Most business owners have become acutely aware of how a change in interest rates can impact their financing decisions. Whether it means taking advantage of a competitive rate and refinancing previous notes or whether it means holding off on acquiring a needed piece of equipment until the monthly payment becomes more manageable; the interest rate associated with obtaining debt can play a major role in the decisions a business owner makes in the day-to-day operations of their company. But, how do interest rates impact the sale of a business? Is there a correlating relationship between interest rates and activity in the M&A market? If there is, what is the importance of timing the sale of a business based on the indications provided by the Federal Reserve? All of these questions are important to consider as a business owner begins to contemplate the potential sale of their company.
The Federal Reserve has indicated that it is planning on increasing interest rates as it is continuing to pull back from its decade-long effort to stimulate economic growth. As of November, 2018, the Wall Street Journal Prime Rate was 5.25% whereas one year prior it was 4.25%. This metric is important as it consists of a survey of the 30 largest banks and is the rate at which banks will lend money to their most credit worthy customers; additionally, this rate will move up or down in lock step with changes made by the Federal Reserve Board. So, what does this mean for those who are in the market to sell their business? An increase in the federal funds rate increases the cost of borrowing and hence affects the value of merger deals, especially if a portion of the transaction is being financed through loans. If the company to be acquired is highly leveraged and the cost of debt goes up, the internal rate of return is impacted, lowering the valuation of the company.
The timing of when a business enters the open market for sale as well as the speed at which interest rates rise also plays a role in the impact that interest rates have on activity in the M&A market. A methodical rise combined with a strengthening economy, which the United States has experienced over the past 18 months, should not have a detrimental impact on the aggressiveness with which buyers enter the acquisition market. The reason that a controlled and steady increase in interest rates mitigates the risk associated with increased cost of debt has to do with the corresponding increase in corporate confidence. With interest rates having been at historical lows over the past several years, many companies in the market to buy are armed with strong balance sheets earned via normal operations of the business as well as having taken advantage of low market interest rates to issue debt. This cash held on the balance sheets of acquirers in the market may deflect some of the increase in borrowing cost due to the availability of deployable capital. Specifically addressing those sellers looking to sell a business in the middle to lower middle market space – a slow rise in rates will give them an opportunity to cash out and use this new-found liquidity to put their money back to work in a recovering and dynamic market.
In conclusion, the general consensus is that rising interest rates aren’t going to put a damper on mergers and acquisitions activity, at least not in the near-term. However, as interest rates continue to increase, there will come a time when the increased cost of borrowing shifts the economics of valuation and activity. The buyers most affected by the increase in rate will be those that rely heavily on financing through loans to complete an acquisition. Fortunately for sellers, interest rates being at historical lows has helped buyers compile large amounts of cash on their balance sheet which, when combined with acquirer confidence in the business and consumer marketplace, a taxation environment that can be viewed as business friendly, the ideal conditions for selling begin to take shape. It is important to take note that an increase in interest rates does not have as large of an immediate impact as the speed at which those interest rates increase. As the Federal Reserve continues to be relatively transparent with their intentions regarding gradually increasing interest rates, and with firms having taken advantage of historically low interest rates and compiling large amounts of cash on the balance sheet, the ideal time to sell a business, particularly one in the lower middle market space, will be sooner rather than later. As time goes on and increased rates continue to take a bite out of returns on investment, there will come a time when the balance will shift from a sellers’ market to one that is in favor of the buyer.
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