The Dividend Cafe - A Consideration Being Missed

Episode Date: October 11, 2024

Today's Post - https://bahnsen.co/3Y5HlWw Strategic Acquisitions and Private Markets: Insights from Dividend Cafe In this episode of Dividend Cafe, David Bahnsen, managing partner at the Bahnsen Group, discusses various financial and investment themes. He covers the importance of his firm's week-long meetings with portfolio managers in New York, where they engaged in portfolio introspection, macroeconomic discussions, and considered potential opportunities and risks. Major topics include inflation, subdued growth expectations due to 'Japanification', and rich stock market valuations with concentrated sector impacts. The focus then shifts to strategic acquisitions in private markets, especially public companies acquiring private firms to address a backlog of unsold businesses, which could result in significant M&A activity. David also highlights the role of private credit in funding leveraged buyouts, emphasizing the robustness and low systemic risk within the private credit market. Listeners are encouraged to explore additional insights and charts on DividendCafe.com. 00:00 Welcome to Dividend Cafe 00:33 Portfolio Management Insights 02:00 Macroeconomic Considerations 04:32 Inflation and Growth Expectations 05:52 Valuations and Market Dynamics 06:38 China's Structural Challenges 07:09 Private Markets and Strategic Acquisitions 13:44 The Role of Private Credit 16:54 Conclusion and Additional Resources Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to the Dividend Cafe. I am David Bonson, the managing partner at the Bonson Group and the person who brings you the Dividend Cafe every week. And today, Friday, I'm recording actually from my apartment in the city because I will shortly be heading to the airport to go back to our California office where I'll be for the next almost two weeks. I haven't been there for a while. It'll be really nice to be with the California team for a couple of weeks, see a lot of clients

and record Dividend Cafe in that beautiful studio that we have in Newport. In the meantime, I want to talk to you all today about something that I kind of teased a little last week, which was the fact that one week ago at this moment, we were wrapping up a week of meetings with our portfolio managers, asset management partners here in New York City, sometimes hedge funds, sometimes alternative managers, other times bond managers, different asset classes, some people that we had just met, others that are people we've known for many, many years. It's for those of you who are clients who know all about this, forgive me for the redundancy, but it is something we've done for many years and written about, talked about quite a bit. And it allows us the ability as an investment committee

to not only have a lot of time together in discussion and debate, in consideration, but also to have this time with others where we can bounce ideas off them, hear their perspective, critique what they're doing, and just really force ourselves to do a whole week of real portfolio introspection. There's macroeconomic considerations. There's particular portfolio execution considerations. Look, for someone who has made their living managing money for like me and who loves doing it, it's a lot of fun. It also is a very serious week. I have talked about over and over again over the years.

I don't really believe there are times when everything's calm and cool, when people will say like, oh, wow, things are a little crazy right now. and cool when people will say like, oh, wow, things are a little crazy right now. It's usually describing something that is always happening, just taking on a different shape or size or manifestation. And so it isn't so much that, oh, well, this year we had to go talk about inflation, or this year we had to talk about subdued growth. Or this year, we had talked about the election or about China. There's various things that have to be discussed every year that represent potential headwinds, that represent tail risk, and sometimes represent opportunities or questions, vulnerabilities, but also the untapped opportunity.

So I think a week ago, I may have mentioned, I was writing about China and really still processing a lot from the week. And Brian and Kenny and I spent a lot of time this week decompressing further. We were together all day, every day into the evenings the week prior. But really when all said and done, there's a few particular portfolio adjustments we're making, and that we're going to write about for clients Wednesday next week. And there are a few macro considerations, but the major things that get talked about at every meeting, and with different perspectives from different people that we can talk to, I write about all the time. So I can tell you that, oh, yeah, a lot of people think that whatever inflation expectations end up being is going to impact bond

yields. That's not exactly news. And there's differing opinions about what inflation expectations will be and what, therefore, the impact of bond yields and other economic considerations and financial market considerations will be. I have already gone on record with our perspective about this kind of thing, that effectively, I think the goods inflation, producer price inflation is already effectively at 0%, if not lower. And then the housing market is frozen and will disinflate but can't disinflate until the Fed is successful in sort of dethawing that market and allowing buyers and sellers to start transacting again. And that's really where I see the inflationary backup is just in housing, in the data.

And I think that that's just simply a matter of getting transactions to happen. So that's kind of number one, universally being discussed inflation. Universally being discussed number two, growth. And I'm well on record here. Our long-term growth expectations are subdued because we are of the belief that we are in a Japanification period brought about by both excessive government debt and the policy response to such. But the short and medium term outlook is much more tricky. There are people who believe that there is the possibility of a boost in growth in a short or intermediate term that could be catalyzed by CapEx. I've talked about this at great length. I'm not at all against this thesis. I don't think it's a foregone conclusion, but I think that some form of business investment that

juices productivity for a time is entirely possible. A catalyst to the catalyst of CapEx could very well be on-shoring, re-shoring, and other change in manufacturing activity. But then there are plenty of things that could prevent such from happening. A fiscal issue around tax and regulatory policy after the election, and not to mention a shortage of labor. That's a little trickier, but our longer-term growth expectation is one we have a kind of point of view on and have for some time. You know, you can look at the stock market valuation subject. I talk about it so often,

Dividend Cafe, I hesitate to even bring it up. But there's not a question that valuations are rich. There is plenty of question as to when that will matter. It is simply untimable by definition until it can be identified with the vantage point of the rear view mirror. And I think history is very clear on this. I think right now, the excessive valuations are very concentrated in a couple of particular sectors and spaces, and perhaps more democratized in their impact because of the massive increase in cap-weighted index investing that's taken place since the last time we had a valuation bubble like this. And then the fourth and final category I'd say that's pretty universally discussed is China. Bond managers, hedge funds, equity managers, US-based, international-based, everybody is talking about China. I wrote about it last week. You know our feeling, we do not consider

them to be going through cyclical challenges that therefore have cyclical, exciting opportunity. We believe they're going through structural challenges. And that's why we essentially consider ourselves to be very avoidant of the Chinese equity story in particular. So what is something that came out of these meetings that I think is unique, different, interesting, and worthwhile? It's going to sound for a brief second like it's very bespoke and very granular and not of interest to everybody. And if you bear with me, I do believe that there's a pretty broad application. For us, our exposure to public equities in the US is largely the mass majority of that exposure is to dividend growth investing,

which is what we believe in as a almost religious principle in our investment philosophy. Private markets are something that many of our clients have exposure to. Some do not. There is a tolerance for illiquidity for some people and not for others. A lot of considerations that go into the risk profile and suitability of one being engaged in private markets. So when I talk about private markets, it's easy for a lot of people to say, I don't think this really affects me. Or if you're not a client of ours, you may just think I am not interested in this private alternative stuff. But what I'm about to say is actually something that does impact everybody. Everyone in the industry is aware there's plenty of conversation inside baseball

about the fact that a lot of deals were done. There was very low interest rates and a real heavy appetite for deal and a lot of liquidity sloshing around that enabled a fair amount of transactions and private equity. Let's call it 2020, 21, early 22. A lot of companies were bought and the sponsors, the private equity folks buying these companies, you're now in the third, fourth, soon to be fifth year of some of these deals. Their investors want money back. And they bought at a certain valuation and they would like it to be at a higher valuation when they sell. They bought at a certain earnings level. They'd like it to be at a higher earnings level when they sell. That part is mostly executed very well. But the valuation issue and then the

interest rate, they may have borrowed at a certain rate when they bought, but now it's a higher borrowing rate. And so the exit multiple may not be what they kind of penciled a deal to. And you see an absolute backup of exit transactions for the private market space. You don't see a big deterioration of value where deals are happening. They're largely happening at good marks at where companies had priced them to be or even better. But there isn't a panic sale to get out. People are not desperate, but we're at a very abnormal level of deals that need to be brought to fruition. And so as I thought about that and discussed it with several top tier

managers, including some managers who lend on these deals, as opposed to being on the equity side, it was very clear to me that one of the common exits of private equity transactions has been off the table, selling to a bigger private equity company because of high borrowing cost and the desire to get a better multiple buying than what the exit multiple would be to sell. So a difficulty of matching buyers and sellers there. And then IPOs, I've talked about, written about lately that there's a much lower appetite for IPOs. What that leaves you is an option that I had not considered enough that I think is going to be a really substantial part of capital markets activity in our country

for several years. And that's strategic acquisitions of private companies by public companies. And I think that you may see a little bit of give in the exit multiple for the seller because buyers in public markets don't like to pay a multiple for a company they're buying higher than the multiple they already trade at. And public multiples are high, but in some sectors, they're not as high as where private deals are. You're going to see some good deals. You're going to see some bad deals. You're going to see varying multiples. You're going to see different credit conditions around it. But I think that there is no way to remove this backlog, address the backlog of companies that

have been bought that need to be sold apart from public companies making strategic acquisitions. So why do I bring that up as something that I think affects everyone? Well, first of all, for us as dividend growth investors in public equity, we happen to own quite a few companies that would be either directly or tangentially connected to the deal side of this. Investment banks, M&A, lenders on these transactions, asset managers. So within the financial services sector, there is a play here on just increased activity. M&A has been very subdued the last couple of years. It had been really hot a couple before then. We think, we think in a period, there's going to be a lot of deals. So that's number one,

is just simply being exposed to what the public market opportunity is there, where there are good dividend growing companies to capitalize on it. But then number two is anyone invested in public equity is likely going to end up having to deal with the possibility of companies they own making bad deals and then making good deals. And so it is not something you bring up to say this is a risk or this is a good thing. It is both at once. It requires adjudication and discernment. And I believe it will happen at a level that we're not fully appreciating at this time. And so there's always been a strategic acquisition of private companies in the public market. But I think you're going to see it elevated. I think you're going to see it impact, especially organic earnings growth constrained companies

that want to use M&A as a means buying growth inorganically. And that can be done very, very well, but it often is not. And so this is a theme that I want to pay a lot of attention to actively, proactively in the years to come. Now, a tangential issue that I'll close with that is also related is most of these deals get done with borrowed money. And I've talked ad nauseum over the last couple of years about how private credit has really out-competed a lot of the bank loan market and the high-yield bond market to underwrite a lot of these deals. They're lending to private equity sponsors through private channels. And what I mean by that is it's debt that doesn't trade and isn't held on a bank balance sheet. So the money comes from investors. And investors that don't have a timeline for return of capital, it's not callable.

And that's where, of course, the difference in the bank market where deposits, the funding mechanism are always callable at any moment. This private credit market, I consider to be a great victory for capital markets in America and an enhancement to the systemic safety of our banking system when a lot of deals can be done that are productive and yet not held from a risk profile inside the banking system. Why would someone prefer this to the bond market? There's speed, there's execution, there's value creation. There's a number of arguments as to why someone would go private credit versus the bond market, transparency, disclosures. There's a lot of issues that play there, but those are strategic things for the borrowers

and the lenders to think about. Systemically, all of us in society, I'm just arguing that there's something that has been conducive to economic growth at play that is not adding to systemic risk, in my opinion. But the question that comes up a lot is, well, are we at the end of the opportunity set here? A trillion and a half dollars has gone into underwriting, leverage buyouts, private credit funding, private equity deals. Aren't we into the thin part of the opportunity set now? And I think it underestimates the many, many, many, many trillions of dollars of lending

opportunities that exist against assets, against different types of collateral, different types of terms. The level of depth of lending in the banking system and in the bond market. No, there's a richness of opportunity there, but there is still a principle at play maintaining high quality underwriting, diversification, attractive terms, suitability for who exactly is doing it. I am not a private credit bear or a bear about other things because of private credit. And there's people in both those two categories, sometimes both at the same time. I would be none of the above. But one of the takeaways from this last week that Brian, Kenny, and I really shared was appreciation for the opportunity in structured credit, in asset-based lending, private credit. And the fact that there are perhaps bad lenders coming

into fray is somewhat immaterial. There's always bad deals, but we want to avoid those. We want to avoid the bad players, stick with the operators that are worthy of our investment. And that's what we think we're doing, but don't see it as a systemic story. In fact, see it as a huge growth story. There are other nuggets in DividendCafe.com that I won't have time to here right now in the video that I encourage you to check out. There are a couple of different charts, including a chart that visualizes the whole private credit universe that I don't know if they're going to be able to put into the video or not. And so if you haven't seen it here in the video, I definitely would love for you to check it out at DividendCafe.com. Then I'll look forward to being with you back in California next week. If you missed the last couple episodes, we did thoroughly discuss

China last week. We did our big, huge election issue the week before, talked about the Fed the week before that. So there's been a few doozies here at Dividend Cafe the last few weeks, and we'll see what's in store for next week. I do thank you for listening and watching and reading the Dividend Cafe. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, member FINRA and SIPC, with Hightower Advisors LLC, a registered investment advisor with the SEC. Securities are offered through Hightower Securities LLC. Advisory services are offered through Hightower Advisors LLC. This is not an offer to buy or sell securities. No investment process is free of risk. There is no guarantee that the investment process or investment opportunities referenced herein will be profitable. Past performance is not indicative

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