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Are the offers back?

Written by The Anand Market

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Good morning. Ethan here; Rob is gone. Disappointing earnings and bleak forecasts sent Tesla shares down 6% after hours yesterday. Which raises an interesting question: If an EV-specific bankruptcy causes Tesla to underperform, how long will the Magnificent Seven Group survive? Every idea is welcomed : ethan.wu@ft.com.

The return of mergers and acquisitions

For almost two years, negotiations were in a lull. The contours are familiar. The combination of rising interest rates, macro and geopolitical instability, and the end of the pandemic boom has created enormous uncertainty around valuations. Sellers and buyers found themselves far apart on price, so trading volume collapsed everywhere from private equity and venture capital to IPOs and investment banking.

But with consensus on a soft landing and falling rates solidifying, predictions of an imminent return to M&A are suddenly everywhere. This dispatch from Davos published last week in the Financial Times captured the atmosphere:

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

“Over the past 24 months, there has been a mismatch in valuation expectations between buyers and sellers. There is now a real sense of pragmatism taking hold,” said Anna Skoglund, who heads the European financial and strategic investors group at Goldman Sachs.

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

“It’s a good time to step in,” said Scott Nuttall, co-chief executive of KKR. “There is less competition for deals and multiples have decreased.”

It’s not just about Davos chatter. In a note to clients published this week, Emmanuel Cau of Barclays explains that the rebound in transactions has already started. He underlines :

  • A slight increase in mergers and acquisitions. Measured in volume or value, deal flow increased in the fourth quarter of 2023 compared to the previous quarter:

    https%3a%2f%2fd1e00ek4ebabms.cloudfront.net%2fproduction%2f0cd0386e eae4 4e7d 94f5 0d91be71d37b
  • Better vibes in the C-suite. Positive public speaking investment bank and private equity executives join in improving U.S. business trust surveys.

  • Financial strength of American companies. Profits are rising again, analyst expectations are optimistic, company balance sheets are not heavily leveraged, and cash balances are high. There are alternative funds for mergers and acquisitions.

  • Valuations are not crazy. Excluding Big Tech, forward earnings multiples for U.S. stocks are within the historical range and in line with multiples for other markets, as Rob explained 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 mergers and acquisitions, as IG bonds provide an important source of transaction financing.

  • The markets are already realizing this. There has been an anticipated rally in shares of listed PE companies, which would benefit most from a resumption of M&A, as shown in the chart below:

    pe stock line chart beat the market on an uptick in trading (june 2023 = 100) showing we are back

This case is made easier by the fact that more transactions are precisely what one would expect in a reasonably strong economy with a falling cost of capital. As Cau writes, “the main obstacles to financial market activity appear to be reversed in one fell swoop.” (If you want to see more graphs of his rating, Bryce Elder wrote a nice article on FT Alphaville.)

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A nagging question is what balance trading activity is returning to. In other words, an improvement from a low baseline doesn’t mean we’re back to the dynamic deal market of 2021. This is particularly important for private equity firms, which are clinging to a record backlog of $2.8 billion in unsold investments. More dynamic financial markets are encouraging, but one must suspect that the EP’s problems are far from resolved.

What we can expect from private credit

If mergers and acquisitions return, they could well boost an already frenetic sector of finance: private credit.

Unhedged has written at length about private credit, the hottest asset class in 2023. As a reminder, “private credit” generally refers to direct lending to businesses, 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 amounted to $1.5 trillion. Of this total, $400 billion is “dry powder,” funds committed but not yet deployed. At the risk of forcing the metaphor, the dryness of the accords means that dry powder stays dry. Fewer transactions, fewer opportunities for direct lenders. Now that the IPO market may be about to reopen, all that money needs to find a place to go.

So, what returns should investors expect from private credit? I posed this question to Peter Hecht, CEO of AQR and former finance professor at Harvard Business School. He and his colleagues recently refreshed their estimates five to ten year return expectations across all asset classes, including a private credit modeling trial.

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Hecht uses a yield-based model, attempting to extrapolate expected returns based on current market prices relative to history. From there, its starting point is a Academic article 2018 studies the returns of 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 these striking similarities in performance, Hecht argues that one can model private credit returns like HY bonds, subject to two adjustments. First, it explains the predominance of variable rate debt in private credit (as opposed to fixed rate bonds); second, for greater use of leverage per PC. The result: an expected real return of 3.6 percent. This compares to 3 percent for HY stocks, 3.8 percent for U.S. stocks and 4.2 percent for global stocks. Private credit yields appear competitive, but not extraordinarily so.

These are broad market returns, the kind available from a perfectly average private credit manager. A particularly skilled fund manager can generate better returns, but not every investor will pick a winner. Hecht told me:

Private credit and private equity should be in investors’ portfolios, if you can underwrite them. But I would say the typical investor is a little overconfident. They believe there is structural alpha in these asset classes, even without any manager selection skills. I think people need to be more humble about their private allowances.

Be careful of dry powder.

A good read

And Wang’s long walk through Thailand.

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