Fed Fertilizer and Economic Green Shoots
Updated: Oct 23, 2020
Message from our Chairman
Colleagues and Friends, The first half of 2020 is clearly not the one anyone anticipated or hoped for. We’ve had to cope with a combination of the Covid‐19 pandemic and quarantine; a Saudi‐Russian oil price war; a potential unprecedented worldwide economic depression and unemployment; increased evidence of global warming climate change; non‐stop negativity from the news outlets; political polarization and extremism from both parties; emerging nationalism and pull back from global institutions; social unrest and upheaval; and a Saharan dust plume. We have all had to learn to navigate the "new normal" and that concept morphs daily depending on the latest news about the virus and all of these other variables. Psychologists worry that people are suffering post‐traumatic stress disorder due to the shock of the loss or disruption of their livelihoods or workplace, loss of their social identities, and the continual threat that serious illness and/or death will strike. However, it is not actually post stress, it is the new normal for current stress levels.
Having worked as a professional over 50 years of my life, the one guiding principal that has seen me through other extremely challenging times is the knowledge that most people want to succeed, they want economic stability and they are willing to work to achieve their goals. I believe we must learn from yesterday, seize the day today, and be hopeful for tomorrow. We can learn from the 2009 financial crisis, where, despite the hard times, industries and individuals emerged stronger than ever. We learned how to be resilient and be better prepared for future events. The M&A sector (and Falls River Group) had a remarkably strong year in 2009 because, in the turmoil, buyers and sellers acted with decisiveness and resolve. Gone was the illusion of status quo and associated excuses for delay would continue when the world was imploding with the financial crisis. We sold four businesses in the midst of one of the worst economic disasters in decades. What did we learn from that crisis and what are we telling clients today? Extremely challenging market dynamics create exceptional opportunities! Crystalize your thinking about your vision for the business tomorrow and your role in it. Should you take some or all of your chips off the table? While each of you will have to answer this for yourselves, consider the following four questions:
How long will your sector take to recover to post 2020 levels? (many industries took 3 to 5 years after 2009)
Will the new normal mean a more conservative approach to household and corporate spending born from risk aversion from 2020?
If GDP stays down for an extended period, what is the new normal for unemployment rates?
After unprecedented economic stimulus, do you really think tax rates will remain at the lowest in modern history?
Having been the lead banker on over 500 transactions, I have seen how exceptional opportunities are realized when people position their company for sale well before they go to market. The following are key considerations in preparation for a successful transaction: realistic valuation expectations; a strong management team; and a defensible market position. If you have these qualities, and you answer the questions above as taking a long time before the dust settles, then you must talk to your Advisors and be nimble on the timing of the transaction.
The Falls River Group team wishes each of you a very successful and happy second half of 2020!
Sincerely, Kerry Dustin Chairman FRG Insights
The beginning of 2020 showed strength in Middle-Market M&A through Q1. Obviously, the impact of the Covid-19 pandemic began to be felt in Q2. Q2 M&A deal activity overall plummeted, resulting in a 50% drop in deal activity in the first half of 2020 compared to 2019. Valuation: In general, discount rates are higher, and the buyers are pushing more of the risk onto the seller. Valuations on businesses will be lower if the business had head winds going into 2020, but the strong will survive and thrive. You can expect to see more restructurings and distressed sellers as a larger percentage of M&A deals in the next 12 months. There are buyers looking for bargains via restructurings and distressed sellers. However, high quality companies will still command top dollar. There are trillions of dollars looking for investment opportunities; Private Equity has $2.5 trillion. Management team: When seeking a premium valuation it is imperative to have a strong management team in place. If a buyer feels they will need to replace important management positions post transaction they become less willing to pay a premium for the desired company. What are some of the characteristics that make up strong management? In‐depth knowledge of the business, the markets and the competition; team players; understanding of their purpose in the organization and alignment with Newco’s vision and goals; they are opportunistic; they know how to communicate; and they want to grow with the business and know how to do it. Defensible market position: It is imperative that buyers understand what the company does, what products it offers, what its market strategy is and why it is better than the competition. If there is no defensible market position, or a road map on how to get there, the company will not be worth as much. Timing: Deal timelines will be extended due to the pandemic. People are not going to want to physically get into a room together to negotiate and hammer out deal details. M&A due diligence will also be extended as people are navigating via their home offices or with reduced staff. Buyers requiring financing contingencies will have to deal with the unsettled debt markets and lenders who will require more stringent terms. It is important to start now if you intend to sell in the next 12 to 36 months. There is a queue. Once a comprehensive vaccination is discovered, approved and distributed, there will be an enormous back log of deal activity. Trusted Advisor: This may be the most important decision you make. Key factors in your choice should be:
Nimbleness: In today’s market, this is critical. You and your Advisors must have the support and communication necessary for trust because you both may have to seek new approaches to resolving deal issues. This can only come from highly experienced Advisors, generating constructive solutions, without conflict, where you and your Advisor are working together “in sync”.
Fed Fertilizer and Economic Green Shoots In early March, the magnitude of the pandemic was only starting to be fully understood. Politicians were debating and arguing over the best course of action to stem the tide of economic mayhem. Fiscal conservatives wanted to extend cheap credit to corporate America. Progressive economists wanted assurances that benefits would be given to workers in terms of wages and economic relief. As the debate roared on Capitol Hill, the Federal Reserve stepped in with an array of aggressive actions designed to limit economic damage including up to $2.3 trillion to support households, employers, financial markets, and state and local governments. "We are deploying these lending powers to an unprecedented extent [and] ... will continue to use these powers forcefully, proactively, and aggressively until we are confident that we are solidly on the road to recovery," said Jerome H. Powell, Chair of the Federal Reserve Board of Governors.
Fed Fertilizer Near‐zero interest rates; supporting financial market functioning; lending to securities firms; backstopping money market mutual funds; repo operations; direct lending to banks; temporarily relaxing regulatory requirements; direct lending to major corporations: commercial Paper Funding Facility (CPFF); supporting loans to small and mid‐sized businesses; term Asset‐Backed Securities Loan Facility (TALF); direct lending to state and municipal governments; supporting municipal bond liquidity.
Economic Green Shoots
•Manufacturing in the mid‐Atlantic region showed that conditions are improving. The regional Fed’s business conditions index rose to 27.5 in June from negative (43.1) in the prior month. Any reading above zero indicates improving conditions. Economists polled by MarketWatch expected a negative 20 reading. •U.S. retail sales surged 17.7% in May for the biggest monthly jump ever. •U.S. durable‐goods orders rebounded 15.8% in May. •Pending home sales in May jumped 44.3% from April, according to the National Association of Realtors, marking the largest one‐month jump since the survey began in 2001. Very low mortgage rates are the impetus. •Permits led housing starts and the fact that permits are higher at a 1.220 million pace against only 974,000 starts pace means that starts should grow substantially this summer. •The FOMC projected the U.S. economy to shrink by a median of 6.5 percent of gross domestic product (GDP) in 2020 but is expected to recover to a growth rate of 5 percent by 2021 and above 3.5 percent by 2022. •The Institute for Supply Management's (ISM) non-manufacturing index was at 57.1 percent in June, well above expectations and an increase of 11.7 percentage points from May - the biggest one-month jump ever. •The rebound has been powerful enough that U.S. auto was able to keep factories open and working through their normal annual summer shutdown. •Property showings in the real estate market are also up 27 percent as of mid‐June, and the Mortgage Bankers Association is reporting a rebound in the number of new mortgage applications. •The unemployment rate fell to 11.1% in June, a notable improvement from the 14.7% rate in April and 13.3% in May. •Delta Airlines announced that it is restoring some flights between key cities such as New York and Atlanta. The airline is also restoring daily flights to Canada, the Caribbean, Central and South America, Mexico, and Europe. •Last week President Trump signed an executive order instructing regulatory agencies in the Executive branch “to use any and all authority to waive, suspend and eliminate unnecessary regulations that impede economic recovery.” •The University of Michigan's consumer sentiment for the US rose to 78.9 in June 2020 from 72.3 in the previous month and above market expectations of 75, a preliminary estimate showed. There was an improvement in the outlook for personal finances and more favorable prospects for the national economy due to the reopening of the economy, with more consumers expecting declines in the jobless rate than at any other time in the history of the survey. 2020: The New Normal
There will be a new normal that people and businesses will be forced to adapt to in the coming months in order to survive. What will not change is the need for more “fed fertilizer” to keep the economy rebounding for the foreseeable future. According to chief global market strategist at Invesco, Kristina Hooper, “most major economies have been agile and generous in their fiscal stimulus; that needs to continue, or else green shoots could quickly wilt and die." We forecast that Q3 will be slow and that by Q4 there will be "green shoots" as the enormous amount of pent-up demand to put equity to work will push valuations higher for the "good companies." And what is a good business? One that has a defensible market share; serves a need in the new, normal, Covid world; has diversification of suppliers and customers; has eliminated marginal product lines and operations that are unprofitable; one that has a strong management team and vision for the future; and has adapted to the new normal, becoming nimble enough to withstand the second, third, or fourth wave of the disease and even new viruses. Is this the time to make strategic acquisitions? Yes, if the buyer's balance sheet is strong and expansion fits into their long-term strategy after taking the reality of a prolonged recovery into account. Many private equity firms are partnering with companies looking to make acquisitions and are aligning with existing management teams to buy-out existing owners. There is always opportunity, even amid this unimaginable tragedy. Because of the significant uncertainty in the markets, the Fed has indicated it will keep the economy in recovery mode so we can expect more "green shoots."