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 three risks we are watching in today’s relatively healthy economic environment, the expanding credit supply and loosening creditor standards and increased competition in the PE market thanks to soaring purchase price multiples, among other topics.
Recent economic data paints a picture of a generally healthy U.S. economy, and accordingly, there are few traditional signs of any near-term slowdown. In the second quarter of 2018, real GDP grew at a 4.1% annualized rate – its fastest quarterly growth rate since 2014. Through the first half of the year, the economy grew at a solid 3.2% rate, which is above average for this expansion, while nominal GDP recently surpassed $20 trillion for the first time.
As has been the case this cycle, the U.S. labor market remains quite strong. Despite July headline payroll gains being a bit lower than expected at 157,000, the unemployment rate dropped back to 3.9%, while the so-called “underemployment” rate, which includes discouraged workers and those working part time for economic reasons, fell to a new cycle low of 7.5%. The labor market is running above what most economists consider full employment, which would suggest wage pressures would materialize at some point. Recently, the employment cost index, a broad measure of total labor costs, increased 2.8% year over year, its fastest growth rate since fourth quarter 2008. While this could prove to be fleeting, sustained growth in total labor costs of greater than 3% would likely have a material impact on price inflation. Core inflation has shown signs of firming but has yet to rise to a worrying level.
Further supporting the notion that there are few traditional signs of an economic slowdown, the index of leading economic indicators is up 5.8% year over year and 3.3% over the past six months and has not declined in the past 28 months. While the ISM Manufacturing Index fell in July, it is now essentially unchanged since July/August 2017 and is consistent with continued economic growth. New housing starts were down in June, though household formation, which bodes well for future housing demand, rose strongly. The seasonally adjusted Case-Shiller 20-City Home Price Index is up 6.5% year over year, and most measures indicate a robust residential housing market.
With a relatively rosy economic picture in the U.S., markets are expecting the Federal Open Market Committee (FOMC) to hike overnight interest rates two more times in 2018, which would bring the fed funds target rate to a range of 2.25% to 2.50%. In its August statement, the FOMC upgraded its assessment of growth from “solid” to “strong” – the first time it has used this term since May 2006. While other changes to the statement were only marginal, the lack of change was significant in that it showed the Fed has not let the looming trade war with China affect its near-term view of the economy or its expected rate hike trajectory.
Though the economic environment appears relatively benign, we will highlight three risks we have been watching. First, there is clearly a wide range of outcomes for the trade war, and while we hope cooler heads will prevail, recent developments have only shown continued escalation. The situation is worth monitoring, but we believe it is inherently unpredictable.
The second is the ongoing expansion in corporate debt. The Fed’s Flow of Funds report shows total outstanding corporate debt above $9 trillion in first quarter 2018, 36% higher than its prior peak before the crisis. While corporate earnings have also grown, this large debt burden of relatively low-interest rate debt could pose problems for the U.S. economy down the road, especially if interest rates rise. The third is the rise in federal spending and the gradual unwind of the Fed’s balance sheet. The U.S. budget deficit had been improving through early 2016, when it was as low as 2.2% of GDP. Despite rising GDP, the U.S. is currently running a deficit of 3.7% of GDP, which is troubling on two fronts. The first is that coupled with the runoff of the Fed’s balance sheet, there is an increasing amount of new U.S. Treasury debt issuance for the market to absorb, which could eventually cause Treasury yields to rise. The second is that a large fiscal stimulus nine years into an economic cycle with the market above full employment could potentially cause the economy to overheat, stoking inflation while limiting the amount of fiscal response available from the U.S. government when it is truly needed in the next recession.
While the trade war is a wildcard and could certainly have a material near-term impact, our view is that the latter two risks are slow-burning issues that business owners and markets should be mindful of.
The Credit Market
In June, the FOMC voted to increase the target range for the federal funds rate to between 1.75% and 2%. This was the second raise in 2018 and was widely anticipated by the market. The committee stated that its policy remains accommodative and supportive of the strong labor market and target inflation of 2%. Fed officials now view four total rate hikes as likely in 2018, suggesting confidence in the state of the U.S. economy. As illustrated in the following chart, the yield curve has shifted upward accordingly over the past year, but most change has occurred on the short end. Since June 2017, the spread between the one-month and 30-year Treasury has narrowed from 2.00% to 1.21%. The Fed will continue to raise rates so long as economic growth continues to fuel inflation.
The following chart shows the current supply of credit, as indicated by the amount of commercial and industrial (C&I) loans issued by U.S. commercial banks. The buildup of credit issuances continued through the second quarter, and as of June 2018, commercial banks carried $2.2 trillion of C&I balance sheet assets, up from $2.1 trillion a year prior. The 5.4% year-over-year growth is a continuation of the long, steady credit expansion that has lasted since the Great Recession. Compared with the prior peak of $1.6 trillion in October 2008, today’s C&I loan market is nearly 40% larger. Furthermore, the chart also understates the credit expansion’s true scope because it excludes nonbank financial institutions, which re-emerged out of the recession as an increasingly significant source of debt capital, particularly to the private markets. These sources provide additional liquidity to the market and have intensified the competition among lenders.
With so much liquidity, some are concerned about the deterioration of creditor protections. Borrowers have more negotiating power, which appears in pricing, and in covenants, which govern what borrowing businesses can and cannot do. Covenants protect creditors and are particularly important when interest rates rise and economic conditions worsen. Generally, today’s borrowers can carry more debt, pay back or amortize debt at slower rates and report lower leverage through the allowance of add-backs and pro forma adjustments. If businesses become challenged individually or more broadly from an economic downturn, lenders will recover less principal because they have fewer claims and opportunities to intervene. The preceding chart also shows the Federal Reserve’s “Senior Loan Officer Opinion Survey on Bank Lending Practices,” which suggests that banks eased their credit standards and terms for C&I loans to large and middle-market businesses in the second quarter. All senior loan officers that reported eased standards cited more aggressive competition from other banks or nonbank lenders as a reason. Additionally, many reported a better economic outlook, improved industry dynamics, increased tolerance for risk and less concern with legislation as important reasons.
The corporate spreads chart below illustrates the additional return required by the market for taking incrementally more risk. Tighter spreads mean that investors either require less return or that the market perceives the investments as less risky. Spreads have held fairly constant through the second quarter, and at the end of July, spreads vs. Treasuries were 0.98% for A, 1.51% for BBB and 3.41% for high-yield rated bonds. Given our progress through this market cycle, evaluating risk-reward trade-offs becomes increasingly important to making smart decisions. Fundamental investors should remain diligent in evaluating opportunities, and the world will await updates from the Fed in the months to come.
The Private Equity and Mergers and Acquisitions Markets
Many have speculated that the PE industry is becoming overheated. The asset class has produced strong growth and double-digit returns since the financial crisis. The resulting investor influx has led to record dry powder and fierce competition. However, it seems the PE industry has room to grow, as the data shows that fund managers are continuing to put capital to work, despite market frothiness.
In a recent McKinsey study, 90% of limited partners (LPs) said they expected private equity to outperform public markets in coming years. This optimism has led new and nontraditional PE investors (such as high-net-worth individuals and family offices) to line up to invest in the space. The number of PE investors has risen 45% over the past decade. Currently, more than 2,000 active U.S. PE investors have 3,800-plus active funds.1 This scenario is not ideal for investors, who still must pay PE firms management fees of 1% to 2% of this committed capital. As such, LPs have put tremendous pressure on fund managers to deploy capital.
U.S. PE deal flow in the first half of 2018 represented a 2% volume increase compared with the first half of 2017. In all, 2,247 deals were completed, totaling $263.9 billion in value. This high activity level will likely continue for the foreseeable future due to the aforementioned record dry powder levels and easy access to debt financing. However, finding quality assets at an attractive price is no small feat. The intense competition for deploying capital has spurned several years of high purchase price multples. While current purchase price multiples are below 2017’s 10.6x high, they remain elevated at 9.8x through the first half of 2018.
With soaring purchase price multiples, fund managers find themselves struggling to stand out in competitive auction processes and have had to rethink their overall organization design. A Boston Consulting Group article pointed out that many PE firms have the ability to drive change in their portfolio companies but are far less successful in implementing change in their own internal operations. General partners (GPs) are placing increased emphasis on creating new business development strategies to keep up with competition. Direct sourcing methods and industry vertical expertise have become invaluable. Firms that can innovate and think outside the box will be able to produce better, more consistent deal flow. As fund sizes increase, it is imperative that fund managers invest time in creating more formalized internal processes for such things as prioritizing investment opportunities, business development and staffing.
Fund managers are struggling to find assets that meet their investment criteria at a reasonable price and are turning to value creation strategies that usually require more hands-on involvement and additional capital. In this new environment, financial engineering has been replaced by operational improvements and digital transformation as the required means for value creation. GPs are extracting value from high-priced assets by utilizing more internal and external resources, such as operating executives, senior advisors or outside board members.
The middle market, in particular, continues to exhibit increased appetite for add-on acquisitions, a strategy that allows fund managers to deploy capital more quickly at a more attractive entry price. In many cases, PE investors now view their original purchase as a platform investment. Tuck-in acquisitions now account for over two-thirds of buyouts in the U.S. and are particularly common in the healthcare and energy sectors.2
Research shows that platforms with add-ons take about one year longer to exit vs. standalone portfolio companies. As such, current PE hold periods are averaging 5.9 years, as opposed to the standard three to five years.3 Through the first half of 2018, total exits and total amount of capital continued to decline. Extended PE investment timelines affect the amount of time it takes to return capital to LPs. Some firms have even started offering “long-dated” funds to address the new norm of longer timelines. These funds allow managers more flexibility in timing investments and exits and put operational improvements in place.
Both global and U.S. M&A activity hit all-time highs during the first half of 2018, driven by mega-deals in the media sector. The value of deals announced globally year to date is $2.5 trillion, up 64% year over year and the strongest year-to-date period since 1980, when record-keeping began. U.S. M&A was the largest category, rising 82% to $1.0 trillion. Repatriation of foreign cash resulting from U.S. tax reform was positive for North America but will likely have a negative effect on cross-border M&A.4 However, it is important to note that these transactions may have been front-loaded into the first half of the year as deal makers fear an all-out trade war.5
Overall, the U.S. economy remains on healthy footing, and nine years into this economic cycle, few traditional signs of a slowdown have appeared. GDP growth is solid, the labor market continues to be strong, and the index of leading economic indicators is up. However, there are several risks worth watching, and we remain alert about the trade war, expansion of corporate debt and the U.S. budget deficit. Meanwhile, the credit markets continue seeing increased liquidity, with the post-crisis credit expansion remaining on a steady upward trajectory. The large amount of liquidity has some concerned about deteriorating creditor protections, and studies indicate that credit standards are easing. Finally, thanks to strong performance and returns since the financial crisis, the PE market continues to see an investor influx that has resulted in record dry powder, sky-high multiples and fierce competition. M&A activity is also strong both globally and in the U.S., with activity reaching all-time highs in the first half of the year. However, it remains to be seen whether this heightened activity took place due to concerns of a full-on trade war in the coming months.
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© Brown Brothers Harriman & Co. 2018. All rights reserved. 2018.
1 Source: PitchBook.
4 Source: Thomson Reuters.
5 Source: Axios.