed companies globally has declined steadily over the past five years. Doidge, C. et al. (2018), “Eclipse of the public corporation or eclipse of the public markets?” ECGI Working Paper No. 547.

late-1990s. As yesterday’s “growth stocks” migrate to private portfolios, Duke Professor Elizabeth de Fontenay cautions, “the public stock market is quickly becoming a holding pen for massive, sleepy corporations.”24

TABLE 3

Decline in the Number of Publicly-Listed Companies25

Peak End of 2017* Decline

Netherlands 392 102 -74.0%

Mexico 390 141 -63.8%

South Africa 754 294 -61.0%

France 1185 465 -60.8%

US 7322 3439 -53.0%

Brazil 592 335 -43.4%

UK 2913 1858 -36.2%

Israel 664 431 -35.1%

Germany 761 450 -40.9%

Switzerland 289 228 -21.1%*Four-Year Average

FIGURE 8

Growth in Private Companies Mirrors Fall in Public Listings26

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With little prospect for additional multiple or margin expan-sion, portfolio-wide returns over the next 5-to-10 years will depend more on growth. And as growth gravitates to private portfolios, investors will need to adjust allocations to reflect current realities rather than those that prevailed a decade ago.

24 Fontenay, E. (2017), “The Deregulation of Private Capital and the Decline of the Public Company,” Duke University Working Paper.25 WDI Database, February 201926 PitchBook 3Q 2018 M&A Report; CRSP.

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Portfolio Construction Still Looms Large a. Structural Rather than Cyclical Demand Growth

While excess returns over the secular horizon will largely accrue to human rather than financial capital, the cyclical sensitivity of a portfolio’s return profile will still depend on the composition of the underlying assets. Investors should not be spooked by the prospect of a downturn, but they also should not pretend one will not occur either. At this point in the cycle, investors should increase exposure to sectors that exhibit less depen-dence on global GDP growth.

TABLE 4

Industry Fundamentals and GDP27

Sector Period Correlation withNominal GDP Beta

Revenues EBITDA Revenues EBITDA

Financials 1992 -2018 68% N/A 5.66 N/A

Energy 1992 -2018 50% 57% 5.36 8.92

Materials 1991 -2018 67% 61% 3.58 4.77

ConsumerDiscretionary

1990 -2018 73% 44% 2.86 1.92

Info Tech (IT) 1991 -2018 52% 37% 2.19 2.53

Industrials 1990 -2018 66% 72% 2.1 3.51

Consumer Staples 1990 -2018 30% 29% 0.73 0.69

Healthcare 1994 -2018 0% 9% 0.01 0.25

Overall 1982-2018 69% 69% 2.54 2.62

FIGURE 11

Health Expenditures Depend on Demographics 28

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27 Carlyle Analysis; S&P Capital IQ Database, December 2018.28 Carlyle, 2018. WDI Database.

Table 4 reports the statistical dependence between the cash flows of eight industries with GDP. The first two columns measure the correlation between the industry’s aggregate sales and operating earnings with GDP, while the next two measure the “beta” or sensitivity of industry cash flows to a given change in GDP (a 1% drop in nominal GDP has been associated with a 5.66% drop in financial services industry revenues, for example).

As is obvious from the table, the aggregated cash flows in the health care sector have evolved independently from GDP over the past 25 years. That’s largely because health expen-ditures tend to be a function of demographics and the long-run convergence in living standards fostered by globalization (Figure 11). Health care tends to be the rare sector whose cash flows are both “low-beta” and fast-growing, with largely idiosyncratic risks stemming from changes in public policy and therapeutic breakthroughs. For Asian economies that are growing old at the same time that they are growing rich, health expenditures are likely to grow significantly faster than the broader economy.

Indeed, the cyclical sensitivity of the returns on a specific investment often has much more to do with the strategy, or value creation proposition, than industry or geography.

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The other low-beta sector, “consumer staples,” is best conceived as a geographic rather than sectoral strategy. Traditionally viewed as a “defensive sector” involving expen-ditures that consumers in advanced economies are loathe to cut from their budgets, this category really captures consum-er spending that tends to accumulate through time rather than vary over the cycle or in response to interest rates. On this basis, it is the rise of the Asian consumer—especially in China—that best captures this persistence.

While Chinese consumption slowed in 2018 in response to the intensifying trade dispute with the United States—an idiosyncratic political shock—the medium-term outlook re-mains extremely favorable. While rising household income growth will account for the bulk of the increase, generation-al shifts in savings rates and attitudes towards debt should make large contributions as well. China’s national savings rate remains more than 10 percentage points above Ko-rean levels and nearly 20 percentage points above that of Japan. At the same time, Chinese household indebtedness stands at barely half of Korean levels and 20% below those of households in Malaysia and Thailand.29 These disparities should narrow over the next decade, particularly given the shift in the macroeconomic framework away from exports and investment towards growth centered on consumption, services, and advanced industries.

If Chinese consumption follows the path of the Japanese, Ko-rean, and Taiwanese economies at similar per capita income levels, household spending should rise from 38% to 55% of GDP over the next 15-20 years. The difference is that with 1.3 billion people and a starting GDP in excess of $13 trillion, the rise of the Chinese consumer is likely to have a far great-er impact on global economies and investment portfolios. If broader GDP expands at a 6% real rate over the next decade, consumer spending would advance by more than 8%, on av-erage, or growth of nearly $400 billion per year in 2019 terms.

FIGURE 12

Chinese Household Consumption Share of GDP Barely Half of U.S. Levels30

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29 Zhang, L. et al. (2018), “China’s High Savings: Drivers, Prospects, and Policies,” IMF Working Paper No. 18-277.30 Carlyle,; World Bank WDI Database, April 2019.

FIGURE 13

Expected Path for Chinese Household Savings (Near-Term)31

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Household Saving Rate (LHS)

b. The Uncorrelated Returns from ManagingComplexity

The cyclical sensitivity of each asset in a portfolio depends on a number of factors that extend well beyond its location and industry categorization. While health care sector revenues typ-ically exhibit little dependence on GDP, sometimes policy risks are correlated with the economic cycle, such as when public insurance cutbacks occur during economic downturns.32 And while a negative economic shock generally depresses demand for energy, these effects tend to be concentrated in “up-stream” sectors, with shipping, pipelines, refining and electric-ity transmission and distribution largely unaffected. Long-term structural change in energy consumption should also ensure that demand for battery technology and renewables grows steadily through any recession.

Indeed, the cyclical sensitivity of the returns on a specific invest-ment often has much more to do with the strategy, or value creation proposition, than industry or geography. For example, carving out a subsidiary or division from its corporate parent and turning it into a standalone business is a complex process that involves significant execution risks. A new management team needs to be assembled; accounting, sales, legal, and product development functions often need to be established or reinvented; the ownership of physical and intellectual property must be disentangled and valued appropriately; and an entirely new corporate culture and strategy needs to be conceived and transmitted throughout the business. And all of this needs to occur without any material cost overruns or loss of revenues.

Similar execution risks are evident in infrastructure, where coordination with political leaders, labor unions, and other stakeholders often adds another layer of complexity to the project. The returns to redeveloping airports, dredging ports, building pipelines, and transitioning electricity generation to renewable sources all involve multidimensional optimization problems inside of fixed budget and time constraints. Real es-tate renovation or redevelopment often involves similar risks,

31 IMF Working Paper 18/277, December 2018.32 Cleeren, K. et al. (2016), “How Business Cycles Affect the Healthcare Sector: A Cross-country Investigation,” Health Economics.

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as the details of the projects have to match the precise tastes of the target business or household demographic without cost or time overruns. Energy investments often involve similarly complex political dynamics and increasingly depend on the diffusion of technology to boost the productivity of existing fields.

In each of these cases, the investment may succeed or fail across any of these dimensions, but that success or failure has nothing to do with the returns on the S&P 500 or any other index of global assets. Such execution risks provide uncorrelat-ed returns that depend on the human capital of the financial sponsor, its CEO networks, and other partners. The more complex the undertaking, the smaller the pool of potential rivals and higher the expected returns on the requisite human capital.

c. Diversifying Risk Through Time: LongerDuration and Countercyclical Deployment

Cyclical variation in returns is not just about economic funda-mentals, but also the predictable movements in multiples and financial conditions. At cyclical peaks, risk premia tend to be low, credit spreads tight, and asset price multiples reach levels that leave little-to-no margin for error. Returns on investments made during these periods could disappoint even if the busi-ness, or cash flows from the asset, perform according to plan.

However, the practical importance of such financial market volatility depends on the holding period. For example, the re-turn on an investment held for one month is entirely explained by financial market volatility; there is not sufficient time for fundamentals to make a difference. Conversely, the return on an asset held in perpetuity is explained entirely by its cash flow growth; fundamentals are all that matter. Empirical estimates of the relationship between these two extremes reveal that multiple contraction declines nonlinearly with the expected holding period. An asset held for 10 years assumes 60% less multiple contraction risk than one held for three years (Figure 14).

FIGURE 14

Risk of Multiple Contraction Declines Nonlinearly with Holding Period33

0%

10%

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40%

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1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76

Cum

ulat

ive

Retu

rn E

xpla

ined

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tiple

s

Holding Period (in Quarters)

Asset Held 3 Months:Return Mostly Attributable to Market Volatility

Asset Held 20 Years:Return Almost Entirely from Fundamentals

Risk Reduction from Extending Duration

33 Carlyle Analysis of S&P Capital IQ Data, June 2018.

Cyclical risks could be further diversified through opportunistic or countercyclical credit strategies that deploy capital during periods of heightened volatility. Empirical evidence reveals that credit (loans and bonds) absorbs a disproportionate share of the decline in enterprise value during market downturns relative to its seniority in the capital structure.34 During these episodes, the market price of loans and bonds drops below its “intrinsic” value, which means that above-average returns on credit often become a necessary condition for non-negative returns on equity. This is not simply dollar-cost-averaging, but the active exploitation of capital structure arbitrage opportu-nities that allow investors to simultaneously increase expected returns and downside protection. By scaling up capital deploy-ment during these periods, investors can boost cumulative returns and diversify market exposure through time.

Conclusion

Investors should be calm but not complacent. The looming end of the current cycle is not as material a risk to portfolio performance as the secular decline in expected returns. Fi-nancial capital is not the scarce resource it once was; the rise of the “virtual” company and structural surplus of corporate savings have depressed equilibrium returns to savers. Today, it is human capital that relaxes constraints on growth and gener-ates outsized returns for investors.

Rather than worry about when this cycle will end, investors should focus on the steps required to ensure that the strong portfolio performance of the past several years persists through to the next cycle and beyond. To that end, investors should: (1) seek investment partners rich in human capital, with replicable growth strategies, CEO networks, and global platforms; (2) in-crease exposure to secular rather than cyclical growth drivers, such as health care expenditures and household consumption in China; (3) focus on strategies that generate returns from uncorrelated execution risks; and (4) diversify market risks over time through investment strategies that pursue longer holding periods and countercyclical capital deployment.

Economic and market views and forecasts reflect our judgment as of the date of this presentation and are subject to change without notice. In particular, forecasts are estimated, based on assumptions, and may change materially as economic and market conditions change. The Carlyle Group has no obligation to provide updates or changes to these forecasts.

Certain information contained herein has been obtained from sources pre-pared by other parties, which in certain cases have not been updated through the date hereof. While such information is believed to be reliable for the pur-pose used herein, The Carlyle Group and its affiliates assume no responsibility for the accuracy, completeness or fairness of such information.

References to particular portfolio companies are not intended as, and should not be construed as, recommendations for any particular company, invest-ment, or security. The investments described herein were not made by a single investment fund or other product and do not represent all of the investments purchased or sold by any fund or product.

This material should not be construed as an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicita-tion would be illegal. We are not soliciting any action based on this material. It is for the general information of clients of The Carlyle Group. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors.

34 Thomas, J. and M. Jenkins. (2019), “Credit in Downturns,” The Carlyle Group.

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Jason M. Thomas is a Managing Director and the Director of Research at The Carlyle Group, focusing on economic and statistical analysis of the Carlyle portfolio, asset prices, and broader trends in the global economy. He is based in Washington, D.C.

Mr. Thomas serves as the economic adviser to the firm’s corporate private equity and real estate investment committees. His research helps to identify new investment opportunities, advance strategic initiatives and corporate development, and support Carlyle investors.

Previous to joining Carlyle, Mr. Thomas was Vice President, Research at the Private Equity Council. Prior to that, he served on the White House staff as Special Assistant to the President and Director for Policy Development at the National Economic Council. In this capacity, he served as the primary adviser to the President for public finance.

Mr. Thomas received a B.A. from Claremont McKenna College and an M.S. and Ph.D. in finance from George Washington University where he studied as a Bank of America Foundation, Leo and Lillian Good-win Foundation, and School of Business Fellow.

He has earned the Chartered Financial Analyst (CFA) designation and is a financial risk manager (FRM) certified by the Global Association of Risk Professionals.

CONTACT INFORMATIONJason ThomasDirector of Researchjason.thomas@carlyle.com(202) 729-5420