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 and mergers and acquisitions (M&A) markets. The following article addresses the economic roller coaster of 2020, shifting lending standards since the onset of the COVID-19 pandemic and private equity deal activity over the course of the year.
To say the U.S. economy has been on a roller coaster in 2020 would not do it justice. GDP declined a record 31.4% (on an annualized basis) in the second quarter, only to rebound by 33.1% in the third quarter. Even after bouncing back, however, GDP now stands 3.5% below its fourth quarter 2019 level. The strength and resilience of personal consumption is driving a solid recovery from the pandemic recession, but the economy has not returned to pre-COVID-19 levels of output, and the pace of recovery is slowing.
Trends in the labor market, however, paint a slightly less rosy picture. After losing 22.1 million jobs in March and April this year, the U.S. has regained 12 million jobs through October. Still, the economy has 10 million fewer jobs than it did in February (an almost 7% drop). First-time claims for unemployment, which had been running just above 200,000 per week (near an all-time low) early this year, jumped to almost 7 million in March. Claims have been declining but are still averaging near 800,000 per week. There were 7.3 million continuing claims for unemployment as of November 12 vs. 1.7 million in early March. The unemployment rate continues to decline, showing ongoing positive momentum in the labor market, but at 6.9% (as of October) stands at almost twice its February level of 3.5%.
The difference between the fate of the labor market and GDP is, of course, the massive amount of government stimulus bestowed upon the economy through the CARES Act, though this support has started to wane. Enhanced unemployment insurance, for example, ended in July, and the Paycheck Protection Program (PPP) ended in August. Those programs clearly had a positive impact on personal consumption, and thus GDP, but with expectations for a divided government, the size of future stimulus is now thought to be lower.
The other effect of a divided government is that financial markets are now reassessing changes to the legislative agenda. Whereas both individual and corporate tax reform looked probable under a “blue wave” election scenario, a likely Republican majority in the Senate will likely prevent any substantial change on these fronts. The midterm elections loom large, however, with 20 Republican Senate seats up for grabs vs. only 13 Democratic seats.
We would be remiss if we didn’t mention the actions of the Federal Reserve in this update, since they had such a large (positive) impact on the real economy. What looked like it could have been a full-blown liquidity crisis a la the 2008-09 financial crisis was quickly quelled by the Fed with the announcement of a plethora of liquidity support programs. Even without actual deployment of the dollars the Fed dedicated to each program, the programs had an immediate effect and have since restored the flow of credit in the economy, a necessary ingredient for any economic recovery.
Looking ahead, we expect the pace of economic recovery in the U.S. to be dominated by the country’s success in solving the COVID-19 crisis. Fiscal stimulus can be a factor, but with case counts in the U.S. spiking and potential vaccines on the horizon, the nation’s public health outlook seems the more dominant element. Lastly, beneath the surface of countrywide GDP and employment figures, there are stark differences in how certain sectors and geographies of the country have fared, and these dynamics will continue to play themselves out. The travel and leisure industries, for example, have been decimated by the virus, as have traditional brick-and-mortar retailers; however, companies that benefit from the shift from offline to online consumption have generally fared well. Many CEOs have remarked on recent earnings calls that the economy has seen the acceleration of five years of ecommerce trends in the span of six months.
The Credit Market
The Federal Reserve’s decision to enact a near-zero interest rate policy in March is expected to be its directive for the foreseeable future. In the Federal Open Market Committee’s (FOMC’s) November statement, the board cited economic hardship and uncertainty resulting from COVID-19 for its accommodative position and reaffirmed its commitment to using the Fed’s full range of policy tools to provide stability. Consistent with its dual mandate, the Fed stated it intends to maintain this strategy until inflation remains modestly above 2% for some time and the labor market rebounds. While a timeline for meeting these objectives is uncertain, a poll of all 17 surveyed Fed officials in September estimated rates will be kept near zero through at least the end of 2021, with 13 projecting rates would stay this low through 2023.
Corporate spreads provide information on how the market values risk and credit quality through the additional return required for providing capital to incrementally riskier borrowers. As shown in the nearby chart, at the end of March, spreads for high-yield bonds peaked at over 10% – reaching levels not seen since the 2008-09 financial crisis. As uncertainty regarding the pandemic arose, the premium between holding riskier high-yield issuances and A-rated bonds (deemed safest) grew to 8%; however, quick monetary and fiscal policy responses, such as resuming quantitative easing, zero interest rates, the PPP and the Main Street Lending Program, helped to partially quell the uncertainty. Spreads since then have contracted, and as of early November, the premium between A-rated and high-yield bonds has narrowed to 4%.
The below graph shows all commercial and industrial (C&I) lending to companies overlaid by the net percentage of U.S. banks tightening or loosening credit standards. Unsurprisingly, domestic banks reported increasing lending standards through the first half of 2020. The sudden rise in C&I loans between March and June represents increased utilization of bank credit lines and lending provided under government COVID-19 relief programs. More recently, the Fed published its third quarter “Senior Loan Officer Opinion Survey on Bank Lending Practices.” As of October, 71% of large and middle-market banks reported that they had somewhat or considerably tightened lending standards over the past three months, with the remaining 29% stating their standards remained unchanged. When asked the reasoning for higher standards, 88% cited less favorable or an uncertain economic outlook as somewhat or very important in their decision.
Lenders have accordingly adjusted lending terms to match the uncertain outlook of the economy, including increasing the spread on loans over a banks’ cost of funds, charging a higher premium for riskier loans and instituting more restrictive covenants and collateralization requirements. Additionally, given lower base rates, more institutions are adding interest rate floors to floating loans. Despite tightened credit standards, the low interest rate environment presents an opportunity for business owners to work with sophisticated banks to creatively structure debt facilities unique to their needs.
The Private Equity and Mergers and Acquisitions Markets
The first half of 2020 was turbulent for the private equity market as a result of the COVID-19 pandemic. Due to the tightening up of credit availability and economic and market uncertainty, private equity managers turned their focus to triaging the immediate issues facing their portfolio companies, such as liquidity and covenant compliance. At the same time, fund managers and their employees had to navigate the nuances of conducting business virtually for the first time.
Steady deal activity in the first quarter of the year gave way to the challenges of the pandemic in the second and third quarters. Third quarter private equity deal activity of 3,444 deals worth $453.2 billion represented year-over-year declines of 16.2% and 20.6%, respectively. While activity remains depressed, third quarter deal count and value were both higher than the second quarter. This may suggest that the private equity market is recovering as managers adjust to the new normal.1 While most industry sectors faced headwinds from COVID-19, technology, media and telecom (TMT) showed resiliency as a result of the increased need for innovative, scalable technology.2 In addition, the pandemic has created a number of potential investment opportunities, such as assisting existing portfolio businesses, investing in emerging industries that have thrived in the current economic conditions and purchasing distressed assets.
Privately held company valuations remained high at 12.7x through the third quarter, the second-highest level recorded over the past 10 years.3 Valuations continue to be driven by the abundance of dry powder ($1.7 trillion globally as of July 2020) and accommodative debt financing markets.4 In addition, the pandemic has spiked prices as fund managers have focused on opportunistic investing and demand has increased in certain sectors, such as TMT.5
Conversely, the average EV/EBITDA transaction multiple for healthcare services declined significantly from the prior year. The healthcare services industry has been negatively affected in the short run by the COVID-19 pandemic, as both practices and patients avoided preventative checkups and elective treatments.6
Private equity activity is on pace to hit a 10-year low in terms of number of exits and an eight-year low in terms of value. Through the third quarter, U.S. private equity firms exited 576 portfolio companies worth $216 billion, representing year-over-year declines of 29.3% and 23.6%, respectively. However, as a result of Joe Biden winning the presidential election, the potential change in tax policy (increased taxes on carried interest and top marginal earners) may drive general partners to exit their portfolio companies sooner than planned.7
Through the third quarter, 167 funds closed on $127.6 billion, representing 27.4% and 42.7% reductions vs. the prior year. While this is a sharp decline, 2019 was a record-setting year, with over a dozen mega-funds closing. As such, 2020 was already slated to be a slower year for private equity fundraising.8 The COVID-19 pandemic has thrown a wrench into traditional fundraising, which used to require a more personal touch. Fund managers now need to conduct meetings with potential investors virtually. Decisions are being made without in-person meetings, something unheard of pre-COVID-19.
M&A activity rebounded in the third quarter as corporates and financial sponsors turned to the middle market to complete deals. Some M&A is being pursued as firms try to take advantage of opportunities presented by the pandemic, while other firms are engaging in M&A activity as a defensive measure to survive. The presidential election and whether or not there will be a stimulus package will set the stage for M&A activity into 2021.9
Overall, we will continue to monitor the slowing economic recovery in the U.S., but expect the pace to be largely driven by how the country resolves the COVID-19 crisis. In the credit markets, while lenders have tightened their credit standards, low interest rates still present an opportunity for business owners to seek out debt facilities unique to their needs. Finally, in the private equity market, there are signs that managers are adjusting to the new normal, with activity rebounding in the third quarter following a difficult second quarter.
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2 “Private Equity Deals Insights: Midyear 2020.” PricewaterhouseCoopers.
5 Institutional Investor.