Dear Clients, Team Jefferies and Friends,
In February 2022, we shared with you our thoughts about what happens when interest rates begin to suddenly increase from a prolonged period of suppressed levels. In March 2023, we wrote about what happens when interest rates increase to the point that potential equilibrium can be seen on the horizon. Today, we would like to talk about what the world could look like when everyone can earn a reasonable risk-free rate – let’s call it 5% plus or minus 50 basis points – on their personal cash balances. We are not drawing a line in the sand by declaring that the Fed’s battle with inflation is finished and 5% +/- is the absolute final terminal risk-free rate of interest. We are merely saying that we believe we are relatively close to the equilibrium point and if so, now what?
Our thoughts on what a 5% +/- risk-free rate of interest will look like:
- Return of Capital Formation. We have now all experienced the frozen nature of capital formation when it is impossible to quantify the risk-free rate of interest. It has not been fun. Buyers want to wait, and sellers don’t want to reduce prices when they know the chances of a transaction occurring are slim. If you cannot estimate the ultimate rate that someone will receive in a savings account or intermediate treasury bonds, how can you accurately value venture capital, private equity, growth stocks, high yield bonds, or merger/acquisition candidates? Earlier this year, we started to see some very early green shoots until the regional banking crisis, the failure of a large European bank, and the U.S. debt ceiling fiasco all served as weed killer, postponing the inevitable resurgence. Today, green shoots are returning, and while nobody can be certain of the near-term outlook, we are cautiously optimistic. We (and our competitors) have begun executing successful block trades, staple financings for buyouts, debt deals, mergers/acquisitions and even successful IPOs. The buyside has begun looking for value across asset classes and sellers are finally beginning to engage at prices that can result in successful transactions. The risk-free rate is upon us, and thankfully we can now begin the much needed return to capital formation.
- Price Discovery. In previous letters, we discussed at length the complications caused by free money. It artificially pushes investors further and further out on the risk curve in search of the elusive yields required to match their assets with their liabilities. But the further you are out on the risk curve, the heavier the inevitable toll is when you need to re-mark your portfolio to the new reality of 5% risk-free rates. There is always a lag between public and private markets, but an established consensus risk-free rate allows – and some would say forces – more realistic price discovery for all investments. While painful at first, this is a good thing. It is the first step towards attracting new capital to situations as well as smart mergers, acquisitions and consolidations. And it leads to the formation of a new base of realistic value that can be built upon over the long term with the result being stronger companies, continued innovation and incremental value creation.
- Pent Up Demand. Capital formation is the grease that lubricates commerce. Companies need to refinance debt, raise equity for research and development, acquire assets strategically to improve margins and grow, and convert from public to private (and vice versa) ownership to accomplish long-term objectives. With most of these transactions recently frozen, only companies with immense flexibility or those with no choice but to transact, have done so. As a result, there is now a year-and-a-half worth of delayed corporate strategic objectives that must be met by companies and private equity owners. This won’t happen overnight, but we expect transactional success to spur more activity, which will be good and important for all of our clients, and hopefully for us as well.
- Investor Mindset. Regardless of the asset class an investor specializes in, understanding the risk-free rate liberates the investor to pull their investing trigger finger. When capital formation begins in earnest, pricing can be validated, and relative value once again becomes a useful arrow in the quiver. You can determine which asset class has true value, and which may be overpriced. Everything from stock picking to identifying smart acquisition candidates becomes more actionable. An added bonus of more normalized interest rates is that investors responsible for endowments and other large pools of capital can finally return to what generally serves them best: having a diversified portfolio that also includes a healthy allocation to a broad array of fixed income securities. Investors wind up being just as frozen as companies when the inability to calculate the risk-free rate freezes capital formation. It takes two to tango, and while early, the music may be beginning to play.
- What Can Go Wrong? Because there is always a lag between interest rate increases and the slowing of the economy and inflation, nobody knows if we have taken enough medicine yet to solve our problems. It is always possible that we have not taken a strong enough dosage and there will be a resurgence of inflation and the resulting pain it causes. Or maybe we were overprescribed (hard to believe since the free money party lasted so long) and the economy is in for a harsher landing. Both could be significant problems that could affect capital formation. Further complicating our recovery, we all know that we live in a world rife with unexpected surprises and shocks, which could have calamitous results or pleasant surprises. So, we are not waving the “all clear” flag and encouraging people to downshift into their fastest gear. However, we are generally optimists who believe the world always eventually finds its right equilibrium to move forward, and we now see enough signs throughout our company, and the global economy, that we believe we are either at or near this cycle’s nadir of capital formation.
This has been a complicated first half of the calendar year for all of us at Jefferies and we suspect for all of our global investing and corporate clients. Since early 2022, we have felt like we are all dressed up with nowhere to go. Our strategy as a firm has always been to make sure we are secure during these challenging periods, which is only possible because our 5,403 Jefferies team members embrace our unique culture and because we have built this firm atop a strong and conservative capital foundation. With these two pillars firmly in place, we can prioritize serving our most important constituency: our clients. Being strong internally also allows us to continue playing offense while others may be forced into defense. On a targeted basis, we have been aggressively adding to our human capital with A+ new partners who will join our proud existing team, all in a quest to better serve each of you. Moves like these can only be accomplished during times of duress when great talent realizes there might be a better home for them to serve their clients. Obviously, slow times are also the toughest time to pull the investment trigger in new human capital, but this is a strategy that has served us well over the decades and one of the best ways we have built Jefferies. While nobody has a crystal ball, we do believe we are entering a new stage of activity and capital formation. While it may have fits and starts and unknown surprises, we are confident in the inevitable return and importance of financial activity and we are doing our best to position ourselves for the next decade to best serve our clients.
Enjoying a healthy 5% risk-free rate on our savings while eagerly embracing the potential bigger opportunity with each of you,
Rich and Brian