Rising interest rates aren’t going to put a damper on M&A activity, at least not for now. But buyers understand that each new rate hike is a small hit against their overall return.
On the sell side, 48 percent of business brokers and advisors predict that rising interest rates will have a negative impact on sellers. But on the buy side, that number is much higher, at 75 percent, according to the Q1 2018 Market Pulse Report published by the International Business Brokers Association (IBBA), M&A Source and the Pepperdine Private Capital Market Project.
A quarter point increase here and there is not going to stifle the strong marketplace we have right now. But over time it will affect the economics of valuation and activity.
In March, the Federal Reserve raised benchmark interest rates from 1.5 to 1.75 percent and signaled that two more increases would be coming in 2018. The feds are taking things slowly, so the increases shouldn’t shock the system. But with economic outlooks strong, we can expect even steeper increases in 2019 and 2020.
As the cost of borrowing increases, deal value will be affected, particularly when a large portion of the deal is being financed through loans. When the cost of debt goes up, return on investment declines.
In the short term, it would take a significant increase to really change sentiment in today’s market. We still have historically low rates. When I got into the industry in 1998, the prime interest rate was at 8.5 percent and there were a lot of deals getting done. Prime today is at 4.5, so there’s considerable room for growth before we hit historic norms.
Combine today’s still low interest rates with the trillions in corporate capital sitting on the sidelines, confidence in the business and consumer marketplace, and the recent tax cuts, and you have ideal conditions for selling. All these factors well outweigh the interest rate hikes.
In fact, seller market sentiment (a measure of who holds leverage in the market) hit a record high in four of five market sectors, according to the Market Pulse Report. Despite the continued push of baby boomer retirements, there still aren’t enough quality deals to meet demand, and buyers are paying a premium to beat their competition at the negotiation table.
In the meantime, prudent buyers will be recalculating their return on investment targets. Each rate hike means more money going to debt service and a little less to principle.
Buyers don’t just purchase the physical assets of a business; they buy future cash flows. They have to weigh what they can buy a company for against the costs to grow organically. Currently we’re in much more of a buy rather than build mentality. But each rate increase shifts the balance a little.