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 key economic factors affecting monetary normalization, the recent uptick in commercial and industrial (C&I) loans and the mixed start to 2018 for PE.
The initial U.S. gross domestic product (GDP) growth estimate for the first quarter indicates the domestic economy grew at a 2.3% annualized rate. While this is below the 2.9% to 3.2% growth seen in the prior three quarters, there has been a trend in the past few years for first-quarter GDP to come in noticeably weaker. Digging into the report’s details, the slowdown in consumption growth was perhaps the largest disappointment, but with the labor market continuing to show strength and the tax cuts boosting disposable incomes, the outlook for consumption is still relatively strong.
On the business side, manufacturing Purchasing Managers’ Indices (PMIs) in both the U.S. and rest of the world have changed their direction after reaching new highs during 2017. Still, both indices are well over the neutral level of 50.0 and indicate an optimistic stance from businesses that is consistent with continued global economic growth.
Finally, international trade has been a hot issue, with the Trump administration involved in a trade spat with China that has yet to be resolved. The U.S. and China have taken a hard line so far; however, at the same time, both continue to express a desire to negotiate. While net exports are a relatively small portion of U.S. GDP, gross exports are larger, and certain industries such as agriculture remain overly exposed. Logic would suggest there is enough to gain on both sides to strike a deal, but if negotiations fail, a trade war could have a material impact on global growth.
Turning back to the U.S., the domestic economic focus remains squarely on the labor market and inflation – and what developments mean for the normalization of monetary policy. Various labor market indicators show that the labor market is quite healthy. Nonfarm payrolls have risen by an average of 198,000 per month over the past six months, the unemployment rate is at an 18-year low, and broader measures of unemployment that include marginally attached workers and those working part time for economic reasons continue to decline as well. The voluntary job “quit rate,” an indicator of worker confidence, has been steadily rising for the past eight years, and the share of small businesses reporting that jobs are difficult to fill rose to a new high in April.
Despite this, both wage and price growth have only shown modest increases so far. Given how volatile the data is, markets appear jolted every time a wage growth measure spikes, only to see it fall back a few months later. Viewed over a longer time horizon, however, wage growth still appears to be in a gradual tightening phase as measured by both average hourly earnings and the broader employment cost index. In addition, recent research from the Atlanta Federal Reserve shows the retirement of the baby boomer generation is holding down wage growth, as boomers retire from relatively high paying jobs that are then replaced by lower-paid, younger workers. Partially isolating this effect, median wage growth is higher than other national average wage growth measures.
Core price inflation (CPI), which receives more attention, has been increasing for the past six to nine months, although recently released April figures again showed a more subdued change. The Core CPI was flat at 2.1% year over year in April, and the Core PCE (personal consumption expenditures) – the Fed’s preferred measure – was close to target at 1.9% in March.
Taking all this into consideration, the Federal Reserve increased the fed funds rate in March to a range of between 1.50% and 1.75%. Market pricing of fed funds futures contracts implies a 100% chance of a June rate hike, with the market’s most likely scenario showing an increase in the fed funds rate to a range of 2.00% to 2.25% by the September Federal Open Market Committee (FOMC) meeting. Beyond that, markets appear relatively split over whether the Fed would also hike rates a fourth time in December. Projections from the March meeting indicate that officials expect a slight overshoot of inflation vs. the Fed’s 2% target but that the FOMC also expects to raise rates above what it views as the “natural” or long-run equilibrium rate in order to contain inflationary pressures.
With the continued rate increases and slightly more hawkish outlook emanating from the Jerome Powell-led Fed, bond markets have started taking note, with broad aggregate bond indices showing a nearly 2.5% loss year to date. The yield curve has steepened sharply since the beginning of April, and 10-year Treasury yields rose above 3% in mid-May, their highest level since summer 2011. While the 3% may be an important psychological level for markets, this is just the latest move in a rising rate environment that has seen the 10-year yield rise by 1.7% from its low of 1.36% in July 2016.
The Credit Market
At his February swearing-in ceremony as Federal Reserve chairman, Jerome Powell restated the Fed’s goals of encouraging price stability and maximum employment to support future growth. After nearly a decade of relaxed monetary policy, credit has been more accessible and cheaper than ever. Recent actions and the guidance of tighter policy indicate a turn from the status quo; however, policymakers will be challenged.
While higher rates give the Fed more power to intervene at the next downturn, higher inflation makes debt repayment cheaper. For debt holders, including the U.S. government, inflation lowers the real value of principal and interest payments. In the late innings of this economic expansion, policymakers seek balance between managing inflation to their 2% target and staying accommodative enough to “ensure that credit, which is vital for a healthy economy, will be available to families and businesses throughout the business cycle, so they can invest in a brighter future,” as Powell stated at his swearing-in. The yield curve is the field they play on.
On the short end of the curve, the FOMC voted unanimously in March to raise rates from 1.5% to 1.75% and in May to maintain the current level. The market has priced in an additional rate hike at the next meeting in June and is divided on whether there will be three or four total adjustments in 2018. The long end of the curve, which is influenced by global demand and expectations, also rose, albeit at a slower rate. The 10-year yield increased about 60 basis points over the past year and in April breached the 3.0% threshold for the first time in four years. As the curve flattens, a policy that is too aggressive could unintentionally invert the curve and signal the warning for a recession. When short-term rates become higher than long-term rates, the time value of money no longer holds true. On a fundamental level, an upward sloping yield curve preserves the efficacy of credit by ensuring that investors are compensated to forego current consumption for future investment. We will keep a close eye on the curve.
The following chart shows the current supply of credit, as indicated by outstanding C&I loans, which reached $2.17 trillion at the end of April 2018, up from $2.10 trillion a year before. The long upward trajectory reflects a 36% expansion of credit since the pre-Great Recession peak of $1.60 trillion in October 2008. As of April 25, 2018, growth accelerated to 2.2% year to date and 3.5% for the year in what appears to be a breakout from the tabled growth of the past few years and 3.3% CAGR since the 2008 peak. While it is too early to tell if this recent uptick will continue, a recently stabilized supply of new loans alongside investors flush with yield-seeking capital has created a borrower-friendly market. Borrowers are refinancing debt at lower rates and on terms that offer fewer creditor protections. In the Fed’s most recent “Senior Loan Officer Opinion Survey on Bank Lending Practices,” the majority of senior loan officers cited more aggressive competition from other banks or nonbank lenders as a “very important” reason for eased credit standards or loan terms.
Corporate spreads reveal the market’s pricing of risk as the additional return required for incrementally riskier investments. Spreads over Treasuries over the past year have remained tight, despite what appears to be a riskier market with a rising fed funds rate and relaxed investor covenants. At the beginning of May, spreads over Treasuries stood at 0.97% for A, 1.50% for BBB and 3.34% for high-yield rated bonds. The availability of capital and credit continues to hold down pricing. Like the stock market and broader economy, it is important to remember that the debt market is also cyclical. With indicators suggesting that we are closer to the top than the bottom, borrowers and investors alike should be aware that over the cycle peak comes credit tightening and the process of deleveraging. As Ray Dalio says, the process can be either beautiful or ugly. We will watch the Fed to keep tabs on how the process is going.
The Private Equity and Mergers and Acquisitions Markets
The impact of tax and other regulatory changes is likely to be the wildcard for 2018. The reduced corporate tax rate and non-U.S. profit repatriation changes will likely give many companies more free cash flow to complete acquisitions. This, combined with a continued healthy U.S. economy, should spur M&A activity. For PE funds, increased free cash flow may result in more buyers for their assets but will also create increased competition at the auction block. Unprecedented dry powder, high valuations and fewer investment opportunities have already lead to a fiercely competitive market that will likely continue for the foreseeable future.
U.S. middle-market PE deal flow got off to a mixed start in the first quarter of 2018. While total deal value increased 17% in the quarter vs. the prior year, volume decreased 40% from the prior year. In addition, although average deal size in the first quarter was down from 2017’s highs, it remained higher than any other year in the dataset. Conversely, add-on activity has continued growing and now accounts for more than half of all buyout activity. Almost 30% of PE-backed companies now make at least one add-on acquisition, compared with less than 20% in the early 2000s. PE firms use add-ons as a way of decreasing their average purchase price multiples and increasing value creation opportunities for their portfolio companies. While the pace of overall deal-making has slowed, private equity interest in the technology and healthcare sectors continues to rise. Investors are attracted to the recurring cash flows provided by SaaS business models as well as the utility of add-ons in a fragmented industry such as healthcare.1
According to the March 2018 Antares Compass report, 89% of PE sponsors were “confident” or “very confident” in the U.S. economy over the next 12 months. However, increased optimism may spurn continued high leverage multiples. Middle-market EBITDA (earnings before interest, taxes, depreciation and amortization) multiples remain elevated at 10.5x, albeit slightly down from a record-breaking 2017. As such, PE firms have put significantly greater focus on business development strategies in order to distinguish themselves from competitors in highly competitive auction processes. Discerning investors are looking to find quality investment targets by depending heavily upon direct sourcing models, creative structuring, buy-and-build strategies or having exclusive insight into particular industry segments.
Middle-market fundraising (in terms of dollars raised and number of funds closed) remained strong through the first quarter of the year. Middle-market funds accounted for the majority (79%) of capital raised in the first quarter as fundraising for mega-sized vehicles of $5 billion or more slowed during the quarter. However, several firms are targeting to close on sizable vehicles by year-end. Smaller funds (between $100 million and $250 million) also showed a decreased fundraising pace. Many first-time funds have joined the fundraising trail in recent quarters. These funds tend to focus on specific sectors and companies within a certain size range.2
In the first quarter, exit value dipped to just $11.9 billion after totaling $20 billion in each of the past eight quarters. Total exits of 165 represented a 26% decrease from the prior year. This trend is likely the result of a decrease in strategic activity. PE-backed companies are increasingly being sold to other PE firms (secondary buyouts, or SBOs) as the need to exit aging portfolios grows. SBOs accounted for 50% of all PE exits in 2016 and 2017, and this trend continued into 2018. In addition, as it takes time to execute deals and integrate businesses, the recent surge in add-on activity has increased the median exit time by about one year.3
M&A activity was off to a slower pace in the first quarter of 2018 compared with recent years in terms of both deal value and deal count. However, there have been a high number of announced deals that have yet to close. This, coupled with the effects of corporate tax cuts, will likely lead to an increase in deal flow through the remainder of the year.4 According to EY’s “Global Capital Confidence Barometer,” executives are encouraged by recent policy reforms and positive economic growth. Fully 72% of U.S. executive respondents expected the domestic M&A market to improve over the next 12 months, a considerable increase from 25% of respondents six months ago. In addition, 54% of respondents expected to actively pursue M&A in the next 12 months, a climb of 12% since October 2017. Furthermore, 61% of respondents expect their M&A pipelines to increase – three times as many as one year ago, suggesting deal activity is poised for growth despite the slow start to the year.5
Despite first-quarter GDP growth below the prior three quarters, the U.S. economy remains healthy. Changes in the labor market and inflation, and their impact on the normalization of monetary policy, continue to be the focus of U.S. economic activity as the market waits to see how many more times the Fed will hike rates throughout the remainder of the year. In the credit markets, the environment is positive for borrowers, who have been refinancing debt at lower rates and on terms that offer fewer creditor protections as lending standards ease. Despite the combination of rising rates and relaxed lending standards signaling a potentially riskier environment, corporate spreads remain tight. Finally, in the PE market, 2018 started off with mixed results, with deal value up and deal volume down. Though multiples have decreased slightly from 2017’s record numbers, they remain high, forcing PE firms to focus more heavily on their business development strategies to separate themselves from the crowd.
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© Brown Brothers Harriman & Co. 2018. All rights reserved. 2018.
1 Source: PitchBook.
2 Source: Akerman Perspectives and PitchBook.
3 Source: PitchBook.
5 Source: EY’s “Global Capital Confidence Barometer.”