The U.S. high-yield and investment-grade debt markets saw significant increases in 2017 over 2016 in dollar volume and number of issuances.1 The U.S. equity indices reached new highs throughout the year, with the Standard & Poor’s 500 index ending the year up 19.4 percent.
The slow, steady expansion of the economy (one of the longest expansion cycles on record) and the current favorable market conditions, along with the recently enacted reduction in corporate taxes — which could drive earnings expansion — have fueled optimism for robust capital markets activity in 2018. Questions linger, however, about the sustainability of the bull run and whether volatility can remain at historically low levels.
A number of factors will impact the strength and mix of capital markets activity in 2018.
Corporate Tax Reform. While it is too early to assess the ultimate impact of the corporate tax overhaul on the U.S. capital markets, a few themes have emerged. In general, the new tax law reduces the value of debt by both (1) lowering the corporate tax rate from 35 to 21 percent, which reduces the value of the tax shield provided by interest deductions, and (2) imposing a cap on interest deductibility to 30 percent of EBITDA. (See “US Tax Reform Enacts the Most Comprehensive Changes in Three Decades.”) As a result, companies will need to re-evaluate the cost of their debt, and some issuers could gravitate toward equity or equity-linked securities, where the new interest deductibility rules and a rising interest rate environment could make pricing more attractive for companies’ capital-raising strategies.
Companies also may find themselves with significant additional cash on hand due to the lower tax rate and the one-time mandatory deemed repatriation of money held overseas at discounted rates.
Potential uses for this additional cash include M&A activity, share buybacks and dividend recapitalizations, all of which could bring about higher stock prices and promote additional equity market activity.
Companies may find themselves with significant additional cash on hand due to the lower tax rate and the one-time mandatory deemed repatriation of money held overseas at discounted rates.
On the other hand, tax reform could quell some secondary follow-on market activity, particularly block trades, if private equity sponsors choose to hold their positions longer to capture additional gains from potential stock appreciation as a result of potential increases in earnings.
Alternative Financing. The average age of all venture capital-backed companies going public has risen from 5.1 years in 2006 to 7.6 in 2016, demonstrating the continuation of a multiyear trend of companies choosing to stay private longer. This trend is the result not only of the JOBS Act increasing the number of shareholders private companies can have before they are required to go public, but also of the wealth of private capital and secondary financing strategies available. As a result, companies have been able to raise substantial primary capital and provide liquidity to existing shareholders and employees outside the public markets and at valuations often significantly exceeding what public investors are willing to pay. The seeding of the SoftBank Vision Fund in 2017, which to date has raised nearly $100 billion to invest in technology companies (including a notable investment in WeWork), may only prolong this trend.
A number of private companies also may be contemplating strategies to become public outside the traditional IPO process, including (1) by being acquired by publicly traded SPACs, effectively allowing a company to avoid the associated time and expense of Securities and Exchange Commission registration and minimizing market risk, and (2) through direct listings of shares without an accompanying capital raise, providing immediate liquidity for shareholders (who would otherwise be subject to IPO lockups) with no dilution. The success of Spotify’s proposed direct listing could set a new precedent for companies with significant scale and a large investor base.
A number of private companies may be contemplating strategies to become public outside the traditional IPO process.
Increased financial leverage also has led some companies to look for alternative financing. Average leverage ratios, as measured by net debt relative to EBITDA, are near their highest since before the financial crisis for nonfinancial firms in the S&P 500. Some highly leveraged companies have issued mezzanine-style preferred securities to raise capital without increasing their leverage. Typically, these hybrid instruments are carefully structured to be treated as equity by rating agencies to avoid increasing a company’s leverage for ratings purposes.
Federal Reserve Activity. The monetary policy of the Federal Reserve may significantly impact the U.S. capital markets throughout 2018. The Fed has begun the process of reversing several years of quantitative easing and has continued to gradually increase interest rates, resulting in higher borrowing costs. Further rate hikes are anticipated in 2018, which will particularly benefit companies that are operated primarily in the United States (as a stronger U.S. dollar will increase the value of domestic products).
On the debt side, many companies are issuing longer-term bonds to extend the maturities of their debt and lock in a lower interest rate as a hedge against higher borrowing costs in the future. Approximately 20 percent of the investment-grade debt issued in 2017 was 30-year notes.