In each quarter’s issue of Owner to Owner, we review aspects of the business environment on three fronts: the overall economy, the credit markets and the private equity (PE) and mergers and acquisitions (M&A) markets. The following article addresses the effect of President Trump’s policy proposals on the economy, the availability of credit and uncertainty in the M&A and PE markets caused by the new administration, among other topics.
The U.S. economy continues to post steady, although somewhat uninspiring, growth numbers. In the fourth quarter of 2016, real GDP rose at a seasonally adjusted annual rate of 1.9%, and for the full year, the economy grew 1.6%. For some perspective, from 2010 to 2016, the economy expanded at a rate of 2.1%, putting recent figures squarely in line with the type of progress the economy has made on average over the past seven years. The labor market is in good shape, with the unemployment rate standing at 4.8% and the three-, six- and 12-month moving averages of nonfarm payroll gains all in the 175,000 to 200,000 range, although a pickup in wage growth remains elusive. In addition, corporate profits have bounced back to positive year-over-year growth after a prolonged earnings recession, the residential housing market remains strong, and the availability of credit, discussed more in the next section, is good. Looking ahead, as of January, the manufacturing PMI, one of the more reliable predictors of future growth, stood at 56.0, which is the highest level in over two years and seems to indicate a sense of optimism from the highly cyclical manufacturing sector.
The biggest change to the economic outlook over the past three months no doubt comes from the new Trump administration. President Trump’s agenda has upended the post-crisis economic dialogue that has almost exclusively focused on monetary policy, both in the U.S. and worldwide, to one that is heavily focused on fiscal policy. Trump and, to a slightly lesser extent, the Republican House have made bold proposals regarding trade, immigration, regulation, taxes and fiscal stimulus (such as infrastructure), any or all of which could carry significant economic implications.
The sometimes rough outlines of policy proposals emanating from the Trump administration leave a wide range of outcomes in key variables such as growth, inflation, employment, interest rates, equity values and the strength of the dollar. The consensus seems to be that the Trump administration will enact many proposed reforms, including tax reform, an infrastructure bill and a regulatory rollback, and that most of his policies should promote dollar strength, and perhaps firmer growth and inflation. We believe some of these views are possible but would note three underappreciated counterpoints to the consensus view. First, the market is likely overestimating how easy it will be to push through reforms, as some members of Congress do not see eye to eye with President Trump on a range of issues. Second, we consider the outlook for the dollar more uncertain than recognized given that the Trump administration has publicly advocated for a weaker dollar, recently commenting that a strong dollar hurts its plan to promote growth in manufacturing and other export-oriented sectors. And third, at some point the sheer amount of uncertainty and volatility created by the Trump administration may catch up with the market and businesses, both of which generally operate better in a less uncertain and volatile environment.
Thus, it was no surprise that minutes from the Federal Open Market Committee’s December meeting show that Federal Reserve officials grappled with “considerable uncertainty” about the effect the incoming administration would have on the economy. This suggests that absent a rapid acceleration in inflation or some other development that forces the Fed’s hand, it will likely wait until its June meeting to consider an additional rate hike, when there is perhaps some more clarity on the fiscal outlook. We believe there are many productive areas where Congress and the Trump administration could come together to enact meaningful reform that would both promote growth and allow interest rates to normalize further in 2017; however, this process will likely not unfold in a smooth fashion.
The Credit Market
While it is uncertain when the Fed will hike rates again, the credit market certainly seems to have ushered in a new era of rising interest rates for the first time since the 2008 recession. The U.S. Treasury yield curve has shifted upward across all maturities due to the aforementioned expected rise in inflation stemming from the Trump administration’s commitment to promote domestic economic growth. On the short end of the curve, one-month rates increased from 0.20% to 0.44%, while on the long end, 30-year maturities rose from 2.32% to 3.06%. Rates increased most significantly at the five-year maturity mark, from 1.14% to 1.93%. Rising rates mean companies will need additional cash flow to service new debt, suggesting transactions requiring capital will become less frequent or transaction prices may have to fall. So far, the increase in rates does not appear to have had much of an effect on the credit market. Reported sentiments from banks remain relatively unchanged based on the Federal Reserve Board’s “Senior Loan Officer Opinion Survey on Bank Lending Practices” from this past January.
From September 2015 to September 2016, banks expressed a tightening of credit standards. Over the past two quarters, the net percentage of banks reporting a tightening of standards were 1.4% and 1.5%, respectively, indicating standards have remained relatively unchanged throughout the last six months. Banks that indicated a tightening of standards for the fourth quarter of 2016 reported a less favorable outlook on the domestic economy, while those who said there was a loosening of standards did so in response to increasing competition from other banks and non-bank lenders. The amount of commercial and industrial (C&I) loans from banks increased from $2,065 million to $2,093 million between the second and third quarters of 2016 and remained at that level through the end of last year. Importantly, that total amount of C&I loans could still be growing if borrowings from non-banks and other nontraditional lenders are increasing. Domestic banks’ reported concerns that those loosening lending standards are in response to non-traditional lenders support the argument that non-bank lenders are becoming increasingly more prevalent.
Demand for C&I loans also remained little changed. Flattening demand for C&I loans is observable by looking at the stagnant growth of total C&I loans and is in line with recent GDP growth trends. As noted in the previous section, GDP increased 1.9% quarter over quarter in the fourth quarter of last year, which is below the prior quarter’s change of 3.5% but in line with the three-year average quarterly increase of 2.1%. Despite the slight decline, GDP growth remains positive, suggesting the fears reported by banks tightening their standards are still precautionary.
Overall, the market for C&I loans last quarter was little changed from the prior quarter. Throughout 2016, the market saw a tightening of standards, which ultimately led to a flattening of total C&I loans outstanding. Lenders and borrowers both appear to be patiently waiting on the sidelines, but credit remains available, particularly for borrowers with strong credit profiles. Borrowers with weaker credit profiles are beginning to see higher fees for new credit facilities but still have access to financing. Given the uncertainties in the broader U.S. market, stagnant lending and borrowing seems prudent. As noted, rising interest rates are a result of the Federal Reserve’s actions and in response to higher anticipated inflation stemming from President Trump’s plan to expand the U.S. economy. As these factors play out, it appears most banks and borrowers in the C&I space will avoid increasing leverage or restructuring existing credit facilities.
The Private Equity and Mergers and Acquisitions Markets
The big story in the fourth quarter of 2016 for the M&A and PE markets was the surprise presidential election victory of Donald Trump. The highly contested and polarizing election had a significant impact not just on the dealmaking climate, but also importantly on the business climate. Key decision-makers were distracted. This led to a slowdown in opportunities coming to market, as well as activity in underlying businesses. Now that we have the election behind us, the discussion has turned to what are the likely regulatory changes that the new administration will implement and what industries will be most affected. There seems to be significant momentum around comprehensive tax reform. Will there be changes to capital gains taxes? What will happen to corporate tax rates? What “loopholes” will be closed to fund lower overall taxes? Will the interest tax deduction be changed or capped? Importantly, when will these changes go into effect? Other specifics around healthcare reform, immigration reform, trade and other regulatory changes will also affect specific industries. These important questions will play out over the course of 2017 and beyond and will certainly impact the M&A and PE environment.
The end of 2016 saw a slight reversal to some of the trends observed in the third quarter as the debt markets started to return to their levels earlier in 2016; however, overall transaction volume was down again in the fourth quarter due in part to the election. Last quarter, both the number of transactions and the total dollars were down for middle-market activity.
Anecdotally, we have seen this trend reverse itself so far in the first quarter, as investment opportunities for BBH Capital Partners are up significantly so far in 2016 both against year-over-year and quarter-over-quarter comparables. It is too early to say whether this trend will hold for the remainder of the year.
Valuations remain high, as we have highlighted historically. The fourth quarter saw the continued normalization in the credit markets in the second half of the year, and this combined with the limited number of opportunities drove valuations to the highest levels since PitchBook started tracking them in 2010. Valuation to EBITDA increased to 9.8x in the fourth quarter. The combination of significant amounts of strategic cash on balance sheets, high public equity valuations and record PE dry powder will likely keep valuations high in 2017.
There remains a significant amount of uncertainty around the new administration, and this will impact certain highly regulated sectors over the course of the year. However, the broader deal climate remains frothy, and it is a good environment for people selling high-quality businesses.
The U.S. economy remains on steady footing, with GDP, the labor and housing markets and corporate profits all in good shape. Looking forward, the economic outlook depends heavily on the new Trump administration’s efforts to implement its proposed policies – all of which can significantly affect critical economic variables such as growth, inflation, employment, interest rates, equity values and the strength of the U.S. dollar. Uncertainty around President Trump’s and the Republican House’s proposals is also affecting the credit markets. While credit remains available, banks and borrowers in the C&I space are waiting to see the Fed’s move toward raising interest rates – largely affected by expected higher inflation as a result of the Trump administration’s plan to expand the U.S. economy – before increasing leverage or restructuring credit facilities. Finally, though the presidential election has brought uncertainty to the M&A and PE markets, the overall dealmaking environment continues to exhibit high valuations and remains promising for sellers of high-quality businesses.
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