April 3, 2023Scroll down
Higher rates are coming after US companies
While fast-rising interest rates have now made their mark on US banks’ assets, corporate borrowers have yet to feel the full impact of the last year’s hikes. When the pandemic hit and central bank liquidity injections saw rates quickly fall to zero, corporate America seized the opportunity and locked in ultra-low coupons in 2020 and 2021. In the former year alone, US companies issued $2.3 trillion in corporate bonds, with another $2 trillion issued in the following year. The effect of zero interest-rate policy (ZIRP) can be seen in Fed data on non-financial companies’ interest payments scaled by their total outstanding debt (see below), which sits at around 3% today, compared to over 13% in the 1990s. Cheap money clearly benefited firms’ expansion—not to mention giving US equity valuations a boost. The data also show how the tide began to turn more recently, as the Fed’s sharp rate hikes sent Moody’s seasoned Baa Corporate Bond Yield flying above 5% in early 2023.
Rising cost of debt promises to further compress corporate profits
A recent analysis published by Calcbench on 75 non-financial firms in the S&P 500 that filed annual reports revealed their debt maturing by 2023 totals $73.6 billion. The weighted average rate on such debt was 2.65%, a rate significantly lower than what’s available to these companies today. As higher borrowing costs begin biting into companies bottom line (see below), investors will have to take a second look at still-frothy valuations.
Indeed, the gradual rippling of Fed policy rates through US company financials reminds us that already in Q4 2022, corporate earnings turned out to be quite short of Wall Street’s expectations, with fewer companies beating than anticipated and the degree of positive earnings surprises notching among the lowest on record. Although exogenous shocks to supplies and logistics stemming from China’s zero-COVID policy and Russia’s invasion of Ukraine have faded, higher labor costs have proven to be very sticky. Combining that persistent wage inflation with climbing interest expenses, even a slight shortfall in revenue will put a serious squeeze on companies’ earnings. Firms have means of reducing liabilities—by slashing investment, for example, or issuing equity—though such alternatives surely don’t provide much comfort to stockholders.
Private lending market has ballooned in last decade
Risks to the real economy notwithstanding, US stocks rose last week, in part due to investors’ belief that the banking crisis was fading in the rearview mirror. Though we never saw SVB or Credit Suisse as major systemic risks, we do put good odds on more drama playing out, and we believe greater risks loom in less conspicuous areas of the financial sector. In particular, the shadow lending market seems an underappreciated destination for potential spillovers from stress to the banking system. Less traditional channels for borrowing and lending have boomed in the decade since the Global Financial Crisis, as tighter financial regulations and over a decade of ultra-low interest rates allowed private equity firms and other specialty lenders to pile up large-size, low-cost loans when making deals. We got a glimpse of this dynamic a couple weeks ago, when struggling US lender PacWest Bank turned to investment firm Atlas SP Partners for a $1.4 billion financing facility. Overall, lending by institutions without a banking license—entities not subject to strict regulations on traditional lenders—amounts to $240 trillion in assets globally, making it hard to ignore the shadow lending market when assessing the impact of 2022’s jolt to interest rates.
Complexity compounds and obscures serious risks
As a chart released by Bloomberg last week illustrates, a characteristic feature of shadow banking is how complicated relationships among borrows and lenders can be. Transactions in these less visible channels can feature a dizzying array of financial actors, including everything from private equity firms and credit funds to pension funds and other institutional investors who can access a wide variety of leverage from banks and specialty lenders.
With the economy slowing down as borrowing costs rise, it’s not hard to imagine corporate defaults hitting private debt providers, cascading out to banks that have offered leverage to private credit funds and causing bigger problems. Fears of just such a scenario actually prompted many banks in late 2022 to begin offloading positions in leveraged funds and to cease underwriting of massive buyout loans. SVB’s collapse and the subsequent failure of Credit Suisse have only exacerbated frigid conditions in the market. Of course, private equity and credit funds, unlike banks, feature lock-in periods as a protection of their capital—in other words, they’re not subject to the risk of a run on the bank. Nevertheless, as we saw in the case of Blackstone’s BREIT fund earlier this year, when investors get a whiff of trouble and gates on redemptions kick in, sentiment can quickly sour and cause distress nonetheless.
In light of all this, it is perhaps unsurprising that when Bank of America released March results of its recurring survey of global investment managers, a “systemic credit event” was seen as the biggest tail risk, with US shadow banking seen as the most likely culprit for setting things off. Needless to say, we continue to watch the private lending ecosystem closely and factor such risks heavily in our decision to avoid taking too much credit risk (especially as spreads remain far lower than seems justified by the conditions we’ve just sketched out).
Jack Ma returns to China, breaks up his company
Back in 2020, Jack Ma publicly criticized China’s financial watchdogs and banks, prompting a halt to the US$37 billion IPO of the firm’s financial arm, Ant Group, and quickly giving way to his self-imposed exile, first to Japan and then to Thailand. In the time since, BABA shares commenced a long downward slide, shedding over 70% of their value entering 2023. Misery loves company, and the firm’s troubles were eventually drowned out by Chinese authorities’ broader crackdown on the nation’s tech industry, sending shares of competitors, including the likes of Tencent, Meituan, and Didi, significantly lower. Those with the patience to ride out those losses were pleasantly surprised last week, when Jack Ma unexpectedly returned to China on Monday to give a talk at a Hangzhou school, generating speculation that the billionaire has gotten back on Beijing’s good side. Just a day later, the firm announced an even bigger shocker: Alibaba’s sprawling tech empire would voluntarily split into six smaller units. Alibaba’s management explained the move as being geared toward providing autonomy to rapidly growing divisions in diverse areas: independence which would make each group much nimbler in its specific domain. That’s similar to Google’s rationale for its 2015 shift to a holding company structure with Alphabet as the parent. A restructuring of Alibaba also plays perfectly to regulators keen on smashing up China’s tech monopolies. Announcement of the breakup was cheered by traders, who sent BABA shares up by 17% last week.
Why should investors prefer six baby ‘Babas?
From an investor’s perspective, there’s yet another rationale for splitting Alibaba up that’s also critical to understanding the market’s reaction. For years now, a big cloud has been hanging over BABA’s shares. In addition to China’s regulatory scrutiny, which focused on everything from anti-competitive practices to issues with the firm’s treatment of sensitive user data, Alibaba faced pressure from US regulators and politicians over accounting access and national security concerns. Moreover, analysts watching the firm’s growth in recent years had become increasingly aware of the longer-term threat posed by increasing competitive pressures in the China tech space, gradually compressing the company’s profitability and limiting its expansion. Looking upon Alibaba’s wide range of businesses in consideration of these complex factors, investors had no real choice but to apply a broad discount to the company’s entire book of business. The breakup of Alibaba into separate businesses has the effect of allowing investors to make decisions about the risks—and hence the value—of each of these underlying businesses individually. Along those lines, the stock market’s very enthusiastic reaction seems likely to come in no small part from a recognition that the sum of the parts, if each one can be valued on its own merits, is probably worth quite a bit more than the whole thing.
The news is out. What comes next?
After announcement of a big corporate action like this, there’s often a long road ahead operationalizing the change. In Alibaba’s case, the splitting-up process could take years, and there is clearly much work to be done curating and implementing a plan for each separate unit, as well as working out exactly how they’ll all fit together going forward. The separation also promises to bring some tough decisions with respect to budgeting. Consider, for example, that among the firm’s separate business units, local services (food delivery and mapping) and international commerce still operated at negative EBITDA margins in Q4, with funds generated by the firm’s cash cow e-commerce division supporting many of the conglomerate’s earlier-stage business lines. Independence brings flexibility and accountability—both of which could boost productivity—but will also focus more attention on each segment’s bottom line, giving investors more transparency into less favorable aspects of the business. And not all restructurings have added value for investors. One of the firm’s principal rivals, JD, took the same route to break off various business units in the past and did not see significant boosts to valuation in the resulting IPOs.
Reading the regulatory tea leaves
Despite the operational and financial risk associated with such restructurings, it’s notable that even JD has announced more planned spin-outs in the wake of Alibaba’s news. One explanation for this recent push to deconglomerate goes back to regulation: tech companies may voluntarily split themselves apart to effectively reduce the area of the target on their backs. We take a different view and believe Alibaba’s restructuring—while in part a response to past pressure from Beijing—sends a fairly strong signal that we’ve long passed the peak of the most recent regulatory cycle. It’s likely that a perceived improvement in the regulatory environment is what gave Jack Ma the confidence to return to China and allowed him to finally make bold moves to unlock value in his company’s shares. This view also lines up perfectly with Beijing’s concerted push for growth and their recognition that sentiment isn’t going to see a sustained recovery as long as there’s this looming threat to entrepreneurs and investors. In that sense, Alibaba’s announcement has rightly been interpreted as a positive development for the entire sector.