How long will the current environment of Loose Lending and High Valuations continue for middle market companies?

By Tom Goldblatt

Everyone involved in mergers and acquisitions, lending, or transaction support agrees that the last several years have been extremely favorable for middle market companies.  Both valuations and multiples of earnings are up over 50%, covenants have loosened significantly, and the total amount of debt and equity capital available for businesses is at record highs. However, as the stock market’s recent volatility continued through December, it appeared to many that change was beginning, and the premium on high-risk debt began to climb. Since that time, however, relative calm has returned to the markets.  The questions on everyone’s mind are how long will economic growth will continue and is it near the end? 

 

This article attempts to explore how we got here, reasons the current economic environment may change, and how the change is likely to occur.

 

How the Current Environment Developed

Multiple converging dynamics created the current economic environment.  Since the Great Recession, the U.S. economy has enjoyed what may become the most prolonged period of sustained economic growth in its history.  During the same period interest rates remained at extreme lows, driving investors to seek higher returns from riskier assets. A significant portion of business lending also shifted from regulated commercial banks to non-regulated private equity firms, hedge funds or BDC lenders.  As more investors competed over the same companies, valuations continued to rise.  The economic tailwind together with cheap, plentiful money has helped keep company defaults on commercial loans and losses on invested capital by acquiring companies at low levels, causing little reason for alarm.

Factors that can Impact the Current Environment:

Many potential triggers could change the current environment. 

·     Rising Interest rates: After years of keeping interest rates low, the Fed began making incremental rate increases over the past year. Increasing debt service alone may cause distress for some highly-leveraged companies. However, the more likely effect of higher rates will be tightening of the liquidity that has allowed companies to more easily absorb the loss of a significant customer, unexpected litigation, or warranty claims arising from a product defect. In the future, an event that might be a mere speed bump could quickly become a “bridge out” situation. Rising interest rates will also shift investment to less risky assets, thereby reducing investment capital for middle-market companies.

·     Slowdown in the Global Economy:  Although the United States economy continues to perform steadily, the outlook for growth in some of the world’s largest economies, such as China and the European Union, looks increasingly negative.  As we learned in the Great Recession, globalization has tied all economies together more than ever.

·     Political Instability in the World: Political instability is growing in many parts of the world, and investors hate political uncertainty. At any time, the challenge to President Maduro in Venezuela, on-going trade wars, Brexit uncertainty, or global cyber-security threats could trigger a change in investor confidence about the future and a rush to safety and lower risk.

·     Long Term Concerns about the U.S deficit:  During the current recovery, Congress and the President have done nothing to reduce the U.S. deficit. On the contrary, recent tax reduction legislation and the aging of the baby boom generation has increased that deficit, which will grow exponentially in the coming decades if Congress takes no action to control entitlement payments or increase revenue.  It is hard to have confidence that our government will solve these problems as ideological differences between Republicans and Democrats grow and the two parties engage in partisan warfare instead of seeking compromise solutions to those problems.

·     Likely recession in 2020:  Most economists are now predicting that the current expansion will run its natural course and end with a recession in 2020.  It is impossible to know if this timing is correct, but consensus continues to build that we are nearing the peak of the current cycle.

·     Increasing labor costs:  For many years following the Great Recession, labor was plentiful and cheap.  As we achieve full employment, wages will start rising while the growing cost of finding and keeping the best talent will reduce profit margins. 

·     Technology Disruption:   Technology and innovation continue to accelerate and cause disruptive economic change, such as online buying’s impact on brick and mortar retail stores.  The transition to electric vehicles, alternative energies, AI-based technologies, and driverless cars is in progress. The full effect of these developments on a wide variety of industries will be profound. Few industries will be immune.

How Will Change Occur?

The National Bureau of Economic Research states that the U.S. economy has experienced 33 distinct economic cycles of expansion and contraction between 1854 and 2009.  History also shows these changes are relatively sudden and steep. Our financial models and analyses become more sophisticated with each cycle. However, the psychology and emotion of investors continues to be the dominant factor in the economy, and the group psychology of markets can quickly cause stampedes.  In all the classic cases, such as the Dutch Tulip Mania in the 1600’s, the South Sea Bubble in the 1700’s, the stock market crash of 1929, and the beginning of the Great Recession in 2008, investors believed that growth would continue indefinitely until suddenly, it didn’t.  The “herd mentality” triggers a stampede to safety and away from the formerly favored investment, as nobody wants to be left holding a worthless asset. The end of the present cycle will inevitably occur.  We cannot predict either the nature or timing of the triggering event. However, we can predict that the end will come fast and hard. 

What Should Middle Market Company Owners Do Now? 

If your company is doing well, represents a substantial part of your net worth, and you’re not sure you want to wait for the next growth cycle to sell your company, you should begin the process of selling your company now while the economy is still healthy.  If you miss this cycle, you will have to work hard to survive many years of economic decline before your company’s value returns to its present level. 

If you cannot, or do not want to sell now, then you should begin taking action to strengthen your company’s balance sheet so that the company can weather the next storm.  The middle market companies that survive recessions are always the ones with the strongest balance sheets.

If your business is already facing challenges, or you are concerned about the next down cycle’s impact on your company, then quickly learn and understand all the strategic options available to you now, before you need them.  If you aren’t sure who to turn to for advice on those options, or who you can trust, contact us at Ravinia Capital and tell us your story.  As a true advocate for company owners, we can quickly help you assess your situation, provide direction, and offer a myriad of strategic options and resources to help you achieve the best possible outcome.

Barry Snyder