November 18, 2019
Categories: Industry News
As we survey the U.S. macroeconomic and capital markets environments, we note heightened concerns on the part of institutional investors and corporations both large and small about where we are in the cycle—namely that we may be at or near a cyclical top, with a subsequent downturn potentially occurring over the next 12-24 months. Certainly the stock market volatility of the last few months has spooked investors, with the “fear index” known as the VIX spiking to a 5-year high on February 9th (1). And yet we remain in the third longest U.S. economic expansion in history, the longest being the cycle that ended with the tech bubble bursting and subsequent economic contraction starting in 2001 (2). The S&P 500 has now ended with positive returns for 9 consecutive years, something that has happened only one other time on record (3). The Buffett Indicator, a measure of valuations favored by Warren Buffett, is now at 143.0%, a high only eclipsed in 2000 before the dot-com bust (4). The personal savings rate is now lower than it was before the financial crisis in 2008, indicating a markedly high level of bullishness on the part of U.S. consumers (5).
We still see signs of strength in the U.S. economy, with the recent tax bill expected to put more cash in the pockets of middle-class spenders, while the unemployment rate stands at a 17-year-low of 4.1% (6). Real GDP still grew at a healthy 2.5% annualized rate in Q4 2017, albeit more slowly than Q3 2017 (7). U.S. corporate profits stand at 9.5% of U.S. GDP as of Q3 2017, significantly higher than the long-term average of 6.6% (8). This economic strength has produced inflation in the Consumer Price Index of 0.5% in January 2018, the biggest increase in 5 months, leading many pundits to speculate that rising interest rates could serve as an anchor that ultimately slows the economy (9). The Philadelphia Fed’s Q1 2018 survey of professional forecasters predicts that over the next decade, the average rate for 10-year Treasuries will be 3.7% and 3-month T-bills will be 2.75%, both in the range of 90-100 basis points above today’s rates (10). Yes, rates are going up, but by historical standards will remain attractive (the average rate on 10-year Treasuries since 1962 is 6.2%) (11).
So where does that leave us? Unfortunately, we don’t possess a crystal ball, nor do we presume to prognosticate the timing of a downturn in the U.S. economy or a slowdown in the capital markets. However, by most measures, when the economic and capital markets indicators are all flashing green, it is prudent to evaluate whether the so-called wisdom of the crowd isn’t merely herd behavior exhibiting a dangerous disregard for economist Herb Stein’s maxim, “If something can’t go on forever, it won’t.”
While 2017 U.S. venture capital funding was up 16% to almost $84 billion (the highest total since the dot-com era), we are keenly aware that when the funding market goes cold, it can do so in a punishing manner (12). During the last downturn in 2008-2009, U.S. venture capital funding fell 50% in a single year, reaching a level as low as a decade prior (13). Additionally, U.S. corporate bankruptcies skyrocketed over 100% from 2008 to 2010 as weaker business models were washed out (14). At the same time, nearly $400 billion in commercial lending by U.S. banks evaporated, leaving underfunded companies with no choice but to suffer serious consequences (15). However, those businesses with strong management, solid business models, and excess cash tend to fare much better—a study in The Journal of Finance found that “ . . . larger relative-to-rivals cash reserves led to systematic future market share gains at the expense of industry rivals. Importantly, this competitive effect of cash turns out to be magnified when rivals face tighter financing constraints . . .” (16). The punchline? More cash on a company’s balance sheet is a meaningful competitive advantage, especially when capital markets tighten up. An “overcapitalized” company will be able to weather the storms of the market cycles much better than undercapitalized rivals across a variety of strategies and tactics, including (but certainly not limited to) pricing power, acquisitions of attractively priced assets and technologies, continued research & development activity, and expansion across sales/marketing channels, product lines and geographies.
We would suggest that at this apparently late stage of the economic, equity and credit cycles, companies would be wise to raise capital in a quantum greater than their financial projections would otherwise suggest. In the now-famous “R.I.P.: Good Times” presentation created by Sequoia Capital in late 2008, venture capitalists Doug Leone and Mike Moritz urged the following to their portfolio companies: “ . . . raise your funding as soon as possible and raise as much as possible” while also recommending that companies “batten down the hatches” ahead of a rough ride (17). We’re not suggesting that we’re in for another 2008-style financial crisis, but prudent advice remains prudent. And when the proverbial tide goes out, we’ll find out which companies have been “swimming naked,” to use Warren Buffett’s colorful metaphor.
Runway Growth Credit (www.runwaygrowth.com) remains committed to funding great companies through whatever economic cycles come our way. We can provide $5 million to $30 million of growth capital to companies seeking a complement or alternative to bank financing or equity, and we have the ability to creatively structure loan facilities that meet companies’ needs, including our ROSE Loan Facility™ (combining the features of a line of credit with a term loan), straight term loans, and multi-tranche facilities. We will continue to hope for the best and prepare for the worst, especially when facing the realities of a late-stage bull market which, because it can’t go on forever, won’t.
1. Bloomberg, February 2018. https://www.bloomberg.com/quote/VIX:IND
2. KKR, National Bureau of Economic Research, January 2018. http://www.kkr.com/global-perspectives/publications/outlook_for_2018_you_can_get_what_you_need.
3. KKR, Bloomberg, Robert Shiller/Yale University, December 2017, January 2018. http://www.kkr.com/global-perspectives/publications/outlook_for_2018_you_can_get_what_you_need
4. GuruFocus, March 5, 2018. https://www.gurufocus.com/stock-market-valuations.php
5. Federal Reserve Bank of St. Louis, March 2018. https://fred.stlouisfed.org/series/PSAVERT
6. Bureau of Labor Statistics, January 2018. https://data.bls.gov/timeseries/LNS14000000
7. U.S. Bureau of Economic Analysis, January 2018. https://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm
8. Fortune, Federal Reserve Bank of St. Louis, Standard & Poor’s, December 2017. http://fortune.com/2017/12/07/corporate-earnings-profit-boom-end/
9. Bureau of Labor Statistics, January 2018. https://data.bls.gov/timeseries/CUUR0000SA0?output_view=pct_1mth
10. Federal Reserve Bank of Philadelphia, February 2018. https://www.philadelphiafed.org/research-and-data/real-time-center/survey-of-professional-forecasters/2018/survq118. https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield
11. YCharts.com, March 2018. https://ycharts.com/indicators/10_year_treasury_rate
12. PitchBook-NVCA Venture Monitor, January 2018. https://pitchbook.com/news/reports/4q-2017-pitchbook-nvca-venture-monitor
13. TechCrunch, April 2009. https://beta.techcrunch.com/2009/04/17/venture-capital-down-50-it%E2%80%99s-not-just-the-recession-folks/
14. TradingEconomics.com, March 2018. https://tradingeconomics.com/united-states/bankruptcies
15. Federal Reserve Bank of St. Louis, February 2018. https://fred.stlouisfed.org/series/BUSLOANS
16. The Journal of Finance, Laurent Fresard, April 2009. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1090156
17. Sequoia Capital, October 2008. https://techcrunch.com/2008/10/10/sequoia-capitals-56-slide-powerpoint-presentation-of-doom/