The Business Environment Q3 2022

  • Private Banking
Thomas Martin, Neriah Ray-Saunders and Christine Hourihan provide an overview of the economy, credit markets and private equity and mergers and acquisitions markets

In each 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 rising interest rates and surging inflation, continued loosening lending standards and the slowdown in the PE and M&A markets.

The Economy

The first half of 2022 was a sea change for the U.S. economy and markets in several ways. Financial, economic and geopolitical trends that have been in place for years or decades have abruptly reversed course, and the knock-on effects are still being sorted out. The economy is dealing with the effects from rising inflation and interest rates, a war in Europe, a lingering pandemic and, more recently, meaningful declines in financial asset prices.

Looking back, inflation readings clearly began to accelerate over the course of 2021, but it was initially unclear what portion of inflation would be transitory and what might prove to be longer lasting. It stood to reason that certain categories of goods had skyrocketed in price but might come falling back down as the pandemic waned and consumption patterns returned to pre-COVID-19 norms. Instead, it became increasingly clear that things like labor shortages and supply chain issues, to name just a few, were going to be at least medium-term issues the economy had to deal with, and price levels continued to rise accordingly. Starting in the second half of 2021, energy costs began to run materially higher than core inflation, which only accelerated further after Russia’s invasion of Ukraine earlier this year. Year-over-year inflation readings for both the Consumer Price Index (CPI) (9.1%) and Core CPI (5.9%) are near 40-year highs.


Chart illustrating CPI and Core CPI from 2016 through June 2022. The latest figures are 9.1% for CPI and 5.9% for Core CPI. If you are in need of the data found in this graph, please contact BBHPrivateBanking@bbh.com.

Over the course of 2021 and into 2022, these inflation developments have spurred the Federal Open Market Committee (FOMC) to take its inflation-fighting responsibilities increasingly seriously. In an effort to combat inflation by slowing the economy, the FOMC has hiked the federal funds rate by 2.25%, and estimates call for rates to rise an additional 1.00% this year to over 3.25%, a level not seen since early 2008. This all stands in stark contrast to the past 10 to 15 years, when the Federal Reserve lowered overnight interest rates to zero and came up with increasingly novel ways to stimulate the economy to meet its 2% inflation target. While the history books have not yet been written on this era, several factors have likely contributed to the recent surge in inflation, from the pandemic itself and the changes in consumption patterns it caused, to years of zero interest rates, the waning deflationary benefits of globalization and, more recently, the $5 trillion of COVID-19-related stimulus deployed into the economy in 2020 and 2021.

The surge in inflation and rates has had a profound impact on asset prices, which threaten to further affect the economy through the wealth effect. In the past 40 years, where declining inflation has been the trend, both equities and fixed income have performed better than long-term averages. Moreover, during periods when rates have risen, it has typically been a sign of a strong economy, and rising equity values have offset declines in fixed income. What is unusual about the current state of financial markets is that both equity and fixed income have sold off in tandem. Year to date, equities are down 20.0%, while the Barclays Aggregate Bond Index is down 10.4%. A 50/50 equity/fixed income balanced portfolio is down over 15% year to date in 2022, the third worst drawdown on record. The other two drawdowns came during periods when the equity market was down substantially more than it is today.

The question now is, how hard will the Fed have to push to get inflation in check, and what will the resulting impact be to economic growth? Most forecasters seem to be calling for at least a mild recession sometime in 2023; however, we believe macro forecasts are notoriously difficult. There are certainly reasons to believe the Federal Reserve may be able to engineer a “soft landing,” such as the strength of corporations (high profit margins and cash reserves) and consumers (record-high savings) providing a buffer against an increasingly hawkish Fed. While the U.S. economy appears quite strong at the moment and has certainly grown through periods of interest rates higher than this, the Fed has raised rates at an aggressive pace, is shrinking the size of its balance sheet (that is, undoing its many years of quantitative easing) and may very well need to do more. There does not seem to be a great historical precedent for the current set of circumstances facing the U.S. economy, so incoming economic data will be especially important to monitor going forward. Most recently, the Employment Situation Summary from the U.S. Bureau of Labor Statistics indicates that the U.S. economy added 372,000 jobs in June, average hourly earnings grew at a 5.1% year-over-year clip, and the unemployment rate held steady at 3.6%. While the current data shows little to no signs of an impending recession, it increases the odds of more hawkish monetary policy from the Fed.

The Credit Market

The FOMC must carefully assess the stance of its monetary policy while prioritizing both maximum employment and a stable long-run inflation rate of 2%. The U.S. economy continues to improve, and unemployment rates have nearly returned to pre-pandemic levels. However, “inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices and broader price pressures,” as stated in the FOMC’s June 15 statement. As discussed in the Economy section, as short-run inflation continues to exceed the Federal Reserve’s 2% goal, the FOMC will continue to moderate its accommodative policy to stabilize pricing while remaining highly attentive to pressures caused by the invasion of Ukraine by Russia and COVID-19-related lockdowns in China. 


Date

Core CPI

CPI

7/31/2016

2.1894

0.8271

8/31/2016

2.319

1.0629

9/30/2016

2.2074

1.4638

10/31/2016

2.1448

1.636

11/30/2016

2.1108

1.6925

12/31/2016

2.1967

2.0746

1/31/2017

2.2717

2.5

2/28/2017

2.2236

2.738

3/31/2017

2.002

2.3806

4/30/2017

1.8827

2.1997

5/31/2017

1.7334

1.8749

6/30/2017

1.703

1.6335

7/31/2017

1.6921

1.728

8/31/2017

1.6844

1.939

9/30/2017

1.6926

2.233

10/31/2017

1.7736

2.0411

11/30/2017

1.7113

2.2026

12/31/2017

1.7758

2.1091

1/31/2018

1.8214

2.0705

2/28/2018

1.8476

2.2118

3/31/2018

2.1171

2.3597

4/30/2018

2.1391

2.4627

5/31/2018

2.2372

2.801

6/30/2018

2.255

2.8716

7/31/2018

2.3542

2.9495

8/31/2018

2.1992

2.6992

9/30/2018

2.1697

2.277

10/31/2018

2.1389

2.5225

11/30/2018

2.2143

2.1766

12/31/2018

2.179

1.9102

1/31/2019

2.1537

1.5512

2/28/2019

2.0842

1.5201

3/31/2019

2.0366

1.8625

4/30/2019

2.0648

1.9964

5/31/2019

1.989

1.7902

6/30/2019

2.1265

1.6485

7/31/2019

2.2101

1.8115

8/31/2019

2.3863

1.7498

9/30/2019

2.3577

1.7113

10/31/2019

2.3145

1.7641

11/30/2019

2.3168

2.0513

12/31/2019

2.2587

2.2851

1/31/2020

2.2612

2.4866

2/29/2020

2.3568

2.3349

3/31/2020

2.0914

1.5393

4/30/2020

1.4322

0.3291

5/31/2020

1.2221

0.1179

6/30/2020

1.1874

0.6457

7/31/2020

1.5696

0.9861

8/31/2020

1.7364

1.3096

9/30/2020

1.7133

1.3713

10/31/2020

1.6106

1.1821

11/30/2020

1.6465

1.1745

12/31/2020

1.6197

1.362

1/31/2021

1.4101

1.3998

2/28/2021

1.2826

1.6762

3/31/2021

1.6464

2.6198

4/30/2021

2.961

4.1597

5/31/2021

3.7976

4.9927

6/30/2021

4.4746

5.3915

7/31/2021

4.2745

5.3655

8/31/2021

4.0003

5.2513

9/30/2021

4.0252

5.3903

10/31/2021

4.5628

6.2219

11/30/2021

4.9285

6.809

12/31/2021

5.4534

7.0364

1/31/2022

6.0206

7.4799

2/28/2022

6.4142

7.8711

3/31/2022

6.4745

8.5424

4/30/2022

6.1606

8.2586

5/31/2022

6.0215

8.5815

In addition, the Federal Reserve began reducing its Treasury and mortgage bond holdings in fourth quarter 2021. It will continue reducing the portfolio by $47.5 billion per month initially, and this figure will increase to $95 billion monthly by September 2022 in an effort to cut down its approximately $9 trillion balance sheet. The FOMC will continue to monitor implications of the economy’s outlook in assessing its monetary policy going forward, adjusting as appropriate if public health conditions, labor markets, international developments and inflation expectations pose a risk to the Fed’s long-term goals for the U.S. economy.

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 (CCC-rated and below), BBB and A bonds peaked at near 11%, 5% and 3.25%, respectively, similar to patterns shown during the Great Recession (albeit high-yield, BBB and A rates peaked at 20%, 8% and 6.5%, respectively, in 2008). Given quick and accommodative monetary and fiscal policy responses and a recovering economy, spreads declined throughout 2020 and 2021. However, spreads have increased since the start of 2022 due to the geopolitical turmoil and rising risk-free interest rates, which increases the cost to borrow to purchase risk assets as well as the rate at which future cash flows from risk assets are discounted. Despite the increase, spreads for bonds rated high yield, BBB and A are at or near 25-year historical daily averages of approximately 5.5%, 2% and 1.3%, respectively.


Chart displaying corporate spreads by quality (A, BBB and high yield) from 12/31/2010 through 6/22/2022. If you are in need of the data found in this graph, please contact BBHPrivateBanking@bbh.com.

The nearby graph shows commercial and industrial (C&I) loans outstanding to U.S. 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 quarterly “Senior Loan Officer Opinion Survey on Bank Lending Practices.” As of first quarter 2022, a net 1.5% of domestic banks loosened standards, making it the fifth straight quarter of loosened lending standards, suggesting domestic C&I lending remains in a borrower-friendly environment. Most banks increased the maximum size of credit lines to firms of all sizes, while a moderate portion reduced loan spreads on credit lines. Anecdotally, we are seeing domestic banks begin to tighten standards, indicated by the rate of change between fourth quarter 2021 and first quarter 2022 reducing to near 0%.


Chart displaying fluctuation in C&I loan issuance and tightening bank standards from 2008 to 2022. If you are in need of the data found in this graph, please contact BBHPrivateBanking@bbh.com.

A strong majority of banks that reported easing standards or terms on C&I loans cited more aggressive competition from other banks and nonbank lenders as the main reason for doing so. Most banks also mentioned an improvement in industry-specific issues, a more favorable and certain economic outlook and improvements in current or expected capital positions as motivators for creating a borrower-friendly lending environment. The survey reported strong demand for C&I loans across all firm sizes due to an increased need among customers for financing inventory, accounts receivable and investments in property, plant and equipment (PP&E). Conversely, a significant portion of foreign banks reported weaker demand and fewer inquiries compared to the prior quarter.

The Private Equity and Mergers and Acquisitions Markets

As the U.S. economy faced unprecedented challenges over the past several years, the private equity industry continued to fare remarkably well. While PE managers faced their fair share of COVID-19-induced volatility, it can also be said that the pandemic “sped things up” in the asset class. At the fund level, traveling less to meet management teams and investors has made general partners (GPs) more efficient. At a macro level, investors have greatly benefited from the monetary stimulus that central banks have pumped into the global economy since March.1 While 2021 was an extremely active year in terms of dealmaking, exits and fundraising, 2022 got off to a tepid start due to fresh challenges, including the threat of higher interest rates and geopolitical tensions stemming from Russia’s invasion of Ukraine.

After an extraordinary year of deal activity in 2021, PE deal activity slowed in 2022 but remains on course for a healthy year by historical standards. During the first half of the year, 4,337 deals closed for a combined value of $529.2 billion. Many of these deals were negotiated in 2021 or early 2022, before the current macroeconomic backdrop turned so bearish. Russia’s invasion of Ukraine (and the threat of further escalations), supply chain disruptions and labor shortages at portfolio companies pushed dealmakers to hit pause for several weeks. Going into the latter half of the year, closed deal activity is expected to diminish, as announced deal flow has slowed.2

The looming threat of higher interest rates also pressured dealmaking activity during the first half of the year. Over the past 20 years, investors have benefited from a downward trend in interest rates. As inflation continues to rise, the Federal Reserve is slated to combat rising prices by lifting interest rates several times during the year. PE managers who have greatly benefited from the run-up in multiples over the past two decades risk the opposite if valuations flatten out. In addition, inflationary cost pressures and the resulting margin pressure pose a threat to portfolio companies.3

While PE activity is unlikely to regain the same momentum it had in 2021 in the near term, events over the past two years have proven that PE managers are exceptionally deft at reacting to unprecedented challenges.


Year Deal Value ($B) Deal Count
2012 $373.60
3,554
2013 $427.40 3,383
2014 $526.40 4,235
2015 $488.30 4,513
2016 $585.30 4,549
2017 $651.30 5,004
2018 $732.70 5,814
2019 $750.70 5,929
2020 $687.60 5,908
2021 $1,231.90 9,171
2022 $529.20 4,337

As with deal activity, U.S. private equity exit activity slowed in 2022. In the first half of the year, 577 PE-backed companies were exited, with a cumulative exit value of $189.8 billion. This sharp decline from the exit activity at the end of 2021 can be blamed on prolonged inflation, geopolitical conflict and subsequent market volatility. Public listings, which drove the record exit activity seen in 2021, essentially disappeared as PE firms held on to their portfolio companies amid stock market declines and valuation adjustments. In addition, the U.S. Securities and Exchange Commission’s newly proposed rules to expand special purpose acquisition company (SPAC) regulations threw another wrench into the exit environment.4


Year Exit Value ($B) Exit Count
2012 $265.60
1,057
2013 $304.70 980
2014 $376.60 1,214
2015 $362.60 1,273
2016 $337.30 1,191
2017 $374.10 1,269
2018 $419.50 1,402
2019 $339.20 1,276
2020 $378.30 1,106
2021 $885.20 1,811
2022 $189.80 577

The overall fundraising environment for buyout and growth equity managers remains favorable. However, GPs are battling for limited investment dollars, as a number of fund managers are currently raising capital and seeking sizable step-ups. The current fundraising demand from GPs is simply overwhelming LPs’ ability to supply capital Not only are there more funds fundraising than ever, but many funds are also fully deploying in three years or less, rather than following a four- to five-year drawdown period. LPs’ pipelines are completely full, and the general consensus is that most institutional investors, despite increasing their allocations to PE, will be fully committed for 2022 by midyear. In addition, the slowdown in PE exits is likely exacerbating fundraising challenges for GPs, as a significant amount of capital that LPs receive from distributions are recycled back into future funds.5


Year Capital Raised ($B) Fund Count
2012 $101.70
218
2013 $150.70 306
2014 $170.40 462
2015 $146.90 430
2016 $200.80 452
2017 $255.30 503
2018 $212.90 465
2019 $329.50 526
2020 $285.20 552
2021 $339.80 577
2022 $176.00 191

North American M&A experienced a slight decline in both value and volume in the first quarter due to higher interest rates, lower valuations and higher borrowing costs. Approximately 4,739 deals closed for a combined value of $611.3 billion, a roughly 20% decrease in both deal count and value from the prior quarter. Even with this dip, M&A activity was in line with that of the past five years, as dealmakers are still finding growth opportunities despite market volatility and valuation adjustments. The Biden administration’s aggressive pursuit of antitrust law enforcement could discourage larger M&A deals going forward due to the uncertainty over impending regulations and potential delays in deals.6


Year Deal Value ($B) Deal Count
2012 $$220.00
2,083
2013 $221.00 2,024
2014 $408.00 2,572
2015 $369.00 2,678
2016 $459.00 2,474
2017 $335.00 2,489
2018 $428.00 2,328
2019 $359.00 2,449
2020 $243.00 2,283
2021 $443.00 2,921
2022 $57.00 557

The past several years have seen a fundamental shift in focus within PE when it comes to environmental, social and governance (ESG) considerations. Sustainable investing has moved from the periphery to a core tenant of fund strategies. Firms are using ESG criteria not just to assess risks and identify value creation opportunities, but also to manage their portfolio, hire and retain talent and ultimately deliver a better investment at exit.7 In BDO’s “Private Capital Pulse Survey” conducted in spring 2022, half of the 200 U.S. private equity fund managers surveyed said that ESG investments were their top choice for where they planned to direct the most capital. Fund managers now see the value that ESG considerations can yield in deal, fund and portfolio activities. Traditional methods of value creation have been challenged by the high valuation deal environment, forcing fund managers to identify new ways to seek a return on their investments.8 While most agree that ESG is here to stay, GPs and LPs are now grappling with how to consistently evaluate ESG performance across portfolios.

Up Next
Up Next

A Balancing Act: Transferring Shares in a Private Business to the Next Generation

Ali Hutchinson, a BBH senior wealth planner, and Ben Persofsky, the executive director of the BBH Center for Family Business, discuss the different methods for transferring shares in a private business to the next generation and cover the implications families need to consider from both a corporate and tax angle.

1 “Global Private Equity Report 2022.” Bain & Company.
2 PitchBook.
3 “Global Private Equity Report 2022.” Bain & Company.
4 PitchBook.
5 Ibid.
6 Ibid.
7 “Global Private Equity Responsible Investment Survey 2021.” PricewaterhouseCoopers.
8 “BDO Private Capital Pulse Survey – Spring 2022.” BDO.

Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2022. All rights reserved. PB-05523-2022-07-06

As of June 15, 2022 Internet Explorer 11 is not supported by BBH.com.

Important Information for Non-U.S. Residents

You are required to read the following important information, which, in conjunction with the Terms and Conditions, governs your use of this website. Your use of this website and its contents constitute your acceptance of this information and those Terms and Conditions. If you do not agree with this information and the Terms and Conditions, you should immediately cease use of this website. The contents of this website have not been prepared for the benefit of investors outside of the United States. This website is not intended as a solicitation of the purchase or sale of any security or other financial instrument or any investment management services for any investor who resides in a jurisdiction other than the United States1. As a general matter, Brown Brothers Harriman & Co. and its subsidiaries (“BBH”) is not licensed or registered to solicit prospective investors and offer investment advisory services in jurisdictions outside of the United States. The information on this website is not intended to be distributed to, directed at or used by any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. Persons in respect of whom such prohibitions apply must not access the website.  Under certain circumstances, BBH may provide services to investors located outside of the United States in accordance with applicable law. The conditions under which such services may be provided will be analyzed on a case-by-case basis by BBH. BBH will only accept investors from such jurisdictions or countries where it has made a determination that such an arrangement or relationship is permissible under the laws of that jurisdiction or country. The existence of this website is not intended to be a substitute for the type of analysis described above and is not intended as a solicitation of or recommendation to any prospective investor, including those located outside of the United States. Certain BBH products or services may not be available in certain jurisdictions. By choosing to access this website from any location other than the United States, you accept full responsibility for compliance with all local laws. The website contains content that has been obtained from sources that BBH believes to be reliable as of the date presented; however, BBH cannot guarantee the accuracy of such content, assure its completeness, or warrant that such information will not be changed. The content contained herein is current as of the date of issuance and is subject to change without notice. The website’s content does not constitute investment advice and should not be used as the basis for any investment decision. There is no guarantee that any investment objectives, expectations, targets described in this website or the  performance or profitability of any investment will be achieved. You understand that investing in securities and other financial instruments involves risks that may affect the value of the securities and may result in losses, including the potential loss of the principal invested, and you assume and are able to bear all such risks.  In no event shall BBH or any other affiliated party be liable for any direct, incidental, special, consequential, indirect, lost profits, loss of business or data, or punitive damages arising out of your use of this website. By clicking accept, you confirm that you accept  to the above Important Information along with Terms and Conditions.

 
1BBH sponsors UCITS Funds registered in Luxembourg, in certain jurisdictions. For information on those funds, please see bbhluxembourgfunds.com


captcha image

Type in the word seen on the picture

I am a current investor in another jurisdiction