In each quarter’s issue of Owner to Owner, we review aspects of the business environment on three consistent fronts: the overall economy, the credit markets and the private equity (PE) and mergers and acquisitions (M&A) markets. The following article discusses the link between personal consumption and corporate profitability trends, the reasons behind tighter structuring of commercial and industrial (C&I) loans and the future of currently high valuations, among other topics.
Economic data through early November was somewhat mixed; however, October’s stronger-than-expected employment report cast an upbeat tone on the economic outlook and increased expectations that the Federal Reserve will raise rates at its December meeting. Two seeming disparities in economic data merit discussing though.
First, while the headline GDP growth number receives the most attention, trends in domestic consumption (approximately 70% of GDP) matter more for future economic growth, yet on a quarterly basis are often drowned out by noise in other GDP components. Thus, we use an alternative measure from the Bureau of Economic Analysis (BEA): real final sales to domestic purchasers, which removes the volatile components of government spending, inventory building and net exports and provides a clearer picture of domestic consumption trends. As the nearby chart shows, this series is less volatile than GDP, and while both data points were +3.9% in the second quarter, real final sales was more robust in the third quarter (+3.2% vs. +1.5%), indicating a healthier U.S. private sector than headline GDP alone does.
Second, U.S. corporate profitability data points in opposite directions. S&P 500 earnings – more weighted to multinational companies – and certain parts of the energy sector have declined year over year, while figures from BEA’s national income and product accounts (NIPA) show gains. The NIPA data – which measures income from current production – represents a broader data set, has higher small company representation and omits many components of GAAP net income (e.g., asset write-downs). While seemingly at odds, taken together, these data sets confirm a stronger domestic economy with continued weakness from, among other things, overseas profits of large U.S. multinationals and energy companies.
ISM’s manufacturing and non-manufacturing indices further confirm these trends. While they tracked each other closely in 2014, the manufacturing index – dominated by responses from many large, multinational, export-oriented companies – declined from 55.1 to 50.1 this year, while the non-manufacturing index increased from 56.5 to 59.1. The manufacturing index historically generated more headlines, but the U.S. is now a service economy: the sector comprises roughly 80% of corporate economic activity. It’s no surprise, then, that the economy has held up well despite the manufacturing index’s decline.
Lastly, the economy eagerly awaits the Fed’s December 16 decision on interest rates. In Chair Janet Yellen’s November 4 testimony to the U.S. House of Representatives, she referred to December as a “live possibility” for the first increase. Before that testimony, the fed funds futures market was assigning a 50% probability to a December hike. This rose to 56% after Yellen’s comments and 70% following October’s employment report. Employment gains of 271,000 were strong. The unemployment rate hit a cycle low of 5.0%, and average hourly earnings increased 0.4% month over month. Year-over-year 2.5% wage growth still likely gives the Fed something to desire; additionally, we’ve seen the three-month annualized change in the core personal consumption expenditures (PCE) deflator weaken to 1.3% and the quarterly employment cost index (year-over-year change) fall from +2.6% in March to +2.0% in June and September. Any uptick in inflation readings before the Fed’s next meeting would also support a rate hike – the Fed will be able to digest two Consumer Price Index reports, including one the day before the meeting. With the Fed having done its best to telegraph a shallow trajectory of rate increases, BBH thinks a hike would remove substantial economic uncertainty; while it may cause temporary financial market volatility, we believe it will be a net positive for the economy.
The Credit Market
Market participants have assigned a “more-likely-than-not” probability to a Fed December rate hike, and economic data appears supportive to sentiment. Domestic credit markets remained accommodative during the third quarter and continued to show brisk growth, albeit at a more modest pace than during the first half of the year. For the 19th consecutive quarter, the Fed measured growth in commercial banks’ C&I loan portfolios, putting the total at $1.91 trillion as of September 30, 2015. That notched a 7.8% increase in C&I loans during the third quarter, reflecting a slower rate of growth than the 12.7% and 10.8% seen during the first and second quarters of 2015, respectively.
Demand for new C&I loans remains robust as the fourth quarter takes shape. Commercial banks’ issuance of C&I loans continued through the first month of this quarter, finishing the week ended October 28 at $1.93 trillion – a more than $200 billion increase over the end of Q3 2014. October’s month-end figure puts C&I loan growth on pace to exceed a rate of 10% during 2015; this has been supported by an accommodative underwriting environment most recently characterized by the 23rd consecutive quarter during which a majority of loan officers reporting contracting C&I loan spreads on debt issued to large and middle-market borrowers.
For almost six straight years a majority of C&I loan officers have reported spread contraction in their loan books. Having said that, it is worth noting that for only the second time since the end of the Great Recession that same population reported tightening loan standards during the third quarter.
This indicates that while C&I loan growth has held up well in an environment of general spread contraction, a measurable population of C&I lenders have begun to respond by requiring greater structural protections in the new, cheaply priced debt being issued. This is far from a contracting credit market; we are, however, seeing signs that some of the slack is being reeled in. The shift toward tighter C&I loan structuring seems to be both anticipatory and reactive at the same time.
The reason for tighter structuring by C&I loan officers is perhaps best viewed with bifocals – there are two things to focus on. On one hand, an effort toward tighter structuring can be viewed as anticipatory: lenders looking into their (usually clouded) crystal balls may see less accommodative credit markets ahead. On the other hand, tighter structuring could also be seen as reactive in nature; after all, the high-yield debt market has gone through a risk repricing driven in no small part by companies operating in the energy industry, where high-yield risk pricing (measured by option-adjusted spread [OAS] to Treasuries of comparable maturity) recently settled at more than a 460-basis-point (bps) risk premium to a “general” index basket of high-yield corporate debt instruments. As debt issued by borrowers during the U.S. shale boom of 2010 to 2014 matures and refinances into a high-yield market bearing energy risk premiums several multiples of what they were at $100 oil, when they were priced in the 50 bps range, we expect these energy-linked refinancings to write their own stories as we wrap up 2015 and look into the future. There will almost certainly be further industry consolidation.
Private Equity and Mergers and Acquisitions Markets
The M&A and PE markets remain very accommodating for sellers as the second half of 2015 winds down. The trifecta of positive economic fundamentals, an accommodative lending environment and well-capitalized strategic and financial acquirers continues to support historically high valuations in middle-market transactions.
The pace of deal flow has also leveled off, and it is likely to tick down in 2015 following a record year last year. This trend is expected to continue as we move further into the current economic cycle. Strategic and financial buyers alike are more frequently being forced into highly competitive processes for attractive acquisition targets. Investment bankers generally will say that they can’t remember a time when they have had as much leverage with buyers as they do today.
There remains a significant premium for assets where the sellers can demonstrate that the business can be a credible acquisition platform. In these cases, financial buyers are frequently outbidding strategic acquirers. PE firms believe that they can justify “overpaying” for a scalable platform and a strong management team if they can later “cost average down” by pursuing aggressive acquisition programs. They believe they can acquire smaller businesses for a relatively low valuation multiple and subsequently extract synergies to create value. One trend seen more frequently recently is owners taking their business to market without doing the work of extracting the synergies and asking the next buyer to pay for the synergies through “pro forma” adjustments. If an owner plans to take his or her business to market, demonstrating a credible inorganic strategy can be a powerful value driver, and oftentimes, acquirers will pay for the acquisitions whether or not the seller has actually fully integrated them.
Despite all the good news, the recent softness in the public equity markets has created headwinds for business development companies (BDCs), investment funds that raise capital from public or private equity investors primarily to lend to small and medium-sized businesses. As mentioned in this section in previous issues, publicly traded BDCs have provided a growing percentage of the capital used to finance PE leveraged buyout transactions. A number of the larger players in this group have traded lower this year, and their market capitalizations are at or below their book value. The low prices have constrained their ability to access the public markets and raise new equity to deploy; as such, BDC equity funding is down significantly this year.
Many people will point out that some of the decrease in listed BDC inflows has been absorbed by other alternative financing structures like middle-market collateralized loan obligations or other private pools of capital, but the ease at which BDCs were able to raise and deploy capital was a significant driver of the high valuations and accommodative deal terms in the recent M&A boom. We are watching closely to see if this is just a blip on the radar screen or some early cracks in a seven-year PE bull market.
The economic outlook for the remainder of 2015 appears positive. While overseas profits of large U.S. multinationals and energy companies have indicated weakened earnings, personal consumption trends suggest a strong domestic economy. Though the credit markets continue to see robust growth in C&I loans, lenders have begun to tighten structuring – an action taken in anticipation of less accommodative credit markets and in reaction to the high-yield debt market’s risk repricing, thanks largely to energy industry participants. Finally, while historically high valuations in the M&A and PE markets persist, it remains to be seen whether challenges faced by BDCs – a key driver of such valuations – could bring a seven-year PE bull market to an end.
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