For years, the private markets have grown accustomed to a few things. Ultra-cheap money. Eager investors. And a reach-for-yield dynamic that has forced capital aggressively into alternative asset classes, including private equity, venture capital and more recently “cryptos” like bitcoin and ICOs. The effects have been dry powder accumulation, higher deal multiples and downward pressure on return multiples.
All of this was enabled in the wake of the 2008 financial crisis by massive, globally coordinated central bank easing that featured the lowest interest rates in modern history (with negative interest rates persisting in Europe) and trillions in asset-purchase stimulus taking place under the guise of "quantitative easing."
Three years into its policy tightening campaign, the US Federal Reserve announced Wednesday that it was taking the next step towards policy normalization. Starting in October, at an initial rate of $10 billion per month and increasing to a maximum of $50 billion in $10 billion increments each quarter, the Fed will allow its bloated $4.5 trillion balance sheet to shrink.
The move has been dubbed "quantitative tightening" by the cognoscenti in a display of inspired creativity. (Separately, policymakers also recommitted to another interest rate hike in December, shrugging off worries about uneven inflation and tepid GDP growth to focus instead on labor market tightness.)
But the Fed has some way to go if it's going to return to a pre-crisis balance sheet of less than $900 billion.
As they say, though, a journey of a thousand miles begins with a single step. And next month, the Fed will take that step, allowing maturing US Treasury bond and mortgage security holdings to roll off by forgoing reinvestment. Already, the one-year Treasury yield has returned to levels not seen since 2008:
Make no mistake: This is the beginning of the end for what's widely seen as the enabler of the current low volatility rally in pretty much every major financial asset class. The chart from Goldman Sachs below demonstrates that the massive increase in global money has directly translated into higher valuations:
On a cyclically adjusted basis, US equities were only more expensive heading into the peak of the dot-com bubble. High-yield bond spreads are languishing near 20-year lows at 3.7% over Treasuries compared with an early 2016 energy-crisis high of 8.6%.
Combined with a lack of entrepreneurial activity, this has created intense VC interest in the new businesses being formed, which has caused round valuations (especially late stage) to balloon and unicorns to grow in number. It's also bolstering PE activity by ensuring a low cost of credit and lenders that are eager to play. And it's driving M&A activity, as cheap credit mixes with high corporate profitability to make takeovers more lucrative.
Trillions of dollars and years of excess mean that these dynamics will enjoy a momentum effect—especially in light of the cautious pace for unwinding that the Fed has outlined. There could even be near-term benefits to certain sectors, with the shares of publicly traded banks rallying on the hope of a steepening yield curve—the difference between short-term and long-term interest rates—bolstering net interest margins and thus profitability. That's already helping drive a rebound in bank M&A activity this year.
But be aware: Change is in the air.
For more insights into PE, VC and M&A activity, and the macro factors driving current trends, be sure to check out the content in our reports library.
Article by Anthony Mirhaydari, PitchBook
