It has been a busy month in the world economy and in the bank business especially. On March 10 a large commercial bank in California was closed for lack of ability to pay depositors. It has produced a wave of concerns about how much debt is out there and how banks have managed it.
The PBS show Frontline produced a summary of the issues that can be said to have led to the crisis. It aired on March 14 in many markets. A central theme of the show was that in response to the 2008 financial crisis the Federal Reserve cut interest rates to almost zero. They stayed there for a very long time. When interest rates are low people look for other places to put their money and since 2008 we have seen huge inflows of investment to hedge funds and private equity. In the past two years we saw a rage develop to acquire cryptocurrency and NFTs. In many instances people borrowed to acquire these assets and lots of businesses borrowed at these crazy low rates to acquire other businesses or to buy back their own securities. How could you lose when you could borrow at 2-3%?
The problem is starting now to ricochet. For the decade from 2008 to the beginning of 2018 the LIBOR rate; the rate banks loan to each other was under 2%. By the beginning of 2019 that rate had slowly risen to 3% but then started to trail off. By January 2020 it was back down to 2%. Then the pandemic hit and in response the banking world dropped rates to 0.25%. As we now know, there was a lot of money still on the sidelines and, coupled with “free easy” PPP loans from governments, the race to buy equities of all kinds was on. The S&P500 went into the pandemic at 3,300. We saw the American economy essentially shut down from March through June 2020, yet by July 31, the SP500 was back to 3,300. It fully recovered in 120 days despite the fact that we had no vaccine to fight COVID and a supply chain in complete disarray. By the end of 2021 the S&P500 was at 4,800, an increase of 40%. Now inflation was the wolf at the door and central banks started to tighten credit fast. The LIBOR at the end of 2021 was 0.5%. Ten months later it was at 5.5%, an eleven-fold increase. The days of cheap easy money were over and borrowers who had been at the window were now paying huge amounts for the same debt they had financed at incredibly low rates. In a word, this is what is stressing the financial system.
So, what does this say about business valuations? When you can borrow cheap, a buyer of a business can afford to pay more to acquire the nettlesome competitor or the attractive new business. We saw businesses self for multiples of sales where the benchmark has long been multiples of earnings. Who cared? The buyer was financing at 3-5%. Well, not anymore. Today’s buyer is starting to pay real interest and that means that they aren’t so generous when they are looking at business acquisitions.
In practical terms, this means that if you are using the sale of a comparable business where that sale was effected between 2009 and 2022, the sale price is probably inflated because the interest rates to acquire the business were so low. Thus, if you see an expert report that is heavily reliant on direct market sales in contrast to an income approach to the valuation of a business, you need to ask how the direct market approach can be reconciled to the income approach.
To analogize, if you were in the market for a car back when you could finance at 4.5% over 60 months with $5,000 down, your payment for a $50,000 car would be $840 a month. But if interest rates jump to 7.5%, the same vehicle now is a touch over $900 a month. So beware of price comparisons based on transactions completed in a completely different lending market.
The Frontline episode is here;