What’s Causing the Pullback in Capital Market Deals?

Many firms that operate in the capital markets come to us when assessing market conditions in the hopes of issuing, underwriting, or investing in deals. The discussion topics typically include the rationale for the capital-raising, the specific tactic or vehicle, and what headwinds we might face from the markets. That last topic has come up more frequently, which has translated into a trepidation to raise capital and, ultimately, lower issuance in 2022. Which particular factors are giving firms pause when issuing potential deals?

To answer that question, we should cast our minds to 2020. That year was such a big one for capital markets issuance, but the main impetus for firms to take part in that market surge was simply to raise capital as a defensive tactic and survive the knock-on effects of the COVID-19 pandemic. Strategic plans were focused on keeping the bottom line afloat, maintaining liquidity, and ensuring businesses could weather the storm.

When the calendar flipped to 2021, we saw economies start to recover from COVID alongside a notable surge in M&A activity. That year ended up being a record year for M&A volumes, as a lot of those M&A deals were due to occur in 2020 but were put on hold until 2021 because of the pandemic. As a result of the M&A flurry, capital markets activity pivoted from a means of survival to a path for companies to grow, expand, and acquire.

But what a difference six months has made: the market has spent a large portion of 2022 in correction as investors continue to digest value disruption. Drops in the global public equity markets, supply chain bottlenecks, and the interest rate hike have all fueled the recent surge of volatility. The interest rate hike is a particularly crucial market factor, as we've just emerged from a long spell of low interest rates and cheap credit. Many businesses took advantage of those beneficial conditions and increased their leverage, which has pushed leverage multiples to a level similar to those from the 2007/2008 crisis era.

We now have this perfect storm of events that's sucking confidence out of the system and driving profound drop-offs in equity capital markets activity across the board. There are spillover effects in the IPO, follow-on, and private markets, as well. In recent years, firms have sought out IPO alternatives, most notably SPACs and funding from financial sponsors willing to invest their record levels of dry powder into later stage private companies. However, we've seen that volume drop off in 2022 as well. In most cases, the businesses that these sponsors were to have previously invested in are now appearing riskier. They have more leverage and now have to bear additional interest rates. We've seen plenty of tech companies grow very quickly with very lofty valuations from funding rounds, but they're not reaching profitability.

So, where do the capital markets go from here? First and foremost, confidence needs to be restored. We need to see public equity markets rebound and start to grow again when they emerge of this bear market. A reduction is volatility will also be key. When I talk to contacts in the market, they note that firms need about six weeks of market stability in order to price and launch an IPO. (Peer group valuation multiples trading all over the place amid market volatility makes this process much more difficult.)

Another factor that can help boost broader activity are some well-performing IPOs. Overall IPO performance on the 1-month and 6-month basis has been down. Additionally, a lot of those poor-performing IPOs have come through the SPAC route (about 92% of companies that went to market via SPAC are trading below the initial IPO price), which marks another area where investors could gain confidence if performance ticks up. We’re now seeing a shift where investors want to invest more in profitable companies that have stable and recurring free cash flow. Porsche’s potential Q4 IPO could be a huge story in this space of the market if it prices this year, as a positive deal result could help restore confidence in the market and drive subsequent activity.

One area within capital markets that might see some pickup quite soon is convertible bonds. Convertible bonds give issuers an opportunity to raise debt financing through lower yields by providing investors with upside for equity appreciation. With interest rates going up, issuers might find this space to be a hospitable one.