Are deals back?

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Good morning. Ethan here; Rob is off. Disappointing earnings and gloomy guidance sent Tesla shares down 6 per cent after-hours yesterday. Which raises an interesting question: if an EV-specific bust leads to Tesla underperforming, how long will the Magnificent Seven grouping survive? Any thoughts welcome: ethan.wu@ft.com.

The M&A comeback

For the better part of two years, dealmaking has been in a lull. The contours are familiar. The combination of rising interest rates, macro and geopolitical instability, and the comedown from the pandemic boom created huge uncertainty around valuations. Sellers and buyers ended up far apart on prices, so transaction volume collapsed everywhere from private equity and venture capital to IPOs and investment banking. 

But with the soft landing/falling rates consensus solidifying, predictions for an imminent M&A comeback are suddenly everywhere. This Davos dispatch in the Financial Times last week captured the mood:

“Sellers have conceded to lower valuations and the pressure to meet a certain return on investment is ticking,” Pete Stavros, co-head of global private equity at KKR, told the FT at the World Economic Forum in Davos . . . 

“For the last 24 months, there has been a disconnect on valuation expectation between buyers and sellers. There is now a real sense of pragmatism setting in,” said Anna Skoglund, who leads the European financial and strategic investors group at Goldman Sachs . . . 

. . . Buyers were standing ready to strike a flurry of deals as prices began to reflect new realities such as higher financing costs and more uncertain economic conditions, said executives at some of the industry’s largest groups.

“This is a good time to lean in,” said Scott Nuttall, co-chief executive of KKR said. “There is less competition for deals and multiples have come down.”

It’s not just Davos chatter, either. In a note to clients published this week, Emmanuel Cau of Barclays lays out the case that the deals bounceback has already begun. He points to:

• A small M&A uptick. Measured by volume or by value, deal flow rose in the fourth quarter of 2023, compared with the quarter before:

  

• Better vibes in the C-suite. Positive talk in public from investment banking and private equity chief executives fits with improving US business confidence surveys.

• Financial strength in corporate America. Earnings are growing again, analyst earnings expectations are optimistic, corporate balance sheets aren’t highly leveraged and cash balances are high. Spare funds for M&A are out there.

• Valuations aren’t crazy. Excluding big tech, forward earnings multiples for US stocks are within the historical range and in line with other markets’ multiples, as Rob discussed last week. 

• Credit markets are roaring. Investment-grade bond issuance has had a record start to the year, as the FT’s Harriet Clarfelt wrote over the weekend. This should support M&A, as IG bonds are an important source of deal financing.

• Markets are already catching on. There has been an anticipatory rally in the shares of listed PE firms, which would most benefit from an M&A recovery, as the chart below shows:

  

This case is helped by the fact that more dealmaking is precisely what you’d expect in a reasonably strong economy with a declining cost of capital. As Cau writes, “the main impediments to capital market activity look to be reversing all at once”. (If you want to see more charts from his note, Bryce Elder has written a nice piece over at FT Alphaville.)

One nagging question is what equilibrium dealmaking activity is returning to. Improvement from a low baseline doesn’t mean we’re back to the rollicking deals market of 2021, in other words. This matters especially for private equity shops, which are hanging on to a record $2.8tn backlog of unsold investments. Livelier capital markets are encouraging, but one has to suspect PE’s problems are far from over.

What returns to expect from private credit

Should M&A return, it could well energise an already frenetic corner of finance: private credit. 

Unhedged has written at tedious length about private credit, 2023’s hottest asset class. To recap, “private credit” generally means direct loans to companies, often involving a private equity backer and a small handful of lenders (or even just one). In 2023, the amount of capital committed to private credit totalled $1.5tn. Of that total, $400bn is “dry powder”, committed but not yet deployed funds. At risk of straining the metaphor, the deals drought has meant dry powder staying dry. Fewer deals, fewer opportunities for direct lenders. Now, with the IPO market perhaps poised to reopen, all that money has to find somewhere to go.

So what returns should investors expect from private credit? I put this question to Peter Hecht, managing director at AQR and a former finance professor at Harvard Business School. He and his colleagues recently refreshed their estimates of five-to-10-year return expectations across asset classes, including a stab at modelling private credit.

Hecht uses a yield-based model, trying to extrapolate expected returns based on current market pricing relative to history. From there, his starting point is a 2018 academic paper studying returns at hundreds of private credit funds since 2004. The paper finds that private credit performance, net of fees, is nearly identical to public market benchmarks for high-yield bonds and leveraged loans (with betas around 1 to 1.2 and virtually no alpha).

Given such striking similarities in performance, Hecht argues you can model private credit returns as HY bonds, subject to two adjustments. First, he accounts for the prevalence of floating-rate debt in private credit (as opposed to fixed-rate bonds); second, for the greater use of leverage by PC. The result: an expected real return of 3.6 per cent. That compares to 3 per cent for HY, 3.8 per cent for US equities, and 4.2 per cent for global equities. Private credit returns look competitive, but not extraordinarily so.

These are broad market returns, the sort available with a perfectly average private credit manager. An especially skilled fund manager can generate better returns, but not every investor is going to pick a winner. Hecht told me:

Private credit and private equity should be in investors’ portfolios, if you can do the underwriting. But I’d say the typical investor is a little overconfident. They think there’s structural alpha in those asset classes, even without any manager selection skills. I think people need to be more humble about their private allocations.

Dry powder beware.

One good read

Dan Wang’s long walk through Thailand.

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