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 current state of and expectations for both monetary and fiscal policy, trends in bank lending practices and rising PE and M&A deal sizes, among other topics.
The U.S. economy’s performance since the financial crisis has on average been modest, and recent data still fits with that characterization. For one, GDP growth in recent quarters has followed a highly familiar pattern. In the fourth quarter of 2016, real quarter-over-quarter GDP growth in the U.S. came in at 2.1%, which is equal to the three-, five- and seven-year trailing averages. And in the first quarter of 2017, growth was a lackluster 0.7% – consistent with data from two of the past three and three of the past five years, where first quarter GDP has disappointed only to rebound later in the year. There are several possible explanations for this that range from seasonal adjustments made to the data as well as abnormal weather that shifts consumption to different quarters. In any case, while it is quite clear that the U.S. economy is no longer growing at a 3% to 4% clip as in prior years, we remain of the opinion that it is holding up well.
With the April employment report, any indication that the weak March report was the start of a larger (negative) trend was put to rest. Payrolls grew by 211,000 in the month, and the unemployment rate declined to a new cycle low of 4.4%. This report adds further fuel to the fire that the Federal Open Market Committee (FOMC) should be leaning more in the direction of policy normalization than it has in prior years. With respect to the FOMC’s longer-term projections for the unemployment rate, the most current reading of 4.4% is well below the longer-run estimate of between 4.7% and 5.0%. With GDP running in line with long-term estimates of 1.8% to 2.0% and inflation now closer to the Fed’s 2.0% target, it calls into question why the fed funds rate is still so far from its longer-term target. While the FOMC has been more vocal about normalizing rates than in the past (including talk of balance sheet normalization as early as December), the market remains unconvinced the committee will hike rates as quickly as its projections indicate. The market’s continued skepticism over several years has proved accurate, but a key driver of financial markets in the coming year will again be whether the Fed actually follows through on its projections to tighten policy. The market views a June rate increase as a certainty but beyond that is divided on whether another will occur in 2017, leaving plenty of room for surprise.
Beyond the Fed, both consumers and financial markets appear somewhat overconfident on the prospects for economic reform from the Trump administration. Consumer confidence is near all-time highs, equity markets continue to set records, and market volatility, which usually spikes during times of great uncertainty, is close to all-time lows. While there is no shortage of opportunities for reform, the details are in many cases still vague, and we believe this administration will continue to find it challenging to push its agenda through Congress. President Trump has the somewhat perilous combination of an ambitious agenda, a narrow Republican majority in the Senate and a low approval rating. The priorities for 2017 have so far shifted between tax and healthcare reform and could change again, which leaves many important – but as of yet unanswered – questions. To name a few, how would the economic impacts of healthcare reform affect consumers? How would a change in tax policy affect incentives for businesses to invest? How would new trade deals (such as a renegotiation of NAFTA) affect U.S. workers? Would an infrastructure spending bill be inflationary, and would it yield tangible productivity improvements? The range of outcomes in these areas is wide, and our crystal ball is no clearer than anyone else’s. We acknowledge, though, that fiscal policy, dormant for years, is once again active and every bit as important as monetary policy. If there are any early lessons from healthcare and tax reform, any new policies may take shape in start-and-stop fashion over an extended period of time, meaning policy uncertainty is likely something we will be living with for the foreseeable future.
The Credit Market
The credit market has remained relatively unchanged over the past several months. At the end of 2016, the U.S. Treasury yield curve shifted upward across all maturities due to anticipated inflation stemming from the Trump administration’s commitment to promote domestic economic growth. Since then, the short end of the curve has come up slightly, but the long end is unchanged, leading to a flattening yield curve. The rise in short-term rates is in direct response to the Federal Reserve’s March 15 decision to raise the fed funds rate from between 0.50% and 0.75% to between 0.75% and 1.00%. This marked the second time the Fed raised its target rate within a six-month span. Meanwhile, the unchanged long-term rates seem to reflect broader market sentiment that the outlook for long-term economic growth remains moderate.
As noted in the previous section, overall guidance suggests that a June rate hike is highly likely, while the market is divided – though growing more confident – that there will be three total rate increases in 2017. If the long end of the yield curve does not rise with short-term rates, the Fed may have to taper its rate hike plan or begin selling longer-term securities from its balance sheet to avoid further flattening of the yield curve.
Rising rates will contribute to higher borrowing costs and should be a tailwind to banks’ profitability. Helping borrowers, credit spreads have narrowed since peaking in February 2016. Spreads for high-quality credits have remained low and exhibited very little volatility, highlighting banks’ continued eagerness to make new loans to high-quality borrowers. Spreads for lower-quality borrowers have been more volatile but steadily declining. Narrower spreads suggest lenders are not as pessimistic about the direction of the U.S. economy as they were a year ago when oil prices were rapidly declining.
Results from the Federal Reserve’s latest quarterly survey on bank lending practices indicated that banks’ lending standards for commercial and industrial (C&I) loans to businesses remained relatively unchanged in the first quarter of 2017, with a small net fraction reporting a loosening of standards. Those that responded with loosening standards noted declining credit spreads and more aggressive competition from banks and nonbank financial institutions as their reasons for doing so. This is the third consecutive quarter that standards have remained flat after four consecutive quarters in which the majority reported tightening. While inquiries for new C&I lines of credit were also essentially unchanged, a modest fraction of lenders reported weaker overall demand. Among those banks, the most commonly cited reasons were a decrease in M&A activity and reduced investment in plants or equipment. As a result of unchanged standards and demand, the total amount of C&I loans outstanding was also flat, standing at $2,093 million on April 1, 2017 – the same at which it started the year.
Overall, actions by the Federal Reserve over the past six months have led to a rise in near-term rates, but long-term rates remain unchanged. A drastic change in the credit markets is unlikely in the near term, as lending standards remain little changed, and demand for new C&I loans continues to be flat due to moderate economic growth and the lower volume of M&A transactions.
The Private Equity and Mergers and Acquisitions Markets
There remains a great deal of uncertainty in the PE and M&A markets, largely due to the new administration. Regulations included in President Trump’s aforementioned tax reform plan that would likely affect private equity include changes in carried interest tax, interest deductibility and corporate tax rates. In addition, the administration’s focus on regulatory and trade reform could spur M&A activity, and its plan to increase infrastructure spending could lead to new PE investment opportunities in the transportation, clean water, telecommunications and energy sectors. Healthcare reform and immigration reform will also have a large impact on several industries.
In the first quarter of 2017, middle-market PE firms closed fewer deals compared with prior years but trended toward making larger investments. This shift is driven in part by the larger funds that were raised over the past few years, which led to a record level of dry powder. Middle-market PE firms have been seemingly influenced by an improved economic outlook and have sought bigger targets to deploy larger levels of capital across a similar number of deals. Also contributing to the increase in deal size is the number of investments made in the IT sector, which have historically been larger in size. In contrast, the consumer sector has taken a significant hit due to the concerns regarding new trade policies.
The recent increase in deal size also holds true for M&A activity, with the median transaction size for each M&A type up considerably year over year in the first quarter.
Anecdotally, the number of investment opportunities reviewed by BBH Capital Partners is up significantly so far in 2017 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.
Exit activity in middle-market PE was at its lowest in nearly four years last quarter. This is unsurprising, as investors have exited most pre-2008 investments, and the majority of investments made between 2014 and 2016 are not yet ready for a sale.
Valuations in the first quarter of 2017 also remained high. The continued normalization in the credit markets combined with the limited number of attractive opportunities and the possibility of corporate tax cuts drove valuations to the highest levels since at least 2010.1 Valuation to EBITDA increased to 10.9x last 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 through the remainder of the year. The Fed’s modest rate hike has kept financing incredibly cheap for corporate and financial sponsors. However, buyers paying such high multiples will be overly exposed in the case of an economic downturn.
Middle-market PE firms continued to show strong fundraising performance in the first quarter of 2017, largely due to a surge of funds with between $1 billion and $5 billion in commitments. After a two-year plateau, middle-market vehicles are now set for their next growth period.
Overall, it seems as though there is a good amount of market enthusiasm heading into the remainder of 2017. Still, there continues to be a significant amount of uncertainty around the new administration and how the new reforms will affect the PE and M&A markets.
The U.S. economy is on steady footing. On the monetary policy front, the market remains skeptical that the Fed will hike rates as quickly as it projects, and with the exception of a June increase viewed as a near certainty, opinions are divided. Fiscal policy is once again on the table, bringing with it a flurry of uncertainty around several areas of reform. In the credit markets, while near-term rates are rising, long-term rates remain unchanged. In addition, lending standards continue to be relatively unchanged, and demand for new C&I loans is flat. Finally, despite uncertainty around the effects of potential reforms by the Trump administration and lower deal volume, activity in the M&A and PE markets appears healthy, with deal sizes, valuations and fundraising all rising.
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© Brown Brothers Harriman & Co. 2017. All rights reserved. 2017.
1 Based on data from PitchBook, which started tracking valuations in 2010.