Paul Volcker, who was Fed Chairman from 1979 to 1987, recognized that inflation was the result of the marriage of two cousins: asset inflation and price inflation. “The real danger comes from [the Fed] encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking, in effect standing by while bubbles and excesses threaten financial markets,” Volcker wrote in his memoir⁵. Volcker’s predecessors had encouraged these risks, but he would not. Market interest rates were already high by historical standards, but inflation was still higher, growing by then at an annual rate of close to 15 percent, the fastest ever in the United States during peacetime. Fed economists at the time, running their models, concluded that a recession was likely, and soon. Volcker’s strategy involved letting interest rates rise in 1980-81 to levels unparalleled, then or since, and to become strongly positive in real terms. Fed funds rates rose to over 20%. Ten-year Treasury notes to over 15%. Thirty-year fixed rate mortgage rates rose to over 18%. The prime rate reached 21.5%. Volker will be remembered as the “Federal Reserve knight who killed inflation.”⁶ It remains to be seen whether current Fed Chairman Jerome Powell will be able to wield Volcker’s sword.

Then and now, inflation was not an outside force attacking them, as politicians and central bankers both like to portray it, but an endogenous effect of government and central bank behavior. Volcker’s successors, beginning with Alan Greenspan, focused solely on consumer price inflation, probably because it was easier to track but more likely because it was more politically popular to fight price inflation than asset inflation. The Fed could keep cutting rates and keep increasing the money supply, just as long as the price of goods and services did not rise too quickly. The price of assets was ignored. It is always controversial when the Fed engages in restrictive monetary policies and doing so to burst an asset bubble causes immediate pain: “To raise interest rates in the face of a bubble is always to pay a certain price to head off an uncertain threat—and to incur the wrath of politicians and the public, who love nothing better than a soaring market,” wrote Sebastian Mallaby in his biography of Greenspan. When asset inflation is high, people call it a “boom” and do not complain. In July 1998, Greenspan warned that stock prices might be unsustainably high, which made investors panic expecting that the Fed would raise rates and tighten the money supply. Between July and August, stock market prices fell nearly 20 percent, prompting the Fed to cut rates again from 5.5% to about 4.8% in just a couple of months. In mid-November 1998, the Fed cut rates again. The stock market rocketed higher: in 1999, the S&P500 rose 19.5% and the NASDAQ jumped more than 80%. Since price inflation was not rising, and labour costs remained subdued, Greenspan argued that cutting rates would act as “insurance” against a debt crisis in Russia and the failure of Long-Term Capital Management, a highly-levered hedge fund, that were threatening to destabilize markets at the time. Although the Fed Chairman also acknowledged the impact of low interest rates on the stock market and initially hesitated in easing – “I do think the concerns about an asset bubble are not without validity, and that is where I have my greatest concerns about easing,” Greenspan said⁷ – he fomented what other Fed governors called a “bubble economy syndrome.”⁸

A key pillar of Greenspan’s policy framework as Fed chairman was to control price inflation, ignore asset inflation, and then bail out the financial system when asset prices collapsed. When signs of price inflation were starting to emerge in late 1999/early 2000, the Fed increased rates and then quite suddenly investors re-examined valuations in a world where the cost of money was increasing. The stock market crash of 2000 wiped out US$2 Trillion of value and prompted pleas from bankers, investors and politicians for help. Greenspan obliged and began quickly cutting interest rates to 3.5% by August 2001. Then, on September 11, 2001, terrorists attacked the United States using hijacked airplanes, killing nearly three thousand people and throwing the economy into a tailspin. The Fed responded with more interest-rate cuts and the cost of short-term lending stayed around 1% until 2004. In June 2004, signs of price inflation were appearing in the economic data and Greenspan began to raise rates slowly. Perhaps too slowly, as they were still accommodative and incentivizing speculation and easy lending, and eventually stimulating a housing bubble. Houses, like stocks, were described as a key source of middle-class wealth and a vital retirement investment, so the inflation of their value was welcomed and even celebrated. Between 2003 and 2007, the average home price in the United States rose by 38 percent, to the highest level ever. The seeds were sowed for the worse economic downturn since the Great Depression. The Greenspan era setup a permanent pattern for how the Fed would let asset bubbles inflate and come to the rescue when they would burst. This entrenched a financial regime more tolerant of moral hazard that has lessened risk aversion and ensconced the Fed as lender of last resort.

Volker knew that the job of the Fed was to take away the punch bowl just before the party gets going. Unfortunately, central banks wait too long and when the risks become evident the damage is done and the problem becomes much harder. This is where Powell finds himself today. Volcker’s inflation busting program triggered a sharp recession, and drew strong condemnation from businesses, investors and politicians. In September 1982, the New York Times reported that “the business failure rate has accelerated rapidly, coming ever closer to levels not seen since the Great Depression.” Powell does not appear to have such resolve and there is no political cover that allows the Fed, the Bank of Canada, or any other central bank in the developed world to inflict the brutal shock therapy needed to correct years of negative real rates and cheap leverage. Financial pain is inevitable and only its magnitude is uncertain. Even if rates are not raised enough to stop inflation, rising costs will hurt business and household incomes, banks will be loath to lend, and economic decisions will become distorted. Without a new Volker to slay inflation, investors should be prepared for more challenging market conditions over the next few years.

[5] Volcker, Paul A. “Keeping At It.” PublicAffairs. 2018
[6] Ullmann, Owen. USA Today obituary of Paul Volcker. December 2019
[7] Leonard, Christopher. The Lords of Easy Money: How the Federal Reserve Broke the American Economy. Simon & Schuster. January 2022
[8] Ibid. The phrase was attributed to Thomas M. Hoenig, President of the Federal Reserve Bank of Kansas City from 1991 to 2011.

Article excerpted from the Q3-22 investor letter

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Researchers at the Bank for International Settlements (BIS)¹ updated a previous study on the rise of zombie companies and found a significant increase in their number due to large-scale government support measures and massive easing of monetary conditions in the wake of the COVID-19 shock. The BIS examined a sample of almost 32,000 publicly listed firms from 14 OECD countries going as far back as 1980; however, private, unlisted companies, particularly SMEs², play an important role in the economy and their exclusion from the dataset may underestimate the zombie share. The BIS estimates that Canada registered the highest zombie share in 2017, at 20% (versus the 15% average), and that this is likely up by more than three percentage points since 2020. Among listed SMEs, the share of zombie companies is around 40%. Since zombie firms are more leveraged, they are the most susceptible to rising borrowing costs. These companies have stayed afloat in recent years by accessing easy money, selling assets, and through government support that encouraged (some might argue, imposed) banks’ forbearance. Banks have been blamed in the past for fostering the genesis and survival of zombie companies by delaying debt restructurings or liquidations. For example, the rise of zombie firms in Japan in the 1990s was linked to banks which “evergreened” loans to avoid charge-offs that would have pushed them against regulatory capital limits.³

Kearney, a global management consulting firm, recently published a study that corroborates the BIS’ research. Kearney examined approximately 4.5 million records of 70,000 publicly listed companies from 154 industries and 152 countries.⁴ It then filtered out the debt service burdens of these listed companies and stress tested them for higher interest rates to determine whether they match the definition of a zombie company. Kearney found that if interest rates were to rise by a factor of 1.5, the number of zombies would increase by 17 percent—assuming there is no change in the companies’ performance—and by as much as 38 percent if interest rates were to rise by a factor of 2. This would lead to an immediate risk of insolvency for many zombie companies and have negative spillover effects that would threaten a wave of insolvencies. This scenario appears totally realistic given today’s backdrop of falling share prices, rising interest rates, persistent inflation in many of the leading economies, and the threat of recession.

Private companies will not be spared. Data from Lincoln International (“Lincoln”), which analyzed the aggregate change in company earnings and market multiples for approximately 900 U.S. private companies with less than US$100 million in EBITDA, reveals the potential for a sharp decline in interest-coverage ratios for private equity-backed middle-market companies as yields increase. According to Lincoln, credit spreads have widened by 100 bps on average in 2022, with most of the move occurring in the second and third quarters. Lincoln said the average interest-coverage ratio on private companies it tracked was 2.2x in the third quarter of 2022, compared to 2.4x in the second quarter. However, these metrics were calculated using trailing interest expenses and earnings. If the effects of rate and spread increases in the third quarter are reflected (keeping earnings constant), the interest coverage ratio would drop to approximately 1.6x. A recessionary scenario would challenge the ability for these private companies to service their debt. Typically, private equity sponsors have been willing to inject capital to support their struggling portfolio companies, like they did in 2020-21, and keep debt obligations current. However, rising interest rates, declining valuation multiples, and persistent inflationary pressures may alter the investment thesis of some sponsors that will not be able to earn a sufficient return on the rescue capital.

We have argued that zombie companies crowd-out growth in more productive companies by locking resources, leading to a perpetual misallocation of capital that could be invested instead in businesses that are growing. Kearney estimates that the scale of this misallocation amounts to about US$500 Billion globally, not including the credit losses and other obligations (such as unfunded pension liabilities) which would not be satisfied in a bankruptcy. The real estate industry has the highest percentage of zombies today and the share is expected to increase in line with interest rates. According to Kearney, hotels and airlines are also among the most vulnerable industries globally, where the share of zombie companies doubles under both of its stress scenarios.

Banks and governments have prevented the normal functioning of the business life cycle by letting zombie companies persist. A firm’s viability should be an important criterion for its eligibility for government and central bank support; otherwise, there is risk of excessively dampening corporate dynamism by protecting already weak and unproductive companies. Canada has one of the most efficient insolvency regimes in the world and regulators and legislators should be encouraging zombie companies to use formal restructurings to resolve financial obligations and reset capital structures so that their businesses can start fresh. We stand ready to shore up companies that would be viable in less extreme circumstances.

[1] Banerjee, R and B Hofmann. “Corporate zombies: anatomy and life cycle”, BIS Working Papers, September 2020 (revised January 2022)
[2] Small and medium-sized enterprises with annual sales of less than US$50 Million, according to BIS data.
[3] Caballero, R, T Hoshi and A Kashyap (2008). “Zombie lending and depressed restructuring in Japan”, American Economic Review.
[4] “Zombie companies are on the increase worldwide.” A.T. Kearney, Inc., September 2022

Article excerpted from the Q3-22 investor letter

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In Canada, regulatory capital ratios are determined in accordance with the Capital Adequacy Requirements Guideline issued by the Office of the Superintendent of Financial Institutions (“OSFI”), which are based on the capital standards developed by the Basel Committee on Banking Supervision (“BCBS”). The highest quality of regulatory capital, according to the BCBS, is common equity Tier 1 capital (“CET1”) because it absorbs losses immediately when they occur. CET1 is the sum of common shares, retained earnings, other comprehensive income, qualifying minority interest and regulatory adjustments. Banks are required to maintain specified minimum levels of CET1, Tier 1 (CET1 plus other capital that is unsecured, not guaranteed, and is junior to all bank’s creditors including depositors), and total capital, determined as a percentage of risk-weighted assets.

The U.S. Federal Reserve (the “Fed”) has substantially implemented all of the BCBS’ voluntary standards (under the Basel III Accord agreed upon by members of BCBS in 2010-11) and plans to phase in final recommendations related to risk weightings beginning in January 2023. Under the Basel III rules, banks apply weights to assets based on riskiness to calculate the risk-weighted assets (“RWA”) against which they are assessed a capital charge. Government-guaranteed assets like cash, Treasuries, and certain mortgage-backed securities have a 0% risk weight and therefore there is no capital charge against them for this purpose. Most residential mortgage loans have a 50% weight (35% in Canada). Corporate loans that are unrated or rated below A- are assigned a risk weight of at least 100%.

In the U.S. and Canada, the CET1 capital requirements are made up of several components, including: (i) a minimum CET1 capital requirement of 4.5 percent of RWA; (ii) a capital conservation or stress capital buffer (“SCB”) of at least 2.5 percent; (iii) a minimum 1.0 percent surcharge for systemically important banks (“SIBs”); and (iv) a countercyclical capital buffer (“CCyB”) for SIBs that raises bank capital requirements during economic expansions as a proactive attempt to protect against insolvency in future downturns. The Fed has not used the CCyB; in Canada, OFSI administers the CCyB, called the Domestic Stability Buffer (“DSB”), which came into force in fiscal Q3-19. The DSB is reviewed by OFSI on a semi-annual basis and will range from 0-2.5% of a bank’s RWA.

During downturns, regulators would allow banks to reduce their CCyB without risking restrictive supervisory actions in order to continue to supply credit and facilitate the recovery. CCyB therefore provides surviving banks with incentives to not reduce their assets to comply with regulations and potentially worsen a downturn. For instance, in March 2020, OFSI announced lowering the DSB by 1.25 percentage points (to 0.25%), in response to challenges posed by COVID-19 and to supply additional credit to the economy. OSFI estimated at the time that the measure would support over $300 billion of additional lending capacity.

The minimum CET1 ratio in the U.S. and Canada for SIBs is currently 8.0% and 10.50%, respectively. The difference is primarily due to the Fed not requiring a CCyB.

Bank capital requirements are increasing, and this will have significant implications on credit availability. In the U.S., starting in January 2022, banks had to adopt a new approach (the Standard Approach to Counterparty Credit Risk or SACCR) to measure the counterparty risk of “off-balance sheet” derivatives. For most U.S. banks, SACCR increased the RWAs associated with derivatives contracts. In addition to the capital impairments faced from the sell-off in rates, credit spread widening, and the adoption of SAACR, U.S. banks also have to contend with annual stress capital buffer tests. The most recent results from these tests, released at the end of June 2022, point to higher required regulatory capital than expected by some of the largest banks in the country. Morgan Stanley estimates that the three largest banks (JP Morgan, Bank of America and Citigroup) alone will need to lower their RWAs by more than US$150 billion in aggregate by the end of the year if they maintain a one percentage point management buffer on top of their regulatory capital minimums. These changes affect banks’ ability to buy back stock and pay dividends but it will also undoubtedly have a bearing on capital formation, particularly in curbing riskier loans that add to RWA balances. Banks have no choice but to optimize, or as JP Morgan Chief Financial Officer Jeremy Barnum puts it, “actively manage,” their RWAs. After releasing reserves for the past six quarters, U.S. banks have built over US$1.4 billion in reserves during Q2-22.³

The situation is similar for Canadian banks, which have been building reserves in recent quarters. OFSI’s most recent semi-annual review put the DSB at 2.50%, reflecting their “assessment that key vulnerabilities remain elevated and have increased while near-term risks are moderate but rising given an environment of heightened uncertainty.” In the context of increased uncertainty, OSFI expects that “management and boards of directors exercise vigilance and heightened prudence in their capital management practices with a view to preserving capital.”⁴

Furthermore, since SIBs are required to demonstrate a minimum capacity to absorb losses, beginning in fiscal Q1-22 (i.e., starting November 1, 2021), SIBs in Canada⁵ are expected to maintain minimum Total Loss Absorbing Capacity (“TLAC”) ratios, intended to facilitate an orderly resolution of a SIB faced with credit losses which potentially render it non-viable. The risk-based TLAC ratio (“RB-TLAC Ratio”), defined as the sum of the Tier 1 and Tier 2 capital⁶ of a SIB divided by its RWA, with the ratio expressed as a percentage, was set a minimum of 21.5% by OSFI in August 2018. The RB-TLAC Ratio has been tracked by domestic banks since fiscal Q1-2019 but did not become binding on SIBs until fiscal Q1-22.

OSFI currently expects SIBs to have a minimum RB-TLAC Ratio of 21.5% plus the DSB, for a total of 24%. As of fiscal Q1-22, the RB-TLAC Ratio for SIBs in Canada was 26.54%, the highest level for the ratio since being tracked (see Figure 1).

Figure 1. Canadian SIBs Total CET1 and RB-TLAC Ratios
Source: OFSI

We believe investors have not fully appreciated the impact that new bank capital requirements will have on credit markets and the resulting boon to alternative lenders like TEC. In response to a tightening of the DSB, all types of lending conducted by Canadian banks will become more expensive. A study conducted by the Bank of Canada showed that a one percentage point tightening in CCyB decreased lending by between 12-17 percentage points.⁷ Given the higher risk weights ascribed to corporate and commercial loans, and increasing business insolvencies⁸, we expect Canadian banks’ business lending in Canada to fall. With the elevated uncertainties in the macroeconomic outlook, the descent could be dramatic. Recent commentary from banks reflects conservatism being a key issue for capital going forward. Royal Bank of Canada, the country’s largest bank, expects CET1 ratio to remain above 12.5% going forward.⁹

The biggest line in bank’s RWA is their loan portfolio, which means regulatory capital pressures will force banks to make tough choices in their lending books. The CFO of Citigroup noted on an investor conference call that the bank is requiring some of its least profitable trading clients to post more collateral and is even dropping some of them. JP Morgan indicated that it would distinguish between franchise and non-franchise lending and reduce the latter. The cost of financing is increasing not just because of higher rates but due to reduced supply. Longer term, better holders of RWAs such as business loans are firms that do not have the same regulatory capital pressures as banks. For pension funds, endowments, sovereign wealth funds, and high-net worth families and individuals, the addition of loans to their portfolios is attractive and best accessed through alternative, non-bank lenders with established track records in their target markets.

[3] Credit Suisse Research, July 25, 2022
[4] OSFI Industry Letter dated June 22, 2022
[5] Six Canadian banks are designated as SIBs: Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, National Bank of Canada, Royal Bank of Canada, and Toronto-Dominion Bank.
[6] Tier 2 capital is supplementary capital of a bank and includes expected credit loss provisions, revaluation reserves, qualifying preferred stock, subordinated term debt, hybrid instruments, and certain minority interests.
[7] Chen, David; Friedrich, Christian (2021): The countercyclical capital buffer and international bank lending: Evidence from Canada, Bank of Canada Staff Working Paper, No. 2021-61, Bank of Canada.
[8] Up 27% year over year as of May 2022 (Office of Superintendent of Bankruptcy Canada).
[9] RBC company reports, June 3, 2022. CET1 ratio as at fiscal Q2-22 was 13.2%.

Article excerpted from the Q2-22 investor letter

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Some investors are more vulnerable to inflation than others, especially retirees. Retirement assets in Canada are largely held in defined benefit (DB) plans, which place the burden of higher costs generated by rising inflation on sponsors. These costs can become prohibitive for those DP plans that are auto-indexed to CPI; however, even plans without indexation, will be adversely impacted if they base member benefits on final average salary since rising inflation typically leads to larger future salary increases. Actuaries typically make assumptions about future inflation as a component of their actuarial discount rate and certain benefit calculations. For 2022, actual inflation assumptions for inflation are 2% but if realized inflation is higher, then the difference is an increase in an indexed DB plan’s liabilities.¹ This is a major reason why most private-sector DB plans have moved away from offering inflation protection.
Actuaries should increase their inflation assumptions to better protect against the eroding purchasing power of retirement benefit dollars; however, investment consultants would argue that revising only the inflation rate ignores the correlation that exists between inflation and interest rates and certain asset classes. If inflation remains high, interest rates would typically go up, as well as the return on equities over the long-term. DB plan sponsors would be consciously funding higher benefits with the expectation of receiving inflation generated investment returns. Unfortunately, chronically low interest rates enticed investors to chase risk and abolish fundamentals of valuation, causing a run up of prices that have front-loaded more than a decade of what would have been future returns. In a rising interest rate environment, the value of a DB plan’s liabilities may reduce, improving the financial position of the DB plan, but only if there’s no offsetting decline in the return expectations of the plan’s assets. Unfortunately, the outlook for pension fund returns is very low.²

In a lower expected return environment, selecting a portfolio to hit an overly aggressive return target can lead to adverse financial outcomes. Sponsors should be very cautious about simply taking on more investment risk to achieve a higher return. Over the next ten years, investing should focus on the pension plan maintaining solvency until a future environment offers more favorable investment expectations. Plan sponsors will need to lower their actuarial discount rates to reflect the direction of expected asset return projections. There is no asset allocation that can perfectly hedge against inflation risks but it is clear that some asset classes do perform better than others in inflationary environments. Not surprisingly, cash is usually the worst performer. Plan sponsors will have to look to alternatives that can protect the downside if risk markets correct and provide returns uncorrelated to other asset classes. Adding private debt, especially asset-based lending (ABL), makes a lot of sense for pension plan portfolios in the current environment. ABL provides good inflation-hedging potential because of floating interest rates, short durations, and the sources of protection and repayment (i.e., underlying asset collateral) increasing in value.

[1] FP Canada Standards Council, Projection Assumption Guidelines, effective April 30, 2022.
[2] The Pew Charitable Trusts, a non-partisan, global research and public policy firm, published a chartbook updating research on the performance of 73 of the largest U.S. state pension funds and forecasts typical pension fund portfolios to yield total returns of only 6%. May 2022.

Article excerpted from the Q2-22 investor letter

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Long term, the EU is likely to shun Russian natural gas. The EU Commission has already outlined a plan under which the flow of gas from Russia to the EU by 2023 could be cut by two thirds. The U.S. is helping by diverting cargoes of liquefied natural gas (LNG) to Europe; however, the Spring is the optimal time for natural gas utilities to store natural gas in preparation for cold months which are two seasons away and the rising overseas demand is curtailing reserves for near future needs. There is less gas in storage right now than normal, with current storage at 1.567 trillion cubic feet, or about 16% below the five-year average for supply.³

The global outrage over Russia’s invasion of Ukraine has caused oil traders and importers to abstain from buying Russian cargoes. In our maritime shipping business (WAYF), we have decided to avoid Russian cargoes and service providers from both a moral and practical standpoint. This kind of collective thinking is resulting in longer trade lanes and higher ton-mile demand, which will disrupt physical oil supply and skew oil prices to the upside.

In 2020, ARK’s CEO, Cathie Wood, predicted that oil demand “hit a secular peak” and that prices would fall to US$12 per barrel. Ms. Wood maintained her forecast in March 2022 even as oil prices hovered above US$100 per barrel, citing accelerating demand destruction. Oil prices remain elevated notwithstanding that the world’s most populous country, China, is in lockdown. Oil prices will stay volatile due to geopolitical uncertainties and investors should exercise a high degree of caution in underwriting investments based on price forecasts for oil. For now, we prefer to side with Charlie Munger who recently exclaimed “I can’t think of anything more useful than oil!” and avoid energy intensive, price-takers that cannot pass on higher costs to their customers.

[3] Source: U.S. Energy Information Administration

Article excerpted from the Q1-22 investor letter

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Although the start of 2022 has witnessed a healthy recalibration of public technology company valuations, median U.S. VC pre-money valuations continued to climb in Q1-22. Early-stage valuations surged to US$67 Million from US$45 Million in Q4-21 as non-traditional venture capital investors, including hedge funds, increased their focus on earlier deals. The rapid pace of dealmaking has created an environment where the due diligence process has significantly shortened, according to the VC coverage group at J.P. Morgan. Heated competition for deals sometimes leaves only a weekend for VC partners to get to know founders and their businesses before having to commit capital, which has driven early-stage valuations to sky-high levels. Pitchbook estimates that the venture market had amassed more than US$230 Billion in dry powder at the end of 2021, a record high.

Momentum in VC deals might be robust but exit counts and values have collapsed. Q1-22 posted only US$33.6 Billion in total capital exits for venture capital-backed companies in the U.S., a precipitous drop from the previous three quarters of over US$190 Billion each. Traditional IPOs have neared a complete halt so far in 2022, representing the weakest start to the year since 2016. Some companies are forced to revisit SPACs and are exploring other dual track M&A options. As mentioned above, technology continues to be the most targeted sector for M&A. With corporate balance sheets flush with cash, approximately US$2 trillion in the S&P 500 alone, and financial sponsors holding another US$2 trillion of dry powder, corporate buyers will be keen to plug their innovation deficits.

The lofty valuations of VC backed companies depend on longer duration cash flows and terminal values, which get quickly revised downward when discount rates increase. VC market adjustments will trickle down from the public markets and affect later stage companies first. The ten largest VC backed listings in 2021, which including Rivian, Coinbase, and Roblox, now combine for a US$121 Billion market capitalization, less than half their total post-money exit valuations. Exit valuations for VC backed companies are also resetting lower. J.P. Morgan recently observed that investors are requiring more structural and downside protection in deals, such as payment-in-kind dividends and liquidation preferences. Many of these companies will be confronted with the immensity of investor expectations that will not be met and be forced to either “down round”, restructure, or divest. The opportunity for distressed lenders experienced in the technology sector will be significant. After all, it is the technologies of failed companies that become the scaffolding upon which future innovations are built.

Article excerpted from the Q1-22 investor letter

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The dual threat of inflation and the Russia-Ukraine war shook markets around the world in the first quarter of 2022. In the U.S., the S&P500 posted its first negative quarter in two years, down 4.95%. The NASDAQ was down 9.10%. U.S. bonds fell 5.93%, the worst quarterly decline since 1980, with corporate bonds and high-yield down 7.69% and 4.84%, respectively. Even leveraged loans, which traditionally provide stability against a backdrop of rising rates, reported negative returns. According to the S&P/LSTA Leveraged Loans Index, leveraged loans recorded their first negative return since Q1-2020, down 10 bps for the quarter; first lien loans fell 12 bps and the largest 100 loans in the index lost 44bps.

The first quarter reflected a healthy recalibration of the market after a period in which investors were indiscriminately buying everything on the expectation that valuations could only move higher. Despite the negative start to the year, and valuations that still appear too high, investors do not seem to be giving up yet and new lows in equity markets bring out emphatic calls from investment strategists to buy the dip. Today’s forward P/E ratios have unrealistic growth expectations, with Russell 2000 companies, for example, expected to deliver 36% growth this year (forward P/E currently about 20.5x).

The clouds over financial markets are becoming darker as the tone from central banks becomes increasingly more bellicose. Bank of Canada Governor Tiff Macklem stated in his opening statement to the Senate Committee on Banking that “the economy needs higher rates and can handle them” and that BoC is committed to using its policy rate to “return inflation to target and will do so forcefully if needed.” Similarly, U.S. Fed Chair Jerome Powell recently admitted that the U.S. Fed should have raised rates sooner to cut inflation and that the central bank will do “whatever we need to do to get inflation back to 2%.” The strong labour market and wage gains will discourage policymakers from scaling back planned monetary tightening and the pernicious effects of inflation on real incomes of households and businesses will likely mean more aggressive rate hikes than currently priced into markets.

The quality of corporate earnings is deteriorating as management teams become more cautious about growth prospects. Over half of Canadian firms surveyed in March 2022 by the Bank of Canada anticipated that their sales would be lower this year due to supply chain disruptions, labour-related constraints, and increased economic uncertainty.² As benchmark yields climb sharply amid inflation concerns and rising interest rates, funding costs, unsurprisingly, are also increasing. Large, rated companies tapping the syndicated loan markets in April 2022, for example, paid 5.71% on average, 74 bps more than at year-end 2021. Smaller, lower-rated borrowers have been more heavily impacted by their debt servicing costs, which tend to be floating rate, and their access to funding markets has become tighter according to commercial banking surveys. The growing negative sentiment in lending markets, however, has yet to have a significant bearing on technology issuers.

Technology accounted for a record high 37% share of all M&A loan offerings in Q1-2022, according to S&P LCD, from less than 5% in 2013. Purchase price multiples for tech companies in the 12 months through April 30 were the second highest on record, at 12.3x, or 1.75x higher than the 2021 average. This is also a full turn higher than the 10-year average through year-end 2021. Furthermore, during that 10-year period technology deals have, on average, commanded purchase price multiples nearly three-quarters of a turn higher than all deals across all sectors. The higher purchase prices for technology buyouts have been supported by higher leverage rather than equity contributions which drove a higher share of multiples in 2019. S&P LCD data shows that tech companies leveraged up an astonishing 7.2x to fund acquisitions in the sector; contrast that to the 10-year average for leverage taken on by tech companies to fund leveraged buyouts through year-end 2021 of 5.85x. This debt appetite in the technology sector far exceeds the broader market, where average leverage for LBO deals across all sectors over the last twelve months was 5.9x, which is also a record high but consistent with the 10-year historical average.

Lenders’ enthusiasm for technology company debt is understandable. Based on term loans tracked by S&P/LSTA Leveraged Loan Index, since 2015 only six companies from the technology sector have defaulted. Companies in the oil and gas sector, meanwhile, suffered 30 issuer defaults. Within TEC’s investment portfolio since inception, just one loan in the technology sector has ever defaulted and that was for $1.5 million (or 0.03% of all investments by amount). Technology has been one of the few sectors that has continued to post positive earnings through the fourth quarter of 2021. In the latest earnings season, tech companies in the S&P 500 have reported average year over year revenue growth of 13%, four percentage points higher than companies across the broader index.

With further interest rate hikes and repricing of risk premiums expected in the coming quarters, interest coverage for tech companies will become a problem. Not only will aggressive leverage levels choke financial flexibility, but multiple compression will also reduce enterprise-based loan-to-values. Sharply higher costs including wages, which are accelerating in a sector where the war for talent is extremely, competitive, will erode the debt cushion of technology loans. The backdrop for technology credit is significantly worsening and is setting up conditions for a near-term distress cycle in a sector not accustomed to loan workouts.

[1] Benjamin Graham and David L. Dodd. Security Analysis, 1934.
[2] Results are from the Bank of Canada’s Business Leaders’ Pulse survey. Responses were collected from 152 firms between March 4 and March 10, 2022.

Article excerpted from the Q1-22 investor letter

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