New Year, New Economy, New Strategies

Good afternoon, everyone, and thank you for being here. Welcome to our new webinar series designed to support business leaders with helpful and timely information. I'm Brendan Chambers, leader of First Citizens Middle Market Banking Group. And our first webinar, New Year, New Economy, New Strategies, is a great example of what we're planning to present in this forum.

2023 is shaping up to be a post-pandemic year with many opportunities and uncertainties. This seems like the perfect time to take stock of where we are and where we're headed on such topics as the economy, M&A and taxes. We have here today a wonderful group of participants who are ready to share their insights.

Phillip Neuhart is the director of market research and economics for First Citizens Wealth Management. Phil has been with First Citizens since 2016 and has over 15 years of experience. He is an expert in the economic and market trends, investment opportunities, and portfolio management. Phil tell us about how the economy is performing now, where the trends are leading, and what that means for inflation, interest rates, GDP, employment and more.

We also welcome Justine Tobin, who is the founder and managing partner of Tobin & Company Investment Banking Group. Justine founded Tobin & Company in 2001. She has over 35 years of experience and has built a firm that focuses on mergers and acquisitions, valuations and broker-dealer services. She has great visibility into what is happening with M&A activity, private equity trends and overall middle market behavior.

We're also pleased to have Cristanne Leitner here, who is the Senior Vise President at LevitZacks CPAs. Cristanne has been with LevitZacks since 2009. She has 35 years of experience as well-versed in all aspects of tax and accounting. Cristanne and her firm are in constant touch with financial trends, tax changes and other factors impacting the middle market. LevitZacks is a leading accounting and tax firm on the West Coast.

And once again, I'm Brendan Chambers, and I lead First Citizens Middle Market Banking Group. We provide loans, deposit solutions, Treasury services and more to companies across a wide variety of industries. All right, I could not be more excited to hear what our panelists have to say today about the forces shaping our sector.

Just one final note before we get started, we expect to have time at the end of this presentation to take some questions from the audience. If you already have a question in mind or if you think of one during the discussion, please click the Q&A at the bottom right-hand corner of your screen, type your question in the box and then hit send.

All right, and if—with that, we will just jump right into this. So I'm going to start Phil—I'm going to start with you if that's all right. Phil, First Citizens Wealth Management is constantly monitoring the latest economic data and market trends. What's the current climate for middle market companies, and what trends are you most likely—are most likely to impact them in the future?

Yeah, it's a good question, certainly. When you think broadly what we'll sort of start in the macro, and then we can get more micro as this hour progresses, but it's going to be a year of economic slowdown globally. Really, the exception to that China as China reopen but really slow down, and it's a time of uncertainty. Think about higher interest rates, elevated inflation, slowing growth, as I mentioned.

We, from an economic standpoint, see a 60% chance of recession in the US over the next 12 months. We do have monetary and fiscal policy uncertainty. It's quite high. We have a Fed that's still hiking. We think they will continue to do so.

We have fiscal policy uncertainty, the debt ceiling debate could—we sort of have a repeat of 2011 this summer, which would be fun for everybody. We have a very tight labor market, something we continue to hear from our clients, and certainly a difficult operating environment. So a unique and interesting period but definitely a challenging one.

Sort of, from my view, it is a time for businesses to be nimble. If you look at SEO or small business surveys, certainly, there's caution entering the marketplace. That does not mean it's not an environment which we can operate. We're still seeing some economic growth. The labor market is still strong, but certainly, it is a time to be nimble and strategic in terms of your thinking.

Super helpful. Thank you. As you said, we'll get into more of that as we go through today's session. But let me turn it over to Justine. I think this is very interesting.

Justine, you deal with middle market clients who are buying and selling all the time. Some are trying to buy a competitor or expand into a new business through acquisition. Others want to sell off a portion of their business, and of course, others still want to cash out. So what are you seeing trend-wise in middle market M&A, and what's ultimately driving that activity?

Sure, Brendan. Thank you very much, and hello, everybody. It's a pleasure to be here with you all. So let's talk about trends. I'm going to talk about macro trends. And the topic of conversation in M&A is everyone's saying M&A is down, and it's true.

Volume in 2022 around M&A was down 44% from 2021. Quite a big number, but what everyone fails to remember is that 2021 volume was up 81% from 2020, which wasn't much different from 2019, which wasn't much different from 2018 and 2017. So when you go up 81% and come down 44%, you're at about the same spot. So we're at the same spot really in M&A volume since we were in 2020, 2019, 2018.

We are seeing a pullback, though, in M&A, and mostly because of asset valuations how do we value our assets, and how do we come to a conclusion and a mutual price on valuations on what that asset should trade for when we're doing M&A. And this is all changed because of interest rates. It's all about interest rates. It's not about really anything else. It's about inflation only because interest rates have been impacted from hawkish central banks trying to deal with inflation.

So, as we raise our interest rates, the discount rate that you use to value an asset goes up and as because an asset value is only the value of the future cash flows discounted to the present. And when you have a really low rate, which we've had for the past 15 years, you can discount back to an expanded asset value because of your compressed rates. As rates escalate when you're doing a DCF, the asset value actually compresses, and that's why we've seen asset values come down.

So the median Enterprise Value to EBITDA multiple in 2022 was 11.4 times. And in 2021, it was 12.7 times. So we've seen a drop of about a turn in asset valuations in multiples and deals that are getting done, but it's simply because of interest rates. It's not a higher-risk premium. There's really not concerns about earnings performance necessarily when it comes to M&A. Everybody in the middle market is still just chugging along.

So the real thing to think about when it comes to trend and how to affect your strategy is M&A is still happening. Valuations may have changed a little bit, and it's hard sometimes to get the two counterparties to agree on valuation.

That makes a lot of sense. So it's really all about the discount rate and how the interest rate is impacting the overall discount rate.

Exactly, interest rates affecting values.

You hear there's a lot of explanations out there in the market about what is really driving that activity, but I think you bring up a great point, and it's really—it's relatively simple—

Very simple. It's very simple—

[INTERPOSING VOICES]

You also brought up a really good point about the heightened level of—in the past. And so we're comparing it to—

Let's compare apples and oranges.

[INTERPOSING VOICES]

Right, and let's remember our levels in 2022 and going into 2023 are about the same as what we had before 2021.

Interesting. Thank you. That's very helpful. All right, and now over to our panelists and tax expert, Cristanne. Cristanne, thanks again for joining us and giving us the benefit of your experience and insights. I'd like to start by asking you to tell us about some of the impacts from tax law changes related to R&D expenditures. I've been hearing a lot about this.

[LAUGHS]

Well, thank you. It's very nice to meet you, and it's a pleasure to be on the panel. But one of the things that impacted me the most is realizing how much of what we do is impacted by politics and political decisions that are made because, basically, this impacts what accountants do every single day. And you realize tax laws are passed because of a stronger lobby for this industry or that industry.

So a lot of the changes that came about because of the TCJA—the Tax Cuts and Jobs Act, the Trump era tax cuts—really are impacting 2022 and beyond. So with regard to research and development, starting in 2022, the TCJA now requires companies to capitalize and amortize research and development costs over five years.

And if the research is done internationally, it's over 15 years. And that is such a significant change from prior years, and it may impact many businesses. They've now included software development as part of this act, and it's subject to these new rules.

So if you think about it prior to this change, there really wasn't a lot of commentary and discussion as to is it expensed as R&D, is it expensed as ordinary and necessary business expenses because who cares? It's all fully deductible. Now that we're under this new guideline, companies are going to have to absolutely take a deep dive into what is the definition of this research and development.

So you have to really go to history and define what that means, and it's defined as an information to discover information that would eliminate uncertainty concerning the development or improvement of a product. So if you think about it, if R&D is included, say, in an existing business that has sales and it has a mature market, it should be currently deductible as long as the research you're doing is not related to a new product line, a new development, a new resource.

So you have to really look at the entity and see what is—has the company reached the point of generating income to have that new law applied. So what we generally do is we'll take a look at a business if they've historically been claiming research and development tax credits as a starting point. Credits are much more restrictive.

So R&D tax credits are really wages involved in research, contract research and supplies. And then you have to look at what are the other costs related to those costs. So, in other words, we have to now look at rent expense— allocated rent expense for the area in which the scientists are doing the research. We have to look at overhead. We have to look at utilities. So all of those ancillary costs that are not included as part of the credit have to now be capitalized and amortized, assuming they are related to that research.

So some of the things that—I mean, this is a huge change and really the biggest answer is planning, planning, planning. That has to be proactively done. It started in January '22. But we're dealing with this right now because we're filing 2022 tax returns.

So the first step is really determine what is the status of the business. Is it in a startup mode, in a new traded business? Is it a mature business? You have to determine that.

The planning also has to include the interplay between loss carryovers and R&D tax credits. For example, if you've got a biotech company that receives, say, a $5 million grant from an NIH. They use that money. They pay the research of $5 million but now think about the impact that 80% of that is not going to be currently deductible. That's a big problem. So unless you have other expenses that are going to offset that taxable income. It's got—it's a big concern.

So really, the bottom line is recommending every return that has research and development is to extend it because, quite honestly, there's a lot of commentary that there's congressional support to extend this and delay it all the way to 2026, even though this is retroactive back to January 1 of '22. So part this extension is actually part of the Build Back Better Act that is stuck in the Senate right now.

So you really need to understand the changes because it also impacts financial statements. It's going to be creating deferred tax assets that are going to sit on a balance sheet. It impacts current and deferred tax provisions. So it's a big part of financial statement presentation.

And financial statements for GAAP purposes have to be based on the law at the end of the year. So accordingly, it's going to impact financial statement presentation regardless if the law is actually pushed back to 2026. So the prediction is basically there's maybe a lot less costs that are classified as research and probably lower R&D tax credits in the future. That's—

Going forwards. So people just rationalize, I guess, whether it makes sense to really—to proceed with all of the work that would go into trying to qualify for those tax credits going forward.

Exactly.

That makes sense. I think that will impact a lot of clients in the middle market because that was something that we see a lot of our customers historically have taken advantage of. The one piece I'd like to just ask you a little bit more about is the piece about going back to January even if it's extended to 2026. I don't fully follow that piece of this.

Well, this happens all the time. That's why it's always challenging to practice as a tax accountant because we are always trying to predict what's going to happen. And so let's say that's why we're recommending the extension because if they change the law and it goes retroactive back to January 1 of '22, it's going to impact your filing and your taxable income calculation.

I got it. That makes—that makes sense. Great. Well, never easy, right?

[INTERPOSING VOICES]

That's super helpful. Very interesting. All right, coming back to Phil on the economy. Phil, we're hearing a lot about inflation—of course, it's kind of the buzzword these days—and the Fed raising interest rates.

So I'm interested—I'm sure everyone's interested in your view on how this all plays out. Is the Fed going to pause and begin to reverse? And I think the market's kind of predicting some things here. So I'm really just interested in your thoughts and what this means for the overall business economy.

Right, so the last part first is exactly what Justine mentioned. I mean, higher rates, higher discount—discount values, and that suppresses asset values whether that be private or public. So little reminder. Inflation peaked last June at 9.1%. It's most recently at 6.4%, but it still has a long ways to go.

The Fed's targets 2% versus at 6.4. We're over three times the Fed's target. The Fed started hiking rates last March, just a year ago. Feels a lot longer than that, but that's the move pull up a charge of the two-year Treasury. And you could see a market that did not see it coming.

End of 2021 had no idea, and rates shot up higher, and that has had huge implications in private and public markets. We expect the Fed to raise the overnight rate at least two more times in March and May, probably 25 basis points each time that would bring the Fed funds rate the overnight rate to 5 and 1/4.

We could talk about the shape of the yield curve. It does not necessarily mean long rates move with the Fed funds rate, but at least in the overnight space. That's what we think. But it's not out of the realm of possibility that the Fed hikes further. We do think they pause around the middle of the year. That could be the June-July time frame.

Right now, Fed funds futures, if you believe them have the Fed pausing in July. But futures have been pretty wrong. Even a few weeks ago, futures were saying the Fed would not exceed 5%. Now they have the Fed well exceeding 5% in just a matter of a few weeks.

We will learn a lot more on March 22. So that's the Fed's next meeting. But it's also a quarterly meeting in which they release the update of their economic projections. So in that they say, where do we think the Fed funds rate is going to be, or was the committee think on average? The Fed funds rate will be at the end of the year.

As of December, they said 5.1%, which basically means a couple more hikes. You're in a range of 5% to 5 and 1/4 %, call 5.1%. What do they do in those projections? I think that that's something that's going to really move markets leading up to March 22nd and certainly after that.

What do they do in terms of the projections? Maybe they don't move them much. What if they were to move them up more than the market expects? That would be really interesting. We do not expect a major Fed reversal this year. In other words, we think they pause sometimes middle of the year.

In terms of cutting, we have not been a big believer of that for quite some time now. Futures are starting to move our direction. If you look at Fed funds futures, not much in terms of cuts. Maybe something very late in the year. It just seems unlikely does the Fed's going to do all this work to fight inflation.

They were late to the party, but they're here now. And then just reverse it. We find that pretty unlikely. They'll be dependent. Could the economy weaken more than they expect? And they're cutting very late in the year possibly. I still think they're going to be in a rush.

Remember, with all of this, Fed policy impacts the real economy with a lag, depending on what study, anywhere from 12 to 18 months. Some parts of the economy. It could be six months, but they only started hiking a year ago. So the Fed—they know this. They've even acknowledged. They include the word lag in their recent Fed statements—FOMC statements.

So they know this. They want to see the impact of their hikes feed into the real economy. So they don't want to just hike forever. They want to pause and let that feed into the real economy. But we don't think they're quite done yet in terms of headwinds for business, and just to what Justine said, of course, cost of borrowing goes up.

So it's not just the discount rate but cost of borrowing. That is the impact on slowing the economy. That takes time to feed in, but we do think. We think these are choppy waters this year. When you look at risk markets, we think it is fairly choppy. Doesn't mean it's that terrible of an operating environment, just certainly more difficult than the easy money we've had really since the Great Financial Crisis.

So I want to get your take on just some of the recent data that's come out recently kind of surprising to the upside on employment and some other things that are out there. You don't think that could lead to a surprise of 50 instead of 25 in March?

It could. It could. Certainly, if you look at markets, they're pricing a chance of 50, and I don't think it would be that incredible of a shock. But if you look at the minutes from—the FOMC minutes from yesterday, most agreed on 25 basis points in the last meeting.

It's a possibility, but they know they're walking a tightrope, and they want to hike rates. They want to fight inflation, but they know this is coming into the economy with a lag. So yes, I don't think it's all that shocking if they do 50 basis points. The market won't like it. Equity market certainly will not.

But if they were to at the next meeting, there will be some guidance that will enter the market through speeches, through comments to the press, et cetera. So we'll have a better idea of that, I think, before it happens. I doubt it's a surprise if they go 50. I think orders more likely, but absolutely it's a possibility.

Well, it seems like they have been very much trying to be out in front and tell the market what they are going to do. It just doesn't seem like the market always listens.

[INTERPOSING VOICES]

The Fed said what they wanted to do this year and their projections late last year, and the market just did not believe them really until the last couple of weeks, which—why that is? I don't really know. We thought it was pretty confounding.

Even if you look at the close of their last meeting, the market still did not believe them. So statement—press conference markets still do not believe the Fed that they would go north of five. It really took some interviews and further statements to get the market there.

So they are trying with all of their will to sound hawkish because they want the market to tighten up a little bit. They want financial conditions to tighten. That's how they reduce inflation, but the market's going to think what the market's going to think. And has been skeptical of them to this point, but I tend to believe them. I think they're going to keep hiking, but I don't think that they just go forever because they want to see monetary policy tightening feed into the real economy.

Right. That's very interesting, and it'll be interesting to see how it all plays out. And I know it keeps you on—keeps you on your toes every day but thank you. All right, well, that kind of makes me wonder how—to your earlier comments, Justine, how that could impact M&A.

So M&A is all taking place in the context of inflation and higher interest rates. Are buyers willing to pay up in light of inflation, or are they bidding less because the carrying costs will be higher? And how do you really assess the revenues and earnings in this environment with the uncertainty that Phil just spoke about.

Sure, Brendan. I'm happy to answer your questions. What's interesting is the concept of paying up with inflation. Inflation costs causes consumer prices to go up, but remember inflation doesn't really affect much. It does inside the company. Your revenues increase, and your expenses increase, but it's really about interest rates.

So just because there's higher inflation, you're not going to pay more for a company. It's because interest rates are going up that your asset values are declining. So that's really where we're going to see can we have a meeting of the minds on valuation.

And some deals have fallen apart because there was an expectation that, in 2021, I could sell my company for 12 times so that's I want that number now. And you don't get that number now if 12 times is the range that you're in middle market companies are going to be lower than that. That's a total multiple value that includes large corporates.

What we're really seeing in M&A right now is that we're seeing middle markets stay very busy because they were really blocked out of the 2021 market. Everyone was so busy. There's only so many bankers or so many—only so many M&A attorneys to get the work done.

And if your M&A attorney is busy on doing a deal for Cisco, then he's going to spend the time, or she's going to spend the time on that deal, and you can't get that person's attention or even just getting the private equity market to pay attention to you if you're just, let's say, a $250 million entity, and you're selling off a division. It was hard to get attention.

Now is the opportunity for middle market to get in there and especially because middle market companies could have also been distracted because they were dealing with COVID issues, such as supply chain and human resources issues because we're smaller companies than the large corporates.

So M&A is busy. Everybody I talk to, my M&A friends in banking and attorneys, are all as busy as they were or busier. And it's the same here at Tobin. We're, in fact, getting more inquiries around M&A because our middle market clients have more time to think about M&A. They have the time to think about getting rid of a division that costs more to operate now because of higher rates or doesn't really fit, and they didn't have a chance to think about it before, or they can think about add-ons.

So the opportunities for everyone listening here are a few fold. If you want to sell a division of your company, it's a great time to do it. Private equity is ravenous, and they're looking for add-ons. They're not necessarily interested in creating new platforms. But if they have a water valve company, they're going to want to add on more water valve companies or putting in some vertical integration around that.

So if you have a company, a division that should be well carved out, should be able to stand alone in the financials by itself, and have good quality of earnings, it's time to go out and sell that. It's a great opportunity. These private equity guys—we get 5 calls a day from them.

If you're not prepared to do that, start that activity now—that exit planning of getting those ready from getting them out to the market. Buying opportunities are coming around if you have a division of a competitor that you're interested in, but it also is going to come from distress of smaller companies who have been relying on funding to get through the marketplace.

So VC funding is really difficult right now. And we are seeing this. We're seeing more distress coming to the marketplace for M&A. We're been talking to a company in Austin, pretty small, 50 million of revenue, and can't get the VC funding they need.

Most of their VC investors were tech companies, and they're getting hit and—this whole situation has really hit tech companies a lot. So they're dealing with the remnants of the problems that they've been dealing with for the past year, and they don't have more money to put into this company that's a little more manufacturing-oriented. And they're really struggling.

So we're talking to them about getting investments growth equity capital from strategic buyers, but there may be a point where they need to sell the whole company. And we're talking to some of our other friends that they're seeing other companies that can't get funding that are going to have to sell in order to survive.

So this is an opportunity for middle market companies to add on something kind of new and exciting to our companies that may have been kind of getting a little less modern and an opportunity to kind of add some new ideas, new growth, especially if it comes around ideas around more digital interaction for our clients, more recurring revenues, more ESG focus—those kind of things that have become very trendy in M&A. How do I get some of that because I'm trying to create value in M&A. How do I add value into my company by potentially doing acquisitions?

That's very, very interesting and I get—you bring up some great points about how—it's good to hear everybody's busy first of all, but how also everybody thinks of M&A in really strong economic periods of economic growth. But I guess it has its place and really any period of economic activity. So—

Absolutely. So one other point, Brendan, about that is that the question was can you get a price? So a lot of our clients didn't want a 2021 price. They were locked out of that market and they couldn't get there. So they're happy with the 2022 price, which is a 2019 price. They'll take that, and that's why we're still seeing the activity and less resistance about having to get a high value.

I do caution companies that are thinking about not selling and they want to wait for a value that they would get in 2021. Don't do that. We've been through a few cycles. We saw people who didn't sell in 2007 never got to sell again. We saw this in 2000 never got to sell again. Companies became irrelevant. So don't wait.

Hard to time the market is—Mr. Neuhart would tell us. Yes, absolutely. That's great. Thank you. Appreciate it.

Welcome.

Cristanne, we talked a little bit about R&D expenditures a few minutes ago that was super helpful and how that's going to impact business taxes going forward. I've also heard a fair amount about changes in bonus depreciation. Can you shed any light on that for us?

Sure, of course. Again, part of the TCJA active Trump-era tax cuts. They're starting to expire. There's been so much commentary as to what does that mean? How has that impacted? So the great part of this Tax Act was bonus depreciation being allowed at 100% of depreciation for qualified property placed in service.

So depreciation to have instant deduction for infrastructure for equipment and spur investment. It lowers your effective tax rate basically. So this bonus depreciation has actually been in place from 2007 to 2027. However, starting in 2023, it's starting to become less each year. So in 20—and as of January 1, 2023, the rate drops to 80% deduction. 60% in 2024, all the way down to 2027, when bonus depreciation is scheduled to go away altogether.

So what can you do to try to help this situation? I mean, we always have the mantra, you know, defer income, accelerate deductions. So if a company is looking to expand equipment, obviously, you want to buy it in 2023 versus deferring that purchase to 2024 when bonus rates are reduced to 60%.

You also want to identify costs that potentially could be classified as repair expense versus capitalized assets because there are new repair regs that allow that. And then what appears to be coming back in favors now that bonus is being reduced each year is this concept of—we call it Section 179, which was instant deductions of asset purchases, but there are a lot more restrictions.

So between taking bonuses on some types of assets Section 179 and others, you may end up getting the same result. So you can really pick and choose the assets to expense. One—go ahead.

So if you're going to invest in capital equipment, sooner rather than later is the time—

Absolutely. That's part of always year-end planning. One of the things that can be done that's very powerful is regarding real estate and it's called cost segregation studies. And because I work primarily in the real estate industry, it's a way to maximize that depreciation and minimize the burden by front-loading the depreciation for the real estate.

So what it is? It's an engineering study. It segregates a building into the cost components to the proper life—the shorter life 5 year, 7 year, 15 year versus the life of the building, which is either 27 and 1/2 or 39.

And that's huge impact. One of my clients owned 18 apartment buildings, became a new client, never had a cost segregation study. And let's just say the impact of doing this study for him will wipe out his tax for many years. So it's very, very powerful.

Sounds like it could be very powerful. That's interesting. And we've heard—we've heard a little bit about segregation studies, especially when companies go and build a new office building manufacturing facility or what have you, but very interesting. Thanks for your—thanks for your comments.

Of course.

All right, I'd like to turn back to Phil, our economic expert. Let's talk just a minute about the labor market. I know there's been a lot of headlines around that. We're hearing about a lot of hiring challenges, the war for talent, and higher employee wages.

But at the same time, you hear a lot about these big tech companies laying off a lot of people. And then a lot of employees still sitting on the sideline, never coming back into the workforce post-COVID. So how do you see—how well these trends continue to unfold? And what does it mean for our clients that are out there trying to find skilled workers at reasonable compensation levels? So I think you might be on mute.

Thank you. Appreciate that. If you—labor markets are still incredibly strong. I mean, if you took me back a year ago and told me the Fed was going to hike rates to the extent they have, I would've told you what the labor market softened pretty materially, and it just hasn't.

We have 1.9 job openings in the US for every unemployed person. The unemployment rate is 3.4%. We've had 11 million job openings in the US in total. And yes, we are seeing layoffs in tech, particularly. Justine mentioned the issues in that space.

The truth is a lot of those layoffs are cutting some excess. There were some irrational exuberance to use a '90s term in tech, and we're rolling back honestly to staffing levels that these companies were at not that long ago. So that feels pretty specific.

Does not mean it won't broaden out. I think it could, but right now, it's still in tech. Labor force participation. It has improved over the last two years. There's sort of this narrative that there's been no improvement. There has been improvement, but you're still below the pre-pandemic level, and there's a lot of structural issues for that.

We can spend a whole panel talking about the structural issues within our labor force. But the idea that participation rate is going to get back to the pre-pandemic level is pretty unlikely, in my view. Hopefully, we could see improvement, but I think this is a long-standing issue.

It is pushing wages higher. Most recent data point average hourly earnings up 4.4%. That number was near 6% at its peak last year. So we've seen some improvement from the perspective, of course, of employers, not necessarily employees. But it is well above average—4.4%. The 15-year average is about 2.9%.

So you're running pretty hot. That is having an impact on company margins. I pull up a chart of S&P 500 forward margins. They're coming down some of that certainly wages.

We do think there will be some modest loosening in the labor market as the economy slows, but it will still be tight compared to previous economic slowdowns. This is just unprecedented to have this many job openings even as an economy globally is pretty clearly slowing.

On the skilled worker front, that we think will continue to be an issue. They will continue to demand a premium. A lot of these issues were exacerbated during the pandemic era, but they existed before. We were talking about issues with skilled labor for decades now well before the pandemic. I think that just some of the population coming out of the labor force exacerbate a lot of these issues.

So the data says it, but we also hear it from the clients. I mean, I know Brendan, you and I are on the road a lot. Repeatedly, regularly, we hear clients say they don't feel fully staffed.

So I don't think it's going away anytime soon. I think there will be some loosening. It just seems unlikely to me that rates continue to climb that the global economy slows that we don't see some loosening of the labor market. I think we do.

But I think it's going to feel different. It's going to feel different than entering past recessions if that's what we do in or at least pass economic slowdowns. So certainly, a unique period in the labor market.

Yeah, I agree. I'm interested, though, in what you just said. So can you have a recession with the labor market as strong as it is today? So the short answer is no, and it's why our recession probability is 60% and not 85%, 90%.

And the reason it's not a slam dunk is that the labor market stays so strong. 70% of GDP is consumption—personal consumption of various sorts. We are a consumer economy. We've not been a manufacturing economy for a very, very long time.

So as long as the consumer is strong, we do think there is strength there. It's something I always find interesting is there's a lot of emphasis on consumer sentiment. Consumer sentiment absolutely matters. It has very little efficacy on consumer spending because cinnamon is driven by inflation, disdain for Washington, 24-hour news.

But if you have a job, you're probably going to dinner Friday night, and that's—if you have gone to dinner any Friday night lately, you've seen that. If you've gotten on a plane lately, you've seen that. So there is underlying strength there because the labor market.

Look, Goldilocks—how is our 40% play out of no recession? Goldilocks is labor market hangs in there even if it softens. The Fed hikes to a point and then waits, and we get by. The yield curve would tell us that's not what's going to happen.

Other indicators would tell us that's not necessarily what's going to happen, but that is how this becomes a unique period. And I think we have to be open-minded about that. We're coming out of sort of 100-year event.

So looking at past recent recessions, people like me love to say, oh, this is kind of like 1991. Well, no, it's not. We did not have a global pandemic in 1989 and then a recession in 1991.

This is completely different. We had a complete shutdown of the global economy and a complete reopening that has driven inflation, of course, along with fiscal, monetary stimulus. So we're in a unique period. Maybe it plays out in a unique way.

That's interesting. Yeah, I do think it's unique, and I know we like to look at history to help predict, but maybe, in this case, to your point, it's not as good of an indicator. Thank you, appreciate it.

Absolutely.

Justine, so tell me a little bit more about the pace of middle market M&A given the economic conditions that Phil just talked about. So are buyers more—in your practice, are buyers more anxious to close the deal quickly before interest rates go up further, or are they taking their time to ensure that they don't rush into a bad decision?

Thanks, Brendan. And part of this answer goes back to an unanswered question I asked in the last round, and you said how does one judge revenue and quality of revenue and quality of earnings, and I didn't really talk about that. And so deals are slowing down in pace.

2021 was fast, fire hose. The company that you really have wanted is going up for auction, you've got to move fast. They're not going to let you do enough due diligence, and you just grabbed it because you wanted to beat the competition.

I recently heard Cisco, the technology company, one of their corporate development people. Talk about all the M&A they did in 2021. In early 2022, they're doing nothing right now. They've got growth hangover.

So, with that, they—and they've acknowledged that they've got to kind of integrate this and bring it into the company. So that fast pace is changing. And even before the pandemic, quality of earnings and understanding due diligence in a company was getting much more serious.

And so what we're really seeing is that people really need to make sure all of you all out there when you're selling an entity because it's really about the sell side wanting to think about this is make sure you've got audited financials.

Even if you're smaller, just go ahead and get your audited financials. And then you're going to end up going through a quality of earnings analysis with your buyer. This is becoming more and more prevalent. You're likely going to have to pay for it. Go ahead and start getting in touch with your accountants and your consultants get these things in place because people—the buyers really want to understand the quality of those earnings.

So to answer your question about pace, pace is slowing down also because financing is a little harder to get right now. So a private equity group may have been doing a 70% loan to value or 60% loan to value on an asset they are acquiring. That number is coming down to more like 40% or 50%. They have lots of dry powder. They can put more equity into making a deal happen.

But then also—then it's maybe if you're not going to get the bank financing you want in making an acquisition, you might want to look at private placements. And we know that First Citizens has a private placements group and that you guys often say, look, there's not enough room for a traditional bank loan, but let's go to the private placement group and have them add some financing. And that takes a little time as well.

So everything's kind of slowing down in pace, and it's mostly because of these structural issues that we're seeing, especially around increased rates and, therefore, lack of debt financing. And then the greater need to do really much more in-depth due diligence.

Very interesting. That's kind of what we see and what I would assume, but interesting to hear about it from your perspective. And yes, I think audited financial statements are—from a banker's lens are always, always helpful. And we see a lot more quality of earnings being done as well. So that's very helpful. Thank you.

You're welcome.

All right, Cristanne, I understand there's more tax changes in store for middle market businesses. You've already talked us through a couple of them, but can you describe kind of what we should be looking for from a business interest deduction and those changes that are coming down the pipe as well?

Sure, of course. Thank you. One of the changes that a lot of businesses didn't really—they were not impacted is this Section 163(j). So it's a business interest limitation because if a business wasn't really highly leveraged in the past, they weren't subject to these limits.

Now we have escalated interest rates. Interest expense becomes a much larger part of a business's profit and loss. So prior to TCJA, once again, we could fully deduct interest expense against the income of the business.

After 2019, these limits started to kick in. And in 2022, there's an adjustment limitation as well. So there are certain exceptions to this rule. It's regarding average annual gross receipts. If you're 29 million or less, you are not subject to this limitation.

But it's really basically just a calculation—mechanical calculation. You take a look at your interest expense is equal to the deductible portion is your business interest income, and then 30% of your adjusted taxable income, and some other types of interest. So the starting point for this is taxable income without regard to any business interest, net operating losses, or adjustments.

So, of course, interest rates increase dramatically. And now, this depreciation adjustment is applicable. So if, for an example, let's say I had an operating business and it had EBITDA on 2022 of a million 5, but interest expenses escalated dramatically. Let's say it's $3 million. And depreciation because a bonus depreciation is $1 million.

So my taxable income before any limitation is a loss of $2.5 million. I then add back $3 million of interest expense. So my adjusted taxable income is a $500,000 figure times 30% is $150,000.

So all of a sudden, I have a $3 million interest expense that was paid, and I only get to deduct $150,000. So $2,850,000 is carried over to the following year. It's pretty dramatic. So the calculation really would be the $1.5 million EBITDA less the $150,000 of interest less depreciation of a million. So all of a sudden, I have taxable income of $350,000, where before I have—it's a loss company, and it had a loss of $2.5 million. I owe federal tax at 21% of over $70,000.

So, in 2021, it allowed—the calculation allowed depreciation to be added back to your adjusted taxable income, which actually created a tax of about $10,000. So, all of a sudden, you have a significant tax increase just by the 22 change from the act. So that's pretty dramatic. And honestly, this is a really difficult conversation to have with a client that didn't plan for this.

I'm sure.

I mean, absolutely. So what are some of the things that can be done? One of the areas—and this really goes back to strong lobbyist—is the real estate industry. You can make an election for a real estate company to be an electing real property, trade or business.

And if you make this election, which just means you take the depreciable life of your building and qualified improvements over a slightly longer life, and you actually get out of this limitation of interest because when this law first came out, and I deal with a lot of real estate, all of a sudden you have a big limitation on interest that you weren't anticipating.

So that's a real great deal. But if you're not in that business, there isn't any other way out of it, really. I mean, so really what's the answer? Reduce borrowing to limit your interest expense. But the long-term impact is it may cause a lot of contraction in businesses if interest isn't currently deductible. It's impacts a business, absolutely.

[AUDIO OUT]

Can't hear.

Brendan, it's your turn. You're on mute. Major, major impact. So really, really appreciate that insight. And 2022 is sure shaping up to be an interesting year from a tax perspective. So thank you—

Every year. Every year is fun.

I know, but those are three big items that are significant changes and certainly will impact a lot of our clients. So thank you. Really great stuff. I appreciate everybody's—all three of your insights. I think now we've got some time to take a few questions from our audience.

As a reminder to ask a question, please click Q&A at the bottom right-hand corner of your screen. Type your question in the box that pops up and then hit Send. So while we gather—while we gather the questions, let me just say that First Citizens Middle Market bankers are deeply engaged with our clients and helping them anticipate how to navigate these current market conditions.

We have a wide range of financial solutions for companies in all stages of their lifecycle. So if you have a question we didn't get to or question that you'd rather not address in a public forum, please give us a call or drop us an email. Just Google First Citizens Middle Market Banking and click the link that comes up.

All right, well, we do have some good questions here. Let me see. All right, here we go. Our first question—I'm going to actually—Justine, if you don't mind, I'm going to turn this one to you.

I see that—I see that owners of—here's the question. I see that owners of middle market companies sometimes sell out to their employees. Is that trending up or down these days? And what are the risks or rewards versus sale to a private buyer?

So I did anticipate this question a little bit. When you're selling your company to your employees, you're not really using an investment banker. So I don't really do this. When we do have clients who are interested in doing an ESOP, we refer them to two places.

We refer them to an attorney who can do that. And if you need those referrals, we can help you with that. And then we do know a few bankers who focus on ESOP sales and selling to one's employees. We do see that.

My sense is that I didn't look up the numbers, but I think it's less than 10% of sales that happen. And I think there's issues in that it's a really long, difficult process. And I think it's harder to get your money out as the owner.

What we often see from our clients is that it's a great idea, and they want to try it. But in the end, it's just too difficult. They don't get the money they want, so they decide to just go to a private sale. And sometimes, I think when they investigate the benefits, that doesn't really match what their expectations would be.

There are ways to reward your employees in selling your company, especially if you're selling to a financial buyer to a private equity group. They're going to want management team—senior management on the participation in the ownership in order to motivate them. And there's ways to structure that in order to have the employees participate as well. So that's something to think about.

OK, so you see more of that than what an ESOP kind of a structure?

—see much ESOP at all, mostly because we don't do it. Even in those discussions, we just don't see it happening a lot.

Interesting, yeah. I do think it is important to tie in the management team, though. So you're right. There's certainly good ways to do that. We got this question a couple of times. So I'll guess, Phil, this is probably for you. How worried should we be if the debt ceiling isn't lifted? And any additional thoughts on kind of the US debt situation?

Sure. So it's a good question, a question we're getting all the time. In fact, we recently did a webinar, and I just showed the S&P 500 during 2011. Showing you the—I actually had to come back early from a vacation that summer.

You don't want brinksmanship. And 2011 was an example of that. Certainly, markets will not like. Even brinksmanship markets would not like. Now hopefully, cooler heads will prevail, and a resolution will be reached at some point this year if it were truly not to be lifted.

In other words, we're talking potential technical default from the US Treasury. That is a really ugly scenario. I think that is a tail risk. I don't think that's the base case. I think the base case is that there will be a lot of politicking sort of 2011 style, and some sort of resolution will be reached.

But if the question is how worried should we be? If it's just not lifted at all, we should be very worried. That is ugly on many fronts. Remember 2011, the debt ceiling was raised, and US Treasuries were downgraded by the S&P.

So just the fact that they played with fire got us downgraded as a nation. So it's ugly. It would have a lot of impacts across both fixed-income and equity markets, which, of course, public markets always leak into private markets. As I look at my two panelists, there is always connection there.

So, yeah, we don't want that. I don't think that's the base case. I think that it's a great opportunity to rattle sabers, and that a resolution will be reached.

Yeah. You definitely see it leading up, but hopefully, generally when you get right down to it, it seems to get to be dealt with. Let me just add—

Only thing I'll add, Brendan, a little stat I read this. I can't claim that I did this work, but so I hope it's correct. But the only developed nation—developed nation that has a debt ceiling like ours is Denmark, and their debt ceiling is double their current debt. So they don't really have a debt ceiling.

So this is a very—we created this first half of the 20th century. This is not something that's been around the entire history of America. We sort of—so we have a self-created crisis. And I think the reasoning behind it might make some sense—contain spending, contain debt.

The issue is that we just inevitably raise it, but every decade or so, we have a crisis to do what's going to happen inevitably anyways. So it's a very unique to the US situation and something that certainly is frustrating for market participants.

Very, very, very interesting, and I guess we tend to—sometimes we create our own issues as to your point. Let me ask you just as a follow on to that question. So how—with interest rates going from basically zero to where they are today, how concerned should we be about the sustainability of US—of interest payments on US debt?

Yeah. So look, we've seen an explosion of fiscal stimulus. There was a lot leading into 2020, and then we really went exponential in 2020. Look, I think the US is creditworthy—the largest economy in the world, and the government has taxing authority.

But that doesn't mean that we don't have a fiscal overhang. It's just good old Econ 101—public spending crowds out private investment. So I think it does slow the potential growth of the US. And with rates rising, that becomes more of an issue.

So now I don't think that the US isn't creditworthy. I think we are certainly. I think the Treasuries are telling you that the 10 year at this moment at 3.9% if we weren't creditworthy, it would not be 3.9%. It would be much higher than that. But we do—so fiscal restraint would be welcome, I think, by the markets. And higher rates are only compounding that issue.

Yeah. That's something that will be out there. The payments on US debt have certainly gone way up. Last—I will ask one more. We've got one more quick question here.

Cristanne, we hear a lot about wealthy individuals moving from high-tax states to lower-tax states. And I'm not just asking you this because you're in California. But do you ever hear the same with the business customers? I mean, are people kind of switching jurisdictions in this market?

Oh my—this has been going on for many years, but the statistic that just came out is we've lost 500,000 people in the last two years leaving the state of California. It's basically mass exodus, particularly in certain industries. Tech industries are moving out of the Bay Area, Silicon Valley. That's been really crazy, but absolutely.

This is a high-cost-of-living state. This is not an employee-focused state. And they've actually are trying to pass a bill that is an exit tax. So you would be paying a tax to exit the state of California. There is massive overreach by the government, and just be aware of Gavin Newsom because I think he's going to be somewhere in the federal government here pretty soon.

Interesting. Wow, an exit tax. That's—I hadn't heard that. That's interesting. Well, maybe I'll get—that gets—I guess the whole intent is to get people to think twice but thank you.

Exactly.

Appreciate that. Well, I must say that this has been just a really wonderful discussion and a tremendous kickoff to our middle market webinar series. My sincere thanks to our three panelists for sharing their time and expertise with us.

To our audience, please watch our website and your email for more information about our next webinar a little bit later in 2023. We'll have more to share with you as we get closer, but you can be sure it will be worth your time to listen in. Thanks again for your time today, and have a great, great rest of the week. Thank you very, very much.

Thank you.

Thank you.

Thank you.

Thank you.