Author: cvernon

If They Build It, Buyers Will Come

Stalled sale processes have become the norm in the private equity market due to several factors, including a mismatch between buyer and seller expectations around price and interest rates. Private equity owners have been forced to pivot from the traditional leveraged buyout model, now taking on less debt as they look to create an asset that will be attractive to potential acquirers. One way to do this is to build a better business, including via add-on acquisitions, which have been growing as a proportion of buyout transactions for the last several years. In 2008, add-ons accounted for 50% of deal volume. In the first quarter of 2023, that amount was close to 80%.

Add-ons offer several benefits to private equity firms. First, they are an efficient way to expand and diversify a business’s geographical footprint, customer base, and product offering. Second, add-on acquisitions tend to be smaller businesses, and thus typically less expensive than larger platform investments, allowing the private equity manager to average down the total cost of the combined investment. Third, add-ons tend to be accretive, increasing revenue, EBITDA, and EBITDA margins. Taken together, with proper integration, the end business can become a more attractive acquisition target for both large private equity firms and corporations.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Will the Summer Heat Make the Market Sweat?

With June and the Treasury’s estimated X-date quickly approaching, the debt ceiling issue came to a head over the weekend. While the spending deal reached between President Biden and House Speaker McCarthy still needs to be approved by Congress, it is an important milestone in the U.S. avoiding its first-ever default. While that worst-case scenario would have had catastrophic impacts on the economy, markets — as measured by the CBOE Volatility Index (VIX), known as the fear index — remained relatively calm. The VIX is measured using option activity and gauges the market’s appetite for volatility. Usually, the market and the VIX are negatively correlated, meaning the VIX increases as markets go down. As shown in the above chart, during times of stress, including debt ceiling uncertainty, the VIX tends to be more dynamic, with sharper jumps and falls. With markets having spent the last year heavily focused on inflation, labor markets, and the path of interest rates, which now seem at least near the peak, debt ceiling negotiations were overall taken in stride by equity markets. It is generally accepted that a VIX level above 30 indicates more investor uncertainty, which we have seen reached multiple times over the last few years, though during the month of May, the VIX peaked around 20. As noted, while the House and Senate still need to consider the bill this week, the most likely outcome is the debt ceiling bill is signed into law before the U.S. would have had to default on its debt obligations, removing one more headwind for markets this year.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Secondaries Not So Secondary Anymore

Secondary market volume has grown from $37 billion in 2016 to a high of $132 billion in 2021. Despite macroeconomic instability, 2022 was still the second-highest year on record at $108 billion. The secondary market was initially dominated by LPs in need of liquidity, selling at a significant discount. Today, the secondary market is more institutionalized and the reasons for selling on the secondary market have expanded — only 10% of sellers are selling for liquidity reasons, while 64% of deals are done for portfolio management. The increase in GP-led transactions has also added to secondary market volume.

As the secondary market has grown significantly, the space has become increasingly undercapitalized. As shown in the top chart above, the ratio of dry powder to deal volume has steadily declined over the last several years, excluding 2020 when COVID hit deal volume. There is estimated to be only about one year of dry powder available to support the growing supply in the secondary market, well below the ratio in the buyout market. The limited amount of capital relative to secondary market volume has resulted in deals trading at significant discounts, as shown in the lower chart. Buyers can be more selective and have the opportunity to purchase high quality assets at a discount. From here, while there are still challenges given the level of macro uncertainty, there is a clear opportunity for investors active in the secondary market.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Raise the Roof

Investor questions continue to mount as the U.S. nears the Treasury’s estimated debt ceiling “X-date” of June 1. While there are some signs that progress is being made between President Biden and Republican leaders, the two sides still seem far apart on a deal to raise or suspend the country’s debt limit. Failure to do so would result in the U.S. defaulting on its debt for the first time and would have significant economic consequences. According to the Council of Economic Advisors, even a brief default could lead to the loss of half a million jobs, a 0.6% contraction in real GDP, and a 0.3% increase in the unemployment rate. An extended default would be even more dire, with a forecasted loss of 8.3 million jobs, a 6.1% reduction in real GDP, and a 5% increase in the unemployment rate.¹

As shown in this week’s chart, raising or suspending the debt ceiling has become a fairly common occurrence over the last several years, though the process can be political, contentious, and last minute. This week, amid continued talks between staff, President Biden and Speaker McCarthy, along with other congressional leaders, held a meeting both sides described as “productive.” Both parties are seeking a deal to prevent default, though agreeing on the details — future spending cuts, federal aid work requirements, and clawing back unspent COVID funds, among other Republican demands — remains a delicate process. Markets are closely following the debt-ceiling developments and, while the severity of consequences from a default will hopefully lead to a timely resolution, both equity and fixed income should brace for ongoing volatility from here.

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¹Council of Economic Analysis, The Potential Economic Impacts of Various Debt Ceiling Scenarios

It’s Getting Hot in Here

If global temperatures rise more than 1.5° Celsius the planet and its inhabitants could face severe consequences as a result of climate change. In 2022 — using temperatures from 1951–1980 as a baseline — the average global temperature rise was 1.4° Celsius, pushing the planet close to its tipping point. We are already experiencing more frequent and severe heatwaves, droughts, floods, and storms as well as rising sea levels and melting ice sheets. In fact, 2015–2022 were eight of the warmest years on record. The effects of rising temperatures are impacting people, ecosystems, and economies around the world and will only intensify in the coming decades unless we can bend the emissions curve and stabilize global temperatures.

To do so, the Intergovernmental Panel on Climate Change — a scientific body established by the United Nations and comprised of hundreds of climate scientists — has urged immediate, rapid, and large-scale reductions in greenhouse gas emissions. This would require systemic changes and large investments across all sectors of the economy, especially within energy, agriculture, transportation, heavy industry, and buildings.

For investors who are so inclined, there are a variety of methods to assist the cause, particularly for reducing portfolio-level climate risks as well as leveraging assets to foster society wide-decarbonization that aligns with a net zero future. Approaches can include engaging high-emitting companies to set science-based emissions reduction targets and create climate transition plans, increasing investments in “climate solutions” such as renewable energy infrastructure, assessing portfolios and assets for exposures to physical and transition-related climate risks, and subjecting a portfolio to climate-related stress tests and scenario analysis. Of course, all of these approaches involve trade-offs between risk, return, and impact; investors will ultimately have to decide the appropriate balance among these principles based upon overall portfolio and organizational goals.

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Source: See IMF data on annual surface temperature changes

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Down to the Wire: An Update on the 2023 U.S. Debt Ceiling Crisis

In February of this year, Marquette published a Perspectives piece entitled Is the Sky Falling? that detailed the history of the United States debt ceiling, as well as the early innings of negotiations surrounding its possible increase or suspension given the fact that the $31.4 trillion limit was reached on January 19. In the months since, the Treasury Department has been forced to resort to “extraordinary measures” in order to prevent the U.S. from defaulting on its obligations, including suspending sales of state and local government series Treasury securities. Those measures, however, will likely be exhausted in the very near future according to the nonpartisan Congressional Budget Office (perhaps as early as June), at which point the federal government will ultimately be unable to pay its obligations fully and, as a result, have to delay making payments for some activities and/or default on its debt obligations. This is commonly referred to as the x-date. It is worth pointing out that a number of large Wall Street firms have brought their forecasts of this date forward in recent days.

This newsletter analyzes potential repercussions of a U.S. default and options for a resolution of the debt limit impasse in Congress.

Read > Down to the Wire: An Update on the 2023 U.S. Debt Ceiling Crisis

 

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

The Eagle Has Fallen

When First Republic Bank’s 84 branches opened Monday morning, they belonged to the since-failed bank in signage alone after a tumultuous several weeks marked by depositor flight and a portfolio of loans that had dropped substantially in value amid rising interest rates. Three of the four largest U.S. bank failures have occurred in the past two months, with First Republic, now the second-largest bank to fail in U.S. history, behind only the 2008 collapse of Washington Mutual, the latest.

Despite an initial $30 billion lifeline from the U.S.’s largest banks in the wake of the Silicon Valley Bank (SVB) collapse, First Republic went on to lose more than $100 billion in deposits during March. Regulators took control of First Republic and oversaw a sale to JPMorgan Chase on Monday morning. JPMorgan, already the nation’s largest bank, will take on all $92 billion of deposits remaining at First Republic and “substantially all” of its assets, including $173 billion of loans and approximately $30 billion of securities. As part of the agreement, the FDIC will cover some of First Republic’s loan losses and provide JPMorgan with $50 billion in financing, with the deal estimated to cost the FDIC roughly $13 billion. JPMorgan will also return the $25 billion in uninsured deposits its large peers deposited into First Republic as part of the Treasury’s March plan to prop up the bank.

While the U.S. banking system is not yet out of the woods, the demise of First Republic, another regional lender with a concentrated depositor base and an investment portfolio that was overly exposed to rising rates, does not come as a surprise and does not change the contagion narrative. Markets have remained calm with generally solid earnings reports from other regional banks and ongoing support from the FDIC. While overall macro uncertainty remains, the risk of a broader breakdown in the U.S. banking system does not seem to be an imminent threat.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Unleashing the Power of AI

The launch of ChatGPT — a chatbot technology that can mimic human-like understanding and generate well-crafted, conversational responses — marks a pivotal moment for artificial intelligence (AI). Similar to the mainframe era of the 1950s, the rise of PCs in the 1980s and 1990s, and more recently the mobile and cloud era, AI could become the next technology platform that drives significant productivity gains and transforms our world.

The advancement of AI systems has resulted in increased adoption of the technology by various organizations, including businesses and governments. While the integration of AI within the economy brings excitement, it also raises questions about its impact on productivity, the potential displacement of human workers, and whether it will be used ethically. While limited adoption prevents us from being able to fully measure the effects AI could have on the workplace, the chart above summarizes the cost savings and revenue benefits noted by firms that have implemented AI within their organizations. On the cost side, the functions most widely benefiting from AI adoption were supply chain management (52%), service operations (45%), strategy and corporate finance (43%), and risk (43%). On the revenue side, respondents broadly saw increases in marketing and sales (70%), product and/or service development (70%), and strategy and corporate finance (65%). While there are fair criticisms of AI, the potential benefits are clear. As we continue to navigate the rapidly evolving landscape of AI, we must work to ensure that this powerful technology is harnessed in a way that benefits both individuals and society as a whole. By doing so, we can unlock the full potential of AI as the next transformative technology platform.

Not Summer Yet

It seems only fitting that I write this as snow is falling the day after it was a beautiful 80° and sunny; a harsh reminder that our Midwest summer is still a ways off. All in all, it was a mild winter by Chicago standards with only a few days of brutal cold and even fewer with measurable snow. Nonetheless, the freedom to comfortably wear shorts and soak up the sun last weekend was hopefully a preview of another glorious summer to come. But we’re not there yet.

The same could be said for capital markets. For anyone who read our market preview, the common narrative was “wait for the second half of the year” — which naturally coincides with summer in the northern hemisphere — please forgive me for taking advantage of the low-hanging parallel. Running with the analogy laid out above, though, the parallels are easy. If an investor hibernated during the first quarter and awoke to what markets delivered for returns, the results would be pleasing. Almost every major index across stocks and bonds was positive, with growth stocks roaring back. However, the temptation to focus exclusively on returns without regard for the environment would not only be irresponsible but a genesis for unhealthy expectations.

In this edition:

  • The murky economic outlook:
    • Regional banking crisis recap
    • Labor market update
    • Recession probability
  • Fixed income confidence
  • Equities’ surprising returns
  • Hedge fund opportunities
  • Real estate uncertainty

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

1Q 2023 Market Insights Video

This video is a recording of a live webinar held April 20 by Marquette’s research team, featuring in-depth analysis of the first quarter of 2023 and themes we’ll be monitoring in the coming months.

Our Market Insights series examines the primary asset classes we cover for clients including the U.S. economy, fixed income, U.S. and non-U.S. equities, hedge funds, real estate, infrastructure, private equity, and private credit, with presentations by our research analysts and directors.

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