By Tom Gresham
After a strong year for deal activity in 2021, credit markets substantially cooled in 2022 as the prospect of interest rate increases grew and then became reality. Brett House, a macroeconomist and senior fellow at Massey College at the University of Toronto, says the current economic climate points to challenges for many startup companies, but also opportunities for investors able to take advantage of shifting conditions.
House, who participated in June on a CAiP panel on leveraging private debt and corporate credit, shared his thoughts on the landscape in a recent interview. He says deals have “dried up” and financing access for middle-stage, early-stage, and new startups is becoming more difficult, “which is exactly what would be expected in a rising rate environment where there are also exogenous geopolitical shocks that are affecting risk appetite.
Brett House
“It is creating a more credit-constrained and investment-constrained environment for startup companies that are attempting to scale,” House says. “On the investor side, though, it does mean that a point of dislocation like this presents the possibility of some opportunities. There’s far more attractive pricing on offer. When the herd of investors is moving in one direction, it is often a propitious time to move in the opposite direction in terms of investment targets.
“As credit markets have dried up, that implies a mismatch between supply and demand that is increasing the rates paid for access to capital, either on an equity or credit basis,” he says. “For investors that have a relatively medium-to-long-term time horizon and that have liquid capital right now – most private equity and debt investors are operating somewhere around a 5-7 year horizon – this is an investment opportunity that offers better multiples than was the case even six months ago.”
Currently, there is “an enormous amount” of private debt and equity capital on the sidelines, House says, adding that it might take some convincing for them to deploy this dry powder.
“I think a number of investors are looking for a little more clarity on where growth is going and the prospects of a recession on the horizon, because that would have substantial implications for the companies and organizations in which they wish to invest and their near-term and medium-term cash flow prospects,” House says. “I think they’re looking for a better sense of exactly how high inflation and interest rates are likely to go, which has increased interest in shorter-duration, variable-rate investment products to hedge some risk.”
In the current uncertain and volatile environment, House says investors should be particularly discriminating about proposals and consider sectors with favorable immediate growth prospects.
“If you look at the continuing exit from the most acute phase of the pandemic, the parts of the Canadian and American economies that have been the slowest to reopen have been relatively high-touch, relatively close-proximity service sectors like culture, entertainment, hospitality, tourism, sports, and recreation,” he says. “These are the areas where we’re likely to continue seeing spending focused, even in the context of aggregate, slowing demand, because people are pivoting away from buying things to fill up their houses and make their home offices and nests more pleasant places to be. They want to get out. They want to travel. They want to go to restaurants. They want to do things again. So these are the areas where employment continues to increase and where demand continues to rise. These are the areas that are likely to continue to see ongoing sales increases, even if there’s a broader slowing of growth, such as we’re seeing now.”
Another area where House sees promise for investors is rental assets within the real estate sector.
“As interest rates go up, the marginal buyers in some markets are getting pushed out of the possibility of buying certain properties and are instead moving into rental spaces, perhaps with the idea of waiting a couple of years until market conditions become more favorable for them,” House says. “You’re seeing rents go up substantially in major cities around North America, both because people are returning to cities and going back to offices, but also because people who were hoping to buy are now being knocked back into the rental market.”
Ultimately, House says the landscape figures to remain “murky for quite some time.”
“We’re in a period of flux,” he adds. “In circumstances like this, you need to look at a combination of data points, and you have to triangulate amongst them to try to develop the best view over the economic horizon that you can get. I think, on the balance of probabilities, that a softer landing rather than a recession is my base case for the future, but you’re not going to have certainty on that for some time. We’re in a volatile period, and you have to take risk-adjusted decisions on the basis of the odds that currently exist. If it were certain, everyone would know what to do.”
For more from House, he can be found on Twitter at https://twitter.com/BrettEHouse and on LinkedIn at https://www.linkedin.com/in/brettehouse/.
