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Carlyle Macro Perspective Jan 20091


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A well done analysis of the current economic conditions and opportunities for investment.

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Carlyle Macro Perspective Jan 20091

  1. 1. Trends & Opportunities in the Global Economy Our Macro Perspective And Its Implications for Private Equity January 2009 1
  2. 2. Deleveraging 2
  3. 3. The Debt Build-up in the US Economy Is Unprecedented and Unsustainable The debt level is close to twice its long-term average and  is well above its previous peak during the Great Depression US Debt/GDP (1929 – Q2 2008) Source: SocGen, “Mind Matters: Bonds – speculation not investment,” 01/06/09. 3
  4. 4. Leverage In All Sectors of the Economy Increased Over the Past Decade Mortgage debt rose particularly quickly due to the low  interest rate environment of the early 2000s, lax lending standards, and rising house prices Debt Outstanding by Sector (1998 – Q3 2008) Source: Economicdata, Q3 2008. 4
  5. 5. The Credit Crisis Is the Inflection Point: Deleveraging Is Gathering Steam What we have seen so far ― mortgage defaults, falling  house prices, bank failures, and lower economic activity ― is only the initial stage of a longer deleveraging cycle After decades of growth, household debt in the US has only  recently started to contract Net Borrowings by US Households Source: Greed & Fear, 18 December 2008. 5
  6. 6. What Is Deleveraging And Why Is It So Destructive? Deleveraging is simple: it occurs through debt repayment  or default  But its consequences for the economy are myriad Debt repayment reduces spending as consumers and  businesses use up available cash Defaults impair creditors’ ability and willingness to lend,  decreasing the credit supply The inability of businesses and consumers to borrow further  reduces aggregate demand Lower demand, a higher cost of capital, and the reduction of  the available money supply result in lower asset prices Price declines give rise to deflation, which encourages  businesses and consumer to hoard cash, further reducing economic activity 6
  7. 7. The US Recession 7
  8. 8. Deleveraging Has Given Rise to the Most Severe Recession Since World War II An array of highly negative influences are buffeting the US  economy House price declines  The end of mortgage equity withdrawals  Low availability of credit  High private sector interest rates  Low levels of disposable income  Rising unemployment  Wealth destruction  A rising savings rate  Loss of confidence  Deflationary pressures  These factors are elements of deleveraging or its direct  results, and they are severely depressing aggregate demand and economic activity 8
  9. 9. The Housing Market Shows No Sign of Stabilization The housing market failed first because it was there that  debt levels, interest payments, and credit standards were the most egregious Falling house prices produced the first major wave of  defaults and financial sector losses But the housing downturn is far from over ― price declines  accelerated to their fastest rate in October 2008 S&P/Case-Shiller US House Price Indicies (% change YoY) Source: Greed & Fear, 31 December 2008. 9
  10. 10. Price Declines Are Likely to Continue Extremely high inventory levels point to further price  declines of at least 10% (on top of the ~25% fall experienced since mid-2006) Inventory levels above 8 months supply are consistent with  further steep price declines US Unsold Housing Inventory (months’ supply) Source: Merrill Lynch, 26 November 2008. 10
  11. 11. Further Price Declines Will Have Negative Consequences for the Economy Additional price declines of this magnitude will result  in ~50% of mortgage holders owing more than their homes are worth(1) This could trigger a new round of defaults as owners  walk away from their homes and mortgage obligations A new wave of mortgage defaults would produce  additional losses for the financial sector, further reducing creditors’ willingness to lend Reduced credit and the hit to household wealth  resulting from lower home prices would reduce spending and further depress economic growth Sources: 1) John Mauldin, “Outside the Box,” 15 December 2008. 11
  12. 12. Mortgage Equity Withdrawals (MEWs) Have Practically Disappeared Lower house prices and higher lending standards mean that  home owners can no longer borrow against the value of their property US Mortgage Equity Withdrawals ($ billions) 224 212 205 193 163 159 141 147 134 96 94 87 49 10 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 2005 2006 2007 2008 Source: John Mauldin, 10/31/08. 12
  13. 13. The End of MEWs Is Highly Significant Borrowing via mortgage equity withdrawals sustained a  much higher rate of economic growth than would otherwise have occurred GDP Growth With & Without MEWs % Source: John Mauldin, 10/31/08. 13
  14. 14. It Has Become Difficult to Borrow Banks are trying to shrink their balance sheets and mitigate  their already massive losses, so they are refusing to lend to all but the most qualified borrowers Percentage of Banks Reporting Tighter Credit Standards Source: Unicredit, 24 October 2008. 14
  15. 15. It Has Become Expensive to Borrow And when banks do lend, they are charging much higher  interest rates despite the Fed’s dramatic rate cuts Private Sector Interest Rates (proxy)(1) % Source: Merrill Lynch, 26 October 2008. Note: (1) Includes an equal rating of jumbo mortgage rates, new car loan rate, home equity loan rate, 5-year ARM, 3- month Libor, high-yield bond rate, and bank rate 15
  16. 16. Consumers Not Only Can’t Borrow, They Also Have Little Disposable Income Consumers are now spending a record 14% of after tax  income on interest and principal repayment(1) Consumer Spending on Energy, Interest Payments, Medical Expenses, Food and Taxes as a 65 Share of Personal Income (%), 1980-2008(2) 64 63 62 61 60 59 58 57 56 55 '80 '83 '86 '89 '92 '95 '98 '01 '04 '07 Sources: (1) Merrill Lynch, 8 January 2009; (2) The Gloom, Boom & Doom Report, August 2008 16
  17. 17. Rising Unemployment Is Eroding Consumer Demand Unemployment is rising rapidly as companies reduce  staffing levels in the face of economic weakness 2.7 million US jobs have been lost since December 2007   The official US unemployment rate rose to 7.2% in December and may well peak above 10% Monthly US Private Sector Change in Employment (000s) Source: BNP Paribas, 07 January 2009. 17
  18. 18. Wealth Destruction Is Further Suppressing Consumption Merrill Lynch estimates that 20% of US wealth (or $13  trillion) had been destroyed by the end of Q4 2008 Household balance sheets have already sustained half the  percentage loss that they did during the Great Depression(1) Change in US Household Wealth through Q3 2008(2) Sources: (1) Merrill Lynch, 8 January 2008; (2) Economicdata, Q3 2008. 18
  19. 19. The Savings Rate Is Already Rising But Has Much Further to Go People are responding to wealth destruction and economic  uncertainty by saving more, which is further reducing demand for goods and services The US savings rate is likely to rise above 8%  US Savings Rate (% of Disposable Income) Source: Unicredit, 24 October 2008. 19
  20. 20. The Depth of the Retrenchment Is Shown By Historically Low Confidence Levels Uncertainty and fear on the part of consumers and  businesses is a key factor in lower levels of economic activity Low confidence levels indicate that worse is to come  US Savings Rate (% of Disposable Income) A record low Source: Greed & Fear, 31 December 2008. 20
  21. 21. Deflation Is A Threat And Could Entrench the Demand Collapse Lower demand for goods and services is translating into  lower prices If expectations for lower prices become entrenched,  consumers and businesses will hoard cash to buy later  This could have a devastating effect on demand (precedents include the Great Depression and Japan’s Lost Decade) Change in Core CPI vs. ECRI Leading Indicator of Inflation Source: SocGen, 12 December 2008. 21
  22. 22. How Bad Is It? 22
  23. 23. The Carnage in the Financial Sector Is Without Precedent Since the Depression Financial institutions have sustained losses totaling more  than $780 billion on their holding of debt instruments  Money-center banks including WAMU and Wachovia have effectively failed, as have dozens of smaller banks  Only the provision of government capital and guarantees has prevented a complete meltdown IMF Comparison of Losses Across Financial Crises(1) $ bil 1,400 1,400 Actual (white) and 1,200 expected (red) losses on US debt 1,000 780 instruments 800 600 420 400 235 200 0 US Savings and Loan Japan Banking Crisis Asia Banking Crisis Credit Crisis (2007 - Crisis (1986-95) (1990-99) (1998-99) ???) (1)International Monetary Fund, “Global Financial Stability Report,” October 2008. 23
  24. 24. We Are Witnessing the Steepest Manufacturing Downturn on Record In December, new manufacturing orders fell to their lowest  level since recordkeeping began in 1948 The core PMI index of manufacturing activity fell to its lowest  level since 1980 ISM Manufacturing Index: Current Downturn vs. Post War Recession Average Average Recession Current Recession Source: Council on Foreign Relations, Paul Swartz, December 2008. 24
  25. 25. The Ever-Resilient American Consumer Is Faltering Consumer spending has fallen for six consecutive months  (July – December) in the sharpest retrenchment on record Discretionary spending has been particularly hard-hit, falling  at a 15% annual rate over this period  Car sales fell at an astonishing annual rate of -38.7%(1) Real Personal Consumption: Current Downturn vs. Post War Recession Average(2) Average Recession Current Recession Sources: (1) Merrill Lynch, 8 January 2008; (2) Council on Foreign Relations, Paul Swartz, December 2008. 25
  26. 26. Corporate Profits Are Under Severe Pressure and May Well Deteriorate Further Earnings estimates for 2008 and 2009 have been cut in half  over the past year Earnings Estimates for the S&P 500 Earnings Estimates for the S&P 500 (2008) (2009) December 2007 $84.00 March 2008 $81.52 February 2008 $71.20 April 2008 $72.60 June 2008 $68.93 June 2008 $70.13 July 2008 $72.01 August 2008 $64.66 September 2008 $60.00 September 2008 $58.87 October 2008 $54.82 October 2008 $48.52 January 2009 $48.05 January 2008 $42.26 Source: John Mauldin, “2008: Annus Horribilis, RIP,” 3 January 2009 26
  27. 27. Financial Globalization Has Broken Down In a climate of extreme global risk aversion, private capital  flows into and out of the US Economy have come to an abrupt halt Private Capital Flows Into And Out Of the US (% of US GDP)(1)(2) Source: Brad Setser, “The Collapse of Financial Globalization,” 29 December 2008 27
  28. 28. Global Fallout 28
  29. 29. The Credit Crisis Has Struck Europe With A Vengeance Debt levels and house prices had risen to unprecedented  heights, and deleveraging is now proceeding apace Many of Europe’s largest financial institutions have  sustained massive losses and have been bailed out Euro Area Domestic Credit / Bank Leverage: Europe vs. USA Euro Area GDP (1) (Assets/Equity)(2) 38x % 325 300 21x 275 250 225 200 2000Q1 2002Q1 2004Q1 2006Q1 2008Q1 Europe USA Sources: (1) European Central Bank, November 2008 (2) Citibank, “A Downward Spiral.” 17 September 2008. 29
  30. 30. The Economic Deterioration in Europe Rivals That of the US in Severity Demand has dried up for similar reasons as in the US, and  GDP is falling (down 0.2% in Q3 2008) Consumers are retrenching in the face of credit contraction,  falling house prices, and the need to pay down debt  Companies are seeing unprecedented order short-falls and are cutting employment and capital spending Eurozone Manufacturing PMI vs. Eurozone Unemployment: New Orders Rate (Green) & % Change (Blue) Source: BNP Paribas, 12 December 2008. 30
  31. 31. Decoupling in the Emerging Markets Has Been Debunked Emerging markets have been buffeted by a litany of  negative economic influences, including: Capital outflows, falling commodity prices, reduced export  demand, credit contraction, and wealth destruction  The economic downturn in the EM universe has tracked (and in many cases exceeded) that of the developed world OECD Economic Activity Indicators Green = Emerging Markets Red = Developed Markets Source: Bradesco, December 2008. 31
  32. 32. China Is Experiencing An Unexpected Hard Landing A steep contraction in export demand and the burst of the  domestic housing bubble are depressing economic activity Growth in the 5% range (or even below) is now a distinct  possibility for 2009 (vs. previous estimates of 8-9%) PMI China Index of New PMI China Index of Export Orders(1) Manufacturing Activity(2) A level below 50 indicates A level below 50 indicates contraction contraction Sources: (1) Emerging Markets Monitor, 5 January 2009; (2) Greed & Fear, 4 December 2008. 32
  33. 33. We Are Witnessing A Synchronized Global Downturn of Unparalleled Strength The fact that the deleveraging cycle is only in its initial  stages means that the global economy is likely to deteriorate further Although they have been revised downwards sharply,  consensus growth expectations remain optimistic PMI Index of Global 2009 Consensus Manufacturing Activity(1) Growth Estimates(2) % 1.4% 1.5 0.9% 0.9% 1.0 0.6% 0.5 0.0 -0.1% -0.2% -0.5 -0.6% -1.0 -0.9% US Euro Area Japan UK September 2008 Forecast Sources: (1) BNP Paribas, 17 December 2008. December 2008 Forecast (2) Goldman Sachs, 10 December 2008. 33
  34. 34. The Policy Response 34
  35. 35. The Government Has Spent Hundreds of Billions to Shore Up the Financial System The $700 billion Troubled Asset Relief Plan (TARP)  enabled the US Government to inject capital into otherwise insolvent financial institutions Systemically important firms such as Citigroup and AIG  received direct bail-out packages which may cost taxpayers hundreds of billions of dollars The US Government has effectively guaranteed inter-  bank lending to counter unprecedented dislocation in the credit markets An array of additional programs, with a total potential  cost of up to $5.5 trillion, are intended to mitigate financial sector losses and prevent further bank failures(1)(2) Notes: (1) Source: Bridgewater, “Daily Observations,” 2 December 2008. (2) Including TARP and above-mentioned bailouts 35
  36. 36. The Fed Is Pursuing Radical Policies to Slow Deleveraging And Combat Deflation The Fed’s interest rate cuts and expansion of the money  supply represent the most radical use of monetary policy on record The Fed has cut interest rates to zero and is printing money  via its program of quantitative easing  The goals are to counteract deflation, spur private sector lending, and reduce the pace of deleveraging Fed Funds Target Rates US Monetary Base (% of GDP)(2) (1) Sources: (1) BNP Paribas, 17 December 2008; (2) Credit Suisse, 22 December 2008. 36
  37. 37. Government Spending Is Set to Skyrocket Via A Massive Fiscal Stimulus Program The incoming administration is likely to secure passage of  a stimulus program worth several hundred billion dollars The Congressional Budget Office estimates that the  Government’s budget deficit will reach $1.2 trillion in 2009  And this doesn’t include the stimulus program or the cost of the various facilities provided to the financial sector Federal Budget Deficit Projections (% of GDP) Source: Merrill Lynch, 26 November 2008. 37
  38. 38. Outlook 38
  39. 39. The Deterioration of the Real Economy Will Intensify in 2009 The US economy will contract at a rate consistent with a  financial sector collapse, a deleveraging cycle of unprecedented strength, and a sharp decline in consumer spending A 3-5% decline in GDP is possible (and perhaps likely)  US GDP Leading Indicator (% change YoY)(1) Source: (1) Economic Cycle Research Institute; data from SocGen as of 20 November 2008. 39
  40. 40. The Financial Sector Will Suffer Massive Additional Losses Waves of additional write-downs are likely as new parts of  the credit universe fall into deep distress Credit cards, auto loans, personal loans, and even prime  mortgages are likely to produce massive ― and in some cases, unsustainable ― losses for financial institutions Banks in the US and Europe remain highly exposed to toxic  assets and are operating with high leverage levels US Banks’ Level 3 Assets European Banks’ Leverage (Multiple of Market Cap.)(1) Ratios (Assets/Equity)(2) 4.6x 4.3x 3.3x Citigroup 2.0x 1.2x 0.8x Morgan Citigroup Merrill Goldman JP Bank of Stanley Lynch Sachs Morgan America Sources: (1) Greed & Fear, 08 January 2009; (2) Greed & Fear, 09 October 2008. 40
  41. 41. Deleveraging Will Produce A Prolonged Period of Global Economic Weakness The magnitude of past credit excesses and the resulting  deleveraging cycle are easily consistent with a peak to trough GDP decline of ~10% On average, in the aftermath of a major financial crisis:  GDP contracts by 9.3% over 2 years  Unemployment rises by 7.0% over 5 years  House prices fall by 35.5% over 6 years  Equity prices drop by 55.9% over 3½ years  The real value of government debt increases by 86% (1)  While the policy response has been particularly vigorous  this time, the problems are unusually large and are global The adjustments in the real economy could meet or exceed  the above-listed averages Note: Source is “The Aftermath of Financial Crises” by Carmen Reinhart and Kenneth Rogoff, 19 December 2008. Based on a study of 18 country-specific financial crises since 1899. 41
  42. 42. Government Policy Will Help But Cannot Arrest the Demand Downturn Fiscal stimulus and monetary easing will moderate the  severity of the deleveraging cycle But the Government’s spending power is limited, and the  future costs of massive budget deficits are high  The Fed’s expansion of the monetary base will be ineffective as long as banks refuse to lend and people refuse to borrow Government Spending vs. Revenue(1) The Money Multiplier(2) Sources: (1) Congressional Budget Office, December 2005; (2) Financial Times, 17 December 2008. 42
  43. 43. Deflation Will Trump Inflation Barring Far More Extreme Monetary Policies The largest deleveraging cycle in history will produce  severe deflationary pressures As borrowers repay loans or default, they reduce both the  available money supply and demand for goods and services  Less money and lower demand result in price declines From August to November 2008, consumer prices fell at an  annual rate of nearly 10% Consumer Price Index for Urban Consumers(1) % -9.9% Great Depression Note: (1) Source is Merrill Lynch, 16 December 2008; data shows annualized four month rate of change 43
  44. 44. Deleveraging Will Ultimately Clear the Way for A New Period of Global Growth Deleveraging (and the negative fallout for the broader  economy) will last for several years but will produce a more stable base for future growth Consumers and businesses will be able to borrow on  sustainable terms  Higher levels of disposable income and pent-up demand will drive a consumption-led recovery 44
  45. 45. Positive Macro Trends Remain Important And Should Not Be Forgotten Emerging markets  While emerging markets will experience downturns over the  next few years, their long term growth prospects remain bright Opportunities for investment and development will abound  Technological innovation  Technology continues to evolve more rapidly than ever before  This will increase productivity and living standards globally  Geopolitical stability  Economic interdependence, cultural transfers, and modern  technology have produced an era of relative global stability Legitimate international institutions exist to diffuse conflicts  45
  46. 46. Severe Market Dislocation Will Produce Extraordinary Investment Opportunities Fear and panic will drive asset prices below fundamental  value, despite extremely uncertain medium-term growth prospects Asset prices and financial markets will hit bottom, and  certain sectors will offer extraordinary value sooner rather than later We expect the following sectors to trough before others  and then recover more rapidly Financial Services  Fixed Income/Leveraged Finance  China/Emerging Markets  Real Estate  Energy  46
  47. 47. Private Equity Opportunities 47
  48. 48. #1: Participate in the Recapitalization of the Financial Sector With a clean balance sheet, the provision of credit will be  extraordinarily profitable New loans can be made on extremely attractive terms due  to high private sector interest rates and credit risk premiums Would be competitors, including many of the world's largest  banks, will have trouble competing due to ongoing risk exposures associated with pre-existing assets Certain private equity buyers are uniquely positioned to  recapitalize financial institutions due to their unparalleled due diligence capabilities and large pools of equity capital Carlyle’s world class financial services team correctly  anticipated the intensification of the financial crisis and avoided investing prematurely 48
  49. 49. #2: Purchase Non-Cyclical, High-Yielding Assets at Discounts to Fundamental Value Opportunities include high yield debt issued by stable  businesses and non-leveraged acquisitions of companies with high and resilient cash flows (ex. utilities) Certain asset classes are pricing in a deterioration of  fundamentals greater than that which occurred in 1933  Such a scenario is unlikely given the relative maturity of the US economy and a superior policy response US HY Spreads: Implied Defaults Far Above 1930s Peak(1) Current HY Spread Peak default rate in 1933 Default Rate (1987-present) Source: (1) Credit Suisse, 9 January 2009. 49
  50. 50. #3: Purchase Assets in High Growth Markets & Sectors at Extreme Discounts Emerging markets and the technology sector, in  particular, present opportunities to buy assets with extremely attractive secular growth prospects Because of the high volatility of these assets, it is likely that  they will trade at severe discounts over the next 1-2 years China will offer particularly attractive opportunities  While exports are suffering, we believe the long-term  domestic demand story remains compelling Chinese Retail Sales (% Change YoY)(1) 24% 22% 20% +20.8% in Nov. 08 18% 16% 14% Sep- Oct- Nov- Dec- Jan- Feb- Mar- Apr- May- Jun- Jul- Aug- Sep- Oct- Nov- 07 07 07 07 08 08 08 08 08 08 08 08 08 08 08 (1) Source: China Statistics Bureau, August 2007. 50
  51. 51. #4: Purchase Commodity Producers & Related Businesses During A Demand Rut The magnitude and speed of the correction in energy  prices has been stunning (although not entirely unexpected) The global recession is translating into lower demand, even  in the Chinese market Prices are unlikely to rebound to their recent highs  But energy prices are nevertheless nearing levels which are  below sustainable levels ― we believe higher production costs, geopolitical risks, and emerging market demand translate into a fundamental oil price of at least $50 Government subsidies and regulations will continue to  support growth in the renewable energy sector Near-term dislocation will create long-term opportunities  51
  52. 52. #5: Purchase Businesses That Will Profit from Powerful Demographic Trends The aging of the baby boomer generation in developed  markets will produce unprecedented demand for certain goods and services This demand will increase even as the broader economy  continues to experience significant weakness The healthcare industry is a particular area of opportunity  Certain healthcare companies have the added advantage of  relying on government spending rather than private sector demand Carlyle’s top-flight healthcare team has a long history of  making successful investments in this sector; Manor Care (the largest operator of skilled nursing facilities in the US) is a flagship investment in Carlyle Partners V 52
  53. 53. #6: Recapitalize Over-leveraged But Otherwise Viable Businesses As margins fall, many over-leveraged companies will fall  into default and will need to be restructured Certain private equity firms have the due diligence  capabilities to separate the wheat from the chaff They will be able to use their available capital to  recapitalize these businesses on highly attractive terms By doing so, we anticipate that they will be able to gain  control of high quality assets at a very low cost 53
  54. 54. There Is Great Scope for Private Equity to Profit During This Downturn Historically, the private equity industry has been able to  generate exceptionally high returns during times of economic weakness and market dislocation Performance of PE Vintages During Growth Downturns Source: (1) The Boston Consulting Group, “Get Ready for the Private Equity Shakeout,” December 2008. 54
  55. 55. Trends & Opportunities in the Global Economy Our Macro Perspective And Its Implications for Private Equity January 2009 55