Navigating Troubled Waters – The Current State of the Capital Markets

Cyrus Chin, Lawrence E. Wilson

Where is an investor to turn in the current economic climate? Public equity markets are trading around or below historic P/E averages even while yields on sovereign debt are near zero, and sometimes below.

Persistently low oil prices have driven deal flow to the lowest point since 2009 despite plenty of available investment capital. And banks are beset with low-for-long interest rates while they battle increased competition from new and unregulated lenders.

Public Equity and Debt

Take a look at stock markets around the world. The S&P 500 Index is trading near its historic high but the index P/E is near the historical average of 16x projected earnings. So what’s driving the index to new highs on historic earning multiples?

Maybe it’s the net reduction of the number of shares that you can buy since 2004. Stock buybacks, mergers and other transactions have removed $4.5 trillion in stocks from the market. Or maybe it’s the dividend yields of over two percent. The picture doesn’t get much clearer for emerging markets: they are undervalued and look like a bargain compared to their historic averages but they have been at this level for some time. Either way, the public equity markets do not look overpriced. Couple that with yields on U.S. government bonds that are around 1.6 percent, and yields on the sovereign debt of other creditworthy countries that are sometimes less than zero, and there is a perfect storm for the balanced portfolio.

Conclusion: modern portfolio theories—in which fixed income-yields offset the reasonable risk-weighted return of equity and alternative investments—are going to be on hold for a little while.

Private Equity Market

Middle-market M&A deal flow for the first six months of 2016 was at the lowest level since 2009. The perception is that the M&A market has two tiers, with a few transactions getting a lot of investor attention and others having trouble gaining any traction. Valuations have been affected in 2016 but remain healthy.

The other important consideration is the amount of funds available for investment, or dry powder, which is a combination of the undrawn commitments to private equity funds and the leverage that a transaction can support. Private equity has undrawn commitments of more than $500 billion and leverage ratios have been running at about 4.0x EBITDA. So every $1 of equity is matched with a $1 to $1.50 of debt. When you combine the undrawn commitments with the magic of leverage you realize there is somewhere around $1 trillion in dry powder available.

So why aren’t there more transactions? As in other years, and in the larger market generally, there is a real difference in the multiples commanded by a $10+ million EBITDA company compared to the multiples that a $5 million EBITDA company will receive. Maybe sellers that see a way to grow their company are holding back a little to capture the benefit of the size premium. And maybe there’s just enough uncertainty about the future for private equity funds to wait and see what is going to happen before chasing some transactions.

Conclusion: although there is an abundance of “dry powder” available for investment, as a result of the undrawn investment commitments to private equity and the increase in leverage that can be brought to bear, there simply are not enough transactions of the right size and right quality to put this money to work.

Commercial Loan Market

When the Federal Reserve raised the interest rate in December 2015, it was the first time in nearly a decade. There are people in the business world that have never seen a rate hike. However, interest rates remain low and there is a prevailing sentiment that they will remain low for awhile.

One of the drivers of the current interest rate environment is stagnant economic growth in the U.S. and other world economies. Almost every recession has been followed by robust growth. Not so with the recession of 2007 – 2009. Although we are currently in the third longest recovery since World War II, we have been limping along because of the anemic U.S. growth rate of 2.1 percent and lingering concerns over Europe and China. Even though we are in a seven-year recovery, there’s probably more downside risk in the U.S. economy than upside risk of long-running, robust recovery going forward.

In addition, a new class of investors is putting money into business development companies and other private credit sources that have economic and regulatory flexibility relative to commercial banks. As a result of these alternative lenders, the commercial banking segment has become increasingly more competitive, and borrowers can use that to their advantage.

Conclusion: borrowers should use the current climate as an opportunity to raise debt opportunistically when they can and not when they need it, extend maturity dates, reprice deals, and amend covenants to their advantage. Take up offers from bankers to go to lunch and keep all borrowing options open.