Good Morning. In this newsletter, we explore the rough patch that the Canadian economy is going through, with unemployment rising despite population growth fueled by immigration. Furthermore, we go down South to see that the U.S. is gearing up for potential interest rate cuts driven by economic cooling. Meanwhile, the global shift towards renewable energy is shaking up investments as green energy surges and fossil fuels falter. Also, Paramount Global and Skydance Media's $28 billion merger promises to reshape the industry, though legal challenges loom. Lastly, leveraged buyouts (LBOs) remain a potent tool for value creation, so stay until the end for a deep dive into LBOs.

ECONOMIC UPDATE

THE SOFTENING CANADIAN ECONOMY

The Canadian economy has recently softened as Canadian GDP growth came to a halt in the second quarter of 2024. Specifically, the labour market has weakened, with the unemployment rate growing by 1.6 percentage points since the summer of 2022. We have seen demand for labour pulling back, demonstrated by a continual drop in job vacancies, hinting at the peak phase of Canada’s business cycle, where surpluses in supply cause labour reductions. The unemployment rate was 6.4% in June, which represents substantial growth. Still, some of this growth can be attributed to a labour shortage during pandemic times, which a now more regulated rate is being compared. While the growth seems alarming, and is certainly not a good sign, the actual unemployment rate is not actually elevated to extremely high levels such as the 8.8% we saw during the global financial crisis.

What is the Source of Rising Unemployment?

In parallel to Canada’s rise in unemployment and the softening of its labour market, Canada’s population has seen large growth due to immigration. This has caused misconceptions and inaccurate connections between the two factors. While immigration will add to the supply part of the labour force, it will add just as much to the consumer side as these new immigrants will increase consumption needs. The Bank of Canada recently released its Canadian Business Outlook survey results and found that in the second quarter of 2024, Canadian businesses have seen their sales numbers heavily supported by population growth. This suggests that without immigration, Canadian consumer demand would have been much lower and possibly led to an even more considerable increase in unemployment.

Rising interest rates over the past two years have been another primary driving force behind the slowdown of Canada’s labour market. Consumer spending in discretionary industries has been significantly cut and this has created a lack of labour demand. Along with this it seems that students and recent graduates have been a large contributing factor. This demographic is really driving the slowdown, as 60% of the unemployment increase in the last two years comes from the age group of 15-29. This demographic accounts for only 25% of the Canadian labour force.

What is the Current Outlook?

The Canadian job market is expected to continue to soften into the near future. Usually there are precursors to a strengthening labour market such as a falling job vacancy rate and increased hiring intentions from Canadian companies, neither of which we are currently seeing any signs of. The bank of Canada will be likely to continue to cut interest rates. If this happens along with inflation continuing to come down, it will alleviate pressure on consumers from a consumption and debt servicing perspective. This will hopefully lead them back into their non-discretionary spending habits, therefore increasing demand for labour.

EFFECT ON THE UNITED STATES

After the sentiment for so long in the US has been that rates were likely to stay higher for longer, there has been a recent shift in this sentiment, and a potential series of rate cuts may be in the cards. On the last day of July, the chair of the Fed, Jerome Powell, announced that the economy is moving towards a point where it may be appropriate to reduce interest rates. This stems from data that the Fed uses to make its decisions, such as a rising unemployment rate and lower inflation figures. Due to this new information, it seems that a rate cut should be announced at the fed's September meeting, and it would take some abnormality in new data for this not to happen. Stock and bond markets have priced in a rate cut of about 25 basis points in September.

Not If, But How Much?

At this point, the market sentiment has shifted towards not asking whether interest rate cuts are coming but at what rate they will come. This will heavily depend on the data that continues leading up to and following the September meeting. Inflation is still at 2.5%, about 50 basis points above the Fed’s target, so if this number does not continue to drop or even slightly increases, we could see a sharp slowdown in the pace of rate cuts. Along with this, unemployment rates have risen from ~3.5% to ~4.2%. If the labour market weakens, this will be another sign that a slowdown in rate cuts is necessary. If both metrics continue to trend towards projected levels, a 25-basis point cut quarterly for the foreseeable future is expected.

MARKET TRENDS

SOCIETIES SHIFT TOWARD MORE SUSTAINABLE ENERGIES

As the global energy crisis becomes more prevalent, the global economy presents a unified a in several markets as renewable energy and transitions to a low-carbon economy become more of a focus. This trend is driven by increasing awareness, government policies, and technological advancements. So, how is it affecting various industries and the future of investment?

New Opportunities for Investment in Renewable Energy 

As the goal of Net Zero becomes more of a CSR priority for other blue-chip companies and the transition towards renewable energy becomes further normalized, new-energy producers that leverage this shift alongside tech growth are becoming more desirable to consumers. Companies such as Nordex SE, a German company specializing in wind turbine development, have seen incredible growth over the past year. Nordex’s stock price has risen over 30% year-to-date. This reflects new opportunities that are presenting themselves within the industry and how consumers view the future of sustainable energy in an optimistic light. Advancing technologies are improving efficiency in such products and making renewable energy even more competitive with other traditional energy sources. Investment toward green energy and infrastructure is expected to reach $2 trillion globally in 2024, these metrics are further revealing growth prospects in this industry in the long-term. 

Government Policies and Incentives 

Governments around the world have begun to implement various policies and incentives to promote the adoption of renewable energy for both the average consumer and other corporations. Several governments have implemented subsidies, tax credits, and carbon pricing mechanisms that influence the increase used in sustainable sources and the decreased use of energy sources causing potential environmental harm. An example of these policy’s is the carbon tax rebate in Canada which is designed to increase carbon prices with proportionate tax credit to discourage Canadians from overconsumption of carbon-based fuels. These policies will adversely influence the financial health of companies responsible for producing these traditional energy sources. 

Decline of Fossil Fuels

As government policies shift in favour of reducing usage, traditional energy investment becomes less, and sustainable sources become more desirable. Investment in fossil fuel companies is beginning to become higher risk. Notably, traditional energy corporate bonds in the capital markets find them on the wrong side of yield spreads. As both regulations shift, consumer preferences change, and technology advances making renewable energies more competitive this may begin to cause decline in the attractiveness of all fossil fuel investments. 

Adaptation of Traditional Industries

The transition to renewable energy sources is also causing an impact on the operations of traditional industries such as automotive, manufacturing, and utilities. Companies in sectors such as these are adapting to changing trends and are investing in renewable energy, and energy efficiency, incorporating this into regulatory operations and product lines. An example of this is automotive giant, Ford Motor Company who has committed to investing $50 billion in electric vehicle technology by 2026 and making fully electronic versions of their most popular models such as the F-150 trucks.

Rise of Sustainable Investing

With the increase of awareness of potential harms of climate change have caused Environmental Social Governance (ESG) investing to become a more practiced investment strategy. ESG investing involves considering environmental, social and governance factors alongside financial factors when drawing decisions in the investment process. The goal of this strategy is to ensure that while making long term financial returns, the investments made are also positively impacting society. 

Translating Trends Into the Market

As focus shifts towards concerns of climate change this will reshape the landscape of various markets, creating new opportunities in some and challenges in others. Investors must consider the long-term impact of how trends will affect various players and if they are well-positioned to benefit from the societal transition to creating a more sustainable future. 

MERGER AND ACQUISITION

PARAMOUNT AND SKYDANCE'S 28B BLOCKBUSTER MERGER

Paramount Global

Paramount Global is a leading global media and entertainment company, home to a diverse portfolio of brands, including CBS, MTV, BET, and Paramount Pictures. Renowned for its extensive content library and distribution networks, Paramount is a major player in television, film, and streaming sectors, producing and distributing iconic films and television series.

Skydance Media

Founded by David Ellison in 2010, SkyDance Media has quickly become a major force in Hollywood, known for high-budget and high-grossing projects. The company produces feature films, television series, interactive content, and animation, and has built a strong reputation for quality and innovation in the entertainment industry.

Deal Overview

On July 7, 2024, Paramount Global and Skydance Media announced an all-stock merger valued at approximately $28 billion, proceeding through a two-step process. Skydance will first acquire National Amusements, Inc. (NAI), which holds the controlling stake in Paramount, for $2.4 billion in cash. Following the acquisition, Skydance will merge with Paramount Global to form a new entity called “New Paramount.” Skydance will offer Paramount shareholders a choice between cash or stock, with a total value of $4.5 billion, along with an additional $1.5 billion infusion to strengthen Paramount's balance sheet. Skydance's investors, including the Ellison family and RedBird Capital Partners, will receive 317 million newly issued Class B shares in New Paramount, valuing Skydance at $4.75 billion based on Paramount's Class B stock price of $15 per share. Additionally, Skydance has pledged up to $6 billion to offer Paramount's Class A shareholders a choice between $23 per share in cash or new shares in the merged company.

Implications

This strategic move aims to consolidate resources and enhance competitiveness in an evolving media landscape. This merger signifies a significant shift in the entertainment industry, potentially influencing market dynamics.

Enhanced Content Creation: The merger will combine Paramount's extensive content library and distribution capabilities with Skydance's innovative production techniques, allowing New Paramount to create and produce a diverse range of films, television series, and digital content.

Increased Financial Strength: With financial support from Skydance, including the $1.5 billion investment, New Paramount will gain the stability needed to invest in new projects and technologies essential for competing in the highly competitive media landscape.

Strategic Synergies: The merger is anticipated to generate significant synergies by combining operational efficiencies and expertise from both companies, likely to result in cost savings and improved profitability, allowing New Paramount to optimize resources and streamline operations.

Expanded Global Reach: The merger will enhance New Paramount's global footprint, enabling the company to distribute content more effectively worldwide. This expanded reach will help New Paramount tap into new markets and audiences, increasing its international presence and revenue streams.

Recent Challenges

Despite the promising outlook, the merger faces significant hurdles. Recently, Paramount Global investor Scott Baker has filed a lawsuit to block the merger with Skydance Media, saying the deal would cost its shareholders $1.65 billion. The lawsuit alleges that the merger's primary purpose is to cash out media mogul Shari Redstone's investment in Paramount at a substantial premium. At the same time, other shareholders receive a significantly lower payout. The plaintiff alleged the merger was unfair and disadvantageous to Paramount's Class B stockholders, who will not receive a fair share of the benefits compared to Redstone and National Amusements Inc (NAI), which own a controlling stake in Paramount. This legal challenge introduces an additional layer of complexity to the merger process, which is already subject to regulatory approvals and other customary closing conditions. The outcome of this lawsuit could significantly impact the timeline and execution of the merger.

MONTHLY FINANCIAL CONCEPT

LET'S TALK ABOUT LEVERAGED BUYOUTS (LBOs)

A leveraged buyout (LBO) occurs when a company, often a private equity firm, acquires another company using a combination of debt and equity to finance the transaction. A significant portion of the purchase price is typically funded through debt, with the acquired company's assets used as collateral. The investment horizon for LBOs generally spans 5-7 years, during which the acquirer aims to enhance the company's value. The fundamental premise of an LBO is to buy low and sell high, with the goal of improving the target company's operations and financials so that, by the end of the holding period, the company is more valuable to potential buyers.

How Does an LBO Generate Returns?

LBOs generate returns primarily through three mechanisms:

1. De-leveraging: As the company pays down its debt, its equity proportion increases. By reducing the debt burden, the acquirer converts debt into equity, thereby increasing its ownership stake and enhancing the overall value of the investment.

2. Operational Improvement: This involves enhancing the company’s profitability by improving efficiency, reducing unnecessary expenditures, and driving revenue growth. The focus is on boosting profit margins through cost-cutting measures, process optimization, and potentially expanding the company's market share.

3. Multiple Expansion: The acquirer seeks to sell the company at a higher valuation multiple than it was purchased. For instance, if the company was acquired at a lower EV/EBITDA or EV/Revenue multiple, the goal is to exit the investment at a higher multiple, capitalizing on improved financial performance and favorable market conditions.

Exit Strategy

The ultimate objective of an LBO is to realize a profit at the end of the investment period. There are several exit strategies available:

Initial Public Offering (IPO): Taking the company public allows it to raise capital from the broader market, which can be used to fund further growth. An IPO also provides an opportunity for investors and employees to realize returns through dividend payouts or share sales, while giving the company access to a more liquid market for its equity.

Sale to Another Investor: Another common exit route is selling the company to another private equity firm or strategic buyer. Secondary buyouts are particularly popular in situations where quick liquidity is desired. However, selling in the secondary market may involve a discount, as the price reflects the value of immediate liquidity.

Other exit options include trade sales, where the company is sold to a strategic buyer in the industry, or recapitalization, where the company restructures its debt and equity. However, IPOs and secondary sales remain the most prevalent methods for realizing returns in an LBO.

A Deeper Dive Into LBOs

What are the characteristics of a good LBO candidate? The following qualitative and quantitative characteristics are important areas of consideration when identifying an ideal LBO candidate.

Quantitative

Size: The size of the target company is the first thing to look at when identifying a viable candidate. Most times companies are too small for the deal to be feasible for a PE firm, therefore even in smaller cases the companies are worth at least $5-$10 million.

Price: An ideal price is crucial to an LBO deal, as even the best company at too high of a price would be a poor candidate. High prices create higher risk for the PE firm as elevated prices means greater risk associated with the price falling over time. Therefore, identifying a stellar company at a reasonable price will drive returns.

Stable and Predictable Cash Flows: Stable cash flows enable funds that are used for interest and debt payments. It’s important to note that the company ideally has minimal CapEx ensuring that they have a lot of assets but not spending as much to free up the cash.

Valuation: An ideal candidate will possess a low to mid-range EBITDA multiple in comparison to others within its industry. This can be determined through a comparable company analysis, looking for a company with multiples traded at a discount to its peers.

Qualitative

Strong Management Team: A strong management team creates the backbone for a successful business. Therefore, an ideal company has an experienced management team with deep industry expertise that have worked together for several years.

Industry and Market Factors: An attractive candidate should possess a strong competitive advantage in an industry with high barriers to entry. Ideally, they should have a strong market position within a relatively fragmented industry.

Financing methods: The target LBO company also needs to be able to service the debt, including interest and principal payments from its operating cash flows. This includes supporting several tranches of debts and potentially alternative debt structures depending on the various needs. If possible, the firm should have a high fixed asset base which they can use as collateral to decrease the interest rate on loans.

Growth opportunities: The target company would ideally have opportunities to grow its EBITDA either through boosting profit margins or increasing revenue. This can be achieved through tuck-in acquisitions, expanding product line for cross selling opportunities, and cutting on excess labor/production capacity.

Exit opportunities: The target company should also have a realistic path for the PE firm to sell its investment and realize a return. This can include selling to another PE firm, a strategic acquirer in the industry, or an IPO.

What Assumptions Impact the Outcome of an LBO the Most?

The assumptions are ranked as per the following:

The purchase and exit assumptions (typically based on EBITDA multiples), as they dictate the general bounds for an LBOs return.

After that, the proportion of debt would make the most difference as it amplifies the impact of the return.

Following this, would include the interest rate on the debt, revenue growth, EBITDA margins, and principal repayments on the debt, as they impact returns but not to the extent that the previous factors impact LBOs.

What’s the Difference Between an LBO and a Standard M&A Deal?

Due to the short-term nature of LBOs, they tend to focus on generating a good IRR (Internal Rate of Return) and MOIC (Multiple on Invested Capital), and subsequently ignore the value of synergies or EPS accretion/dilution. This type of deal is never financed through equity, it is solely debt and cash. Lastly, you often “back into” the purchase price of the target based on the price required to achieve a robust IRR.

In a typical M&A deal, EPS accretion and synergies are in focus as they are the primary source of value creation. Furthermore, they can use equity/stock as a source of financing alongside debt and cash. Given that IRR is insignificant in a typical M&A deal, strategic acquirers are less incentivized to use significant debt in an acquisition so they can avoid high-interest payments.