Insights

We’re Not Going Into a Recession – Here’s Why
POSTED 12.3.19 M&A

As the song goes… it’s the most wonderful time of the year. The holidays are upon us. Aside from time with family and friends, my favorite part of the season is the Wall Street Journal’s Economic Forecasting Survey, specifically – the Recession Expectations forecast question: “When do you expect the next recession to start?”, which comes out every September or October.

It’s a survey of several dozen economists, who chime in on the current health of the economy and when they think the next recession will hit.

It’s one of many coming-year prediction articles, presentations, commentaries, etc. that come out every year around this time from various financial publications, investment banks, and others. As 2019 draws to a close, it’s worth taking a closer look.

I wish you could place bets on this sort of thing because I knew exactly what the Wall Street Journal piece was going to say even before I read it.

How is that possible? Because it’s pretty much the same every single year – and the predictions for 2020 were no exception.

What to Expect in 2020… or Not

As is usual in the Journal’s survey, economists are very pessimistic about the economy in the coming year. In fact, they are certain a recession will happen in the next 12 to 18 months. Before you sound the alarm, let’s go back to this time in 2018… 2017… 2016…

These economists said the same thing: recession in the next year or so. But I don’t remember being in a recession the last few years. Do you?

I don’t think we’ll be facing a recession in 2020. And, as far as M&A activity goes, there will certainly be no or negligible impact from economic conditions next year. That’s not just for lower middle market, but for M&A at all levels.

For a different point of view than the usual dour economic forecast, I like to turn to Christopher Thornburg, PhD, a founding partner of Beacon Economics.

He maintains mainstream economists think that a recession is inevitable every seven to eight years and that because things have been so good – too good – for so long, we’re well due. Not so, says Thornburg.

Looking at the leading economic indicators, he says we’re in good shape.

The ongoing “trade wars” are no issue. The GDP is solid. Consumer spending is stable, if not going up. Consumer savings is up. Debt ratios are lower than they have been in years.

There is one constraint and caution: There are more job openings in the country than people eligible to work. That will slow down businesses because they have so many jobs to fill.

But overall, we’re in a good economy, so businesses are expanding. And that means more M&A activity.

What M&A Activity Will Look Like in 2020

There are other factors that will encourage M&A activity in the coming year:

  • Interest rates remain stable – so the cost of borrowing is not going up, which is one less hurdle to getting deals done.
  • There remains a lot of dry powder held by PE funds – it’s still in the trillions. So there is a lot of cash on the sidelines waiting to be used.
  • There are more emerging, startup PE funds being created now than a year ago, which means more prospective financial Buyers on the playing field.

And because M&A deals are easier to get done and costs are coming down, we’re seeing other side impacts as well:

  • Smaller PE firms can be successful as deals flow down to them. It’s not just the big institutions that are taking all the action.
  • Because there are more M&A deals being done, the top 100 law firms that used to handle the bulk of the transactions – and charge more money – just can’t keep up. That means smaller firms, especially regional firms, are getting more billable M&A legal work.

In general, this “spreading of the wealth” is a good thing. As more revenue associated with M&A is going to more players, services will improve. That’s especially true with Representations and Warranty (R&W) insurance.

The Outlook for M&A Insurance

We’ve seen that there are already more R&W insurance placements because there are more insurers offering this coverage. Even deal sizes under $20 million can be covered. With this increased supply, costs are coming down. And the process for setting up R&W insurance to cover a deal is easier than even a year ago.

So not only will 2020 be a banner year for M&A activity, but I expect a corresponding increase in R&W insurance policies written as Buyers and Sellers recognize not only the above factors, but also the many other advantages of this type of coverage:

  • It removes the need for cash to be held in escrow.
  • It removes the need for extensive negotiations on the indemnification clause in the Purchase and Sale Agreement, as the indemnity obligation is transferred from Seller to insurance company.
  • If there are any breaches in the reps, the Buyer can file a claim with a third party (the insurer) and get paid promptly to cover damages.
  • In short, all the risk goes to the insurer, which makes Buyers and Sellers happy.

R&W coverage also makes negotiations between Buyers and Sellers much smoother. In some cases, it’s the make or break for a deal.

As you look ahead to 2020 and consider your acquisition strategy (or plan to sell your company), it’s worth taking a close look at how Representations and Warranty insurance coverage could give you the edge.

If you’d like to get all the details on how, please contact me, Patrick Stroth, at pstroth@rubiconins.com. Let’s chat before we all get so busy during the holidays.