Recently I spoke with some good friends in the finance space about the global economy, China, and debt capital. One is a vice president and underwriter at a US East Coast private equity firm. The other is the owner of an investment banking firm in the midwestern US. They are steeped in the finance world, which is helpful for me because they can confirm to me the “whys” behind what we are seeing in our domestic and international transaction work. This post contains some themes that arose during our discussions.
Silicon Valley Bank’s Collapse Tanked 2023 for Many Firms
The Silicon Valley Bank (SVB) collapse on March 9, 2023 introduced significant and early trauma into the financing environment. Silvergate, a crypto-centric bank, led the way with its shutdown announcement on March 8. The SVB shock quickly rippled through the venture space and into the traditional banking world. Signature Bank and First Republic Bank failed in March and May. Credit Suisse’s own failures dominated the headlines in March, resulting in its acquisition by UBS in June.
Conservative banks and bankers do not like risk, and the knock-on effects of these significant events in early 2023 were felt throughout the financial system.
Levered (Debt) Deals Have Slowed with Rising Interest Rates
Many deals involve some debt financing, especially those involving motivated sellers. In contrast, repeat purchasers like private equity groups will almost always incorporate a significant portion of debt financing. Investment bankers provide a similar debt financing link to their buy-side clients through their networks.
The reason is twofold, and both of these are true regarding private equity investment partners and debt financiers generally. First, they prefer to spread the loan portfolio risk out as much as possible. Second, they traditionally invest in established businesses with strong track records.
US interest rates continued to rise from near zero during COVID-19 through early 2022. As the economy continued to recover, the Fed sought to contain rising inflation, and interest rates continued to rise in 2023.
It should come as no surprise that when interest rates rise, this increase in the cost of capital will materially impact buyers that typically rely on third-party financing. This is in contrast to deals of all types involving seller financing, which is often more flexible and less dependent on prevailing interest rates. These rising interest rates slowed down the frequency of private equity transactions and deals involving investment banks this year.
The Value of Preserving Existing Banking Relationships
Because so many transactions rely on debt, this year’s 1.5% increase in capital costs at the federal funds level has caused potential buyers to think twice about completing a purchase. The increase has also caused ripples in banks, which in the face of global uncertainty have pushed to increase customer headcounts and overall deposits rather than loan portfolios.
Cue the most valuable asset in any business: its network of relationships. Deals that are getting debt financing this year are happening most frequently with regional banks where the seller has cultivated personal relationships over years or decades.
This means that the bank is already committed to the business and only needs to get comfortable with the new ownership. This is especially palatable for the bank if management stays for a consequential period post-closing.
Third-party financing introduces an additional risk profile into the transaction equation, which is why having a familiar lending party is ideal. This debt-shy scenario advantages buyers that do not need to finance their acquisitions with third-party debt.
My private equity friend indicated that other PE firms where his friends work have seen significant deal flow decrease in 2023, but his firm had steady deal flow because it engages in a significantly smaller percentage of levered acquisitions.
Dry Powder (Available Investment Capital) Will Need to Be Deployed in 2024
Firms that hesitated or otherwise failed to complete deals in 2023 are now struggling to determine when and how to deploy their investment capital. They recognize that they cannot reasonably sit on the sideline for two years in a row. This means that 2024 should be a bumper year for deals compared to 2023.
However, these firms are also closely watching the US presidential race, which saga will unfold throughout much of 2024. We expect increased deal frequency in Q4 2024 as we get more clarity regarding the next US president.
What Happens with China Investment in 2024?
How will all of this impact investment in China in 2024? We expect to see:
Price increases. It will continue to be a buyer’s market with significant risk premiums priced into deals.
Most robust due diligence. It got harder, not easier, to complete due diligence on Chinese companies in 2023. Despite Xi Jinping’s smiles, handshakes, and reassurances, we do not anticipate a more lenient or friendly regulatory environment. See The Essential Role of China Due Diligence.
Earn-outs will be more frequent. With increased risk profiles, sellers will be required to defer a larger portion of the purchase price post-closing.
More contingencies. Letters of intent and term sheets will contain more contingencies, tailored to both global risks and industry-specific risks. See Best Practices for International Manufacturing Term Sheets.
Increased use of R&W insurance. Sellers with an unclear or unsavory past in their China operations will be required to help fund representations and warranty insurance for their deals. See Private Equity Deals Involving China Assets: Lawyers and Rep & Warranty Insurance.
Increased appetite for Mexico and India expansion. Alternative markets to China will continue to be attractive, especially those with alternative trade routes that do not go through the South China Sea. See VCs and PEs Hunting for China Deals Still Need an Exit Plan.
Less leverage on deals. We will see more cash and less debt as overall percentages of a deal.
Conclusion
The financial world can sometimes feel opaque to many who are outside that industry. But these factors trickle down to affect virtually all companies and people. There is great value in understanding how bank collapses, rising interest rates, preserving existing financing relationships, the pent-up demand for deploying capital, and China’s ongoing thirst for foreign investment capital will impact the global business environment in 2024. Winston Churchill’s admonition to, “Never let a good opportunity go to waste” continues to be relevant in today’s international business environment.
