Where does M&A go from here?
When the economy shut down in March of 2020 as a reaction to the pandemic, the government and Federal Reserve stepped in to add liquidity to the system to help consumers manage the lockdowns. Stimulus checks went out to consumers, the Paycheck Protection Program (PPP) was instituted and unemployment insurance was temporarily increased for qualifying individuals who lost their jobs. The Federal Reserve turned on their printing presses and bought U.S. Treasuries and Mortgage Backed Securities, increasing their balance sheet to $9 trillion. In addition, they lowered the federal funds rate from 1.50% to 0%.
With lowered interest rates, the private equity industry could find easy access to funds and investors. They could also lock in lower interest rates, increasing their internal rate of return and, ultimately, the return on their investment.
High consumer demand, supply chain shortage
The economy was upheld in most sectors, with the unemployment rate rebounding quickly. The unintended consequences from the flood of liquidity was much higher consumer demand. Consumers had more money in their pockets but saw a significantly lower supply of goods available because of the shutdowns. This caused supply chain issues and higher rates of inflation.
Price stability and sustainable employment
The Federal Reserve maintained a dual mandate of price stability and maximum sustainable employment. Under the price stability mandate, the Fed targeted a long-term inflation rate of 2%. Because of the flood of liquidity, the current inflation rate is now over 8%. This causes a serious challenge, as the Federal Reserve then must increase rates to try to slow spending – while at the same time, trying not to cause a recession.
The Federal Reserve increased rates by 1.50%, with the most recent hike of 0.75% (with the bond market expecting rates to increase to 2% – 3%). The increase in rates has manifested itself in the mortgage markets, with the 30-year mortgage rate increasing from approximately 2.5%, at the beginning of 2021, to 6% currently. The increase in mortgage rates has already started to slow new home purchases. The balancing act that the Fed attempts to maintain is to raise rates and slow spending, but avoid a recession while doing so. With an increase in rates, valuations on growth companies may decrease. The ability, therefore, for private equity companies to borrow and utilize cash for debt repayments in a higher interest rate environment reduces their fund raising leverage and their return on investment.
In addition to the raising rates, there are still other risks looming in the minds of investors, from the decrease in the stock market, continuing disconnects in supply chain and ongoing inflation, to slowing growth, the upcoming elections and the war in Ukraine. The Federal Reserve is walking a tight rope that resembles a time we haven’t seen since the late 1970s and early 1980s. The best thing is to be vigilant and ready to adapt and see where the Fed takes us.
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