Debt and Taxes

For our final issue of 2010, while others are sifting tea leaves, reading tarot cards, or gazing into crystal balls for what’s in store for capital markets next year, we’ll tell you what our own proprietary super-sophisticated forecasting model is saying.

And if everyone’s bets for 2011 are as accurate as they were for this year, we’ll just take the opposite of their picks, and probably end up right on the money.

Until the Republican sweep in November, everyone expected a capital gains tax increase driving owners to sell their companies before the end of 2010. Didn’t happen.

Then there was agita that the US would slip into a double-dip, market liquidity would dry up, and sellers and buyers would be stranded at the altar. Not.

What about worries that overleveraging of intra-European debt would cause the whole system to domino? Like when those fears first surfaced in May, and markets panicked…for about twenty minutes. Then it was back to business as usual.

And, let’s face it; absolutely no one knew what to make of last week’s announced deal between the White House and Republicans extending Bush tax cuts. Will it increase the deficit, raise rates, spark inflation, kill bonds and hurt credit recovery? Or will it empower consumers, build employer confidence, and send the recession packing?

Just look at where we are now. According to PitchBook, 243 PE transactions closed so far this quarter. Compare that to last year when 4Q deals totaled 367. With only 25 wrapped through last Friday, there could be fewer than 100 in the books by December 31, making it the slowest month of the year! Quite a reversal from all the earlier hype.

The truth is no company was ever bought or sold for tax reasons. Of course, at the margin, fiscal and fundamental factors prod or hinder M&A activity. Clearly some deals got pushed into 2011 when the sense of urgency diminished. But only two things really count: a seller’s need to monetize its investment and the buyer’s ability to finance it.

And right now the $500 billion of uncommitted PE cash combined with a big backlog of frustrated owners who have waited over three years to cash out are what will drive deal activity next year, and for years to come.

Meanwhile, sell-side desks tell of a plump post-holiday pipeline of dividend deals awaiting buy-siders. As long as the high-yield market keeps putting mucho dinero back in the hands of institutional investors—which we think will happen as far as the eye can see—funds will keep pouring it back into refinancings and recaps. That will shrink large cap spreads and allocations while leverage and prices will test record highs.

But the middle market, always marching to its own drum, begins next year as it did 2010, with limited lending capacity—especially at the lower end—and a lot of demand. Which means spreads will stay north of L+500 and total leverage south of five times Ebitda.

We don’t really have a black-box model, just a healthy dose of skepticism that anyone has a clue about 2011. But with few options for investors seeking high single-digit yields and low single-digit defaults, we think the loan market will be a pretty good place to be.

Randy Schwimmer is senior managing director and head of capital markets at Churchill Financial, as well as columnist for its weekly “On the Left” newsletter. The opinions expressed here are his own. Reach him at