The Edge of Seventeen (ER, Twenty-Four)

Welcome to the inaugural issue of the Earnout, a print and digital publication focused squarely on the middle (upper, middle and lower) financial services market (what is financial service: hedge, private equity, independent sponsors, venture and just about anyone who transacts in the largest segment of the US economy).

Looking back in early 2023, so many “strange” events occurred and rocked the market; initially I thought that the year was going to be dismal. For M&A, I was right; for the S&P and Dow, I was wrong. The broader equity markets tested new highs, high yield ooutperformed (the constant specter of recession keps spreads wide but the strengh pf the economy kept small company balance sheels afloat - the perfect environment for junk to flourish) and American companies excelled beyond their peer groups in the global stage.

Not withstanding the foregoing, certain sectors of the economy encountered setbacks, most notably mid-market and super regional banks, such as SVB, First Republic, and Signature. These banks struggled to withstand the steep climb in interest rates and the decline in the market value of T-bills they were obliged to hold due to banking regulation (even now regional banks are suffering due to regulatory burdens by either the fed or local lgovenrments (e.g. rent control - which is a post WWII law that shoudl have, but never will, sunset). Such challenges appear to be the norm in an environment marked by interventionist government policies. Regardless of whether the administration is Republican or Democrat, the federal government and Federal Reserve consistently seek to manipulate and suppress the invisible hand guiding the broader marketplace.

Today, as we approach the midpoint of Q2. the broader market isn’t merely hoping, but rather expecting rate cuts (although the inflation print and job numbers suggest a rate cut won’t happen until early Q3). This sentiment is relfected in the pricing of indices like the S&P/Down. Certain economists, particularly those adhering to Keyenian economis (included its evolved form, MMT), believe the Federal Reservce shoudl have already initiated its easing program. We must consider that Fed Chairman, Jerome Powell, doesn’t want to replicate the trajectory of Arthur F. Burns, the Federal Reserve Chairman who hastily cut rates in the 1970’s, only to witness a spike in inflation.

With that said, Powell might want to talk the market into easing interest rates on its own (as some would argue naturally occur) instead of lowering the terminal rate; but I doubt that will happen as interagency pressure to lower the terminal rate will steepen if/when the economy wobbles. The Federal Reserve does not want the economy to tank in an election year (especially considering the non-incumbent challenger hammered the federal reserve for four straight years).

In Q4 2023, the economy posted a growth rate in the 3% rate, which was unexpected and underscores the resilience of the US consumer and the overall economy. However, consumer confidence slipped in November, albeit showing improvement from a low in October, and the Consumer Sentiment Index (CSI) started in 2024 in negative territory (78.8, with the baseline set at 100). So, why is it that the economy is performing modestly while the average consumer, represented by John Q. Public, doesn;t feel positive? If you can answer that question, I am certain that the Biden Administration will hire you immediately.

Either way, most people outside of the coastal bubbles aren’t dressing up in disco outfits and celebrating any “Good Times” (apologies to Kool and the Gang), but instead are wearing plaid flannel and feeling rather grungy (ala Kurt Cobain).

So, how does all of this tie into the “real world”? It is quite simple, deals have stalled out because rising interest rates have increased the cost of leverage. Additionally, there is a lack of liquidity due to more middle-market banks pulling back from acquisition capital, and there is a concern about a “value trap” on behalf of buyers; and seller, conversely, are fighting the last war on “value” - in other words, valuations seen in 2022 and 2021 should be valuations in 2023 and 2024. As my grandmother would say, “dem days are over”.

That could be what the 2024 deal book looks like by the time this year is over. For the first few months of the year, the $2.6 trillion in private equity dry powder will push many deals over the goal line, much like a Jason Kelce tush push.

Together with dry powder, sellers and buyers will bridge the valuation chasm with earnouts, equity rollovers, and stock-for-stock swaps. According the SRS Acquiom, 2023 saw 32% of all deals using earnouts, almost doubling in six years. Earnouts, once scorned by buy-side/sell-side practitioners (excluding commercial litigators), are now commonplace in most transactions, especially when the seller remains in the management team. Furthermore, there will be more equity rollovers in 2024 than in the past, mostly to bridge the gap on valuation.

While cash and creative deal-making will make the first half of the year a winner for deals, persistent inflation and , in this humble attorney’s belief, a higher terminal rate (think only a 50 bps cut) will sap the energy from the “party”. Furthermore, middle-market banks will continue to pull back from deploying acquisition capital, and although that space ill be filled by private credit, the cost of capital for buyers will increase, especially if the terminal rate doesn’t hit the street’s target. Finally (for more bad news), as we near the end of the year, the election will, regardless of who wins, likely make a close to majority uncertain, and there is nothing the market abhors more than uncertainty.

In sum, my advice for 2024 is the heed the wisdom of Winnipeg’s Finest, Bachman Turner Overdrive, and “Take Care of Business” until you can’t “Let it Ride” any longer.