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 mixed U.S. economic data in the first quarter, the strong lending environment for borrowers and fierce competition in PE resulting from record dry powder.
Reading the economic tea leaves in 2019 has become even more challenging than usual. The Federal Reserve has adopted a cautious tone, worried about the subdued rate of inflation, and a handful of measures of economic activity show some degree of weakness in parts of the economy. At the same time, real GDP continues to increase, and employers continue to add to payrolls at a solid rate. What to make of it all?
Real GDP in the United States increased at a 3.2% annualized clip in the first quarter of 2019. Digging a little deeper into the data, however, shows that gains were boosted by large contributions from inventories and trade, neither of which are particularly durable forms of growth. Stripping out trade and inventories, real final sales to domestic purchasers increased a lesser 1.3%, not low enough to be a real concern, but still less than half the headline growth number. At the same time, there has been some cyclical weakness in interest rate-sensitive sectors of the economy (business equipment, durable goods, residential investment and so forth) that was a drag on growth in 2017 and 2018 and that may begin to rebound with the recent decline in interest rates.
The ISM manufacturing index, one of the better leading indicators of growth, continues to decline and in April hit 52.8. At levels above 50.0, the index is theoretically still consistent with continued growth; however, when the index bottomed at 48.0 in January 2016, GDP growth only got as low as 0.4% in the fourth quarter of 2015, and growth spent just one quarter below 1.0%. Others, such as The Conference Board’s index of 10 leading indicators, are still trending up, although the index’s year-over-year rate of growth has slowed. As in past quarters, the employment market remains quite strong, with employers adding 263,000 jobs and the unemployment rate reaching a new cycle low of 3.6% in April. While month-to-month payroll gains are volatile, the trailing six-month average of job gains has been between 196,000 and 226,000 for the past 15 months and today stands at 207,000. The labor market remains far more stable than it might appear during the few outlier months when payroll gains spike in one direction or another.
The yield curve, which inverted briefly at the three-month vs. 10-year point on the curve, is another indicator that market participants fear is flashing red. While the curve did invert for five days at the end of March, and recently dipped below zero again in late May, we believe there is potentially more support for this as a recession predictor if it were to stay inverted for a prolonged period. In addition, it is difficult to argue that, at a real short-term yield of less than 0.5%, Fed policy is helping to tip the market into recession. In past recessions, the yield curve inverted when real short-term rates were much higher. We also continue to believe that long-term interest rates are suppressed by unprecedented central bank asset purchase programs (quantitative easing), both at home and abroad. Due to both low real short-term rates and artificially low long-term rates, we hypothesize that the yield curve might not be as good a recession predictor as it has been in the past. The flatness of the yield curve should not be ignored, but it would be more concerning if it were to stay meaningfully inverted over a prolonged period.
All in all, the data does not yet paint a convincing picture of an imminent slowdown, but nor does it indicate an acceleration in growth. While there are certainly conflicting indicators, given how much noise there is in economic data, it would be more worrisome if there were a sustained, synchronized deterioration in a number of economic variables, which has yet to happen.
While this commentary mostly pertains to cyclical factors, there are still exogenous threats to the economy. In this spirit, the ongoing (and escalating) trade war with China bears mentioning, although to date it has not had a large impact on the economy. To put trade into perspective, gross exports are 12% of U.S. GDP, and exports to China are less than 1% of GDP. The direct effect of the tariffs is unlikely to tip either economy into recession, although as a larger exporter China is more exposed to the trade spat than the United States. Beyond its direct impact, the trade war could have a larger effect on the stock market and economic growth due to its influence on market sentiment and consumer confidence, respectively. As always, other macro risks remain, but from a cyclical perspective, the U.S. economy still appears to be holding up well.
The Credit Market
Consistent with the decade-long economic recovery, the credit market remains robust. Bank commercial and industrial lending to corporations surpassed the prior peak years ago, and the upward trend is understandable given the long period of U.S. economic and financial growth. The nearby chart shows commercial and industrial (C&I) loans outstanding from commercial banks in the U.S. reaching $2.3 trillion in March 2019, up 10.0% from $2.1 trillion in March 2018. The sustained growth represents a 47.9% expansion of C&I credit since the pre-Great Recession peak of $1.6 trillion in October 2008.
Each quarter, the Federal Reserve conducts and publishes a “Senior Loan Officer Opinion Survey on Bank Lending Practices.” In the most recent survey, released in April, the majority of senior loan officers reported C&I loan standards being virtually unchanged from the prior three-month survey. Given the surplus of financial institutions, standards are at historically lower levels and, for some banks, are still being relaxed. Those that reported weaker standards increased credit lines, eased covenants and lowered spreads for their large and middle-market clients. Demand for new borrowings was also weaker, which reinforces competition among lenders. January’s small uptick in standards proved to be just a blip in a long period of easing, marked by a few modest instances of tightening. Performance to date remains strong, as delinquencies and defaults are low. However, the extended period of eased standards and heightened competition from nonbank lenders could materially affect lenders’ ability to recover obligations through the next market cycle. Of the banks that continued to relax their standards, nearly all cited increased competition from other banks and nonbank lenders as the primary reason. It is an exceptionally good time to be a borrower given the availability of capital to refinance at lower rates and on favorable terms.
Corporate spreads provide information on how the market values risk and credit quality via the additional return required for providing capital to incrementally riskier borrowers. During the end of December 2018 and into the beginning of 2019, spreads vs. Treasuries spiked for the riskiest issuances, as the equity market experienced meaningful declines and a pickup in volatility. The spread for high-yield bonds peaked at 5.36% in early January but has since returned to historically low levels, sitting at 3.60% at the end of April, compared with the BBB spread of 1.46% and 0.90% for bonds of high-quality A-rated borrowers. The narrow spread reflects confidence in the corporate sector and an expectation that positive business dynamics will continue to support debt repayment by even lesser-rated borrowers. Alternatively, the narrow spread may also reflect an abundance of capital overly eager to find yield.
The Treasury yield curve has attracted much attention recently as the Fed considers its interest rate policy. The yield curve slope also is considered a warning sign for a recession. Around the time corporate spreads widened before Christmas 2018, a segment of the yield curve inverted. There has been much debate over the cause, relevance and precision of the signal. Traditionally, the difference between the two- and 10-year rate has been identified as the warning signal, and by this measure, the curve is still in normal territory. However, forecasting a recession after an expansion is reasonable given where the economy is in the normal business cycle. Even if the flat-to-inverted yield curve does presage some sort of economic downturn, this does not provide any indication of when or how big it will be. For the near term, the Fed has indicated an accommodative stance with the goal of managing inflation to promote financial and economic stability.
Given the loan market growth, narrowness of spread between the safest and riskiest borrowers and uncertainty around the yield curve, it is especially important to be diligent when making investment decisions. Purchasing at a discount to intrinsic value requires fundamental bottom-up analysis. As a business owner, it appears to be as good a time as any to secure long-term financing given a low premium on risk and current market rates and terms.
The Private Equity and Mergers and Acquisitions Markets
The economic and geopolitical concerns that led to volatility in 2018 have continued into 2019. The recent U.S.-China trade aggressions that culminated in May have led strategists to predict further decreases in the stock market as investors assess the impact of tariffs and retaliatory measures on the global economy and corporate earnings. With less exposure to the extreme swings of the stock market, PE remains center stage for active investors, albeit at a slower pace than prior quarters. As record dry powder levels persist, fierce competition for quality assets continues to be the norm.
2018 U.S. PE deal activity represented the highest deal count and second-highest deal value on record. However, the dramatic turnaround of outflows in leveraged loans at the end of 2018 had a negative effect on the cost of deal financing, causing many general partners (GPs) to hold off on finalizing deals.1 As such, deal activity, both in terms of deal value and number of deals closed, is off to a slow start in 2019. Through March, 993 deals totaling $121.4 billion represented year-over-year declines of 27.9% and 26.7%, respectively.2 While the pace of PE dealmaking has slowed, interest in the technology sector remains strong, most notably in the software sector.
Global PE dry powder has reached an all-time high of $1.3 trillion as of March 2019.3 The continued environment of “too much money is chasing too few deals” has led to elevated purchase price multiples. As such, GPs have turned to buy-and-build strategies, with add-ons comprising 71.0% of all U.S.-based buyouts in the first quarter. This is especially prevalent in the healthcare and financial services sectors due to the fragmented sub-industries and technological changes.4
U.S. PE exit activity slowed in the first quarter, as 164 exits with a total value of $41.1 billion represented quarter-over-quarter decreases of 41.2% and 57.3%, respectively. However, the value of those transactions remained elevated at $287.5 million, and secondary buyouts continue to account for the majority of exits. After a record number of PE-backed IPOs in 2018, only one occurred in the first quarter, a reflection of the volatility in public equities at year-end 2018.5
Fundraising in the first quarter of the year remained on pace with 2018, albeit slower than that of the prior years, with $45.5 billion raised across 29 funds. However, these figures still compare favorably with annual totals over the past decade. Mega-funds continue to drive the strong fundraising numbers.
Tax legislation and a looser regulatory environment helped keep M&A activity strong in 2018. However, M&A activity slowed in the first quarter, with 3,867 deals totaling $777.1 billion representing year-over-year declines of 2.6% and 36.4%, respectively. As in PE, several mega-deals ($10 billion and above) closed in the quarter, and several more were announced. Despite this activity, the M&A market remains uncertain due to a prolonged slowdown in manufacturing output and the cessation of interest rate increases.
Overall, the U.S. economy appears to be on solid footing. While economic indicators are mixed, we remain positive given that there has yet to be a sustained deterioration in several economic variables. In the credit space, it continues to be a positive time to be a borrower, thanks to a low premium on risk and current market rates and terms. Finally, in the PE space, strong competition persists thanks to record dry powder levels, and purchase price multiples remain elevated, resulting in GPs turning to buy-and-build strategies.
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1 S&P/LSTA U.S. Leveraged Loan 100 Index.
3 Preqin Pro.