Benchmark International

Earlier this week, projections for increases in the Federal Funds Rate increased from three 25 basis point increases in 2018 and one in 2019 to four and two respectively. As a “basis” point is 1/100th of a percent and a “25 basis point increase” is an increase of 1/4 of one percent, this means that rater than increasing by 0.75% in 2018, experts now expect a 1.00% increase for the year and a 0.50% increase as opposed to 0.25% increase next year.

This happened because (a) the recent tax cut is expected to boost GDP by an extra 0.3%, (b) the even more recent government spending bill, which is modestly termed “generous”, is also expected to add 0.3% to GDP, and (c) the regulatory roll-back that has occurred over the last 12 months is expected to add another 0.3% to 0.6% to GDP.

This overall boost to growth of about 1% has the experts now calling for an amazing 5% growth in US GDP. When GDP grows quickly, inflation is a strong concern. In order to stall inflation, the Federal Reserve Bank raises interest rates, attempting to throttle the supply of money to tame inflation. (Inflation is caused by too much money chases too few goods and services.)

Commercial interest rates will also increase, and at a faster rate than the Federal Funds Rate, because a booming economy means corporations need more debt to take advantage of growth opportunities, and the combination of major tax cuts with a “generous” spending bill means the government will also borrow more money. Due to the law of supply and demand, more people demanding debt equals increased demand and increased demand drives prices higher; in this case, the price of money.

Our typical financial buyer (10 out of 30 last year, 13 out of 26 the year before) uses between 40 and 60% debt financing to pay the portion of the Transaction Value due at closing. Let us say we have a $10M deal with 20% in an earn out or seller note. That means we could expect the buyer to borrow about $4M. When, two years from now, they borrow at a fixed rate for five years with a bullet repayment of principal, the anticipated 2.5% increase in the commercial interest rate will require them to divert an extra $500,000 of cash flow away from reinvestment in the target company and into interest payments over the first five years of their holding period.

To make selling now even more urgent, financial buyers get much of their money from the same types of institutions that normally invest in bonds but have not been doing so because bonds have paid interest rates that have been absurdly low. As interest rates increase, new bonds have to offer higher interest rates in order to get sold (law of supply and demand again).

When they do that, they attract those institutional investors that have been shunning them and using PE funds as their investment of choice while interest rates are low. And when they move, it’s like a herd of buffalo. You wake up one day, and its upon you. According to the Wall Street Journal on February 8, quoting Prequin, a very good source, “unspent cash accumulation by PE firms” (a/k/a “dry powder”) hit an all-time high in January 2018, topping $1 trillion for the first time ever.

Chances are we have hit “peak capital,” and this will stand as an all-time high for some time to come. Within a year to eighteen months of peak capital, we hit peak valuation.

ABOUT BENCHMARK INTERNATIONAL

Benchmark International’s global offices provide business owners in the middle market and lower middle market with creative, value-maximizing solutions for growing and exiting their businesses. To date, Benchmark International has handled engagements in excess of $5B across 30 industries worldwide. With decades of global M&A experience, Benchmark International’s deal teams, working from 13 offices across the world, have assisted hundreds of owners with achieving their personal objectives and ensuring the continued growth of their businesses.

We are ready when you are.

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Call Benchmark International today if you are interested in an exit or growth strategy or if you are interested in acquiring.