How Do Higher Interest Rates Impact Deal Making

Higher Interest rates generally have a negative impact on Mergers & Acquisitions (M&A) deals as most buyers finance a portion of their acquisition of target companies with debt.  In this article, we will outline some of the negative, but also positive outcomes that higher interest rates have on the lower middle M&A market.

For one, with debt costs surging, acquisitions become more expensive, having a direct negative impact on return on investment, or “ROI”, for an investor. Remember that most buyers finance a great part of any acquisition, thus, higher interest rates reduce future cash flow of the acquired company. For example, a 6% increase in the prime rate from 3% to 9% – being the basis for many acquisition loans – for a $4m transaction with a typical deal structure, will reduce an investor’s acquired company post-closing cash flow by 20% to 25%!

Secondly, higher interest rates typically require more cash flow from a business in order to give banks an incentive to lend. When banks finance an acquisition, they complete a thorough due diligence process to gain comfort that the target will be able to pay back the loan. Higher interest rates, however, increase the risk of a borrower’s default, and thus, lender’s due diligence increases with stricter lending requirements. A stricter lending protocol often results in extended waiting times for loan approval and deal closings. Consequently, M&A deals take longer to close.

Thirdly, high interest rates also affect M&A by raising the cost of buyer due diligence. With more costly borrowing for buyers, acquisition’s due diligence generally becomes more thorough and comprehensive. Simply speaking, with lower returns and a higher risk of default, buyers themselves (not only the lender) will go the “extra” mile to ensure their potential investment will be solid and  “safe” going forward. The result is in more investigation and due diligence by the buyer and its advisors, often increasing the overall transaction costs for both buyers and sellers. 

Additionally, high interest rates increase a target company’s cost of capital and discount rate, both of which will lower that target’s business valuation – to the benefit of the buyer, but to the detriment of seller.

Moreover, with interest rates on the rise, borrowing money is becoming increasingly expensive. This causes businesses to be more cautious about taking on too much debt in M&A deals. Instead, buyers might be opting for more cash and equity transactions with less debt, or in many cases, buyers simply opt to adjust the deal structure by demanding larger earn-outs from company sellers in order to mitigate the risk of a lesser cash flow.

However, with the negative impact of higher interest outlined above, there are also some benefits.

For one, businesses are becoming more conservative about assuming too much debt in deals. This is causing buyers to opt for more cash – and less debt. This outcome can be a good thing, as it will lead to more sustainable M&A deals on more sound footing, ensuring the longevity of the acquired company.

In addition, buyers will weigh the costs and benefits of any potential acquisition more carefully and adjust any previously unrealistic business valuations downward.

Thus, while there are some significant negative consequences of a rise in interest rates on M&A deals, there are also positive outcomes. Buyers and sellers should not be discouraged from engaging into deals – but should carefully weigh the pros and cons of any acquisition before making a decision.

In the end, businesses need to be cognizant how a change in interest rates will affect their acquisition plans by following closely the policies of the central bank.