13 Dec The Great Reset (Q1-22)

When the price of money is zero, the value of everything is infinite. The zero interest rate experiment led by the U.S. Federal Reserve (U.S. Fed) in response to the global pandemic created investor fairy tales that “stonks” only go up, virtual coins are money, and unicorns exist. For the past two years, investors of all stripes, not just Robinhood’s merrymen, abolished the fundamental distinction between investing and gambling and got caught up in what Graham and Dodd would term as “untold mischief.”¹ Investor psychology is shifting and extreme valuations in just about every asset class are set to be repriced as higher interest rates collide with inadequate yields.

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