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 factors pushing up interest rates, an increasingly accommodating lending market amid rising interest rates and the PE investor influx that is fueling competition.
Economic data continues painting a picture of a generally healthy U.S. economy. Recent figures indicate the real economy grew at a 3.5% annualized pace in the third quarter and a 3.3% annualized pace year to date, both of which are above average for this economic cycle. Leading Economic Indicators increased 7.0% year over year in September, the fastest rate since 2010, and as of the second quarter, corporate profits grew 7.3% over the past year. The source of this growth appears broad-based across different sectors of the economy; however, the tax cuts enacted at the end of 2017 have been a key factor supporting growth.
The labor market remains a key area of focus. Because wage growth and price inflation are related, the Federal Open Market Committee (FOMC) continues to watch tightness in employment markets closely. Recent data shows that wage costs have continued to rise, as depicted in the nearby chart illustrating growth in average hourly earnings and the broader employment cost index. Those measures indicate that labor costs are rising at roughly a 3% annual pace, which historically has been consistent with rising inflationary pressures in the broader economy.
Similarly, various measures of price inflation, such as the Consumer Price Index and personal consumption expenditures, also continue rising. Firming inflation is important in that it supports recent indications that the FOMC plans to continue increasing the federal funds rate. As a reminder, the FOMC started its tightening cycle in December 2015 and has now raised rates eight times for a total of 2%. In 2018, these rate increases have also had a large effect on longer-term bond yields, whereas in 2017, yields stayed relatively flat despite rising short-term yields.
In 2018, the 10-year Treasury yield rose at the start of the year and stayed between 2.8% and 3.0% until September, when it rose above 3.0%. As of this writing, the 10-year yield stands near 3.2%, its highest level since mid-2011. This has had a noticeable effect on financial markets, as aggregate bonds are now down 2.6% year to date, while U.S. large-cap equities, up 4.0% year to date, suffered an almost 10% pullback in October thought to be partially related to concerns over rising interest rates. The market is suddenly more attuned to the possibility of higher interest rates, which we expect to continue.
While the interest rate outlook is uncertain, it is worth noting that there are several factors that at the margin are supportive of continued rate increases. None of these mean that rates will increase, as that depends on a wider range of unpredictable factors, but just that we believe there is some continued pressure pushing rates higher.
First, the tax cuts that took effect this year have stimulated the economy and this late in the cycle have the potential to stoke some inflation – and therefore further increases to overnight interest rates from the FOMC. Second, as discussed last quarter, the federal deficit has worsened due in part to the tax cut, but also as a result of increased military, Medicare and Medicaid spending. The Office of Management and Budget estimates the fiscal 2019 deficit will exceed $1 trillion, or 5% of GDP, which will create the need for increased Treasury issuance. Coupled with the Federal Reserve continuing to unwind its balance sheet, there will likely be a noticeable increase in Treasury supply that the private markets will need to digest. With somewhat higher Treasury yields, new buyers will of course be drawn into the market, which may limit any increase in rates, but we believe the supply-demand balance in Treasury markets should be watched closely.
While there remain few if any indicators that signal a classic economic slowdown, one area of macroeconomic concern that bears caution is the buildup of leverage in credit markets. Though the threat of a traditional recession brought on by cyclicality in manufacturing seems somewhat less worrisome today, financial markets and the real economy have grown more tightly linked over time. Growth in debt markets is expected in a strong economy, especially one with low interest rates, but the sheer amount of lower-rated debt outstanding could cause problems if investment grade debt holders sell “fallen angels” into weakness. There is no historical example to point to for how damaging a credit market dislocation could be to the real economy, but the fear would be that the flow of credit could be disrupted to a wide range of businesses as financial markets cope with losses from a glut of lower-rated public market debt.
The Credit Market
Rising interest rates have dominated credit market headlines throughout 2018. In September, the FOMC voted to increase the fed funds target rate by 25 basis points (bps) from between 1.75% to 2% to between 2% and 2.25%, marking the third 25 bps hike this year. The rate hike was not a surprise, but the magnitude of three sequential interest rate increases means that floating-rate borrowers have now seen a 0.75% lift in their cost to borrow so far in 2018. Undoubtedly, these borrowers are beginning to feel the rate hikes’ impact and are testing to see if they can pass on those increased borrowing costs to their customers.
Looking at how the yield curve has shifted over the past 12 months, the effect of the Fed’s rate hikes is clear at the near end of the curve. As of November 1, 2018, the one-month Treasury carried a yield of 2.18% compared with 1.04% one year ago. Interestingly, the rate increases have not affected the tail-end of the yield curve nearly as much. The 30-year Treasuries were priced to yield 3.40% currently vs. 2.86% a year ago – a 54 bps increase in the 30-year compared with a 114 bps at the one-month maturity. Although it is impossible to predict where rates will go over time, the flattening of the yield curve does suggest it may be an opportune time for borrowers looking to lock in fixed rates at longer-term maturities.
Offsetting the impact of rising rates has been the increasingly accommodating lending market. On a net basis, lenders have now reported loosening standards six quarters in a row. As of the most recent bank survey, 15.9% of banks reported loosening standards over the quarter – the highest such percentage since July 2013. Loosening standards means that the banks are increasingly accommodating borrowers on covenants and other terms that regulate and guide credit facilities. Reflective of an accommodating banking market, the amount of commercial and industrial (C&I) loans outstanding has increased to $2.2 trillion as of September 1, 2018. Although this figure has been essentially flat over the past three months, it has risen 5.1% on a year-over-year basis.
Spreads remain tight across all credit qualities, suggesting banks and investors alike are reducing their risk premiums. In October, lower-quality credits (U.S. corporate high-yield bonds) saw a marginal 0.15% increase in the average spread month over month and 0.37% year over year. By comparison, higher-quality credits (U.S. corporate A-rated bonds) saw a 0.01% month-over-month decrease in average spread and a year-over-year increase of just 0.09%. The difference in quality trends is consistent with the two-tail story we see in the market of the haves and the have nots, where higher-quality credits are getting increasingly better terms while lower-quality credits struggle to raise bank-issued debt and credit facilities.
Looking forward, the market is pricing in one more interest rate increase in 2018 at the December meeting followed by three additional hikes in 2019. As such, borrowers that borrow at floating rates must expect their interest rate obligations to continue rising over the next 12 to 25 months. Borrowers need to consider whether they can pass on those rate hikes to their customers or if they should be fixing rates where applicable or paying down principal now to lower their debt service requirements later.
The Private Equity and Mergers and Acquisitions Markets
As mentioned in the Economy section, the major U.S. stock indices fell sharply in the beginning of the fourth quarter as investors reacted to rising interest rates, continued geopolitical turmoil and overvalued tech stocks – and this volatility is expected to continue. With this backdrop, it is no surprise that many view PE as a “safer” place to invest. Research from Hamilton Lane and J.P. Morgan Asset Management shows that stocks are a stunning 13 times riskier than PE funds. The optimism for the asset class and investor influx has led to record dry powder and fierce competition. However, it seems the industry has room to grow, as data indicates fund managers are continuing to put capital to work, despite market frothiness.1
U.S. PE deal activity through the first three quarters of 2018 represented a 2.1% rise in volume and 3.4% value increase year over year. In all, 3,501 deals were completed, totaling $508.8 billion year to date. There are no signs of this high activity level slowing down in the foreseeable future. General partners (GPs) need to deploy record amounts of dry powder, and access to debt financing remains readily available. However, finding quality assets at an attractive price is no small feat as high buyout multiples persist. While year-to-date median EV/EBITDA multiples are slightly below 2017’s record high of 12.1x, they remain elevated at 11.9x.2 In addition, GPs are facing increased competition from strategic buyers flush with cash as a result of the recent corporate tax rate reduction.
Continued high purchase price multiples mean continued competition for attractive assets that meet a limited partner’s (LP’s) investment criteria at a reasonable price. As such, GPs have had to increase their focus on deal origination strategies and value creation strategies. While the majority of PE firms have some form of organized deal origination strategy, data has shown that those with large, proactive outbound origination programs are also top quartile performers across stage, vintage and sector. Specialization in particular industry verticals is imperative, as investment bankers do not want to waste time educating a potential buyer on an industry’s dynamics. Having a dedicated deal origination team frees up the investment team to implement value creation strategies that usually require more hands-on involvement and additional capital. With average investment holding periods of more than five years, a portfolio company’s economic standing can change dramatically with the right strategic initiatives.3
While exit count slid in the third quarter, total exit value remained on pace with prior quarters, and median exit size reached an all-time high. The exit environment should remain healthy through year-end, with several large deals expected to close. The initial public offering (IPO) market is gaining in popularity for PE exits. However, IPOs can be a double-edged sword for PE investors. Partial exits can provide investors with a higher multiple while remaining partially invested and continuing to participate in market upside. However, IPOs take longer to fully exit, which can substantially hinder gains.4
Fundraising has slowed through the first three quarters in terms of total fund closings and dollars raised. The average fund size of $855.2 million year to date is down from $975.5 million in 2017, the first drop since 2015. This decrease is, in part, due to a smaller number of mega-funds closing in 2018.5 LPs, however, have reported that they do not feel as though the PE fundraising market is slowing down. PE’s continued popularity has encouraged new managers and approaches. As such, investors have a greater variety of fund types to choose from, such as industry- or geography-focused funds.6
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. However, U.S. M&A activity and spending in September decreased by 8.3% and 33.9%, respectively, compared with August.7 According to a survey by EY, geopolitical, trade and tariff uncertainties have caused some dealmakers to pause. As such, the year will likely finish with much weaker M&A than how it started. However, EY forecasts that M&A activity will pick up in the second half of 2019, as the majority of respondents believe that global economic prospects are getting better.8
Overall, the U.S. economy continues to be generally healthy, with solid growth surrounding leading market indicators and the labor market. All eyes remain on the FOMC regarding further rate hikes, with several forces indicating increased support, including this year’s earlier tax cuts and a worsening federal budget deficit. Meanwhile, in the credit markets, rising interest rates have led to an accommodating lending market, with lenders increasingly reporting loosening standards and C&I loans on the rise. As the market faces one more rate hike in 2018 and three more in 2019, borrowers with floating rate debt need to expect their interest rate obligations to continue growing over the next one to two years and determine how to address this. Finally, market volatility has made PE a more appealing asset class for many investors, resulting in record dry powder and fierce competition that shows little signs of waning. To stand out, investors are forcing themselves to deliver differentiated deal origination and value creation strategies. In the M&A space, activity has slowed in the second half of the year due to geopolitical, trade and tariff uncertainties but will likely pick up in the second half of 2019 thanks to optimism surrounding the global economy.
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© Brown Brothers Harriman & Co. 2018. All rights reserved. 2018.
6 Buyouts. October 8, 2018.