M&A Market Update: The Impact of Interest Rates

Read Time: 7 minutes

Interest rates affect businesses of every size. Generally, low rates make borrowing money easier. For the past fifteen years, and even more so following the onset of the COVID-19 pandemic, interest rates remained low and amplified business investment. In March of 2020 the Federal Reserve lowered the target federal funds rate from 1.50% to .25% where it stayed for the next two years. As a result of these low rates certain markets boomed; borrowing money was inexpensive and businesses and investors seized the opportunities presented. One such market was M&A, which, after an initial lull at the beginning of the pandemic, peaked in 2021. A low federal funds rate, sitting at .25%, allowed buyers to finance acquisitions at low costs of borrowing.

In stark contrast, in May of 2023, the Federal Reserve raised the target federal funds rate to 5.00%-5.25%, which has increased borrowing costs and decreased returns to investors. Further, lenders have tightened lending requirements in an effort to verify borrowers’ capacities to service debts at higher interest rates. The symptoms of higher interest rates have a direct impact on the M&A market, including deal activity and deal terms.

Interest Rate Impact

Interest rates are intrinsically tied to M&A deals as many buyers finance all or a portion of their purchase of target companies with debt. With senior debt pricing surging to 6.6% in Q4 of 2022 (and continuing to rise another 50-100bps in Q1 of 2023), acquisitions have become more expensive, which has had a direct negative impact on return on investment. In addition, lenders have begun to impose stricter lending requirements that are more difficult to satisfy. When banks lend money on an M&A deal, they complete a thorough diligence process to gain comfort that the target will be able to pay back the loan. High interest rates increase the risk of borrowers defaulting on their obligations; therefore, lender scrutiny and diligence increases. This stricter lending policy often results in longer waiting times for loan approval and lower overall approval rates. As a result, M&A deals are taking longer to close and in some cases are being put on hold.   

High interest rates also affect M&A by raising the cost of buyer diligence and impacting business valuations. As borrowing money has become more costly for buyers, acquisition due diligence has become even more thorough and comprehensive. With less potential return and risk of default, buyers need to be more confident in their target. This results in more investigatory work on the part of the buyer and its advisors, often raising the cost of the overall transaction for both buyers and sellers. Additionally, high interest rates increase a target company’s cost of capital and discount rate, both of which can lower that target’s business valuation.

Deal Activity        

While M&A deal volume has decreased and capital cost increased, there is still a market for quality deals, regardless of high interest rates. This is particularly noticeable in the lower middle-market (e.g., targets with enterprise values of less than $100 million). Deal volume in that segment of the market has declined, but to a lesser extent than other market segments across most industries. These types of deals typically require less financing (relative to larger deals), allowing valuations to remain more consistent, despite current interest rates. This motivates sellers to transact.

Furthermore, many private equity firms and strategic acquirers have unallocated capital commitments, cash reserves and existing credit facilities (or dry powder) that provide existing financing for deals. Thus, there is still plenty of capital available to finance deals. In general, however, the M&A market has still seen many buyers finance deals with debt instead of using available cash, as banks are willing to lend for good deals.

Deal Terms

The recent market dynamics have had a direct impact on M&A deal terms. In order to bridge valuation gaps and return on investment risk, buyers are utilizing what have historically been referred to as more “buyer friendly” deal terms to close deals. Below are some examples of the most common deal terms making a resurgence.

Deferred Payments

When deferred payments are utilized to fund an acquisition, buyers do not pay the entire purchase price at closing and instead make payments to sellers over a period of time after closing, oftentimes on an unsecured basis. When sellers accept such deferral of closing compensation, they lose out on the time value of those funds and stand behind secured creditors if things go bad.

Earn-Outs

With less access to lower cost debt financing, buyers are increasingly­ (4% increase from 2021 to 2022 with Q1 2023 trending higher) requesting earn-outs to reduce the amount due at closing, yet still allow sellers a chance to secure more value for their business. Earn-outs are generally paid if performance targets are met post-closing (e.g., EBITDA, revenue, etc.). In addition to the risk of not achieving post-closing performance targets, like other deferred payments, sellers lose out on the time value of the money they would have received at closing, which time value is much higher during times of high interest rates. While sellers may not want to accept earn-outs unless they can be confident in the continued success of the business, it may be a necessary deal condition if the buyer is unable to get financing for the entire purchase price due to strict lending requirements and the cost of higher interest rates.

Post-Closing Adjustments

Most deals have post-closing adjustments related to the working capital levels of the target. Similar to deferred payments, the party that may otherwise be entitled to a post-closing payment resulting from a working capital adjustment may attempt to collect interest on the funds paid pursuant to the adjustment. The party entitled to receive additional funds loses the time value on the funds from close to the end of the adjustment period. While not customary due to the relatively short time period of a working capital adjustment process, the push to collect interest on these funds may become more common in the current market.

Looking Forward

The Federal Reserve has signaled, and other sources have estimated, that the May, 2023 interest rate hike may be the final increase during this cycle, but that determination is largely dependent on future inflation rate trends. Fortunately, the April consumer price index report for all urban consumers showed easing YoY inflation at 4.9%, not seasonally adjusted. In light of easing inflation, after the May, 2023 increase, many anticipate that the Federal Reserve will begin lowering rates in late 2023 to around 4.50% and to around 4.25% and 3.25% in 2024 and 2025, respectively. The general sentiment is that following a period of rate stability in 2023 and more confidence in a rate decline in 2024 and 2025, M&A deals will pick back up vigorously. Should rates decrease, there will likely be a flood of deals to the market, with many potential sellers currently operating in a wait-and-see mode. In any case, during this period of interest rate fluctuations, it is important for buyers and sellers to consider whether it is the right time to proceed with an acquisition or sale, and, if so, the impact that interest rates will have on valuation, certainty of closing, and deal terms.

This content is made available for educational purposes only and to give you general information and a general understanding of the law, not to provide specific legal advice. By using this content, you understand there is no attorney-client relationship between you and the publisher. The content should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.

Related Services

Explore Our

Newsroom


Learn about the latest legal news, firm announcements, and upcoming events on the topics important to you and your business.

Jump to Page

Necessary Cookies

Necessary cookies enable core functionality such as security, network management, and accessibility. You may disable these by changing your browser settings, but this may affect how the website functions.

Analytical Cookies

Analytical cookies help us improve our website by collecting and reporting information on its usage. We access and process information from these cookies at an aggregate level.