Slightly over a year ago, we shared our thoughts about what might happen as the world transitioned from essentially “free money” into a period of painful “catch-up” spurred by rapidly rising interest rates (see our Boomer’s Guide). We discussed how this period was likely to:
- Reveal the false sense of overconfidence in one’s investing ability when money continually pours into all risk assets, rescuing everyone from their own mistakes
- Force an appreciation that prior valuations may take decades (or may never) be achieved again as expectations become more rooted in reality
- Demonstrate that the transition period from low to high rates is when we often feel most of the fear, uncertainty and pain.
- Cause a temporary cessation of capital formation that can feel like an eternity because it’s so hard to assess the new risk-free rate of interest as the target continuously moves around
We are NOT blowing the whistle and pronouncing that the transition and uncertainty are over; and things are now “all clear.” (Frankly, if we had the foresight to divine that moment, you probably couldn’t find us if you wanted to, as we’d be off on our island waiting to collect the spoils). What we continue to believe, which we shared in our Annual Shareholder Letter, is that we are now closer to the end of the transition period than the beginning. Therefore, we think it makes sense to discuss what effect the new (normalized) interest rate regime may have on all our investing and operating worlds.
We cannot tell you whether the equilibrium rate will settle in the emerging consensus range of 5% to 6%. But as we approach a final parity level, discussions can begin about taking risk and what the future may hold. Remember, we don’t have to wait until the Fed hits the pause button, as market participants will anticipate the ultimate ending of the rapid adjustment period as the slope of increases goes lower and becomes more predictable. Of course, things are never simple and, while inflation is rightfully the number one enemy the world’s central banks are fighting against, there are clearly other complicating cross currents (War in Ukraine, China, Covid, politics, etc.) that make this transition a more multi-faceted monetary experiment than the ones students study in a classroom.
Today, we would like to share some of the themes, expectations and lessons learned from other periods where the risk-free rate of interest was material and the cost of capital wasn’t super cheap:
- The earth will still revolve around the sun. A reasonable risk-free rate of interest and the corresponding appropriate cost of capital does not portend the end of the world. In fact, the period where everything was effectively free is truly the period of uncharted scary waters, and thankfully we are moving beyond it. Companies with good businesses and solid management teams can thrive amid a normalized and appropriate overall cost of capital. The excesses will be fewer and the “get rich quick” scenarios will be scarcer, but the opportunity to build long-term value for all stakeholders will be broadly available. Making mistakes will have greater and more rapid ramifications. Mergers and acquisitions will have to be yet more thoughtful and execution that is much more flawless. Headcount growth will have to be smart and scaled in an appropriate manner. Earnings and cash flow will join growth as value determiners. When spelled out this way, none of these sound so horrible, do they?
- National deficits will be on the agenda again. When borrowing trillions is free, why make hard choices? However, when the carrying cost of this debt becomes meaningful, an increased proportion of the borrowing nation’s future operating budget will be crowded out by higher interest expense. This will force politicians to the place they least enjoy, having to choose priorities that are best for the people versus giddily checking “all of the above” as they go back to their constituents for “high fives.” While this is clearly not as much fun, it is much healthier and more sustainable for the long-term health of our children and their children. Paying fair value for money demands discipline, and that is a good thing. In the old days of normalized interest rates, the deficit commanded much more debate and attention. Look for those days to return and, while not enjoyable, proper medicine works. Please note that this is an entirely separate point from lifting the debt ceiling. The U.S. cannot be allowed to get even close to default for myriad reasons (worthy of a separate note). That said, once this small, but potentially catastrophic, problem is alleviated, the politicians (with the voters’ urging) can get to the important work of making true tradeoffs based on reality of how a normal world works.
- Capital markets will finance anew. Running your company for prolonged periods of time by raising money at increasing multiples of revenues only works for an extremely small sample size of businesses. Investing in the most junior debt of the riskiest companies (at super low rates) works until it doesn’t. We are now officially out of the most robust capital markets environment in our collective lifetimes. Near-free money compounded by Covid stimulus and incredible cost efficiencies from limited travel, etc., made for the perfect storm of rampant capital formation. This was not the real world and this set of circumstances likely will not be seen again in our lifetimes. Actually, we would prefer it never to be seen again because only a massive global calamity would require the governors of the world’s financial system to go down this path again. We would rather pay a normalized cost of capital than suffer a worse return of Covid or God help us, a third World War, both of which could thrust us back into the artificial and perilous world we are finally emerging from. We expect that around the middle to end of this year (assuming no further major exogenous events) the capital markets will resume financing companies and new deals in a moderately healthy manner. Stocks will trade at reasonable multiples of earnings and debt will be priced at reasonable rates. Overoptimistic projections and unduly aggressive cash flow adjustments will be remembrances of the “good old days.” Capital formation will be readily available and priced appropriately for those with a reasonable use case. Growth, technological innovation, and capitalism (with appropriate regulation) will allow good ideas and hard work to win.
- Illiquid investments will not attract all the money—public markets have much to offer. It used to be hard to raise locked up money with significant duration. Marketing efforts for private equity and private debt were long and arduous, as illiquidity was viewed with caution, and offerings had to be priced more attractively than what was on offer in the public markets. But when virtually every investor on the planet was pushed out on the risk curve because almost every fixed income security had negligible or modest yield, folks had no choice but to accept massive illiquidity in exchange for extra yield (which often came with the assistance of leverage). Suddenly road shows for private equity and debt raises became walks in the park, as too much capital chased too few proven investment experts. With rates returning to a more normal level, everyone who invests with locked up capital is now competing with the fixed income and equity markets for spare dollars. The illiquid investors with proven operating and strategic value add will certainly keep attracting enormous amounts of capital. But those less talented will find it much more challenging and the fundraising will take longer, in many cases resulting in smaller raises and in some cases resulting in the closing of funds or readjusting of terms or business models. Again, this is as it should be and a natural evolution as capital becomes scarcer due to its increased cost, coupled with the newfound opportunities in more liquid fixed income and equity securities. Pension funds, endowments and all investors will be able to have more balanced portfolios that will result in solid returns and better diversification. We don’t see anything wrong with any of this.
- Companies will restructure. When things aren’t going as well as one would like, you never have as much time as you think to fix them. The slope down keeps getting steeper, bad momentum is even harder to change than good momentum, and options to fix things become ever scarcer as negativity compounds. This is true for people in their lives, but it is also true for companies. During the recent period of free capital driven euphoria, the easiest way to “fix” problems was to just finance them away and extend your time to deal with reality. Since there was such a scarcity of yield, if you added a mere 50 basis points to your current debt trading levels, there were people eager to accept the risk in exchange for the yield. Those days are gone.
Companies with impending debt maturities must focus more on their bond prices than their equity valuation because, if the debt markets give up on a company, the holders of the bonds eventually become the new shareholders. Auditors anticipate this so they look out one year to decide if they can believe the company will be able to pay their bills going forward or not (“going concern”). Thus, a company’s window to restore the debt market’s confidence is actually one year shorter than most may think. If your debt is trading in the low 70s or 80s (primarily due to the original low coupon issued in the free money period), the problem will eventually be fixed (assuming we are back in the normalized capital formation environment) by issuing debt in the high single or low double digits, which will merely shift some value away from equity towards the new bondholders. However, the equity will have more time to appreciate. This is normal and natural and one of the reasons equity multiples and valuations are coming down as markets anticipate some of this transfer of value. However, if your debt is trading at a much more significant discount, the capital structure must be dramatically changed for the company to continue to thrive. This means either new equity dollars coming into the company, a conversion of existing debt into equity, or a bankruptcy filing that rids the company of excess debt and effectively transfers ownership of the company from prior shareholders to debt holders.
We don’t think this will happen to a ton of companies, as we believe the economy remains healthy enough and the list of troubled over-leveraged companies is not as severe as past cycles. But it will certainly happen more so than the past decade when money was free. This will create opportunities for new investors and management teams to take advantage of the dislocations. It is also an opportunity for companies to finally fix the real issues they have, versus just kicking the proverbial can down the free money road. All of this is normal “circle of life” (think Lion King) evolution that allows the best companies and management teams to continue to thrive and grow, sometimes with the assets and the people of the lesser quality companies that misplayed their hands. Being aware of this “return to reality” can be very valuable for investors. As companies come to understand they don’t have as much time as they think to emerge from a tough spot, it will hopefully spur them to an added sense of urgency and proactivity.
- Dry powder to address future challenges. For the last 15 years, the world was so on edge because of the Great Recession, Brexit and Covid, that every central bank around the globe not only fired their bazookas, but when the bullets ran out, they threw the weapon, and even the box it came in, in desperation to solve the world’s collective problems. By the end, we threw all we had and suddenly we were out of ammo, guns and boxes. With the return of normalized interest rates, central banks are slowly rebuilding their global arsenals, and this too is a good thing. There will certainly be new major challenges that develop over time and it should be welcomed that the monetary authorities will be able to reduce the cost of capital to provide the right stimulus and incentives when needed.
- Jefferies will have an important role. Every company and security will no longer be heavily correlated in a world with a realistic cost of capital, as the tide will no longer lift all boats. Quality research using in-depth analysis and sector knowledge will once again help to determine the best relative value amongst companies and throughout their capital structure. Capital raises will continue, and optimal structures and innovative solutions will be more valuable than ever in minimizing costs. Mergers and acquisitions will need to be even more thoughtful and strategic and be financed with the most optimal capital structures. Restructurings will become more commonplace and specific expertise will be required to fix the capital structure, access additional growth capital and optimize emerging companies for future opportunities. Jefferies is built to help our investor and corporate clients best navigate the return to a world with a true cost of capital. Our macro research capabilities will enable all of our clients to best make sense of the new world and anticipate how today will evolve into tomorrow. Jefferies could not be better positioned to help all of our clients navigate this inevitable return to normalized interest rates. Our balance sheet and liquidity has never been stronger. Our human capital has never been more talented or more cohesive as partners serving our clients. Our products, services and industry verticals have never been more complete or more global. Basically, our firm has never been better prepared to serve our entire client base as we return to a more normalized (and still challenging) strategic and capital markets environment.
Rich and Brian