The Federal Reserve has raised interest rates 11 times since last year. This is the fastest pace of tightening since the early 1980s. However, the consensus among economists and central bankers is that interest rates will now stay higher for longer. This means there will not be any near-time relief from high borrowing costs.
The thinking is that interest rates will stabilize and won’t tick down until later in 2024 or early 2025.
When interest rates rise, it becomes more expensive for companies to borrow money. This makes financing mergers and acquisition (M&A) deals more costly, as companies rely on debt to fund acquisitions. Higher borrowing costs can present challenges to some potential buyers, especially those with weaker balance sheets or those seeking highly leveraged deals.
Rising interest rates will in most cases lower valuations for target companies. This is because higher discount rates are applied to future cash flows, reducing present value of those cash flows. Lower valuations will make targets more attractive to potential acquirers, which will lead to sellers receiving lower offers. Some sellers will opt to wait until the financial markets improve in their favor, but this will take a while.
Interest rates are intrinsically tied to M&A deals as many buyers finance all or a portion of their purchase of target companies with debt. With senior debt surging, acquisitions have become more expensive, which has a direct negative effect on the return on investment. Also, lenders have begun to apply tougher lending requirements that are more challenging to satisfy. When banking institutions lend money on an M&A deal, they impose a comprehensive due diligence process to achieve comfort that the purchaser will be able to pay back the loan. Elevated interest rates increase the risk of borrowers defaulting on their obligations, resulting in more lender scrutiny and due diligence. A tougher lending policy often causes longer waiting times for loan approvals and lowers the rate of approvals. This results in M&A deals taking longer to close than normal. In some cases, they are put on hold.
Increased interest rates also affect M&As by elevating the cost and time of due diligence by the buyer and lowering valuations. As borrowing money has become more costly for buyers, due diligence has become more comprehensive and detailed. Because there is less potential return on the investment and higher risk of default, buyers need to be assured their acquisition is solid. Because there is more investigation involved on the part of the purchaser and their advisory team, it often raises the cost of the transaction for both sides of the deal. Simply put, higher interest rates increase the company’s cost of capital, which can lower the seller’s business valuation.
While M&A deal activity has decreased and capital costs have increased, there is still a strong market for high-quality companies regardless of interest rates. This has proven to be evident in the lower middle market with values less than $100 million. Deal activity in this sector has declined, but not as much as other markets across most industries. It’s typical that these types of deals require less financing, allowing values to remain more consistent, regardless of the interest rates.
Many private equity firms and strategies have unallocated capital commitments that provide existing financing for transactions. There is plenty of cash available to fund deals. However, the M&A market has seen many transactions completed with debt instead of using available cash because banks are comfortable lending for good deals.
Higher interest rates will have an impact on financing structures. In response to higher interest rates, companies may adjust their financing structures by relying more on equity financing rather than debt to reduce their exposure to risk.
The dynamics of the recent market have had a direct effect on M&A deal terms. In order to mitigate the return on investment risks and valuation gaps, buyers are implementing what has been historically referred to as “buyer friendly” terms to close acquisitions.
Two examples of the most common deal terms that are re-emerging from the past days of higher interest rates include:
• When deferred payments are used to fund a deal, purchasers do not pay the entire purchase price at closing but instead make payments to the sellers over a period of time after the deal has been completed and often on an unsecured basis. When sellers accept these kind of deal structures where compensation is deferred after closing, they lose out on the time value of that capital and stand behind secured creditors if things go south.
• When low-cost debt financing becomes scarce, buyers are more likely to request earn-outs to minimize the amount due at closing, but allowing the seller an opportunity to receive more value for their business. Earn-outs are typically paid if performance thresholds are realized post-closing (EBITDA, revenue, net profit, etc.).
An additional option is to offer the seller a bonus if the performance thresholds are significantly surpassed.
However, there is the risk the new owner operating the business may not achieve the post-closing thresholds, and like other deferred payments, sellers lose out on the time value of the capital they would have received at closing. Time value of money is higher during times of high interest rates. While sellers may not want to accept earn-outs unless they are confident the business will continue to be successful, it may be necessary terms to get the deal done if the buyer is unable to get financing for the entire purchase amount due to strict lending requirements and higher cost of interest rates.
Most deals have adjustments after closing related to working capital levels of the business. Like deferred payments, the seller that may otherwise be entitled to a payment post-close resulting from a working capital adjustment may want to collect interest on the funds paid pursuant to the adjustment. The seller who is entitled to receive additional monies loses the time value of those monies from close to the end of the adjustment period. Because rates are high, there is a push to collect interest on those monies. This may become more common in the current market.
In summary, M&A activity is down in this current environment; however, quality companies will always be attractive to quality buyers. Cash is king — but creative financing is a close second.
