In 2022, Edward Chancellor published a book called The Price of Time, which chronicles the historical relationship of economic activity with interest rates. The conclusion of the book is that low interest rates reduce labor and capital productivity by reducing the threshold for efficiency in the deployment of capital. Chancellor observes that long periods of economic malaise tend to follow periods of capital excess. For some, the book could read ominously for the prospects of growth. Reading the book, I became extraordinarily excited about the prospects for Hudson Hill, its current portfolio companies, and future investments. The world is at an inflection point, one that will create immense opportunities for companies that position themselves to benefit from the changes that will result.

To dive deeper into the Hudson Hill opportunity, it is important to first understand the current state of the economy and the changes that will occur due to interest rate rises.

Recent, rapid increases in consumer and producer price indexes starting in 2021 kicked off a series of responses from central bankers dramatically increasing the cost of borrowing around the world.

The increase in consumer prices drove the US Federal Reserve to respond by increasing interest rates. The pace of the interest rate increases was unprecedented. The deviation from the prior fifteen years of central bank interest rate policy is even more dramatic. The increase in interest rates represented a fundamental departure from central banking orthodoxy of the last fifteen years, that low interest rates would result in economic growth.

In his book, Chancellor details the oddity of the recent zero interest rate policy (ZIRP) within historical context. The decline to zero contrasts starkly with the 5,000 year history of interest rates. Only two periods in history experienced interest rates at the zero lower bound – with the only other in the 1920s preceding the Great Depression. In short, periods of low interest rates create hangovers from risk taking that impact economies.

*Source: The Price of Time, Edward Chancellor.*

Interest rates represent a demarcation of time that determines the preference of all actors within an economy including governments, consumers, and businesses. These actors possess the option to spend, borrow, tax, invest, or save. The rational choice for each is determined in large part by the prevailing risk-free, short-term interest rate. The risk-free rate sets the floor on returns required for any economic activity, determining the preference of saving, investing, consuming, and spending.

When interest rates are high, businesses, consumers, and governments are reticent to take on debt, as the cost to service that debt “crowds out” other outlays. When interest rates are low, the inverse is true, incentivizing increased debt amongst governments, consumers, and businesses. In the United States, government debt increased steadily over time. As debt levels increased, the cost to service that debt remained constant. The decline in borrowing costs driven by ZIRP created an incentive for the US government to take on debt. With interest rates increasing, the cost to service this debt is increasing as well.

Chancellor asserts that the ability to deploy capital in a low-rate environment reduced the need to spend that capital productively. Returns to capital declined, reducing the attractiveness of investments. The rate of investment within the United States declined during ZIRP.

The increase in capital availability reduced the healthy cycle of capitalism. The manifestation of healthy capitalism is the emergence of new, innovative companies that replace incumbents. The availability of capital created “zombie” companies by reducing default rates and preventing this healthy cycle of capitalism. Default rates over the last fifteen years were 80%-90% lower than periods of higher interest rates.

Low default rates also impact the churn of employees. When companies default, employees are freed from jobs to start new companies or help emerging challengers. Over the last 25 years, turnover rates amongst US employees declined by 50%.

During the 2010s, total factor productivity (TFP) declined by ~40% from the prior two decades. TFP measures the effectiveness with which capital and labor are deployed in the economy. Rational economic actors, able to procure low-cost capital, did not focus on driving labor or capital productively, as they were able to manufacture growth through the deployment of more and more capital.

*Source: St. Louis Federal Reserve – FRED.*

Productivity matters because it determines economic prosperity. About 150 years ago, the average consumer in the United States owned 200 things. This included clothes, household tools, and tools to generate income. Today, the average American owns 10,000 things. The reason for this vast expansion in standards of living is because all workers are more productive. The combination of technology and processes make the average American worker vastly more productive. As workers produce more, wages rise in real terms, generating greater standards of living. Floyd Arthur Harper, in his book, Why Wages Rise, published data that tracked changes in productivity with changes in wages. As you can see, over a nearly seventy year period, wage gains tracked gains in productivity. The pernicious impact of low interest rates can be seen in this chart. When capital is free, the need to deploy labor or capital productively declines. When productivity does not rise, wages and standards of living do not rise. Low interest rates, rather than spurring economic growth and therefore prosperity, contribute to stagnation.

*Source: Why Wages Rise, Floyd Arthur Harper.*

The corporate metric analogous to TFP is return on invested capital (ROIC). Companies generate free cash flow on capital (debt and equity) deployed over time. In the 2000s and 2010s, ROICs declined. Companies deployed more capital and generated less free cash flow as a ratio than they had in prior decades.

When policy makers approached the zero lower bound in the 2000s, adopting ZIRP was viewed as an experiment. Significant data did not exist on the impact of low rates on economic output. The hypothesis was that low interest rates would spur consumption, which would drive economic growth coming out of a credit induced decline in demand. Rather than inducing demand, low rates contributed to low productivity thereby destroying demand. The resulting low demand drove a cycle of doom that policymakers could not exit for fifteen years.

During this period, prices of assets inflated. Money is an esoteric concept meant to serve as a proxy for productive capacity. Money is the ability to call upon productive capacity at any time – either for saving or consumption. Since interest rates peaked in the 1980s, the amount of productive capacity relative to its value in terms of money declined. Chancellor demonstrated this wealth effect showing that the ratio of net worth to GDP doubled. Without productivity gains, wealth gains are an illusion.

The illusion of wealth impacted nearly every company that accessed capital markets over the last fifteen years. Lower interest rates caused public company financial performance to improve merely by lowering the interest costs on existing debt facilities. In the example below, a public company improved its earnings per share by 26% through lower interest costs, which would cause its market capitalization to increase.

At the same time, public companies were able to manufacture earnings per share growth by continuously issuing debt to repurchase stock. In the below example, a public company manufactured 12% earnings growth by increasing its debt and reducing its share count.

Venture capital experienced a significant increase in liquidity during the last fifteen years, driven by a variety of factors. Successful companies within the venture capital ecosystem raised enormous amounts of money at very low dilution levels (high valuations). In the below table, a “successful” unicorn, one that was able to raise nearly $2b at a $7b post-money valuation, will likely struggle to generate the financial profile to justify this preference stack and valuation. These venture-backed companies supposedly represent the “innovative” companies within our economy. These capital structures will likely inhibit innovation prospectively.

Within the private equity ecosystem, the average transaction became 3x more capital intensive. The same company cost 60% more to purchase in 2022 compared to 2010. Assuming the same organic growth rate, these companies required an 11x increase in the amount of M&A completed during a five year ownership period to generate a 3.0x MOIC return. Debt fueled acquisition growth became the primary means of value creation. As interest rates increase, the capacity to continue this strategy declines, thereby driving a fundamental shift in the ways that private owners of businesses generate equity returns.

So, reading all of this, why are we at Hudson Hill excited?

Across the economic landscape, companies are poorly positioned due to the recent period of capital availability. Public and private businesses are overcapitalized. Public and private businesses are less productive than in prior decades. Methods of value creation won’t work in the new environment. Hudson Hill’s investment approach is to target businesses with advantaged business models that operate in large industries that can grow with minimal capital for long periods of time. Hudson Hill’s approach and infrastructure align on driving revenue growth and productivity gains within its portfolio companies.

Hudson Hill’s Strategic Advisory Board is comprised of a group of seasoned industry veteran executives who partner with our management teams actively to navigate various challenges and opportunities. These executives benefit from decades of running public and private businesses within the specific industries and sub-verticals that our portfolio companies operate. At the same time, Hudson Hill’s Portfolio Transformation Group (PTG) provides functional expertise across the various pillars of business building. The goal of the PTG is to compress the time required to implement a scalable foundation to support further growth. At the same time, Hudson Hill is actively investing in an Executive-in-Residence program, hiring graduates from top business schools directly into senior leadership positions at portfolio companies. The program allows graduates the opportunity to assume more senior positions relative to their experience and creates an opportunity for our portfolio companies to attract world-class talent.

Fundamentally, Hudson Hill is focused on investing in and building companies that can grow for long periods of time. To do so, portfolio companies invest in their businesses – technology, people, and processes – while focusing on driving productivity improvements across all aspects of the businesses. Capital efficient growth has become paramount, and our companies will prioritize high return on invested capital opportunities. The opportunity for Hudson Hill’s strategy is the best it has been in nearly 25 years. This inflection point is Hudson Hill’s opportunity. Across every industry, every company, every asset class, operates inefficient, over-capitalized, non-innovative companies that will struggle to compete in the coming years. Hudson Hill’s opportunity over the next decade is to invest in and build the companies that will challenge these companies. We’ve never been more excited about the road ahead.

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Alexander Stacy

The Hudson Hill Opportunity

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