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US capital markets navigate a cloudy outlook
The US economy entered 2023 with more momentum than anticipated, supported by a strong labor market and healthy consumer spending. While encouraging macro data could keep the growth momentum positive near term, higher interest rates, sticky input costs and financial stability risks will weigh on growth in coming quarters.
In light of robust employment and shifting inflation data, the Federal Reserve will likely continue to tighten policy. The Fed’s forecast of the terminal rate is 5.1% sometime later in 2023 while PwC is modeling 5.25% to 5.50%. Given recent developments concerning some banks’ liquidity, the Fed will probably continue to focus on broader economic conditions while letting its liquidity facilities address any immediate financial stability concerns.
Increasing risks to financial stability could lead to a tightening in credit conditions and curtail bank lending, leading to lower business investment and consumption growth. The full impact of higher rates on the economy isn’t likely to hit until the second half of this year, pushing back the timing of a potential recession. Even if the US avoids an official recession, economic growth will probably remain below potential.
Fewer companies are choosing to go public due to market conditions. Since 2008, the IPO market has mainly been fueled by fast-growing tech and pharma and life sciences companies. Now, most companies planning to list should show a track record of -- or clear path to -- profitability. That’s challenging for many high-growth, high-burn businesses. Several high-profile unicorns that delayed potential IPOs have started searching for new private capital, including debt, to bridge their operations until the market finds surer footing.
While syndicated M&A and leveraged buyout (LBO) activities have stalled, private equity firms remain active in today’s market. Concerns over profitability, rising costs of debt and a reversion to more conservative underwriting standards have become near-term headwinds. These firms are expected to remain opportunistic amid valuation resets in the public and private markets.
A few factors could help the IPO market improve in late 2023. There’s a backlog of IPO-ready companies needing to raise capital. Confidence in a slight recovery in corporate earnings, continued challenges in the debt market and a gradual waning of market uncertainties also could help.
“While early 2023 showed positive signs for the IPO market with a string of new issuances, recent events have negatively affected market sentiment. There remains significant investable cash on the sidelines that will be more than enough to spark the IPO market into life, as long as a sustained recession is avoided and companies accept the new realities of a reversion to historical valuation levels.”
IPO market remains closed for now
- The IPO market continues to be virtually closed for the fourth quarter in a row, with the overwhelming consensus that prospective IPO candidates will need to wait until volatility has subsided for a sustained period of time.
- The market saw a slight increase in issuances from the prior quarters, with 9 traditional and 11 SPAC IPOs raising over $2.6 billion. The number of traditional IPOs this quarter nearly surpassed the entire second half of last year.
- Q1 saw 64 SPAC merger announcements and 29 SPAC merger completions. Moving forward, we expect fewer SPAC IPOs, and most of the SPAC merger activity we see now is from the massive cohort of SPACs that listed in 2021. SPACs that have completed their mergers have generally struggled to recover their deal valuation. The 2021 SPAC merger class, for example, currently shows an average return of negative 66%.
- The SEC approved Nasdaq and NYSE modifications that allow for direct listings to more easily raise primary capital and may encourage more companies to pursue this route.
Venture capital investments continue downward trend
- The venture capital (VC) ecosystem has changed, as funds are deploying capital more slowly and with more precision than in recent years, reflecting more conservative valuations.
- VC investments continued to decline in Q1, with $37 billion invested, although the downward trends appear to be slowing. Recent VC-focused banking issues caused a revaluation of some VC investments, but with the backstop from the Fed and continued technological innovation, the view of the future remains unchanged.
- VC funded companies and their VC backers appear more open to flat and down rounds where necessary in order to continue their growth at more sustainable valuations and ultimately position the company for an eventual exit or sale.
- While fundraising activity has slowed, dry powder remains near all-time highs, providing opportunity for companies with minimum viable products and established business plans.
- Artificial intelligence (AI) and machine learning (ML) companies have emerged as the new darlings of the VC universe. AI and ML companies have received over $4 billion worth of investments. Investors are debating whether new startups will rise to prominence, or if legacy tech giants will capitalize on their existing data and balance sheets as a competitive advantage to leapfrog or potentially acquire these startups.
Debt markets surprise with an increase in offerings
- Reversing the downward trend of IPO and VC capital markets, US debt markets started 2023 with an increase in offerings from Q4 2022.
- Two main factors combined to contribute to the increase: 1) A concern that rates will continue to rise in the short-term led many issuers to want to lock in rates now, and 2) Positive sentiment driven by occasional optimistic market and economic reports led issuers to take advantage of these news windows. As an example, refinancings increased 100% from Q4 to $200 billion, in Q1.
- Positive momentum in the first two months of the quarter ended in early March following banking liquidity concerns. While the Fed is working to contain systemic risk, there’s still concern in the debt markets. Treasury yields have fallen, showing a flight to safety, and there have been strings of no-print days in both the investment grade and high-yield bond markets.
- There was $106 billion raised in the leveraged finance markets. M&A and LBO volume saw a lackluster quarter of just $17 billion, a 35% decrease from Q4 2022. Banks have become more hesitant to commit to M&A and LBO financing this year following their inability to sell and offload debt from many high-profile LBOs last year.
- Private credit is playing an increasingly important role in the market. LBOs financed in the private credit markets have outpaced broadly syndicated financings by a count of 72-4.
- Looking forward, there is a valid need for further evaluation of unrealized losses on bank balance sheets, and there are concerns about economic headwinds and higher costs of capital. However, the vast majority of global banks remain on stable footing, markets continue to function and have reverted to traditional lending practices focused on underwriting based on cash flows, EBITDA generation and more conservative leverage.
Note: IPOs with deal values of less than $25 million, best efforts offerings, oil and gas royalty trusts, business development companies, pricing on OTC Bulletin Board and OTC Pink Sheets are excluded from this narrative. Data from SEC filings and third-party databases are as of 3/31/23.
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