Q1 Markets Review & Outlook: Is Confidence Recovering?

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Alan Tannenbaum:

Welcome to Markets Plus, where we cover the latest market, economic and business trends. I’m Alan Tannenbaum, CEO of BMO Capital Markets. Today, we have one of our most anticipated episodes – our Quarterly Investment & Corporate Banking Market Themes and Outlook. And seeing as capital markets are at an interesting inflection point right now, Warren Estey, Head, Investment Banking for BMO Capital Markets is here to give his expertise and perspective on what we saw in Q1, and how things might play out from here. 

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries. We value your input and hope to keep the show as interactive as possible, so please leave a rating on Apple Podcasts, Spotify, or your favorite podcast app.

Warren Estey:

Thanks Alan. Hi, this is Warren Estey and as Alan mentioned, I lead the Investment Bank at BMO Capital Markets. This is our inaugural Investment Bank podcast, which we plan on bringing to you quarterly. It’ll cover various topics and markets themes that we believe will be of interest to you, our clients. Today, I’m going to discuss what we saw across markets in Q1 and what we see developing throughout the rest of the year.

Speaker 3:

Thanks, Warren! Looking forward to it. Let’s get started.

Warren Estey:

Absolutely. So, overall, it is an opaque environment with a lot of crosswinds: Evolving Central bank policy, Uneven global economic growth, Wars in Ukraine and Gaza, Broad geopolitical tension in the east and west, and the upcoming US presidential election. And yet: The DOW was up 6%, S&P up 10%, NASDAQ up ~9%, equities volume -13, which is close to five year lows, and UST vol at a post-covid low.

Speaker 3:

Why is that?

Warren Estey:

A number of reasons. Market that is leaning into FED rate cuts though it’s recalibrating when and how many as we speak. Resilient economic data we’re seeing is leading investors to the Soft/no landing scenario. Fundamentally being driven by earnings recovery and the earnings calendar. PE multiple expansion ongoing/last six months. In talking to our traders, they’d tell you that it’s still a relatively short term focused market though. Witness the Explosion of single day options contracts as an example. Overall, market is Biased to upside. Accommodative. For capital markets, (ECM/DCM/M&A—the products that enable companies to finance themselves and grow) to work, we don’t a market that is making new high every day, we need one that is characterized by lower volatility so investors can price securities appropriately, boards can bid on assets confidently and they can do it with confidence. That is the type of environment we’ve seen begin to develop in 2024.

Speaker 3:

Ok, that’s really helpful. What about the Equity Capital Market (ECM)?

Warren Estey:

US: Q1 24, $75B over 181 deals in US; Q1 23 $35B over 126 deals in US; Volume +110%; Deals +44%. Canada: Q1 24 $5.4B over 54 deals in US; Q1 23          $3.7B over 92 deals in US; Volume +45%; Deals -41%. U.S. market has seen a real reacceleration of ECM in 2024, particularly follow-ons. Majority of activity can be broadly categorized into two groups: Sponsor / Corporate Monetizations: private equity investors and corporates holding shares of public companies really took advantage of the market backdrop to sell down significant positions. These secondary offerings accounted for approx. 60% of total follow-on proceeds and 36% of total number of deals so they were generally larger deals. Interestingly, approx. 25% of secondary transactions have included companies buying back their shares from sellers as a portion of the offering, which enabled underwriters to create meaningful order book tension and ultimately better outcomes for sellers. Life Science Financings: thanks in part to a significant boost in big pharma M&A activity at year-end 2023 / beginning of 2024, U.S. ECM market saw a resurgence of biotech financings, accounting for approx. 50% of the total number of follow-ons year-to-date. Life Science follow-ons performance has been a 2024 highlight in itself, returning an average of +21.8% across 54 transactions. In Canada, two big themes drove the market Energy, representing 33% of all new issuance. M&A was a key driver of new issuance. Pembina’s $1.28 bln offering and Crescent Point’s $500MM offering good examples. Meanwhile, the U.S. IPO market has experienced a steady reopening. With 14 deals priced for nearly $7 billion in proceeds, the market has proven dynamic across sectors and uses of proceeds. Industries represented have included real estate, consumer and technology businesses, in addition to 7 deals from the healthcare sector. A wide range of trading performance underscores the nuances of the current market, and how Q2 will be critical; deals need to perform well to ensure the growing health of the market overall. Importantly, the forward pipeline looks good. Broad based; BMO will be especially active across industries like Real Estate, Insurance, Industrials, Healthcare and Energy Transition companies. The U.S. Equity Linked market has had a strong start the year, as a diverse mix of corporates were driven to the convertible product for a number of company-specific reasons but a clear driver was high unsecured debt costs. Convertible offerings year-to-date have raised over $16 billion across 24 offerings, 10 of which have come from the Tech sector. BMO has been especially active as a bookrunner across convertibles, including bookrun offerings for Winnebago ($350 million), Global Payments ($2.0 billion), Lyft ($460 million), SoFi Technologies ($862 million) and Microstrategy ($800 million). Take-away for the US equity and equity-linked new issue market overall was that it provided alpha as an asset class for investors in Q1 and so we expect the momentum in that market to continue to build. In Canada, Activity slowly returning to normalized levels but still frustratingly away. IPOs are unlikely to be prominent until later this year or into ’25. Expect M&A-driven equity issuance plus secondaries to be major themes.

Speaker 3:

And what about Debt Capital Markets (DCM)?

Warren Estey:

In US, we closed Q1 at 540bn which is up 34% YoY. This far exceeds previous records and market expectations. The only 1Q that got close to the $500bn mark was 1Q20, but only because the COVID rush kicked in. In Canada we’ve had C$38bn which is up close to 60% YoY (vs 23.8bn). Split in both markets is roughly 50/50 between FIG and Corps. Q1 kicked off with record levels of IG bond supply on both sides of the border, both from a gross issuance and net issuance basis. There were a number of drivers of that: In the U.S., resurgence of M&A supply has been a key driver of supply. Credit spreads on both sides of the border have moved meaningfully lower since late October (~100bps in the U.S. and ~55bps in Canada), incentivizing issuers to step off the sidelines and take advantage of conducive market conditions. Fundamentals remain strong with corporate balance sheets healthy, ongoing inflows into corporate fixed income investment mandates, and strong secondary performance all fueling ongoing demand for new issues across the credit spectrum. Potential volatility in the back half of the year (U.S. elections, etc.,) and the resulting execution risks have caused some issuers to pull forward refinancing activities initially slated for later in the year.

A couple interesting points on the IG market: Following the collapse of Silicon Valley bank in March 2023, general risk appetite for deeply subordinated bank capital saw a dramatic decline and this segment of the market laid largely dormant for most of the year. 2024 marked the broad return of these structures both in Canada and the U.S., demonstrating the resilience of the IG bond market and investor confidence in the financial sector. As an example, BMOFG issued its inaugural US$ LRCN in February for $1Bn which saw support from a broad set of investors and strong pricing which moved 42.5bps from IPTs to land at 7.70%. BMO recently led the inaugural Maple transaction for NextEra Energy Capital Holdings – a culmination of the ongoing partnership across our U.S. and Canadian platforms. The transaction paves the way for other U.S. utilities to follow suite, which, alongside the potential maple index inclusion currently being contemplated, act as dual-tailwinds for more Maple supply as we look ahead, and BMO is uniquely positioned to take advantage of this trend with the seamless partnership between our U.S. and Canadian platforms. Similarly, Canadian borrowers continue to look to the US market to diversify their borrowing base.

Looking ahead, supply expectations for the remainder of 2024 are slightly tempered given robust early activity, but so far issuance continues to surprise to the upside

Speaker 3:

Moving to an area where we’re seeing activity pick up: Leveraged Finance.

Warren Estey:

Let me throw a few headlines at you: TLB $142B—One of 10 busiest quarters of all time; HY Issuance $85B—Strongest 1Q since 2021; LSTA index 96.7—average price of new issues=99.6; HY Index 7.7%--spreads approaching +300bps.

Strongest market in last 24 months w/opportunity to reprice/extend/recap/acq fin…everything on the table. A few themes standout: The recent elevated secondary levels for loans and bonds, coupled with increased investor appetite for risk, are giving borrowers the opportunity to refinance at better rates. The majority of volume in the YTD has been opportunistic (repricings, refinancings, and extensions). Over 63% of volume YTD has been earmarked for refinancings, the largest level in 11 years and the second highest tally on record. LBOs and M&A have made up just 22% of YTD volume, due to elevated cost of debt and a logjam in sponsor exit activity. CLO issuance is up 40% year-over-year, with investors looking for opportunities to put new money to work.

With the M&A market on a gradual growth path, which I’ll touch on later, borrowing costs continue to drop and the IRR math for sponsors improves, we expect a resurgence of sponsor activity in the back half of 2024. Already seen a growing uptick in activity from these set of clients. Sponsors remain focused on high quality, cash flowing businesses in enterprise software, insurance brokerage, and tech-enabled services.

Private credit continues to be a relevant alternative to syndicated financing – especially for our sponsor clients. Although private credit has taken market share from the broadly syndicated market in years past, we have recently seen a reversal back into the traditional leveraged finance markets. Lower spreads and healthier arb have put liquid loan investors back in the driver’s seat for now, with record CLO creation in the YTD. So far in 2024, 27 companies have issued broadly syndicated loans to refinance $11.5bn of debt previously provided by direct lenders.

As markets have recovered and new money opportunities for investors remain limited, we have seen a resurgence of junior capital in the form of senior unsecured notes and second lien term loans.

Looking at the outlook: Historically speaking, in the last three election cycles, we have seen both loan and bond issuance increase materially in the months of September and October of election years vs the same months in non-election years. Loans tend to be flat in November, but bond issuance is higher by an average of 12%. In equities, it’s a mixed bag: in 2012, issuance slowed into the election but then picked up. In 2016, issuance was steady. And in 2020, issuance only increased following the election. We have already seen $138bn in leveraged loan volume this year (over ½ of 2023’s total volume only 1Q into 2024).

Speaker 3:

Great, thanks for that. Switching gears to M&A. What are we seeing there and what can we expect moving forward?

Warren Estey:

US M&A market: 2023 volume was $1.2tn, down 10% from 2022 and ~20% below the 10-year average. 2024 YTD volume up 56% YoY (off easy comps). Energy, Tech, FIG are driving most of the increase. Large cap M&A is back: Already a dozen $10B+ deals this year (Capital One / Discover, $35bn). Corporate deal activity is up 80% YTD as balance sheets are generally strong and acquirers can realize synergies in strategically enhancing transactions. Sponsor activity is up 17% YTD, but still somewhat muted. 27% of total deal activity YTD, compared to a long-term average of ~30%. Fundraising environment is still challenging. Fewer exits / not enough return of capital; GP marks are still too high at many sponsors

Key themes: Valuations have come down from the 2021 peak, although limited datapoints involving scaled assets ($100m+ EBITDA). LBOs impacted by higher interest rates and lower leverage (debt paydown math doesn’t work anymore at 6-7x leverage). Still seeing examples of premium outlier valuations for very high quality businesses – market seeing a “flight to quality.” First Advantage (Silver Lake) / Sterling Check Corp (GS/CDPQ) – $2.2bn, 14.6x. Arcline / Kaman – $1.8bn P2P, 17.4x. EQT Infra / Heritage Environmental – $1.8bn, 17.3x. Lower quality assets have been hit harder.

Transaction structure will continue to be a key tool to bridge buyer-seller valuation expectations. There have been numerous rollover equity / minority stake deals / structured equity. Koch Industries / CPM (AmSec) - $400m structured equity investment. Platinum Equity / US LBM (Bain) – Minority stake purchase. Torquest / Bad Boy Mowers (Sterling Group) – Full sale process where seller rolled a significant stake. Warburg / INRCORE (TJC) – Full sale process where seller rolled a significant stake. TPG Rise/AmSepc (Olympus) – Full sale process where seller rolled a significant stake.

Corporate strategic dialogues remain robust, with a range of transactions and situations commanding headlines. Public to private transactions include: Arcline/Kaman, KKR (Chase, CIRCOR), Apollo (Univar, Arconic), JFL/Crystal Clean, CD&R/Veritiv. Thoma Bravo/Everbridge; Blackstone/Rover and Vista/EngageSmart announced in 2023, closed Q1 24. Unsolicited/hostile bids include: Vista Outdoors (rejected public offer from MNC Capital). Macy’s (investor group recently increased offer after previous rejection). US Steel (rejected Cleveland Cliffs offer, later agreed to a deal with Nippon Steel). Choice Hotels/Wyndham. Companies continue to remain diligent with respect to their business portfolios (GE corporate restructuring) and shareholders (Disney-Trian proxy fight).

Antitrust environment is getting stricter. Last July, DOJ/FTC issued draft merger guidelines; final guidelines released in December; only slightly watered down. More focus on consolidation trends (as opposed to one specific transaction); more scrutiny on private equity rollups. Examples: JetBlue/Spirit merger (recently terminated), Kroger/Albertson’s merger (FTC sued to block), Amazon acquisition of iRobot (abandoned over antitrust concerns). Don’t expect a major relaxation of the antitrust environment if Trump elected; he was tougher on antitrust than the last few Republican administrations.

Pipeline building of assets coming to market. Notable uptick in businesses coming to market later in 2024 — good mix of size and industry. Long list of busted auctions from 2022/2023; many will be coming back to market later this year as markets improve.

Market outlook. Expecting an up year in 2024…haven’t seen 3 consecutive down years in the last 30+ years. Headwinds that curbed deal-making in 2022 and 2023 — rapid increase in borrowing costs, recession concerns, declines in equity markets — have eased. Today, corporate confidence is recovering, economic growth has held up, equity markets are rallying, HY bond issuance is up, corporate cash levels have remained high. Risks remain, but markets and confidence have been resilient despite uncertainties: geopolitical tensions, global election cycles, inflation pressures, global regulatory regimes. However animal spirits continue to build. Strategics proactively reviewing strategic alternatives and considering pre-empting upcoming auctions. Sponsors increasing degree of creativity and aggressiveness in deploying capital.

M&A market dynamics over the next 12-24 months present a tremendous opportunity for BMO to deepen its relationships with our clients with expert perspectives, unique ideas and objective advice.