As private capital has expanded across the lifecycle of companies, Thomas explains why there are now significantly more privately backed firms than public ones, and why a growing share of lifetime returns is realized prior to IPO.
The conversation moves from there into the forces reshaping portfolio construction. Thomas outlines how passive flows are weakening price discovery, why concentration risk has become more acute, and how shifting stock-bond correlations are challenging traditional diversification. His core argument is that investors are not just adapting to a changing market cycle, but to a different structure altogether—one where accessing growth, managing risk, and navigating a higher-for-longer environment increasingly requires a more deliberate allocation to private markets.
The Bridge EP 12, Jason Thomas, Carlyle – Transcript
COLD OPEN
Jason Thomas (00:00:00 -> 00:00:04)
Management teams, entrepreneurs are decidedly preferring private capital.
Sonali Basak (00:00:04 -> 00:00:15)
So, I’m looking forward to talking to Jason Thomas today. He is the head of Global Research and Investment Strategy at Carlyle, but he was also once the director of policy at the National Economic Council. Even
Jason Thomas (00:00:15 -> 00:00:19)
Even If you believe the destination is a public listing, it’s coming so much later.
Sonali Basak (00:00:19 -> 00:01:24)
We’re going to talk about rising correlations across stock and bond markets. Risks that are seemingly brewing in public bond markets today that are making people consider private markets. More and more.
Welcome to the latest episode of the Bridge by iCapital. I’m Sonali Basak, the Chief Investment Strategist at iCapital, and today we are joined by Jason Thomas. He is the head of Global Research and Investment Strategy at Carlyle, a global asset manager with almost 500 billion in assets under management. Jason has a unique view of the world because before Carlyle, he had worked as the director of policy at the National Economic Council. So has a long taken the macro from a policy perspective as well as a markets perspective and brought it all together for us. So, he is going to do that for us now. Jason, thank you for joining us.
Jason Thomas (00:01:24 -> 00:01:24)
Thanks for having me.
Sonali Basak (00:01:24 -> 00:01:48)
You know, when we talk to our clients, there is one problem that really topples all the other problems that they have, which is that they feel that their portfolios are increasingly concentrated. And this is something you’ve written about a lot. What role in particular do private markets play in the concentration problem? Do you think it helps bring people into a greater degree of diversification?
Jason Thomas (00:01:48 -> 00:02:49)
Oh, absolutely. But I, I think the important thing that, to understand when we look at it over the last 20 years, private markets really started as a barbell, which is to say it was early-stage venture, it was late-stage LBOs, lots of delists. And over that period of time, the, the everything’s been filled in. And as what we, what’s happened over that, that period is really yesterday’s growth stocks, promising companies, uh, you know, very attractive growth trajectories. Different industries have really gravitated to private markets. Uh, so there’s now about four times as many companies in the United States backed by private capital than there are publicly listed companies. And, and again, it’s not just that there was some pro rata, uh, shrinkage of the, of the public markets, it is precisely those younger, faster growing businesses that, that have migrated. So today, I don’t think that the diversification we used to take for granted in the stock market is possible without a fairly sizable private markets allocation.
Sonali Basak (00:02:49 -> 00:03:09)
You recently wrote about this in the context of SpaceX saying really that SpaceX was a continuum of this trend. What changes now? I mean, if you fast forward the next five, 10 years, you’re watching these companies go public later and later in life at bigger and bigger valuations. What does that mean in terms of the role of the stock market in, in, in an investor’s portfolio?
Jason Thomas (00:03:10 -> 00:03:13)
It’s, it comes much later in a company’s life, if at all.
Sonali Basak (00:03:14 -> 00:03:14)
Right, true.
Jason Thomas (00:03:15 -> 00:04:48)
So, when you think about Amazon, when it went public, it was three years after its founding, and it was precisely in that kind of donut hole that existed at the time where it needed additional capital for growth, needed some liquidity for the founders. And, and the only o option at that time was a public listing. Today, companies don’t really ever have to go public if they don’t want to. So, 15, 16, 22 years, of course, in the case of SpaceX. Secondly, what we, we look at, uh, in the recent paper is the importance of disclosure. And this is really, when you are a fast-growing company today, it’s very likely because you have some proprietary technology. Maybe it’s a new way of doing business, uh, you know, maybe it’s just your unit economics, and you really would like to keep that private for as long as possible until you attain the scale to find yourself in a different competitive position. You know, you don’t want to provide a template for your competitors to, to essentially appropriate your ideas or move into your market. And, and that’s really significant. And what’s interesting is that when you look at life sciences companies, so companies that have to file a patent to disclose their invention, uh, to secure the patent monopoly, they actually go public at the same age today as they did 25 years ago. So, so I think that that kind of proves, that’s the exception that proves the rule, you could say, because they’ve already had to disclose this information that they’re willing to go public companies that can actually protect their secrets until they attain a scale go public now about almost five times later in their life than they did 20 years ago. It’s
Sonali Basak (00:04:48 -> 00:05:07)
Interesting, a competitive advantage to being private in a lot of ways. You wrote that it’s not that public markets are broken, but they are changing what it means in terms of price, discovery, idea, incubation is what you wrote. Yeah. And allocated efficiency. I thought that was one of the most important ideas here.
Jason Thomas (00:05:07 -> 00:06:23)
Yeah, I think in each of those first, when, when you think about SpaceX or, or some other upcoming potential large IPOs, everyone’s talking about index inclusion. So now passive vehicles that match indexes, uh, essentially account for two thirds of the liquidity that’s being directed at private markets. So, when you’re just buying stocks on a pro rata basis to replicate an index, there’s no real price discovery there. Idea incubation, again, just this idea that the company is with this proprietary technology, younger businesses remaining private, so that’s something that is gravitated out of public markets. And then third, the allocated of efficiency. That’s where you look at the concentration, you know, AI stocks today, accounting for, for over 40% of the s and p of a hundred, just the top 10 stocks in the, uh, us, uh, stock market accounting for, um, a record share of the total, but it, it’s a bit different than it was in the past. In, in the past, the top 10, you could have concentration, but they were in retail or oil and gas pharmaceuticals. Today, eight of those 10 businesses are essentially in the same sector, seven of them pursuing the same strategy. So again, your your allocations, you’re, you’re much more concentrated exposure to single risk factor than had been the case in the past.
Sonali Basak (00:06:24 -> 00:06:39)
It’s interesting, that’s an argument a lot of people make that the stock market has always been concentrated, but there are reasons that it’s more concentrated today than before you made this point. I think what you were going to say is that two thirds of flows go to public equities passively. Is that what you’re
Jason Thomas (00:06:39 -> 00:07:13)
No, no, exactly. So, so I’m, I’m just suggesting that when you think about the price discovery, it used to be that index funds were a great way to give people participation in the stock market whose values the prices were actually being set by informed investors, essentially trying to arbitrage mispricing away, pulling the prices back to fundamentals. Today, uh, the, the, it’s the index funds that are actually setting prices to a much larger extent because those flows of passive investors and stock markets are actually dominating the flows, uh, of the, uh, the informed investors.
Sonali Basak (00:07:14 -> 00:07:53)
So, it’s interesting when you think about, uh, the, the reason private capital has been contributing to portfolio so much for the amount of investors who actually do invest in private assets, right? We know that a lot of individual investors don’t have access this at this point in time or have not, um, gained access. What does it mean for companies that can grow from, uh, you know, the beginning of their life cycle to year 20 or 22? Yeah. In the case of SpaceX, you call it information economics. You got to some of these, um, ideas before in terms of why a company has an advantage in that, in that pre-IPO timeframe. Yeah. But what you’re actually getting, I mean, how much value is being accrued?
Jason Thomas (00:07:54 -> 00:08:37)
Oh, well now I, I think you’re, you’re looking at about twice as much of the lifetime value for a company that goes public is now accrued during the time when, when they’re private. I mean, SpaceX just the most recent example, when you think about going from zero to $1.775 trillion, that was entirely in its life as a private company. And, and look, it’s, it’s traded up, it could trade back down. There’s going to be some volatility ahead. But when you think about all of that had been accumulated while it was private, so again, just going from three years, a median age of going public 25 years ago to 15 or 16 years, the median age today, uh, that, that’s essentially a doubling of the, the total value that’s going to, uh, to the private investors.
Sonali Basak (00:08:38 -> 00:09:27)
So, Carlyle recently looked at what would happen if you shifted some of, uh, traditional, uh, 60/40 away from, you know, just public equity and public debt. And if you took 80%, if you had an 80 20, 80% public credit to 20% public equity and shifted it to become 60% public credit and moved it to 20% public equity and 5% each to private equity secondaries private debt and infrastructure, you looked at what the portfolio outcome would be, and some of that was a higher cumulative return, a higher annualized return. But one of the more interesting things to me was that the drawdown was actually much better, meaningfully better. Yeah. If you did make those shifts, how much is that a consideration in portfolio construction? Just weathering bad times?
Jason Thomas (00:09:27 -> 00:11:19)
Oh I, I think that that’s really central, right? So, you’re thinking about two things with, with diversification and, and looking at private markets. Well, three things you could say. First, obviously the higher absolute return. Second is the volatility drag that you want to lessen that. So, so you’re compounding, uh, you know, more effortlessly over time. And then third, in those bad states of the world, when, when there is the drawdown, how, how much has your portfolio been impacted? So again, you want to maximize your return. That’s how you get the extra two to 300 basis points. Secondly, the volatility drag being lower, the, the portfolio variance is falling through the private additions. And then third, as you, uh, reference, you also have, uh, better experience in those bad states of the world. And it’s important to note that this is actually looking at ex post what had happened. What we’ve found since 2022 is that that diversifying role, that public credit, particularly high-grade sovereign bonds, have played in the past, providing very reliable offsetting deviations for stocks. You know, and this was a period of time when you had QE. So as soon as the, the stock market had a draw down or the economy hit a rough patch, you knew that the fed other central banks were going to launch another round of QE, drive yields down, send their prices higher since 2022, it’s actually the opposite. Stocks and bonds have moved in tandem, the three drawdowns that we’ve seen over the past 16 months, liberation day, uh, whatever happened with Greenland, those concerns. And then of course, March of this year, you had, uh, the 10-year treasury falling almost proportionally to the S&P500. So, I think that many of the results that we’ve seen in these draw down periods in the past where private allocation outperformed a portfolio that did not have private assets actually understates the extent to which there would be greater draw down protection going forward.
Sonali Basak (00:11:19 -> 00:11:43)
It’s interesting. Of the top concerns we hear from clients, one of them is certainly the concentration risk, but another one is that rising stock bond correlation.
Jason:
Mm-hmm .
Sonali:
And if we think about it, you know, it’s interesting the Council of Foreign Relations recently wrote so far that this could be systemic risk in a lot of ways too, because you would experience a draw down in both ways. How many people are actually looking at private markets to mitigate that potential concern?
Jason Thomas (00:11:43 -> 00:12:24)
I, no, I think it’s the, the top of what investors are looking for. Um, it, and also commodities, the difference. So, commodities also provide the diversification. The problem is that there, there’s no return, there’s no current yield. You’re just essentially making a bet on the commodity price rising in those, those bad states of the world, or at least being uncorrelated. So, so that it’s, its trajectory is going to be quite different from that, what you see in, in the stock and bond markets. Private markets provide the uncorrelated aspect to a large extent, but then also the current income if you’re in, uh, private credit or, you know, actually just the, the return, the value accrual. And, and so I think, again, it’s commodities, it’s private markets, but, but that is an important distinction.
Sonali Basak (00:12:25 -> 00:12:44)
Now, I want to go back to what we started to talk about here, uh, in this part of the conversation, which is the bond market. Because this has played out to be a very interesting year, a lot of questions about the trajectory of inflation. What do you think about this sort of hire for longer world that we’re living in now in the feed through across asset classes?
Jason Thomas (00:12:46 -> 00:16:10)
Well, I think that first we, we have to appreciate that in normal times, two or 3% inflation, what’s, that’s the difference, right? We, it’s measurement error. This is close enough, 3% inflation, a hundred basis points above the fed target coming on top of a 25% increase in the price level as we’ve experienced since 2021 is, is, is it’s almost like salt in the wound. You know, it’s just to have prices continue to rise at a faster pace, given the recent past it is, is problematic. What, what is your top complaint? Top complaint about, uh, the current environment is the price level is inflation. And I thought that, um, in the first press conference, uh, Chair Warsh made it very clear that inflation is a choice and the inflation is unacceptable. And also, it was not the excuse of the Iran war, the closure of the Strait of Hormuz. It was references to the last five years of excess inflation. And so, I think that that markets have taken from that, uh, that things are going to be less predictable. You know, there was a time when everyone thought we’re on a glide path to base rates of less than 3%. Now there’s much greater uncertainty about what the future holds and rates where they are today. You know, maybe with us for much longer than we thought. Of course, there’s potential of even rate hikes, you know, as, as we get, uh, to toward the end of the year, depending on, uh, where, where some of these other, uh, prices go. Uh, and, and so I think what, what this means for asset allocation is that this focus on assets with very attractive terminal values, you know, very often software, for example, those, those assets are very, um, highly leveraged to the level of interest rates. Anything that it, where it’s not the current cash flow, you’re actually buying, uh, an asset whose most of their free cash flow comes outside of the underwriting window is, is again, going to be sensitized to rates in, in a way that companies that are generating a lot of current income are not. And so, I think there’s a lot of focus today on duration, what, which is to say how much free cash flow is a company generating today? And that as a way to reduce its sensitivity to, to interest rates and reduce the sensitivity of the overall portfolio to rates. And, and so, you know, when you think about, uh, you can look at payback period, how many years does it take for a company’s current free cash flow to fully amortize the purchase price? Well, in this case of software, at the start of this year, it was over 200 years. So, it gives you some sense because again, you’re paying 12 to 15 times sales, or you’re paying 35 to 45 times EBITDA, or, you know, you’re, again, you’re paying 200 times some cases free cash flow. That, that, that’s the implication of that. And that’s why this focus on AI and disruption in software; everyone talks about the terminal value. Well, well, why would that be? It’s, again, that’s because that, that’s where all the money is arriving outside of that, that 10-year underwriting window. So, I think this has really changed the way that people are thinking about different sectors, different types of companies. It’s a period of digestion, you know, this digesting the sense that rates are not going to converge. It’s taken a long time. I mean, 20, 23 people thought rates would fall as fast as they rose and, and then sort of stuck with us, you know, and then of course, uh, new administration, lots of expectations, there would be very significant rate cuts. Yeah. Um, so, you know, it’s just still digesting this,
Sonali Basak (00:16:10 -> 00:16:39)
You know, it’s interesting, uh, it’s funny to hear you talk about duration risk, because it feels to me that this period of AI uncertainty is causing people to really tighten duration. That’s right. You hear people in the credit markets talking about not being able to underwrite past five years, let alone three years sometimes. And what does that mean in terms of the trade-offs that investors are making? Are investors more comfortable taking on credit risk because duration risk is becoming less attractive?
Jason Thomas (00:16:40 -> 00:18:14)
No, I think that that, what’s what’s interesting is when you think about, um, you know, owning a 10- or 30-year bond, you know, just, just longer, uh, maturity, uh, the question is, you are taking duration risk, you’re taking the volatility. Are you going to get inflated away? What sort of interest rate movements can you expect? How is the price of that bond going to respond to all that? And you find that people were not getting it all compensated for it. I mean, again, this was the QE era, the duration, the term premium essentially went zero, went to zero, or it was negative based on some measures. So, you’re getting no compensation for lending to the government 10 to 30 years. And I think as now people are, are more sensitized to that risk, the volatility of bonds, if, if rates go up as people just saw again, last, um, uh, liberation day, what you paid a hundred dollars for your, uh, 10-year bond, it was worth 94, 12 days later. Right. That, that’s a, that’s a big, uh, fair value loss for something you’re not really getting very much coupon interest to hold. Yeah. So, the alternative is to take a zero-duration asset, essentially something priced off of SOFR 90-day money, and then the incremental spread comes from the credit risk you’re taking. And so, when you’re getting compensated for five, 600 basis points for the credit risk, as opposed to getting virtually nothing for the duration risk, you see that a much better way to generate incremental income is to assume credit risk rather than, uh, you know, the, the duration risk lending, again, mostly to a government or a corporate, uh, at much longer maturities
Sonali Basak (00:18:14 -> 00:18:57)
This crunch on longer term government financing has pretty meaningful ramifications. I’d love to talk to you about it in terms of what it means for certain strategic assets, defense assets, for example, where the fiscal spend is really meaningful, um, to defense. Uh, you know, anything that requires more government spend to facilitate, um, infrastructure spend spending, which is an enormous need in this country, let alone many others. Um, where we’re seeing longer term yields really take off through the course of 2026, what role does private capital, uh, play in terms of these giant build outs? Because this seems like a mega force that really can’t be ignored.
Jason Thomas (00:18:57 -> 00:19:52)
Yeah, I think that, um, one of the lessons of the last few years is, is really that there is, uh, you, you, we’ve compared GDP across economies, across, you know, thinking about NATO’s GDP, comparing it to Russia’s GDP order of magnitude larger, but I think people have become more sensitized. It’s not just GDP because things like, uh, royalties on McDonald’s franchises, or that’s, that’s real income, but it’s not quite the same thing as manufacturing, uh, production capacity. So, if you look at, um, real productive capacity, real industrial capacity across economies, you get a very different view of things. Uh, China’s economy is about the same size as United States in purchasing power parity terms, US economies larger than China’s at, at market exchange rates. But if you look at real productive capacity in the industrial sector, China’s economy is almost four times larger,
Sonali Basak (00:19:52 -> 00:19:54)
And they’ve made a lot of investments as well,
Jason Thomas (00:19:55 -> 00:21:28)
Enormous investments. And, and so I think that that is, that that sort of distribution is something that has a lot of people uncomfortable. Yeah. And I think if there’s one thing to bet on over the next 10 to 15 years, it’s that the distribution of global industrial capacity is going to look very different in the future. And that’s because of the scale of investment that’s going to occur, certainly in the United States, uh, certainly in Europe, but but also in Japan and other economies. And because of the fiscal constraints, because of how embedded most of these economies and governments are, the only way to effectuate that, that, uh, reallocation or the reindustrialization is going to be through private capital. And I think that the interesting thing is how that private capital gets mobilized over the next, again, 10 to 15 years to facilitate that. Very interesting discussions in Europe right now, savings and investment union, of course, the, the United States more developed private capital market that I think is more ready to step in and do so, you know, pretty expeditiously in, in, in concert with the government, with, you know, some additional spending. Uh, Japan, it’s, it’s the same thing. A lot of that is on the exchange rate, making it more attractive to invest, more cost competitive to invest in domestic industrial capacity, of course, also doubling their defense budget. This is, I think, really central to, to the longer-term horizon, uh, with thinking about what are, you know, given the scale of uncertainty, given the technological disintermediation, what can we really count on happening? I think this is central to that.
Sonali Basak (00:21:28 -> 00:21:54)
Yeah. When you think about private markets, more largely, I think one of the interesting things about what’s going on, it’s not just about, you know, an individual investor’s portfolio and changing some of the allocations to fit the realities of market structure. Some of this is macro, the way you’ve put this to me in preparation for this conversation is that it’s mobilizing savings. Yeah. The Europe example seems to me like one of the most obvious ways of this risk transfer that you’re describing.
Jason Thomas (00:21:54 -> 00:23:55)
Yeah. So, I, I think that the issue that’s identified in Europe is that you have more savings in absolute terms in the United States, a higher savings rate, but actually much lower returns on that savings than you have in the United States. And, and the question why is that? It’s because four times as much of the savings is channeled into the banking system. And, and that’s a problem because the bank balance sheets just don’t have the same risk bearing capacity as private markets. They, they can’t take risks on earlier companies, uh, companies with, you know, where, where you’re really not sure they have potentially very discrepant, uh, growth profiles, uh, investing in new technologies, also just the duration, uh, of, of the cash flows when, when the company actually moves into a positive free cash flow position. And so having a, a financial system that’s so bank centric just means they’re actually starving ideas and entrepreneurs of capital. And I think that that is something that is, is really a focus. How, how do you take, again, a larger base of savings, but to channel it into more productive uses? And I, I think that they recognize that that private capital is only a solution. And I would just say that what has been most interesting over the last 10 years has been watching Japan and the way that it has focused on mobilization of private capital, but also, it’s actually invigorate a market for corporate control to actually force delists because they realize that companies would be more productive if they were in private hands to encourage spinoffs, because different divisions of companies would be more productive if, if they were in, uh, private hands. It’s almost as though public policy in Japan was really, uh, aligned with invigorating the private capital market. And it’s had an enormous success when you look at the, the performance of that economy, uh, today relative to, to where it was a decade ago. So, I think the Japan template is one that, that Europe can look to, and I think many other economies as well. Is, is something that when you, when you invigorate these markets, when you mobilize the savings, good things happen.
Sonali Basak (00:23:55 -> 00:24:31)
Yeah. I I’m wondering what you think that comfort with the private assets comes from when it comes to savings products. Right. I mean, if you think about it, um, you and I were talking about this earlier, that the insurance landscape has long invested in private markets for, for a very, very long time, really. And so, when you think about this movement into more individuals getting into private markets, really, to me, the only differences are a, the liquidity as well as, uh, understanding the vehicles themselves. But structurally, there’s kind of nowhere else to go but private, given how much the market is expanding across the globe.
Jason Thomas (00:24:31 -> 00:25:24)
Yeah. I I think, again, we spend so much time talking about the supply side of capital, you know, that new funds being formed, evergreen vehicles, different strategies, but ultimately the, the growth of private capital markets is about decisions made by founders, entrepreneurs and management teams. And if they prefer to access private capital to grow, or for the liquidity for founders, then it means that the rest of us have to actually change our portfolios so that it, it comports with this new investment opportunity set, which is inevitably moving in the private direction. So, so I think that that is, that’s really, it’s very simple. This, this is, it’s not people being forced into to private markets or having no choice. It’s that this is where the investment opportunity set has gravitated. This is where it’s turned. And, and you have to change your portfolio, uh, accordingly.
Sonali Basak (00:25:24 -> 00:26:11)
So, to that end, one of the areas where you’ve seen a lot of investment from the private side is artificial intelligence. We talked about SpaceX, but obviously anthropic and open AI going public in 2026 has really drawn a lot of questions about what role private equity venture capital has played, but also data centers, an enormous amount of private capital going into data centers all across the energy food chain as well. When you think about, um, these build outs, I mean, what is the AI consideration here when you’re thinking about this from an allocator’s perspective? We started talking about concentration risk. Mm-hmm . Realistically speaking, AI is pervasive, right? So how do you access it in ways that make sense for the future-to-future proof your portfolio? Realistically.
Jason Thomas (00:26:11 -> 00:28:03)
The question really for me is, is to how do you make sure that you have exposure without AI consuming all of your incremental risk budget? Because it was interesting talking to allocators at the end of, of 2025, and when they looked at real estate, when they looked at infrastructure, certainly the public stock portfolio, most obviously, they realized that actually almost all of their incremental risk budget was consumed by ai. So again, this, this was a sense that the very bullish on it desiring exposure but realizing they had to have some sense of prudential risk concentration limits. And I think that that is the, the big issue. It, it does in many ways show what can be accomplished when you mobilize private capital, just in terms of the, that the scale of investment, the speed with which it’s happening. Um, to me, the most attractive place to access the opportunity is very much on the energy side. And, and that is also electrical equipment. But when we think about the energy demands, the energy needs, the growth of the energy consumption of data centers, that to me is the key choke point. And it’s also, when you think about energy transition, when you think about the, the demands on electricity for electric vehicles, um, this is something where that we know that there’s productive use to the capital In some cases, you know, there’s a fairly wide range of outcomes. So, if you’re investing in a frontier AI lab, for example, you know, the, the speed of change is, is so rapid that, that there’s a lot of volatility there. There, there is, you’re accepting a lot of risk in the energy space. It’s of course needed for the data centers. It’s needed to power, um, you know, the, the future of the technology. But, but it’s also something that, uh, has a, um, you know, very much an embedded need, uh, particularly as it relates to, again, broader electrification. So, to me, the risk reward is probably most attractive in, in that space. And, and when you’re thinking about in those relative allocations in, in terms of what’s exposed to AI.
Sonali Basak (00:28:03 -> 00:28:11)
Right, is that how you truly find diversification? Just trying to find things that would really live on, in a meaningful way despite the AI theme?
Jason Thomas (00:28:12 -> 00:29:06)
You know, I think that we, one of our, uh, best investments of recent years was it was a company that we knew had exposure to the, a semiconductor value chain. And it was really related to, to lithography and it related to, to testing chips. But the core business was actually medical devices. So, it’s really like, these are the perfect diversification opportunities because you have a great business that has this, um, you know, very dedicated demand as it relates to medical devices and equipment, but it essentially also embeds a call option on AI and semiconductor demand. So, I think it’s, it’s those kinds of investments when you think about like, where, where can I get this, this convex upside in this good state of the world as it relates to ai, while also having a business line, an underlying business that I know is, is going to be time tested and consistent no matter what happens, uh, with the, uh, the technological revolution we’re in the midst of. Right.
Sonali Basak (00:29:06 -> 00:29:10)
Are there really investments now that are kind of AI proof, or do you think it touches everything?
Jason Thomas (00:29:10 -> 00:30:09)
Well, I mean, it’s, it’s your view on robotics, right? I mean, there, there was a period of time where people were, were talking about how software was going to be disintermediated. Business services was in trouble. So, you really needed to focus on, on areas where, you know, you still needed the human labor or that it was in, in, in the physical world. But, you know, if you believe that there’s going to be 80 million, uh, humanoid robots in, in relatively short order, well, you could say that, that nothing is fully AI proof. And that’s why I think it comes back to this idea of duration, that the, the more cash your asset generates today, the, the, the shorter the payback period, the less you have to be right about the future of technology 5, 7, 10 years into the future. And that’s why, as as you mentioned, that that duration in the underwriting and just, you know, writing down or, or assigning higher discount rates to, to cash flows or terminal values further into the future, that’s just a part of the world we live, we live in right now, given the speed of change.
Sonali Basak (00:30:10 -> 00:30:25)
I do find more institutional investors these days are talking about duration risk as it pertains to the government bond market. And it does lead to the question, well, well wait a minute. Are are people looking at government bond duration differently from how they’re taking on duration and risk in private portfolios?
Jason Thomas (00:30:26 -> 00:31:30)
So, when you talk about duration or interest rate risk, it, it’s of course a fixed income concept. And I think we were living in a world where people didn’t even realize that duration risk applies to everything, and it was only the interest rate shock and, and the, the, the downward, uh, move in valuations of, of some of the long duration assets, again, kind of growth software that people said, oh, I, I didn’t realize that this also was exposed to the, to the same, um, you know, risk as as, as the government bond market. So, I, I think again, it it’s just, it’s, uh, digesting that, it’s understanding that yes, the fixed income concepts are really just about how sensitized the market value of an asset is to a change in interest rates. And as interest rates have moved up and as uncertainty has increased in, in, in the out years, and whether it’s because of concerns about solvency from a fiscal situation or speed of technological change as relates to other sectors, it, it exacts the same impact on the market values and, and you have to, uh, incorporate that into your underwriting accordingly.
Sonali Basak (00:31:31 -> 00:31:44)
Do you think though that, you know, just back to the government bond market, because it had been such a big part of investor portfolios, do you think that the comfort with such high traditional fixed income allocations will start to erode?
Jason Thomas (00:31:44 -> 00:33:35)
Oh, I think it has already. I mean, when you look at who is the largest buyer of treasury securities today, it is a hedge fund sector, but it’s doing it as relative value trades, but especially basis trades. So, so it’s borrowing generally 18 times or more, uh, cash bonds, uh, coupon notes and then selling it forward in a basis trade. And that’s why of course, the Fed had to intervene at the end of last year with the reserve management purchases to make sure that the short-term funding for, for the, the, the financing leg of these trades, uh, didn’t have any volatility that was the, the borrowing cost, or almost precisely at the Fed funds interest rate. So, I, I think that you’ve seen, of course, um, foreign investors, uh, reserve managers that have, they haven’t really been selling, but they haven’t been adding to their exposures. And then you have, you know, much of the rest of the market that has just been, you know, a little weary of, of adding to their exposure, particularly seeing, uh, that the amount of debt that is going to be issued on a prospective basis over the next 12 months, the US Treasury has to refinance over $10 trillion of maturing securities. And, you know, I think people are not so sure about the interest rates that, that are, are, are ultimately, uh, going to be carried on the, the coupons that these securities are going to carry. And, you know, when you look at what is, uh, maturing, it generally has relatively low coupons. I mean, these, these were things issued before the pandemic. So, you have, um, on average notes that are 3.2% interest rates now being refinanced into four, four and a half, maybe 5%. So, so I think that this, this just sort of wanting to wait it out or, or find alternatives to the bond market, it’s something that’s very real today. And I, I think that sense is only going to grow over time.
Sonali Basak (00:33:35 -> 00:33:49)
No, I would completely agree with you. And if you think about the feed through, just quickly, what are the ripple effects higher for longer, shorter term, and potentially longer-term interest rates? What are the asset classes in your view that are most impacted by that?
Jason Thomas (00:33:50 -> 00:35:46)
It is this sense that when you, when you look at assets with this terminal value, and this is like the whole year since the, the Anthropic shock from Claude code, uh, since the, um, uh, the analysts on Wall Street have started to know formerly cover the, uh, frontier AI labs, there’s just this sense of, oh, software is going to be disintermediated. And then everyone started talking about software being priced off of its terminal value. And it’s like, this is just accepted as fact terminal value. The, the only reason software is priced off of terminal value is because on average the amount of current income generated, again, the free cash flow, uh, today is so low. So, it, it’s not that this software is just priced off of terminal value, it’s simply that the valuations got so high that the cash flow relative to enterprise value is so low that the payback period extends so far into the future. So I think that this is a issue with, even if you believe that many of these software companies are going to incorporate AI going to be able to fend off these rivals, even if you have a very optimistic case and, and I happen to, I, I believe that by the way, um, it still doesn’t mean that you’re going to rescue the valuation because of the, the upward adjustment in bond yields the, the change in attitudes about interest rates. And I think it’s going to just focus attention on some of those assets. You know, it was even something like, um, uh, internal combustion engine auto parts, right? People thought internal combustion engine were going away. So, they thought that companies that made parts that were exclusively for the ICE value chain were essentially going to disappear. So, the, the value came so low that you can actually underwrite some of these companies generating so much cash over five to seven years to, to fully, uh, repay your cost basis and generate a 20% annualized return on top of that. So
Sonali Basak (00:35:46 -> 00:36:19)
You, you’ve mentioned software a few times, software is one of the concerns around private credit. Sure. Right. Uh, it’s all as an industry at large. Also, this higher interest rate environment provides some really interesting ramifications because on one hand, a lot of private credits floating rate , and so in theory, higher for longer would be good for forward looking money in the ground today, but at the same time, it would mean that the borrowers are sitting under higher interest rate burdens. You know, what’s the trade off in your mind on private credit in this environment?
Jason Thomas (00:36:19 -> 00:37:54)
When you look at the software businesses, I think that the, the credit risk is this existential risk. Do you think software is going away? And, and as I said, I don’t really believe that’s true. We did a survey of our, uh, management teams in the first quarter, and we looked at, again, the AI spending is enormous. IT budget’s growing about 28% year over year. So, what are you intending to do with this spending? How are you financing this spending? Hopefully it’s not just coming out of EBITDA. And interestingly, number one was, uh, growth strategies that in the future there’s expectation of being able to, to increase your revenues with less headcount than would normally be associated. So, you know, you could think about a division of a company that has 200 open, but unfilled positions maybe that would be reduced to a hundred. And the expectation is by leaning into ai, you can achieve the same growth with less hiring than would’ve been required previously. Secondly, um, there is the, um, relationship with, uh, consultants and how much is being spent on consultants. There is some belt tightening there, uh, on a go forward as some of the savings. Third, it’s actually the, um, a lot of IT systems that remain on premises, you know, that very little has gravitated to the cloud over the last five years. So, as you move to these cloud-based AI centric architectures, you’re actually saving on your on-premises maintenance spending and very low on the list with software. In fact, only 12 of 104 companies that were surveyed suggested that there was any intention of reducing their software spend. So, it’s kind of interesting,
Sonali Basak (00:37:55 -> 00:37:56)
Very contrary to the conversation exactly happening
Jason Thomas (00:37:56 -> 00:38:13)
So, you know, I think if people talk to the management teams that are actually spending on AI that, that are really trying to ensure their company is far out on the, uh, technology frontier as possible, they would realize there’s actually less risk to software than I think is is commonly supposed.
Sonali Basak (00:38:13 -> 00:38:18)
So, it sounds like you’re less concerned about software and the impact of the private credit industry. Exactly.
Jason Thomas (00:38:18 -> 00:40:17)
It, it, it’s an equity problem because it was, it’s just the, the entry multiples were much too high. The entry multiples were, were calibrated for a world of essentially zero-base rates indefinitely. And I, I think, so it’s interesting that I think the market has, again, the software worries 20% is that 30% of the, the portfolios in private markets software and, and thinking that this is a private credit problem, when in fact it, it’s an equity issue. And I think for equity, it’s also not necessarily, you know, zeros or bad outcomes in, in an absolute sense, it’s just that this is where all the returns were for many years. You know, 30, 35% net IRR software exposures that today, you know, some cases, if you’re purchased something in 20 20, 20 20, uh, 1, 20, 22, you know, getting out, recovering your full cost might be a good outcome. So, I think that, again, separating the two, and, and in those cases, since the, um, the credit is senior first to get paid in any transaction that they’re going to make out just fine. You know, getting, getting out at par, getting their, their accumulated interest. So again, I think it’s an equity issue as it relates to, um, you know, higher for longer rates. I think that these rates are today are just not that high. You know, base rates at 365, 3 75 is, is actually kind of a sweet spot because it provides a base yield to, to the creditor, but it’s also not so onerous on the borrowers, most borrowers that, you know, don’t have especially leveraged capital structures. So, I think that this is, it’s, it’s good for, for creditors, you know, to get 500 basis points on top of that. And then also when you look at the change in fund flows, right? This is now a market where the fund flows have reversed. So now it’s moving from a market where there were more lenders than borrowers who had a lot of downward pressure on spreads to one where actually spreads are widening, your risk adjusted returns are getting more attractive each quarter.
Sonali Basak (00:40:17 -> 00:40:23)
So, all of a sudden, the environment’s actually getting better for private credit at a, at a moment where a lot of investors have tried to turn away.
Jason Thomas (00:40:23 -> 00:41:25)
Exactly. And, and that’s I think the, the pro cyclicality of fund flows in the market. I, I think we, we need to appreciate that. So right now, I think over again, if, if current trends continue by year end, you’re going to be looking at extraordinarily attractive credit investment opportunities. The flip side of that to some of those marginal borrowers are going to have a bit more difficult time refinancing. So, this is, which rates will be higher and, and, and just, you know, probably wider spreads and also just more conservative underwriting. Uh, you, you see these changes already. And, and if these trends continue, you’ll, you’ll just see that the, the creditor will just take a more conservative view of the enterprise value of a company. The creditor will not be as willing to, to go move to payment and kind, you know, they’ll, they’ll demand cash interest. Uh, they’ll, they’ll be tighter covenants and they’ll just be terms that will be a little bit more onerous for the borrowers. And then again, those borrowers at the margin are going to have a more difficult time refinancing. So, I think that that’s, that’s the change, but again, from a private credit perspective, that things look very bright.
Sonali Basak (00:41:26 -> 00:41:57)
Last question for you. I can’t help myself, you know, we’re in this new, uh, era for the Federal, federal Reserve. Um, the day we’re taping this, it was, it’s the same day that Alan Greenspan passed away. He turned a hundred years old and and passed away above a hundred years old. As we’re watching Kevin Warsh take over the Fed and really potentially unwind a lot of the things that we saw during the Greenspan era, arguably, what’s the most, um, profound thing that investors should really keep an eye out for in the new Federal Reserve?
Jason Thomas (00:41:58 -> 00:43:03)
I think that we had crisis era policy that was understandable and, in many ways, absolutely necessary. That just became very, it became normalized. So, you had policies that were appropriate for a crisis that were pursued during a more normal era. And, and what I think number one, of course is the size of the Federal Reserve balance sheet, but number two is forward guidance. So forward guidance is a way to say, Hey, you know, you’re expecting us to move much sooner than we intend to move. And, and some of these, you know, five-to-10-year interest rates look much higher than we think they should be based on our expected policy path. So, we’re going to communicate more with you about the direction of rates. We’re actually going to buy a lot of bonds to put our money where our mouth is, and we hope that you’re going to, to actually believe us. And, and then the, the financial conditions will ease in proportion to, again, what we’re telling you and then what we’re doing with our bond purchases. And, you know, it’s not so obvious why we need that today, right? That this, it’s
Sonali Basak (00:43:03 -> 00:43:03)
It’s a different era
Jason Thomas (00:43:03 -> 00:44:10)
And you have this, this issue of a hall of mirrors where the market is supposed to be there to tell the Fed something about what they expect for inflation, what they expect for what level of interest rates is appropriate, how they’re digesting new information. But if the market is just doing a pricing things based on what they expect the fed’s going to do, all of a sudden that informational, uh, component of market pricing that the Fed should rely on to help set policy is, is gone because the market’s just reflecting back what the Fed says it’s going to do. So, I think that this new era is actually trying to move back to what, what existed really prior to the crisis where you’re going to, I think presumably reduce the size of the Fed’s balance sheet, we’ll see how much and at what speed, but then also really kind of get rid of forward guidance, let the market sort of make its own judgments about what level of rates is appropriate. Uh, and, and then the Fed can, can actually incorporate that into its own thinking. So, I, I think we’re moving from a crisis policy that was nor that was pursued in normal times to actually how things, you know, used to exist.
Sonali Basak (00:44:11 -> 00:44:14)
So, does that spell more volatility for the bond market?
Jason Thomas (00:44:14 -> 00:45:13)
Oh I, I, I don’t think there’s any, any way around that. And it’s not just the bond market. It’s, you know, the forward rates when the Fed was, was very clearly and conspicuously telling you what it intended to do, what it was telling you, what they thought the, the neutral rate or the terminal rate was. You had forward interest rates. The forward curve for SOFR that we, and it was again, really, um, calibrated to exactly what the Fed was suggesting or intending. Now, I think there’s going to be quite a lot of choppiness to that as, as new data come in, whether it’s inflation or output or or employment, there’s going to be, um, the market has some more freedom now to, to assess what that means. And I think there’s, there’s going to be quite a lot of volatility ahead. I don’t think it’s a market that, that is ready for this. The Fed has been holding the fixed income market’s hand for so long. This, this is going to be, this is like dropping, uh, a child off or kindergarten, you know, and, and waving goodbye. And, you know, there, there’s a , there can be some tense moments, some crying, and I think that’s what we expect to see.
Sonali Basak (00:45:13 -> 00:45:33)
Well, to think back to the Greenspan era, the Greenspan put, you could argue that this is a market that’s been addicted to that put for decades now. How are, how are investors going to wean off this idea that the Fed won’t necessarily step in anymore? Uh, every time there’s an issue?
Jason Thomas (00:45:34 -> 00:47:34)
Well, I, I think this is the lesson from the COVID crisis. You had a, obviously a public health crisis. You had this enormous decline in employment, huge contraction to the economy. No one knew how long or how deep it was going to be. And so, what did the fed do? What the Fed has always done massively intervened. That massive intervention also came with it, uh, statement of, uh, its long run policy objectives in August of 2020 that essentially said they would tolerate above target inflation going forward to make up for past inflation shortfalls. At that time, everyone expected zero base rates, you know, basically for the next five to six years. And that I think is also what allowed for much larger fiscal response to, to COVID. Not only did you have the $2.9 trillion that was spent in March of 2020, right as the, the pandemic really took hold, but another 900 billion in December of 2020, followed by the $1.9 trillion package, the Recovery Act in, um, uh, March of 2021. So, the Fed with this, you know, massive easing, the expectation of the Fed put, you know, any problem, massive intervention unlocked a chain of events that ultimately culminated in a 25% increase in the price level. The constraint here was always inflation, you know, and it’s when people worry about the government not being able to pay back its borrowing that is going to manifest at a higher price level, higher inflation, and again, higher bond yields needed to protect you from being inflated away. So, I think that that what we’ve learned now is the fed, the scale of the intervention going forward has to actually now be constrained because I don’t think anyone given how upset again the electorate is about inflation, about the price level is going to tolerate something like this happening again.
Sonali Basak (00:47:34 -> 00:47:44)
Jason, I’m excited to be following this next year with you. Certainly, uh, it could get choppy, like you said. That’s Jason Thomas of Carlyle, and you’ve been watching the Bridge by iCapital.
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