Headline Trauma: What to Make of Daily Noise and Cycle Timing
By Scott Winship, Managing Director,
Waking up to the morning financial news has become a bit more “interesting” over the last several weeks given a return of significant volatility in the public markets, and a seemingly unending string of domestic economy and geopolitical headlines that swing wildly from fairly normal course to borderline insanity. When you mix in legitimate trade wars and discord between just about every branch of government (and the Fed), and the Alka Seltzer tends to come out of the drawer a lot earlier in the day than is typically the case. With massive daily market movements sparked by a historically broad set of drivers, it’s fairly straightforward to conclude that the M&A markets could be setting up for volatility of their own – after a very long period of sustained upward movement.
Dry Powder and the Potential Market Buoyancy Effect
Whereas markets, by definition, are creatures of influence, it’s important to insulate away from the lunacy of the daily headlines, as a much smaller set of fundamental forces will continue to be the ultimate arbiter of health and receptivity in the M&A markets. From an investment banker’s vantage point in the middle market, it’s fair to state that deal activity and investor interest (both financial and strategic) continue to be very strong – despite the fact that the current M&A cycle has outkicked historical cycle duration by almost two years. Given the long cycle tail, many market observers are left wondering if something is different this time around. In the middle market, there is absolutely no doubt that the meaningful expansion of the private equity asset class (both in the sheer number of funds and the persistent down-market movement of funds that historically focused on larger deals) has created a market buoyancy effect that simply has not existed before. When factoring in a prolonged zero-ish interest rate environment that has effectively eliminated returns in the fixed-income markets, and inconsistent, low returns in public equities, it doesn’t require heavy calculus to line out why alternative investments and their 20%+ return targets have drawn massive and consistent LP attention.
To the point, industry data sources indicate that roughly $650 billion of uninvested private equity capital is available for deployment in the U.S. alone – with both new and existing PE firms raising new funds at their hard caps, with increasing frequency, and in record times. If you apply a 50/50 transaction capital structure assumption to the sideline equity pool, you’re now talking $1.3 trillion of domestic buying power that has to get to work. By any examination, that is simply a tremendous amount of primed capital, and an all-time record level for immediately deployable funds.
Risk Always Lurks in the Background
Despite this record level of deployable capital, it would be naïve to assume that sheer volume, in and of itself, could act as a perfect insulator. One only has to look back a mere 10 years to get the stark reminder of what an exogenous system shock can do to immediately crater the markets. On a less draconian note, a creeping interest rate environment, which has indeed begun to materialize in 2018, will assuredly impact the market as the flow-through of rates to capital structure frames and valuation is awfully close to perfectly correlated. Moreover, if an advancing rate environment tilts the economy into recession, then a larger (macro) package of transactional resets will emerge. As such, regardless of new and/or different market internals, there is no panacea for structural risk.
Is It Different This Time Around?
With the understanding that we can’t genetically modify risk out of the transaction markets, the lingering curiosity centers around the notion that current capital state might create a different (i.e., muted) outcome when increased risk reemerges. Therefore, when contemplating a technical excess of uninvested capital, the next “normal” market turn may in fact be characterized by higher lows than we have seen in past cycles (i.e., the “buoyancy” factor). In other words, the visible premium that has unequivocally resulted from capital deployment pressure over the last several years may remain somewhat intact and slide down the scale with the market, as opposed to simply evaporating. Again, the overhang has never existed at this level of absolute scale, and this is where it could be different this time.
Just like the scary guy with the scythe and the arrival of the tax man, certain things are annoyingly unavoidable in this world, and market cycles are in the same unsavory fraternity. That said, the old saw with the instruction to “get while the gettin’s good” hits with particular force here in Q4 2018, as the markets remain strong, active and efficient, in defiance of historical timing norms. However, we would strongly caution against making assumptions that future market reversals will be met by a softer landing. Theories are called theories for a reason, so if contemplating a strategic or financial transaction, distinct focus should be applied towards efficient execution of administrative housecleaning, lining up substantive discussions with transaction advisors (financial, legal and tax) and making the appurtenant preparations for market entry. Although the visible horizon remains clear, we are materially closer to a market down stroke than we are further away, and that known should absolutely factor into a transaction-oriented decision making process.