Published on September 22nd, 2023
Given no rate increase this week during the September Federal Open Market Committee (FOMC)/Sept 19-20(1), the new mantra of a soft landing seems reasonable with rates plateauing and at peak for much of 2024, although with the hope of a possible rate cut in Q2 2024.(2)
Economist Survey - Rates at Peak Through 2024
Chart 1 Source: Bloomberg News Survey of Economists September 11-14, 2023
The yield curve inversion is a classic recession signal – usually a trigger for rate cuts but in this case the positive interpretation is that ‘rate cuts’, given a soft landing, are not intended to deflect a recession, but rather a structural initiative to begin the march to normalize/reset the economic playing field and establish a degree of predictability. This is critical to business decisions, particularly capital investment, and a healthy deal ecosystem.
I. The Big Picture:
US business resilience has been remarkable: Monetary policy, although front and center survey wise, is not the primary choke point for employers. Rather, it is access to educated / quality labor.(3) The recent labor activism (UPS, Writers/Actors and now United Auto Workers) could complicate this further…. too early to tell as of this writing.
There is a shift in the corporate allocation of capital as decision makers start targeting expansion projects, rather than share buy backs – we are reinvesting in ourselves again with the median company increasing capital expenditures by 15% in expansion programs - (plants / technologies). The general consensus is that capital expenditures will exceed share buy backs for the first time in three years.(4) A couple of key caveats here: i) Artificial Intelligence (AI) is creating a yet-to-be validated optimism for future business growth and is certainly a driver; and ii), with share buy backs now being eye-wateringly expensive with the S&P dancing around 20 times earnings, reinvestment is looking good again!
AI – It’s brand spanking new and has become so pervasive, it feels like it’s old already (!). There is no question about its relevancy though, especially when you consider that between Q1 and Q2 this year the early-stage valuations for AI start-ups almost doubled with deal volume up over 30%, and the target areas largely healthcare, sales, coding, customer support, and game design.(5)Further, four of the top VC early stage investment rounds in the last quarter betted on generative AI.(6)
Compounding growth pressure in terms of core inflation is decreasing and this is critical: the point here is that core inflation carves out two volatile categories – food and fuel, so it is a great gauge on a broad-based basis of longer-term inflationary trends; with this adjustment prices increased at their slowest pace since October 2021.(7) As noted last month, the 2% target is still an aggressive reach and there are externalities that we just can’t predict, as the bias remains towards a tight policy…so here we are for now.
II. But...There Are Always Some Headwinds...!
The venture capital funding cycle is loosely based on an 18-to-24-month funding runway with the hopeful expectation to rinse and repeat….but at a higher valuation. Why is this relevant? Cash was plentiful and valuations forgiving – (high) in 2021 and now here we are in the ‘Re-Fund’ portion of the cycle – (second half of 2023) when there are significant down draft pressures on valuations relative to the 2021 window. Nice way to say there is a significant ‘valuation correction’. Not only is capital harder to access in this environment, the demand – ‘cycle wise’ for capital in mid stage/later stage companies is three times the supply.(8) Further, there are plenty of haircuts – across all industries, with over 14% of US VC deals facing a down round in Q2 2023(9). There will be some adjustments but again on the positive side, with a normalized environment - valuation wise, there should be longer term relief/predictability to the deal ecosystem.
The personal savings rate continues to decline and is now 3.5%, supporting the consensus that the consumer has sawed through the stimulus dollars….the fat is gone and now we’re cutting into some muscle. This also applies to the federal spending run rate with deficits higher now than in low interest rate environments, meaning de facto spending is much higher. So, we face the tension of a hawkish push to kill the inflationary beast – i.e., manage rates without killing the soft-landing scenario that we all want.
Take personal politics out of this discussion but the reality is we are flying straight into an election cycle with an unpredictable glide path given the hyper-polarized electorate. Consider the Fitch US government debt downgrade – (from AAA to AA+), which we seem to have fortunately managed/absorbed but the downgrade triggers still remain - a) “a high and growing general government debt burden…”; and b), “…an erosion of governance…”.
III. Time for Some Tailwinds - The Ecosystem Is/Could be Opening Up - the IPO Market Is Relevant:
We presented a balanced Pros and Cons of our economy and the hope for a soft landing. To the extent investors embrace the “positive soft-landing outlook and rates have peaked” scenario, this bodes well for the IPO market and ultimately the whole funding ecosystem insofar as we all believe that exits will reemerge. The massively successful Arm IPO – (25% surge on the first day of trading) we hope is prescient. This dynamic could reinvigorate the animal spirits needed to stage for 2024. Again, the caveat here is that the 2021 valuation expectations are successfully reset, and the deal ecosystem can proceed rationally.
We believe this funnel/opening bodes well for the M&A world. This implied kineticism may drive mature companies/sponsor-backed platforms to again move aggressively on the acquisition front as they stage for an exit, a particularly relevant consideration for PE sponsored platforms that are managing their own capital cycle and expectations with their Limited Partner sponsors.
IV. Healthcare Wrap Up: The seemingly always strong legs supporting the healthcare segment may be getting a little tired. Chart 1 underscores the contraction of Private Equity healthcare investments through the last quarter, although interest is still strong in payer service and pharma. Healthcare IT Private Equity Deal Count by Quarter
Chart 2. Source: Pitch Book Q2 2023 Digital Health Report
Chart 3 illustrates the plateauing of digital healthcare VC deal investments. The strongest digital health segments remain teletherapy and behavioral health. Median and later stage deals are still facing the exit choke point, specifically IPO accessibility, although as noted earlier, sentiments are strong and this could shift in 2024; given current trends, estimates are that the 2023 digital health funding run rate may be down approximately 25% from 2022.
Digital Health VC Deal Activity 2020 - June 30, 2023
Chart 3 Source: Pitch Book Q2 2023 Digital Health Report
Call to Action
Key take-aways reflected by the trends noted above as we enter Q4 2023 are:
Interest rates possibly plateauing, a first step towards:
A predictable deal ecosystem and exit validation (ARM IPO)
Valuation reality
Inflation is not dead yet but less ‘zombie-like’ and uncontrollable
Resilience remains and a soft landing likely….but adult supervision is needed in terms of managing the debt burden and the ‘erosion of corporate governance’ – i.e., less political posturing and more focused policy
Liquidity events are starting to show signs of life, and finance stacks are adjusting
Technology, in this case AI – whether Friend, Foe or Fad… will be catalytic
There are some very positive trends here that we believe generate the confidence to reengage, review your strategy / plan of action, and with that, consider what Investment Banking transactions are needed to advance your goals. We’ve managed through these cycles before. Experience counts and we are well positioned to support you. Call with any questions and look for our next update.
Sources:
(1) Markets and analyst alignment is that Fed maintains the benchmark interest rate between 5.25% - 5.50%. (Source: CME FedWatch Tool). CPI increases down to 3.2% year on year – decrease form 9.1% in June 2022. (Source: Benzinga September 2023).
(2) Goldman Saches as reported by Bloomberg 8-14-23.
(3) Bloomberg: NFIB Small Business Optimism Index (‘Selected Most Important Problem – January 1986 – July 2023).
(4) Bloomberg: “Share Buybacks Get the Boot as Corporate America Invests in Itself” - July 2023.
(5) PitchBook News & Analysis Research Center. September 8, 2023.
(6) Pitch Book Q2 2023 Healthcare IT Report.
(7) Bloomberg Aug 10, 2023.
(8) Pitch Book August 2023.
(9) Pitch Book Q2 2023 Healthcare IT Report.
*** The content is not intended to provide legal, financial or M&A advice. It is for information purposes only, and any links provided are for your convenience. Please seek the services of an M&A professional(s) before entering into any M&A transaction. ***
For More Information, Please Contact:
Mark offers over twenty years of experience managing all facets of investment banking (M&A, VC/PE and IPOs) as well as company operations; additionally he offers the ability to orchestrate resources and manage the process/personalities required to close complex transactions. Licenses: Series 7, 24 and 63.
Mark Mansfield, Principal MM@GlobalCapitalMarkets.com
Direct: (949) 400-3760
Kimberly Valentine-Poska - Principal
Direct: (949) 933-7730
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