Economic data through July indicate a slightly more robust economy than was evident at the start of the year. Demonstrating the imprecise nature of economic data, the most recent GDP report contained annual revisions for first quarter growth from -0.2% to +0.6%. The advance estimate of second quarter growth came in at +2.3%1. Similarly, after two modest months of payroll gains in March and April, the past three months’ job gains have averaged 235,000, and the unemployment rate remains at a post-crisis low of 5.3%. Looking ahead, the ISM manufacturing index2 declined from 53.5 in June to 52.7 in July, which is consistent with GDP growth of roughly 2%. The ISM’s survey responses, however, are skewed toward large multinationals, and to some degree the recent weakness likely reflects the resurgent value of the dollar which makes U.S. exports less competitive.
News from the Federal Reserve indicates that the FOMC’s first rate hike could come as early as the September meeting, and federal funds futures prices show that market participants are discounting between two and three rate hikes between now and June of 2016. The Fed’s July statement showed a slightly more upbeat view of the economy and also revealed that the committee now has a marginally lower threshold for further labor market improvements before they begin hiking rates.
As has been widely discussed, the last piece of the labor market puzzle is wage gains, and recent data still indicate that wage growth is softer than the Fed would like. After rising to a year-over-year pace of 2.6% in the first quarter, growth in the employment cost index fell back to a 2.0% pace in the second quarter. In deciding when to raise rates, the Fed will have to weigh modest wage gains against other data indicating a more robust economy.
Also standing in contrast to otherwise moderate economic data, corporate earnings, as measured by both the S&P 500 and the BEA3, declined in the first quarter, and S&P 500 earnings are expected to decline again in the second quarter. Two ongoing themes in the U.S. economy that explain part of this weakness are the strong dollar and the collapse in oil prices. After both trends seemed to reverse in the second quarter, in the later part of June and in July, the dollar rose again to near March highs against a basket of world currencies. And crude oil prices declined back below $50, within shouting distance of lows from earlier in the year. Low energy prices have a clear, direct effect on the earnings of the energy sector. With regard to the dollar, however, the effects have been more widespread – some estimate that the S&P 500 derives almost half of its revenues from overseas. As a result, earnings of U.S. multinationals have taken a hit in 2015. In addition, while the U.S. generally does not follow an export-oriented strategy, the sectors of our economy that do export more have seen the competitiveness of their products decline. Going forward, the value of the dollar is impossible to predict, but as the world’s reserve currency, it has as much to do with the pace of growth elsewhere around the world as it does with the internal strength of the U.S. economy.
The Credit Market
Throughout the year, banks have continued to ease lending practices, and over the most recent quarter ended July 31, 2015, that trend has continued with more accommodative interest rate spreads and covenants4 on loans that are not highly leveraged. Continued pressure to grow bank revenues has resulted in cheap and plentiful debt. As evidence, outstanding commercial and industrial (C&I) loans have increased to all-time highs, now at $1.9 trillion; this represents an aggregate growth of more than 50% over the last 5 years5.
Given the aggressive credit environment, however, federal regulators have issued special guidance on leveraged lending, and as a result, banks have begun to reign in underwriting on the most highly leveraged loans. Debt multiples reached a two-and-a-half-year low during the first half of 2015, with total debt to EBITDA leverage averaging 4.6x among companies generating $50 million of annual EBITDA or less, down from a record 5.0x in 2014.6
Despite the contracting debt to EBITDA multiples on highly leveraged loans, debt remains cheap and readily available in many sizes, shapes and forms. As such, more so now than ever, there is a temptation for U.S. manufacturers to use inexpensive debt to expand their businesses. Over the most recent quarter, banks have experienced stronger demand for both C&I and commercial real estate loans7. However, companies that chose to aggressively add debt to their balance sheets, particularly those that are export driven, may have put themselves in a dangerous position. When the Fed begins to raise rates, debt service for these companies may increase, and adding gas to the fire, a strengthening dollar could lead to further company stress due to declining demand from export markets.
News that the Federal Reserve could begin hiking rates as early as September has many companies pondering whether or not they should lock in long-term interest rates. There is a common misconception that “rates have nowhere to go but up.” This very well may be the case for short-term rates, but as shown in the following chart, long-term rates have not necessarily moved in tandem with short-term rates, but rather based on longer-term market expectation.
When considering whether to lock in longer-term financing rates, it is generally advisable to match financing terms (tenor of loans and rates) with the duration of the assets that are being financed. Fixing rates on a long-dated asset, such as a manufacturing plant, can be beneficial because of cash flow predictability. On the flip side, fixing rates beyond the expected life of an asset can lead to paying an unnecessary premium or even hefty breakage fees if the loan is repaid before maturity. For assets that are typically financed with floating rate debt, deviating from that practice and fixing rates is effectively taking a speculative position that may prove to be cheaper or more expensive depending on where rates go. The summary is that there are a number of considerations when making decisions about locking in fixed rate financing.
Private Equity and Mergers and Acquisitions Markets
The M&A market both for private equity portfolio companies and other strategic acquirers has become an increasingly important avenue for growth as businesses find it difficult to grow profits organically. We have seen a decrease in the availability of leverage for private equity investors following last year where leverage levels for PE buyouts eclipsed those last seen in the lead up to the debt crisis in 2008. This has made it more difficult for PE investors to compete with strategic acquirers for attractive acquisition opportunities. The trend we identified last quarter of softening transaction volumes for PE firms has continued with some market watchers predicting that PE acquisitions could be down as much as 20% versus last year. That said, it still has been an incredible sellers market. Despite recent record levels of fundraising for PE firms, the investment to exit ratio has hit a low of 1.7 new platform investments to exits (versus a high of 3.7 in 2009).
As we have pointed out in the past, PE firms are increasingly seeking out “platform” investments in which returns depend on the ability to “add on” acquisitions that provide attractive returns. So far this year, the trend in which nearly two thirds of all private equity acquisitions are “add ons” to existing portfolio companies has continued. Said differently, PE firms are acquiring two “add ons” on average for every “platform” investment.
The U.S. dollar has appreciated meaningfully versus other global currencies over the past 12+ months, and many have questioned what the impact has been on the deal market. Our view is that the largest impact can be found in the profitability of underlying businesses as opposed to acquirers deciding to pursue an opportunity or altering their underwriting assumptions because their currency is relatively stronger than the target. U.S. multinationals that book meaningful revenues in foreign currencies, but have dollar-denominated expenses have seen a negative hit to profitability. Conversely, for businesses that are booking revenues in dollars but have expenses denominated in a weaker foreign currency, the strong dollar has created a windfall. The trend that benefitted U.S. multinational businesses for the better part of the past 15 years is now benefitting foreign businesses. How this change in profitability is viewed by a buyer can have a meaningful impact on valuation assuming it is based on a multiple of profitability.
While currency fluctuations are unlikely to be a primary reason to invest in U.S. or foreign businesses, at the margin, U.S. buyers shopping for foreign businesses might be able to stretch on valuation with the understanding that we are likely closer to a U.S. dollar high than a U.S. dollar low. PE investors in particular can view this as an additional way to create appreciation. However, in our experience good capital allocators view this as an ancillary benefit as opposed to the primary reason to make an investment or an acquisition.
The pace of economic growth in the U.S. continues to grow modestly, and the Fed has indicated that it may increase rates in the very near future. Earnings have faced headwinds, however, due to the decreased price of oil and the strong dollar, which has caused challenges for U.S. multinationals. These challenges, in addition to rising interest rates, could present issues for aggressive borrowers in the future, especially given the accommodative credit environment that we have witnessed recently. Easy credit seems to be tapering to some degree, however, as the ability for PE investors to use leverage has decreased versus last year. This, in conjunction with the aforementioned difficulty in growing earnings organically, has spurred on strategic and PE portfolio company add-on acquisition activity. Through the first half of the year, the economy appears to be on solid footing, and the credit and deal markets continue to be attractive for business owners seeking financing or company sales.
1 All growth rates are quoted as quarter-over-quarter, annualized rates of growth.
2 The ISM Manufacturing Index is a composite index based on new orders, production, employment, supplier deliveries and inventories and gathered by surveying over 300 manufacturing executives monthly. A level greater than 50 has historically been consistent with growth in the manufacturing sector versus the prior month, and a level greater than 42.1 has been consistent with growth in the general economy.
3 The Bureau of Economic Analysis (BEA) compiles an estimate of corporate profits in its National Income and Product Accounts (NIPA) data set that represents a much broader set of companies than the large cap S&P 500 Index.
4 The July 2015 Senior Loan Officer Opinion Survey on Bank Lending Practices.
6 Thompson, Kelly. Forbes. “Leveraged Loans.” http://www.forbes.com/sites/spleverage/2015/08/11/leveraged-loans-stricter-lending-guidelines-sends-middle-market-debt-multiples-south/.
7 The July 2015 Senior Loan Officer Opinion Survey on Bank Lending Practices.