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As of November 2023, the Fed’s target interest rate currently sits at a 22-year high of 5.25 to 5.50 percent, while inflation continues to dilute the dollar to the tune of 3.7 percent. According to financial experts, these economic headwinds have important repercussions on corporate mergers and acquisitions.
“As the Fed raises interest rates to combat inflation, we’re seeing the cost of debt rise for acquisition debt as well,” says Jay Jung, founder and managing partner of strategic finance advisory firm Embarc Advisors.
The effects of inflation and high interest rates on mergers and acquisitions
Previously, businesses leveraged the low cost of borrowing to finance a wide range of projects, which included lower-quality transactions. “Basically, with lower cost debt, they either had more margin of error or more time to rehabilitate the margin structure of these poorer-performing businesses,” Jung explains.
Times have changed, however. As incurring debt becomes more expensive, buyers feel the pinch.
“The higher cost of debt means less margin for error,” Jung says. “It also means conducting more due diligence, and taking more time on each deal.”
In addition, fewer deals are being struck. “Buyers are becoming more cautious,” Jung explains.
A new balance of power
These market forces have also shifted the balance of power among different kinds of possible purchasers. Notably, Jung notes that the current environment is a “great hunting ground” for strategic buyers — corporate buyers that make acquisitions for strategic purposes. On the other hand, private-equity-backed companies that execute rapid acquisition roll-up strategies have suffered setbacks.
“To the extent they used floating-rate debt, these companies have seen their monthly payments rise along with interest rates,” Jung explains. “This has had a negative impact on their cash flow, which means they have less capital for making acquisitions. Meanwhile, strategic buyers tend to have more synergistic opportunities when it comes to acquisition. These cost and revenue considerations allow them to stretch on valuation on the margin.”
According to Jung, this has leveled the playing field between these different types of investors.
Different impacts on different deals
With less capital for acquisitions available, however, the amounts buyers can offer have diminished, which resets valuation benchmarks at lower levels. “Valuations are moderating and dropping overall,” Jung says. “While all transactions have been affected, lower-quality deals are languishing more than higher-quality ones.”
In addition, Jung suggests smaller deals that don’t require financing can hope for a smoother process. “Larger M&A deals usually involve loans with higher leverage,” he explains. “These transactions are seeing more valuation pressure with higher interest rates. Middle market deals, which tend to be less levered, are relatively less impacted, although they aren’t completely immune from these economic factors.”
In addition, the impact of inflation is not uniform across industries. Due to labor shortages and higher labor costs, Jung says, “Labor-intensive commoditized industries that are not able to raise prices or lower cost through, say offshoring resources seem to be impacted the most.”
Novel approaches to mergers and acquisitions
Fewer buyers with large amounts of ready money means that sellers also need to lower their expectations, but in Jung’s experience, some have been slow to do so. “I see this a lot in businesses that provide IT services, which previously enjoyed high valuations and robust activity,” he says.
Hashing out deals has therefore sometimes necessitated novel solutions. “Earn-outs have increased,” Jung says. “While seller’s notes used to be reserved for smaller transactions by search funds and independent sponsors, I’m seeing more of these in larger transactions. This helps bridge the gap, because the buyer obtains a lower cost of capital, while the seller gets to realize their target headline valuation.”
How aspiring sellers should prepare
These dynamics have important ramifications for owners who are looking to sell. “Since the strategic corporate buyers typically take longer to underwrite a transaction, owners contemplating an exit would benefit from building relationships with them early on in the process,” Jung says. “Consider forging general corporate development relationships at trade shows or holding potential partnership discussions, for example.”
Jung also recommends conducting thorough sell-side due diligence as “the best way to mitigate the risk of a failed M&A process.” “This is a strategy in which an M&A advisor conducts investigations on the company to be sold,” he explains. “This gives leadership a chance to fix any issues head-on prior to engaging prospects for buyers.”
How buyers should proceed
Buyers should also do their due diligence. “With the higher cost of leverage, missing something can really hurt the bottom line,” Jung warns.
Sean Shahkarami, founder and CEO of AI and machine-learning M&A company Opilio LLC, concurs on the need for careful analysis. “I’m a big proponent of fundamentals in M&A transactions, especially given the current economic environment,” he says. “This means I would want to see strong cash flow, a strong management team, and a strong track record of success. The other piece of the puzzle is strategy and synergy. A deal may make no sense to one fund, but another fund might have an entire platform for a specific industry where the deal makes perfect sense.”
Jung also encourages buyers to innovate in how they structure deals. “What a seller wants can be subjective,” he points out. “Creative deals that address their pain points or satisfy their desires, even if they might be unorthodox, can lead to a successful deal.”
Since being able to turn an acquired business around as soon as possible is paramount to success in today’s difficult conditions, Jung observes that many middle market buyers engage strategic finance advisory firms towards the end of the diligence period to make sure the buyer can “hit the ground running on day one,” as he puts it. “This enables them to have a remedial plan ready for any deficiencies.”
Long-term success in mergers and acquisitions
As Shahkarami observes, M&A deals are “hard to find in this market, but worth looking for.” By understanding these current trends in the industry and doing their due diligence, both buyers and sellers can continue to strike profitable deals.
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