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 recent GDP figures, the effect – or lack thereof – of low rates on the private credit markets and the continued slowdown in PE and M&A activity.
Economic data through August remains mixed. After a weak May employment report and then worries following the Brexit vote, employment data rebounded strongly in June and July, making the May data look like an anomaly. However, second-quarter GDP growth has been a disappointment, with GDP expanding by just 1.1% on a quarter-over-quarter (annualized) basis and 1.2% on a year-over-year basis. Nominal GDP grew 2.4% on a year-over-year basis, which, outside of the 2008 credit crisis, is a figure more consistent with the depths of various recessions we have had in the 1980s and 1990s. Weak nominal GDP growth puts pressure on corporate earnings and also on both businesses’ and households’ ability to repay debt. The trend in the past few years had been for a strong second-quarter GDP number to balance out a weak first quarter, which did not happen this time around. In addition, prior GDP growth was revised down for four of the past five quarters. Real final sales to domestic purchasers, which strips out the volatile GDP components of government expenditure, inventories and net exports and gives a cleaner look at domestic consumption trends, was up a healthier 2.7%.
Elsewhere, the ISM Manufacturing Index declined from 53.2 in June to 53.0 in July, and the Non-Manufacturing Index declined by 1 point from 56.5 to 55.5. However, strength in the new orders component of the non-manufacturing index was encouraging. Both indices are consistent with GDP growth in the neighborhood of 2%.
The Federal Reserve chose not to raise rates at its June meeting in advance of the Brexit vote, noting that the future pace of rate hikes would take into account “readings on financial and international developments,” a clear reference to the Brexit vote. In July, the Federal Open Market Committee’s (FOMC’s) statement left the door open to a September hike, taking a more positive view of recent economic data and noting that “near-term risks to the economic outlook have diminished.” Furthermore, Chairwoman Janet Yellen spoke at the Kansas City Fed’s annual Jackson Hole symposium on August 26, saying that “the case for an increase in the federal funds rate has strengthened.” Based on these and other comments from Vice Chair Stanley Fisher, the Fed has tried to create the expectation for a base case of at least one rate hike this year, assuming economic data continues on its current trajectory, with the possibility for two increases if the data surprises to the upside.
Regarding Brexit, the vote clearly created uncertainty earlier in the summer that threatened to affect the domestic economy; for the time being, however, its impact has diminished. The consequences of the U.K.’s negotiations on exiting the EU will be protracted, but it is unlikely that much information will be gleaned about its long-term impact over the next few months. The International Monetary Fund, for one, which had spoken of “severe regional and global damage” of a “leave” vote, changed its view in its latest growth outlook, saying it now expects growth outside Europe to be “little affected.”
As we have written several times in this economic update, inflation readings have become one of the most important economic data points, and inflationary pressures seem to be building only at an extremely modest pace. In July, the core Consumer Price Index was unchanged vs. the prior month, and the year-over-year increase fell 0.1% to 2.2%. The core personal consumption expenditure index was up just 1.6% on a year-over-year basis, well below the Fed’s target of 2%. Recent data releases on employment costs as well as average hourly earnings also show no strong uptick in inflation, and instead indicate that wage and price pressures are only gradually beginning to increase. Inflation remains the most important data point that could change the FOMC’s mind in a hurry as to what is the most appropriate pace of short-term rate increases. The next section on credit will look more at speculation around the timing and probability of a Fed rate increase in the second half of 2016.
The Credit Market
As noted, since the Federal Reserve’s December rate increase, much conversation has been generated about the timing of further bumps. However, the expected increments remained quite small in the second quarter of 2016. While the speculation continued, the yield curve shifted down yet again last quarter.
The futures market has shown expectations swinging in both directions. For most of the 12 months leading to the second quarter of 2016, the variation was around how many increases would occur, with the market placing a 54% probability at the end of the first quarter. However, following the Brexit vote in late June, the market indicated as much as a 20% chance of a rate decrease for the first time since the December hike. After markets settled, that probability disappeared, and the strong July jobs report fueled anticipation of more and larger increases. The market is currently placing a 39% probability of a rate hike this year.
Remembering that the Fed’s monetary policy mission is “conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates,” there seems to be small reason to stray from the current course, considering the aforementioned low inflationary pressure as well as the facts that employment levels have been steadily (though slowly) increasing and growth has been at a measured pace. These anticipated movements have seemingly little effect other than signaling the perceived direction of the domestic economy, and despite continuous speculation over the past several quarters, there has only been one change. Some argue that that the main reason to raise rates now is in order to have the option to reduce them again should conditions warrant.
After the large downward shift in the yield curve between 2007 and 2009, most of the rate decrease has been on the longer end of the curve. Credit investors have benefited from this more or less continual decline but are now having to reach on maturity in order to get measurable yield. On the credit front, with the exception of the high-yield market, where spreads have widened in large measure due to the energy sector, spreads remain in line with historical levels in the corporate market.
The multiyear rate decline’s effect on the private credit market has been more difficult to discern in the modestly paced recovery. It took until early 2014 for commercial and industrial (C&I) loans to reach their pre-recession peak, and over time, these have progressed steadily, if unspectacularly. Most businesses borrow based on short-term rates, or for capital projects at rates fixed for five years or less. At these low rates, business owners have not responded to rate movements in making decisions to invest in their companies.
Despite modest C&I loan growth over the past several years, banks appear to have been willing to lend. From 2010 until mid-2015, more bankers responding in the Phoenix Management “Lending Climate in America” survey reported the expectation of loosening rather than tightening lending standards at their institutions. However, more recent studies suggest that attitude may be changing, albeit slowly. Over the past four quarters, the survey has shown a moderate tightening of lending standards. Business owners may take note of this sentiment shift.
Low rates and marginal changes appear to have made little difference in the private credit markets or to private decision-making. The timing of rate moves is interesting speculation, but mainly as an indicator of the Fed’s view of the economy, and not for its direct effect on activity.
The Private Equity and Mergers and Acquisitions Markets
The slowdown in the PE and M&A markets that we highlighted early this year has continued, but because of the significant amount of corporate and strategic capital looking for opportunities, the “hot” properties are still trading at very high levels. The trend of banks tightening their belts has also persisted.
U.S. middle-market PE volume again ticked down in the second quarter as completed transactions declined to 442 and transaction volume fell to $89 billion. We have seen similar trends in our own PE business. The decrease in available transactions has created a sort of “feeding frenzy” for attractive opportunities, which has skewed transaction valuations up. Median EBITDA values for middle-market M&A transactions remain at a frothy 11.3x EBITDA, despite lower senior debt levels.
Buyers are stretching for the properties being brought to market right now that are in favored industries or sectors with attractive growth dynamics, as evidenced by the declining debt percentage of new investments. Investment bankers are frequently commenting that their auction processes are “all over the map,” and some assets are attracting record levels of interested parties. In other situations, buyers are getting bargains, and in some cases, deals just won’t close.
PE fundraising continues to increase as general partners (GPs) are raising new, larger funds and looking to deploy capital in a constrained market. In the second quarter, GPs raised another $63 billion in commitments. Businesses that generally have the attributes PE is attracted to – including predictable recurring revenues, strong management teams that want to remain with the business post-transaction and high barriers to entry – can expect to create better transaction outcomes. Regardless of whether the acquirer is a strategic buyer or a PE fund, the presence of private equity in the auction process will ultimately drive value, speed and more favorable deal terms for the seller.
While this year has seen a slight slowdown in deal activity and valuation, we believe that the market is trending down from historically high levels and remains very healthy for attractive sellers. In addition, it would not surprise us to see deal flow and debt availability flatten out or increase slightly between now and the end of the year.
Economic data remains mixed; second-quarter GDP numbers were weak, while employment rebounded in June and July following a poor May report. Rising anticipation around when the Federal Reserve will raise interest rates continues, and inflation, which is increasing at a modest pace, is the key economic data point to watch, as it may sway the FOMC to raise rates earlier. Speculation around rate increases appears to have had little effect on activity in the private credit markets and private decision-making, and is more of an indicator of the Fed’s view on the future of the domestic economy. Finally, while deal volume in the PE and M&A markets continued to slow last quarter, appetite is high and healthy for attractive companies.
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