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 positive indicators for economic performance in 2021, trends in commercial and industrial (C&I) loan issuance and standards and the healthy PE environment.

The Economy

The U.S. economy has regained its footing and appears poised for significant growth in 2021. Our optimism stems from the triple tailwinds of healthy household finances, easy monetary policy and expansionary fiscal policy meeting a country that is emerging from the COVID-19 pandemic. After a record quarter in the third quarter of 2020, the economy posted solid gains of 4.3% in the fourth quarter and 6.4% in the first quarter of 2021. Looking ahead, the Atlanta Federal Reserve’s GDPNow estimate of second quarter GDP growth stands at 11.0% as of May 7. With GDP less than 1% off its fourth quarter 2019 high, the second quarter is likely to erase all remaining losses from the pandemic and put economic output at a new all-time high.

Various economic indicators also corroborate this optimistic view of growth. Vehicle sales and lumber prices, for example, are in a historic boom and are both emblematic of the strength of the U.S. consumer. In April a seasonally adjusted rate of 18.5 million new cars were sold, the strongest month since July 2005. New housing starts are at their highest level since 2006, and accordingly, lumber prices are off the charts. Lumber futures contracts, which traded at $495 before the pandemic, now stand at $1,670.¹

While many businesses have suffered as a result of the pandemic, much of this distress is centered on a handful of industries at the epicenter of crisis, and the U.S. corporate sector on the whole is strong. 2020 saw a wave of bankruptcies, though aggressive policy actions helped stave off the worst. As seen in the nearby table, a relatively small number of industries representing only 12% of the private sector saw output declines greater than 10% over the full year in 2020. All other industries were either down modestly or had already surpassed their pre-pandemic peak in output by the end of last year. Today, the corporate sector is well capitalized, and bankruptcies have returned to normal levels. Using the S&P Composite 1500, an index composed of small-, mid- and large-capitalization U.S. stocks, as a barometer, corporate earnings also appear strong. With the majority of the index reporting, first quarter 2021 operating earnings are expected to be up 27% over the two years since first quarter 2019.² Similarly, estimates call for full-year 2021 earnings to grow 21% vs. 2019.  

At this time, the consensus among Federal Reserve officials is that short-duration interest rates will remain unchanged through 2023. When to ultimately tighten monetary policy presents an interesting dilemma for the Fed. Acting too soon (or hinting at such) can cause a sudden rise in borrowing costs, straining economic growth. Waiting too long to act (or hinting at such) can allow inflationary pressures to build. Federal Reserve Chairman Jerome Powell plans to minimize such volatility by giving investors plenty of notice before enacting any changes to its bond-buying plans. Any cuts to the purchases would likely precede the first interest rate increase.

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 onset of the COVID-19 pandemic in March 2020, spreads for high-yield bonds (CCC-rated and below) peaked at over 10%, levels not seen since the Great Recession. The premium required to hold riskier high-yield issuances over A-rated bonds (deemed safest) peaked at 8.3% in March 2020 due to uncertainty related to the pandemic. However, this premium generally declined throughout the remainder of 2020 as a result of quick monetary and fiscal policy responses, ending the year at 2.6%. It has further declined in 2021 owing to continued accommodative monetary policy and fiscal stimulus coupled with a recovering economy, amounting to 1.7% as of the end of April 2021 – a premium low not seen since July 2014.

The nearby graph shows C&I lending to companies overlaid by the net percentage of U.S. banks tightening or loosening credit standards for C&I loans to large and middle-market firms. The net percentage data is based on the Fed’s first quarter “Senior Loan Officer Opinion Survey on Bank Lending Practices.” The trend of domestic banks increasing lending standards (instead of loosening them) persists, although the degree of which has steadily declined over the past two quarters, suggesting domestic C&I lending is approaching more of a borrower-friendly environment. The figure was 71% as of third quarter 2020, 38% as of fourth quarter 2020 and 6% as of first quarter 2021.

A strong majority of banks that reported tightening standards or terms on C&I loans cited three key reasons for doing so: a less favorable or more uncertain economic outlook, worsening of industry-specific problems and reduced tolerance for risk. Although a small majority of banks reported weaker demand for C&I loans to firms of all sizes, banks reported that inbound inquiries from potential borrowers about the availability and terms of new credit lines or increases in existing lines essentially remained unchanged from the prior quarter. Conversely, a small majority of foreign banks reported that both demand and inquiries compared favorably to the prior quarter.

The Private Equity and Mergers and Acquisitions Markets

While the 2020 market environment was quite volatile, private equity showed resilience in the face of strong headwinds. Fund managers quickly learned that their and their portfolio companies’ survival depended on their ability to swiftly adapt to the rapidly changing landscape. As the COVID-19 vaccination rollout continues, PE fund managers will once again need to pivot in order to adjust to another new normal. While a number of uncertainties remain, managers have entered 2021 with cautious optimism.

2021 U.S. PE deal making seems to have normalized after a turbulent 2020. First quarter 2021 deal activity of 1,763 deals worth $203 billion represented a decline from the high level of activity in fourth quarter 2020. However, these numbers represent a healthy deal-making environment, which is expected to continue due to pent-up demand. The potential hikes in personal and corporate tax rates have also spurned deal flow, as many business owners are looking to sell before these increases would take effect.⁴
 

While PE exit activity was on pace to hit a 10-year low as of third quarter 2020, the fourth quarter had a record-breaking rebound, and exit activity remained robust through the first quarter of 2021, when U.S. PE firms exited 289 portfolio companies worth $162 billion^.5 One reason for the healthy exit environment can be attributed to the range of exit options, including via special purpose acquisition companies (SPACs), also known as blank-check companies. While SPACs have become red hot over the past year, more SPAC IPOs priced in first quarter 2021 than all of 2020.⁶ PE firms have used SPACs as an avenue for exiting their portfolio companies, and about half of companies purchased by SPACs last year were owned by PE firms.⁷ Conversely, SPACs have also increased competition for deals in an already frothy market. It should be noted, however, that the number of SPACs entering the market dropped dramatically at the end of first quarter 2021.

The M&A market proved to be resilient through 2020. Compared to 2019, total M&A value and volume dropped 21% and 15%, respectively. However, the majority of the depressed activity was seen in the first half of the year. The second half of the year experienced a major uptick in deal activity, and total value during this time actually topped pre-pandemic levels. While uncertainty abounds, there are also a number of tailwinds in the market: Stock markets are at an all-time high, interest rates remain low, and GDP is poised for growth.⁹ Among U.S. executives surveyed, 53% said their companies planned to increase M&A investment in 2021.¹⁰

COVID-19 has also accelerated the importance of environmental, social and governance (ESG) considerations in both PE and M&A. The pandemic magnified a number of problematic societal issues rendering ESG considerations the right thing to do. According to Bain & Company’s 2021 Global M&A Report, “the year 2020 will be remembered as the one in which ESG assumed a prominent place among M&A criteria.” ESG considerations have gone from a “nice to have” to common practice. General partners have become more accountable to their shareholders and to their own employees. In addition to being good corporate citizens, firms have come to realize that incorporating ESG into due diligence can often translate into long-term success and value creation.

Conclusion

Overall, the U.S. economy appears poised for significant growth this year, thanks to healthy household finances, easy monetary policy and expansionary fiscal policy meeting a country that is emerging from the COVID-19 pandemic. Still, we will remain watchful of the next few months of employment data to make sure the April report was just a fluke. In the credit markets, a trend of domestic banks increasing lending standards has emerged over the past year. However, a slowdown in the pace with which this is happening over the past two quarters suggests a more borrower-friendly domestic environment may be on the horizon. Finally, in the PE market, fund managers have entered the year with cautious optimism following a turbulent 2020, with the deal-making environment healthy, exit activity robust and a fundraising activity rebound.