January 2023

Is Singing on Sunday gonna save our soul… now that Saturday’s gone?

New year, new market opportunities! Looking back at 2022 and forward to the year ahead, our office wanted to share with our friends and colleagues where we see potential challenges and opportunities over the next 12 months.

M&A

While record M&A transaction volume from 2021 carried over into the first half of 2022, the punchbowl was ripped away in the second half of 2022 when interest rates jumped from “0” bound to 4.5%1 The leveraged loan market (“jet-fuel” for Middle-Market M&A) was FROZEN. Now 8% is the new “4%” if you can get a bid. In the current environment, we believe there is a clear distinction between two types of companies: the Sunday “saints”, who will continue to transact at attractive valuations, and the Saturday “sinners”, who will keep singing on Sunday with hopes the market will be friendly toward them and the Saturday sins are forgiven.

“Saints,” companies with sustainable revenue growth and consistent profit margins, have and will maintain premium valuations, driven by the expiration date on approximately $2 trillion in private equity and venture capital liquidity (S&P Global Market Intelligence) and flush corporate balance sheets. This trend will continue to hold from 2022, when transaction volumes for businesses with “above average financials” increased as a share of total transaction volume from 64% to 71% year over year and maintained multiple premiums over lower quality companies (GF Data). Lower and middle market companies that have a FastPass through St. Peter’s golden gates will continue to outperform the cyclical and highly interest rate sensitive “sinners” who partied way too hard during the two-year long “Saturday” of rich valuations.

Unfortunately, those companies with high cyclicality and interest rate sensitivity are in many cases already feeling the effects of subdued (and increasingly negative) revenue trends and significant profit margin pressure. Although inflation of supply chain and physical goods costs has by and large subsided, the cost of labor is still working through the expense side of the ledger. In a slow/ no-growth economy, the pricing power that allowed most businesses to offset cost inflation over the last few years is no more. The best-case scenario in these industries is to ‘ride out the storm’, innovate, and be much more judicious with capital availability and operating costs. The bear case is real distress for businesses that were structured for continued growth only to find themselves in one of Dante’s eight circles; think real estate and derivative industries of all stripes. The refinance (or just plain finance) cliff is here and now, and the cost inflation over the last two years isn’t likely to turn fast enough to be of much help.

The Short Version:

The overall economy will muddle along, and inflation will continue to cool, but rates won’t come down fast enough enough to bail out highly leveraged businesses in cyclical asset classes. Choose your battles wisely and pray the hangover from Saturday abates!

General Investing Outlook:

A generation of interest rates at “no to low” yield has created a host of institutional and retail investors who are conditioned to low opportunity cost for holding “risk on” equity or similar illiquid assets versus low-yielding fixed income (also known as TINA, There Is No Alternative). The Fed’s incredible efforts to tame inflation by hiking the Fed Funds rate from .25% to 4.5% inside of 12 months have turned markets on their head and today the era of TINA has been usurped by TONY (Treasuries Offer Notable Yields)! There has certainly been a time lag, but it is our belief that both private and public markets will see substantial revisions to long-term asset allocation in early 2023 in order to lock in lower-risk, interest bearing debt investments and reduce “riskier” equity allocations. We believe that this allocation shift towards fixed income will effectively put a lid on public company valuations, especially in the most interest rate sensitive (highly leveraged) sectors like real estate and high-growth/low-profit tech companies, and that return profiles for markets will be much more subdued than the double-digit annualized ‘risk / equity portfolio returns realized over the prior decade.

Action Item:

If you haven’t already, chat with your commercial banker about yields on liquid deposit accounts! As we enter a relatively high yield environment, banks are getting more competitive with deposit terms.

Another consequence of falling equity market valuations will be that the tailwind of rising asset values that has cushioned some of the economic turbulence of the last few years will dwindle. Even so, demand for labor driven by infrastructure spending, commodity re-investment, and an aging population means a pretty positive outlook for a majority of the working-class economy. However, there will likely be a long and painful downturn for more white-collar industries as businesses focus on getting their administrative and overhead costs under control and develop strategies to address the reality of slower (or negative) revenue trends and margin compression. This is going to be especially difficult for companies who relied on high leverage, “growth at -0- interest rates forever” business plans. Americans (and much of the rest of the developed world) had a huge party for the last couple of years spending on “wants and luxuries” vs “needs” (roads, bridges, cleaner energy!) – that cruise liner is turning in and has run out of booze.

Overall, look for the S&P 500 ten-year annualized trailing return of 12.5% to revert to the 100-year mean of approximately 8% – this will be a LONG-TERM headwind! Probably time to rebalance our own portfolios!

In the News

The price of risk has been re-set… and it’s 11.25%! In an arms-length transaction, the University of California invested $4B at a “questionable” current market price of Blackstone Real Estate Income Trust’s (BREIT) common shares (privately valued at an “8.4%” return in 2022 vs NAREIT Index -35% – who’s right?) but is guaranteed a five-year return of 11.25% annually. This return is directly collateralized by $1 billion in Blackstone (BX) owned shares in BREIT, with the remainder of risk on an unsecured basis (BX is rated A+ by Fitch). This is a VERY telling data point in that it is a bit of a proxy for what a “preferred return” hurdle clears in today’s market—which surprisingly was at an extraordinary rate of 11.25%!!! The price of poker went way up, and puts into question what re-pricing risk exists in Institutional Real Estate and other stressed industries…