Fitch Downgrades and Partners Group - Breitling Deal

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Today, we will learn more about:

1. Fitch Downgrades & Precedents

2. Partners Group Investment in Breitling

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Fitch Downgrades & Precedents

On August 1st, Fitch Ratings downgraded the U.S. long-term credit rating from its top mark of AAA to AA+, citing the nation's high and growing debt burden and the penchant for brinkmanship over America's authority to borrow money. With the last time US debt was notably downgraded by S&P in 2011, this reflects concerns over the nation's fiscal management and political handling of the debt ceiling. It also highlights the ongoing challenges and uncertainties surrounding the U.S. economic landscape. Today, we will deepen our understanding of how Fitch came to this conclusion, the history of the US debt’s downgrades, and what it means for investors.

Fitch’s Reasoning

Over the next three years, the U.S. government's financial situation is expected to worsen. This includes a high and growing debt burden, which has been a concern for the past two decades. The repeated political standoffs over the debt limit and last-minute resolutions have only added to the uncertainty. Fitch has observed a steady decline in governance standards over the last 20 years as well, especially concerning fiscal and debt matters. Even the recent bipartisan agreement to suspend the debt limit until 2025 hasn't eased these concerns. The complex budgeting process, lack of a medium-term fiscal framework, and successive debt increases due to economic shocks, tax cuts, and new spending have all contributed to this erosion. The limited progress in addressing long-term challenges like rising social security and Medicare costs for an aging population further complicates the situation.

The general government (GG) deficit is expected to rise to 6.3% of GDP in 2023, up from 3.7% in 2022 due to weaker federal revenues, new spending, and higher interest burdens. Even state and local governments are expected to run deficits, with the Fiscal Responsibility Act's cuts to non-defense spending offer only a small improvement, and Fitch doesn't expect any significant fiscal measures before the 2024 elections. Fitch also expects the GG deficit will continue to grow, reaching 6.6% of GDP in 2024 and 6.9% in 2025 driven by weak GDP growth, higher interest burdens, and wider state and local government deficits. The interest-to-revenue ratio, a key measure of fiscal health, is expected to reach 10% by 2025, significantly higher than the median for 'AA' and 'AAA' rated countries. Though the debt-to-GDP ratio has decreased from its pandemic high, it's still well above pre-pandemic levels at 112.9% this year and is projected to rise further to 118.4% by 2025. This ratio is over two-and-a-half times higher than the 'AAA' median, increasing the U.S.'s vulnerability to future economic shocks.

Imagine the U.S. government as a household that's been spending more than it's earning. Over the next decade, the interest on that debt is going to double, reaching 3.6% of the country's total income (GDP). At the same time, the population is aging, and healthcare costs are rising as the money set aside for social security and Medicare is projected to run out by 2033 and 2035, respectively. On top of that, tax cuts from 2017 might become permanent, which could mean even less money coming in.

Downgrade History

In August 2011, Standard & Poor's (S&P) took the unprecedented step of downgrading the U.S. credit rating from AAA to AA+. This was a big deal at the time, but what did it mean, and what impact did it have? Back in 2011, the U.S. was recovering from the 2007-09 recession, unemployment was high at 9%, private investment was low, and interest rates were stuck around zero. The federal deficit was a whopping 8.4% of GDP, but the borrowing was seen as necessary to stimulate the economy. Interestingly, the downgrade didn't scare investors away from Treasury bonds. In fact, bond yields declined, meaning there was more appetite for U.S. debt, not less. It was like a sale at your favorite store; people were buying. While the Federal Reserve was implementing "quantitative easing" at the time and buying bonds to keep interest rates low, the real Treasury yield was around zero, and the global saving glut meant there was plenty of money looking for safe assets like U.S. bonds.

Fast forward to today, and Fitch's downgrade paints a different picture. Unlike in 2011, the economy is in a different place. Unemployment is at a 53-year low, interest rates are above 5%, and inflation is double the Fed's 2% target. The deficit is still high at 6.5% of GDP, but the reasons and the response are different. This time, bond yields rose after the downgrade, hinting at how investors took a pause and reevaluated the situation. The real Treasury yield is now 1.7%, and the global saving glut that kept yields down a decade ago is gone. The Fed is now doing "quantitative tightening," that is selling off bonds. Private investors are being asked to absorb more government debt, and this competition for capital could hurt investment and growth in the long run. This time though, the risk is more about deficits and interest rates feeding back on each other, potentially slowing economic growth and costing taxpayers. Notably, interest rates have gone from stabilizing to destabilizing government finances, making interest expense a growing source of deficits. Comparing S&P's downgrade in 2011 with Fitch's recent action, we see two different economic landscapes. In 2011, the downgrade came at a time when borrowing was seen as a necessary evil to kickstart a sluggish economy. Today, the downgrade comes amid concerns about fiscal responsibility, competition for capital, and the potential impact on economic growth.

Lessons for Investors

Until 2011, the U.S. had always been seen as the gold standard of creditworthiness, and the downgrade was a signal that even the mightiest could stumble. Investors were left scratching their heads, wondering what this meant for their portfolios. But instead of fleeing from U.S. Treasury bonds, investors actually flocked to them. Bond yields, which move inversely to prices, declined, showing that there was more appetite for U.S. debt, not less. The downgrade, rather than scaring investors away, seemed to reaffirm the relative safety of U.S. bonds, especially in a world still reeling from the 2008 financial crisis. The Federal Reserve's policy of quantitative easing, aimed at keeping interest rates low, made U.S. bonds more attractive for investors regarding portfolio management. The real Treasury yield was hovering around zero, and in a shaky global economy, U.S. debt was still seen as a safe haven. Investors began to look more closely at the underlying health of the assets in their portfolios and they started to ask tougher questions and think more critically about what AAA really meant. It was really a reminder that even the most trusted assets could be re-evaluated.

For today's investors, the story of the 2011 downgrade is a valuable lesson to be learned, in which can be used to help decipher what is happening today. Markets can react in surprising ways, political noise isn't always the main driver of financial decisions, and understanding the big picture is key to navigating the ever-changing landscape of investment opportunities. For context, when Warren Buffett was asked about the country’s debt problems at the 2011 Berkshire Hathaway Annual Meeting, he reminded his audience that since 1776, America has enjoyed an extraordinary economic journey and the standard of living in the U.S. has increased sixfold since 1930. The capitalistic system, he said, works magnificently and it might get "gummed up" now and then, but it has the resilience to overcome problems. He acknowledged that there are always negatives, but emphasized the incredible power of capitalism to bring the country out of recessions, as it has in the past. His partner, Charlie Munger, summed it up succinctly: "The world is going to go on." Buffett humorously replied, "Now that is wildly optimistic for Charlie."

The Fitch downgrade of the United States’ AAA long-term credit rating could cause investors to sell US Treasuries, leading to a spike in yields that serve as references for interest rates on a variety of loans. To understand better, when a company's credit rating is downgraded, interest rates for borrowing become more expensive because the signal to lenders is there's a higher risk they will not be paid back. However, since U.S. Treasury securities are historically so reliable, this downgrade could disturb financial markets and actually increase interest in U.S. debt. The downgrade has potential reverberations on everything from the mortgage rates Americans pay on their homes to contracts carried out all across the world, per the headlines going on recently. As this current Fitch downgrade seems to be bizarre with the U.S. debt rating being lower than certain countries around the world now such as Singapore and Norway, it is still important to remember that the United States is one of the safest countries to invest in generally, as Buffett always reiterates to never bet against America in the long run.

In the ever-shifting landscape of financial markets, short-term thinking and immediate reactions often create noise that can distract investors from the underlying fundamentals. The recent downgrade of U.S. debt by Fitch and the reactions it has elicited serve as a timely reminder of a historical investing lesson. As Benjamin Graham taught in "The Intelligent Investor," it's essential to separate the signal from the noise and to recognize that market fluctuations are often driven by emotional responses rather than rational analysis. The downgrade of 2011 by S&P and the recent action by Fitch may seem like significant events, but for the long-term investor, they should be viewed in the context of broader economic trends and historical patterns. The U.S. has faced numerous challenges and uncertainties throughout its history, yet its capitalistic system has shown remarkable resilience. As Warren Buffett's optimistic outlook reminds us, the power of capitalism and the underlying strengths of the U.S. economy are factors that endure beyond immediate concerns.

The lesson to be learned from these recent headlines is the importance of a calm and measured approach, grounded in a deep understanding of economic fundamentals. Short-term market reactions can be unpredictable and often driven by fear or euphoria, and by focusing on the long-term perspective and ignoring the noise, investors can navigate these turbulent times with confidence and clarity, guided by the timeless wisdom of investment legends like Graham and Buffett.

Partner Group Investment in Breitling

In an episode of Private Equity Deals, Partners Group, a prominent Swiss investment firm with a footprint in private equity, real estate, infrastructure, and debt, discusses the strategic acquisition of Breitling. Partners Group is based in Switzerland and Denver, CO, the firm manages assets amounting to 130 billion, with 70 billion specifically in private equity. The group applies thematic investing to identify growing markets, paving the way for 'entrepreneurial behavior at scale.' The strategy isn’t just to leverage market inefficiencies but to foster better businesses. The Swiss watchmaker Breitling is a symbol of luxury and style, with a rich history dating back to the 1800s. Originally a toolmaker for pilots, Breitling evolved into a wristwatch, emphasizing beauty and design. The company has seen just four owners throughout its history and was acquired by CVC in 2017. Partners Group acquired from CVC a minority stake in 2021 and increased its ownership in 2022 to over 50% gaining control of the business. This transaction accentuates the investing theme of 'neoluxury' – digitally engaged customers with evolving spending habits.

The transition to a new brand image was marked by George Kern's entry in 2017 as CEO of Breitling. He helped refocus the brand away from aviation, tailoring the message to an increasingly attractive consumer base. This shift saw the brand shedding its iconic wings and embracing boutique design, with a focus on storytelling and interesting personalities as brand ambassadors. At the beginning of due diligence, investment professionals at Partners Capital were worried about the risk that Smartwatches like the Apple Watch posed to the luxury watch industry. In just a couple of years, the Apple Watch became one of the most-sold watches worldwide. However, despite the advent of smartwatches disrupting the industry landscape, Breitling proved resilient, maintaining its category. Instead of a market disruption, the emergence of smartwatches served as a complementary product, used mainly for its functionality, reaffirming Breitling's position as a more formal, jewelry-like piece.

The pandemic has posed a unique challenge for all industries, and Breitling was not exempt. With markets and stores closed, there were questions about sustainable revenue bases. However, due to in-depth industry research and understanding, Partners Group was able to navigate this challenging period. Their trust in the brand's appeal to consumers and the growth path's sustainability proved to be a vital asset. Despite the difficulties, Breitling has remained resilient, even demonstrating the capacity to prioritize amidst the clamor of tasks at hand. This resilience, coupled with the dedication to growth, symbolizes the enduring strength of the Breitling brand. Breitling's journey doesn't stop with luxury watches. With a clear vision to expand its customer base, Breitling has been continuously enhancing its brand image. Initiatives such as blockchain-enabled watch certificates illustrate the brand's innovative thinking. Moreover, there's a dedicated effort to balance gender representation with the introduction of female ambassadors, demonstrating a clear commitment to inclusivity. And lastly, they are looking to expand their pricing structures to include many different consumers. Echoing their customers' growing interest in environmental conservation, Breitling is making strides toward becoming more sustainable. They are acutely aware of their impact on the environment, and their strategic decisions reflect this. For instance, Partners Group specifically has an ESG Team working with Breitling, to ensure the business continues to make eco-friendly decisions. Additionally, with the partnership between Denver, Colorado-based Partners Group, and Swiss watchmaker Breitling, a unique global synergy is at play. This international collaboration underscores the global nature of modern business and the potential benefits of diverse geographic perspectives. It serves as a shining example of how collaboration can bridge cultures and spark innovation. Private equity, for Partners Group especially, is about playing the long game, and Breitling’s story is no exception. The company's high margin cost structure (hovering in the high 30s), coupled with conservative 4x leverage (debt/EBITDA ratio), reinforces the comfort in the scale of the business. Instead of obsessing over immediate exits, Partners Group and Breitling focus on the vision of the business. The investment is about building a sustainable growth story and redefining luxury in an ever-evolving consumer landscape. And until Partners Group is able to achieve their long-term goals within Breitling, they say they won’t even think about selling.

Note: whenever a private equity firm buys a controlling stake in a business, the firm is always thinking about how/when to exit an investment. The last thing you do is hold a business that would not be appropriate for public markets and no sponsor or strategic wants to buy.