In early February we attended the KBW Winter Financial Services Symposium in Florida, which was attended by other investors and representatives from U.S. banks and capital markets firms. Of the +70 primarily U.S. mid-cap banks in attendance, only five had assets over $50 bln. There was a clear division in sentiment between company executives, who are not seeing major issues with their operations, and investors, who have witnessed equity values plummet in 2016. With year-to-date declines in the U.S. financials and U.S. regional banks of ~11% and ~12%, respectively, investors were morose in Florida. The meetings and presentations offered a great opportunity to discuss the economic environment, energy prices, and M&A activity.
- Market Sell-off Viewed as Irrational: Although most participating executives agreed that the economic environment is increasingly challenging, no one assigned a high probability of a recession in the United States, and the general sentiment was that the market reaction was not supported by a decline in fundamentals.
- Capital Markets/Advisory Firms – Restructuring Activity on the Rise: Market volatility is impacting the number of announced M&A deals, but restructuring assignments in the energy and mining sectors are on the rise.
- Capital Markets/Advisory Firms – Private Equity’s Return to M&A: Strategic buyers have sidelined private equity firms in recent years, but executives from advisory firms believe that could change with the severe market correction.
- Mid-Cap U.S. Banks – Energy Prices Impacting Banks Outside of Texas: Banks in the Midwest and Northeast are seeing pressure in their energy books, but noted that low oil prices are positive for most of their clients. For our thoughts on banks in Texas, please see Notes from Texas Bank Tour: Is This Time Different from Previous Downturns?.
- Mid-Cap U.S. Banks – Concerns in Commercial Real Estate: Bank executives commented on the Fed’s concerns regarding the commercial real estate market in the U.S., citing evidence of a decline in underwriting standards as competitors stretch to grow their loan portfolios.
Executives Believe Market Valuations Disconnected from the Economy (Banks and Capital Markets)
Most conference participants agreed that economic environment is becoming increasingly challenging, although no executives in attendance believed that the market’s recent pullback was justified. One bank CEO stated that although the U.S. will not have a “stellar” economic growth number this year, the country is still seeing modest growth, and there is a clear disconnect between the markets and actual economic performance (for our views on this topic, see our Insight, Global Growth – Economists vs. the Markets). Another bank executive noted that although this isn’t the worst environment in which they have operated, he stated “we aren’t seeing the good times that the Fed is seeing” (note – this statement was made prior to the Fed’s recent minutes release).
Representatives from capital markets / advisory firms were generally in agreement with these views, although they were slightly more positive. Aside from energy and other commodities firms (and some internet businesses), they are not seeing a big pull-back in business activity. One executive stated that he has not witnessed any leading indicators which would lead him to believe that we are heading towards a recession. He did note though, that there are concerns that volatility in the capital markets could erode confidence to the point where it leads to a recession.
Market Volatility Impacting Level of Advisory Activity (Capital Markets)
The increased volatility in the financial markets is generally not conducive to M&A, although the slowdown in announced deal advisory activity is being partially offset by a material increase in restructuring assignments, specifically in the energy and mining sectors (many M&A advisory firms offer restructuring advisory services as a counter-cyclical source of revenues). Executives from advisory firms did stress that restructuring is only active in those areas, noting that other business sectors are performing well, in contrast to the stock market’s interpretation / expectations.
One executive commented that he believes that we are in the middle of long “up” cycle in M&A, which he noted typically last 5 to 7 years. When asked about geographic expectations for activity, another representative from the same firm stated that clients in Europe are saying that Southern Europe is in the best shape that it’s been since the crisis, and that he expects deal levels to increase in that region. He offered that he is optimistic M&A activity will increase in Europe when the volatility subsides, citing low oil prices and QE as factors which should help drive further economic growth in that area.
The Return of Private Equity to M&A (Capital Markets/Advisory)
Executives noted that financial sponsors have been less active in deal activity over the past few years given the prevalence of strategic buyers. In this disinflationary environment, strategic buyers have had little top line growth and now have little opportunity for increased operating leverage (as they have already restructured), which has forced companies to use M&A as a tool to grow revenue and earnings. With valuations and volatility where they are, some advisory professionals are expecting a rebound in financial sponsor interest to increase M&A activity. Although the cost of capital for sponsors will now be higher with credit spreads widening, executives from advisory firms expect that this difference will be more than covered by the significant decline in asset prices. They did note though, that it remains to be seen whether or not shareholders will be willing to dispose of assets / cede control at these prices.
Energy Exposure Outside of Texas (Mid-Cap U.S. Banks)
One bank executive stated that although his bank’s oil and gas exposure is immaterial, they are still working towards shrinking that loan portfolio, in line with some, but not all, banks in Texas (see the Insight describing our recent Texas bank tour). He did note that low oil prices are actually helping many borrowers, consumers and businesses alike, to whom the bank has lent money. This sentiment was reiterated by another bank CEO from the Midwest, whose clients are focused on manufacturing, stating that 96% of the bank’s loan book benefits from lower oil prices. He did note that his bank has not yet taken on loss on its energy portfolio, but if the commodity stays at or below $30, he expects the bank will see more “pain” in that book.
Stretching on Terms in the CRE Market (Banks)
In December, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency (OCC) jointly released a statement raising concerns about underwriting standards for commercial real estate loans (CRE) in the U.S. The findings of the regulators’ investigation, including less-restrictive loan covenants and extended maturities, were confirmed by conference participants.
One bank executive stated that competitors in the New York area are stretching to gain market share in CRE. Rival banks are offering favourable terms to grow their loan books, extending credit at fixed rates for 10 years, combined with low cap rates. The same executive expressed hope that additional CRE scrutiny from the regulators should lead to more “rational behaviour” amongst market competitors. Another bank executive based in the Midwest stated that larger competitors were offering CRE loans using 10 to 15-year fixed rates, and although those product offers subsided in the latter half of 2015, he is still worried about multi-family real estate loans.