The U.S. high-yield and investment-grade debt markets saw significant increases in 2017 over 2016 in dollar volume and number of issuances.[1] The U.S. equity indices reached new highs throughout the year, with the Standard & Poor’s 500 index ending the year up 19.4 percent.

The slow, steady expansion of the economy (one of the longest expansion cycles on record) and the current favorable market conditions, along with the recently enacted reduction in corporate taxes — which could drive earnings expansion — have fueled optimism for robust capital markets activity in 2018. Questions linger, however, about the sustainability of the bull run and whether volatility can remain at historically low levels.

Debt Markets. The U.S. high-yield debt market ended 2017 approximately 36 percent higher by volume and 42 percent higher by number of issuances than 2016, ending three consecutive years of decline but falling short of the record highs in 2012-14. U.S. high-yield bond issuances totaled $332 billion (697 issuances) in 2017 compared to $244 billion (491 issuances) in 2016.

The U.S. investment-grade debt market had record volume of $1.42 trillion (2,292 issuances) in 2017, exceeding the previous record of $1.35 trillion (1,902 issuances) set in 2016 and marking the seventh consecutive year of dollar volume increase. AT&T was the largest issuer by volume, totaling $36 billion in 16 issuances, and in July 2017 also had the largest investment-grade transaction of the year at $22.5 billion in connection with its proposed acquisition of Time Warner. Refinancing activity continued to drive both high-yield and investment-grade volume, with M&A a distant second.

Equity Markets. The Dow Jones industrial average reached four 1,000-point milestones in 2017 — the most in any one year — topping out at over 24,000 in December 2017. The S&P 500 and Nasdaq composite also set all-time highs. The gains were driven largely by strong corporate earnings and a favorable macroeconomic backdrop of moderate but steady gross domestic product growth, low unemployment, a strong housing market, high consumer confidence, and the expected pro-business and anti-regulation agenda of the new administration, including the promise of tax reform.

Despite a favorable backdrop of rising equity markets and historically low volatility, the initial public offerings (IPO) market fell short of some expectations going into the year. Many companies chose to take advantage of the robust private markets that have developed in recent years to satisfy their capital-raising and secondary liquidity needs or to pursue an M&A exit (with secondary buyouts by private equity sponsors continuing to make up a large share of M&A activity). With 167 IPOs raising approximately $39 billion, it was a significant improvement over 2016 but still below post-financial crisis highs.

The leading sector for IPOs by volume and number of deals in 2017 was financial services, followed by health care and technology. The two largest IPOs of the year were Snapchat owner Snap Inc. and cable operator Altice USA Inc., which raised $3.91 billion and $2.15 billion, respectively. Despite a solid year, with 27 deals raising $9.1 billion, technology IPOs failed to materialize in the way that some had anticipated. Two of the largest tech IPOs — Snap and Blue Apron — fell short of investor expectations, although a number of subsequent deals — including Roku and Stitch Fix — performed well. Blank check, or special purpose acquisition company (SPAC), issuances increased sharply in 2017, with 29 SPAC IPOs raising a record $8.6 billion (up from 14 SPAC IPOs raising $1.7 billion in 2016).

Follow-on activity was relatively flat, with the number of deals up nearly 20 percent — from 609 in 2016 to 730 in 2017 — but the aggregate volume up only 3 percent — from $150.2 billion in 2016 to $154.3 billion in 2017 — reflecting a smaller average deal size. M&A activity continued to drive follow-on activity, as 18 percent of all follow-on volume raised in 2017 was used to fund M&A. Block trades declined as a proportion of overall follow-on activity, representing 30 percent of total follow-on offerings in 2017, more in line with recent years and down from a record high of 49 percent in 2016.

Looking Ahead

A number of factors will impact the strength and mix of capital markets activity in 2018.

Corporate Tax Reform. While it is too early to assess the ultimate impact of the corporate tax overhaul on the U.S. capital markets, a few themes have emerged. In general, the new tax law reduces the value of debt by both (1) lowering the corporate tax rate from 35 to 21 percent, which reduces the value of the tax shield provided by interest deductions, and (2) imposing a cap on interest deductibility to 30 percent of EBITDA. (See “US Tax Reform Enacts the Most Comprehensive Changes in Three Decades.”) As a result, companies will need to re-evaluate the cost of their debt, and some issuers could gravitate toward equity or equity-linked securities, where the new interest deductibility rules and a rising interest rate environment could make pricing more attractive for companies’ capital-raising strategies.

Companies also may find themselves with significant additional cash on hand due to the lower tax rate and the one-time mandatory deemed repatriation of money held overseas at discounted rates. Potential uses for this additional cash include M&A activity, share buybacks and dividend recapitalizations, all of which could bring about higher stock prices and promote additional equity market activity. On the other hand, tax reform could quell some secondary follow-on market activity, particularly block trades, if private equity sponsors choose to hold their positions longer to capture additional gains from potential stock appreciation as a result of potential increases in earnings.

Alternative Financing. The average age of all venture capital-backed companies going public has risen from 5.1 years in 2006 to 7.6 in 2016, demonstrating the continuation of a multiyear trend of companies choosing to stay private longer. This trend is the result not only of the JOBS Act increasing the number of shareholders private companies can have before they are required to go public, but also of the wealth of private capital and secondary financing strategies available. As a result, companies have been able to raise substantial primary capital and provide liquidity to existing shareholders and employees outside the public markets and at valuations often significantly exceeding what public investors are willing to pay. The seeding of the SoftBank Vision Fund in 2017, which to date has raised nearly $100 billion to invest in technology companies (including a notable investment in WeWork), may only prolong this trend.

A number of private companies also may be contemplating strategies to become public outside the traditional IPO process, including (1) by being acquired by publicly traded SPACs, effectively allowing a company to avoid the associated time and expense of Securities and Exchange Commission registration and minimizing market risk, and (2) through direct listings of shares without an accompanying capital raise, providing immediate liquidity for shareholders (who would otherwise be subject to IPO lockups) with no dilution. The success of Spotify’s proposed direct listing could set a new precedent for companies with significant scale and a large investor base.

Increased financial leverage also has led some companies to look for alternative financing. Ave­rage leverage ratios, as measured by net debt relative to EBITDA, are near their highest since before the financial crisis for nonfinancial firms in the S&P 500. Some highly leveraged companies have issued mezzanine-style preferred securities to raise capital without increasing their leverage. Typically, these hybrid instruments are carefully structured to be treated as equity by rating agencies to avoid increasing a company’s leverage for ratings purposes.

Federal Reserve Activity. The monetary policy of the Federal Reserve may significantly impact the U.S. capital markets throughout 2018. The Fed has begun the process of reversing several years of quantitative easing and has continued to gradually increase interest rates, resulting in higher borrowing costs. Further rate hikes are anticipated in 2018, which will particularly benefit companies that are operated primarily in the United States (as a stronger U.S. dollar will increase the value of domestic products). On the debt side, many companies are issuing longer-term bonds to extend the maturities of their debt and lock in a lower interest rate as a hedge against higher borrowing costs in the future. Approximately 20 percent of the investment-grade debt issued in 2017 was 30-year notes.

ENDNOTES

[1]     Sources for the data in this article are: Bloomberg, Dealogic, Deloitte, Moody’s, PitchBook, PwC, Seeking Alpha and Thomson Reuters.

This post comes to us from Skadden, Arps, Slate, Meagher & Flom LLP. It is based on the firm’s memorandum, “US Capital Markets Expected to Remain Robust in 2018,” dated January 23, 2018, and available here.