After several years of record-breaking levels of merger and acquisition (M&A) activity, late 2022 into 2023 has seen market volatility, persistent inflation, rising interest rates, continuing supply chain issues, global conflicts and fears of a possible economic downturn that have resulted in a significant slowing in deal flow as well as decreased exit values. As the U.S. economy emerged from the COVID-19 pandemic, the Federal Reserve aggressively raised interest rates to combat inflation, raising rates by a historic 3.75 percentage points in 2022 alone. Although only one of many factors at play, interest rates play a critical role in shaping the decisions of both buyers and sellers in acquisition transactions in various ways. While deal volume and valuations have drastically fallen from the highs of recent years, the prevailing high-interest rate environment can provide both challenges and opportunities.
Cost of Capital Financing Structure
One of the most significant ways interest rates affect M&A transactions is financing structure. When interest rates are low, debt financing is cheaper. This lower cost allows buyers the option to use more debt to fund acquisitions as they can afford to borrow more money to finance a deal. On the other hand, when interest rates are higher, buyers may need to rely more on cash on hand and equity financing, which leads to lower leverage ratios and the need for higher equity contributions toward the purchase price. The adverse effect of rising interest rates on the cost of capital also increases the costs of servicing existing debt which impacts the target’s operating expenses and profitability as it is more expensive for companies to pay back such loans. These increased costs of financing acquisitions and servicing debt, as well as the need to contribute more equity financing to support the borrowing, put downward pressure on M&A activity as buyers become cautious about borrowing to finance deals they might otherwise be willing to pursue in a lower interest rate environment. Sellers, particularly those who are considering accepting rollover equity (selling less than 100%) or are subject to an earn-out as a portion of the purchase price, also are impacted by these higher debt service costs in terms of the value of their retained interest. Further, the increased costs of buyer debt generally may also impact the value of any stock portion of the purchase price if the equity of the buyer is offered as part of the consideration. Therefore, even if buyers are able to obtain debt financing on acceptable terms, sellers in this environment may push for lower leverage (more cash upfront) or all-cash deals.
Increased interest rates may also impact a buyer’s “cash on hand” or “dry powder.” As interest rates rise, investors tend to favor fixed-income and credit securities. Higher interest rates increase the “risk-free rate,” which is the rate of return on virtually risk-free investments like government bonds. This, in turn, narrows the equity risk premium or the excess return earned by an investor above the risk-free rate in alternative investments and, therefore, indirectly puts pressure on important M&A activity by impacting new fundraising by PE funds, which restricts the amount of capital available on the buy-side of the M&A market. For example, “dry powder,” or the amount of available cash in private markets/private equity, has been estimated to have reached a record $3.7 trillion at the end of 2022, according to Bain & Company’s Global Private Equity Report 2023. However, the markets are seeing a slowdown in new fundraising, so existing funds are being more conservative with how they deploy the existing dry powder, in part preserving cash for supporting their existing portfolio companies. This same conservative approach applies to strategic buyers with cash on hand as borrowing for their own business needs becomes more expensive, so they tend to conserve cash and slow acquisition activity. As a result, with higher interest rates and volatility in the equity markets, including the market for private capital raises, buyers become conservative and look to preserve cash on hand except for very opportunistic deals. Nevertheless, with higher borrowing costs, buyers with cash on hand may be less constrained than others and find a competitive advantage under current market conditions.
Discount Rate and Valuations
Interest rates can also impact valuations when assessing targets or deciding to put a company up for sale. When interest rates are high, the cost of capital is higher, which means future cash flows are discounted at a higher rate. This can result in lower valuations, as future cash flows, and thus a company’s revenue projections, are worth less in terms of today’s dollars. A higher discount rate of future cash flows can be particularly biting for early-stage or high-growth companies that are not expected to become cash-flow positive for some time. Also, higher interest rates can diminish the value of company assets, further driving down valuations. Lower valuations may induce potential sellers to hold back on putting their companies up for sale, opting instead to wait for an improved economic landscape where valuations might be higher. At the same time, lower valuations can provide an opportunity to make certain targets more attractive (i.e., less expensive), but this would need to be weighed against higher capital costs and economic uncertainties. Another consideration is that significant declines in valuations of companies and their assets, particularly at a time with higher capital costs, can make private investment exits much less attractive for current owners who may have acquired or invested in these companies at a time when valuations were much higher.
Interest rates can also impact the structure of acquisition transactions and the strategic decisions of dealmakers. As noted above, deals may involve more cash and equity rather than debt financing. However, in difficult financing environments, especially where valuations are trending downward (in this case, in part because of rising interest rates), we may see an increase in earn-outs and contingent payments, which are often used in M&A transactions to bridge gaps in valuation expectations between buyers and sellers. These structures allow for additional payments to be made to the seller if certain performance metrics are achieved post-closing. Higher interest rates can have an impact on the use and structure of earn-outs and contingent payments. Where increased interest rates may be driving buyers and sellers further apart in terms of valuations, these structural components can be useful but difficult to navigate. Earn-outs and contingent payments always add complexity and uncertainty to a deal and require careful negotiation between the parties. Sellers will want adequate controls in place to maximize their ability to achieve full payment, while buyers will want maximum flexibility to operate the business in their best interests. This is always the case, but the concerns are heightened in an unpredictable and potentially downward-trending economic environment. In such cases, it becomes much harder to set realistic milestones or for a buyer to commit to long-term obligations such as maintaining the seller’s key team members and continuing to fund certain initiatives. Also, the cost of capital in and of itself may impact financial results. Another potential deal tool that buyers may use is to propose seller financing (having the seller agree to be paid over time in the form of a promissory note, often subordinated to any outside debt financing for the deal). Sellers will be particularly wary of the likelihood of timely payment of such subordinated debt with high-interest rate senior debt that likely includes tighter covenants than in a more favorable deal environment, although the interest on such sub-debt may be attractive.
While rising interest rates increase the cost of capital, decrease valuations and lower deal volumes and activity, higher rates do not necessarily mean fewer opportunities. Companies with cash will have an advantage over those without, as cash can provide certainty, and with lessened demand for acquisitions in the market, those buyers may find less competition for potential deals. Lower valuations may also create more attractive acquisition targets, and some sellers may be interested in selling now rather than waiting indefinitely for the markets to calm. Staying vigilant and monitoring macroeconomic developments will allow M&A parties to make informed decisions – where and how the U.S. Federal Reserve steers monetary policy and interest rates will have a real impact on deal values, deal volumes and deal structures. Savvy M&A operators who understand the challenges and opportunities of a high-interest rate environment and how to effectively adapt therein will still be able to make successful deals happen.