Ten years have passed since the fall of Lehman Brothers marked the beginning of the Financial Crisis, and the recovery has been considerable. The US economy is booming, stock markets are hitting new all-time highs, and confidence levels for both businesses and consumers are flying high. In tandem, the M&A market has also accelerated, with 2017 marking a banner year for deal-making. However, as we wrote about in August, there is growing concern amongst mid-market M&A participants that the best days of the most recent cycle are behind us. Deal volume and worth in H1 2018 were down compared to 2017, and this has begun to sow some concern that things will continue to deteriorate before they improve.
How did we get here?
Bull markets don’t die of old age, whether they’re public or private, so what’s behind the current slowdown? The boom itself, of course, is partly to blame – the law of large number dictates that spectacular growth can’t be continued indefinitely. But low interest rates for 10 years after the Great Recession also helped drive this growth, as investors threw cheap money at potential takeover targets. Exacerbating this was that these low interest rates pushed many investors to take more risk than they normally would to achieve their return targets, in a so-called “reach for yield.”
Are we heading towards a slow down?
As monetary policy around the world tightens and interest rates begin to rise, there is growing concern that the proverbial punch-bowl is being taken away and the good times will end. Is there truth to this? While nobody can say for certain, it does seem likely that the fantastic opportunities afforded to shrewd investors in the early days of the recovery are in the past, and rising interest rates do pose a threat to valuations moving forward.
But the sky isn’t falling
However, this is not all bad. After all, monetary authorities wouldn’t be tightening policy if the outlook wasn’t positive, and a global economy on stronger footing is better for everyone. Beyond this, as the founder of Oaktree, Howard Marks, notes in his book The Most Important Thing, higher prices today imply that future returns tomorrow will be lower, since they’ve already been priced in. The corollary, of course, is that lower prices tomorrow imply better returns in the future, meaning once the adrenaline shot of expansive monetary policy wears off and valuations come off their highs, deals will be done at levels that allow for higher returns than current levels do.
An upside to harsher conditions
Less forgiving financial conditions also have the upside of weeding out companies who are less competitive and have survived only due to a constant influx of cheap money. Once returns on less risky assets rise, the money flowing to these “zombie” companies should begin to taper off, forcing them either to collapse or improve. While this process can be painful in the short term, over the long haul it is beneficial for everyone, as it ensures only efficient, well-run businesses survive.
A difficult transition
After a decade of very accommodative monetary policy in response to the worst financial crisis since the Great Depression, there is bound to be some discomfort in the market as it adjusts to its new paradigm. While business sellers obviously prefer higher prices, markets are all about equilibrium and buyers must also be afforded their days in the sun, as well. That they are tightening their purse strings as of late implies they are foreseeing lower returns in the future – something nobody wants to hear, but which is a natural part of a recovering economy. A breather on valuations and multiple expansion can make for a difficult transition, but it is beneficial for the overall health of the market; as such, it shouldn’t be feared but welcomed as an unavoidable aspect of the ebbs and flows of the economic cycle.