Acquisition Financing Prognostication with Declining Rates

Posted on: November 19th, 2024

acquisition-financing

As the Fed decides to ease interest rates, middle market acquisition financing structures will benefit in a number of ways. The underlying values of middle market companies will increase leading to a higher enterprise value and lower loan to value ratios for existing portfolio companies of acquisition financing lenders. At the same time, as interest rates decline, variable rate loans will have reduced interest payments, decreasing the level of debt service and increasing the debt service coverage ratios.

Unlock Opportunities in Acquisition Financing as Interest Rates Decline

On both the underlying enterprise value and debt service basis, the credit risk of existing portfolio companies will improve for acquisition financing lenders. At the same time, previous easing periods have ushered in new periods of market bullishness. This often is seen through expansion of debt multiples and relaxation of covenants to win deals. This rising tide environment is caused by too many lenders rushing into the market at the same time, causing a decrease in credit quality and a reduction in the risk adjusted returns for the entire market. Whereas over the past two years, the acquisition financing market was super selective, the credit window will now open fully and all deals – whether high quality or low quality – will get done.

Given the level of dry powder in the market, there is the potential for a large scale move in the acquisition financing market which will benefit all companies seeking capital. Banks will need to get more aggressive in the market given the rise of alternative private debt funds to maintain market share and are likely to overshoot as they traditionally do. New debt funds are likely to also be more aggressive to continue their inroad into the direct lending market. The interplay between the banks and the debt funds could create a strong credit market upcycle for all companies in the market, which is likely to mean bigger loan tickets and lower all-in interest rates.

In the acquisition financing arena, capital availability is destiny as companies require reliable access to capital to grow over the long term. Unforeseen capital needs usually arise when acquirers least expect it. This can cause some concern for the acquisition financing provider, especially when covenants tighten up and that working capital availability is utilized faster than expected.

Mezzanine debt borrowing is usually a straightforward activity that many companies use for funding of transitional growth. Mezzanine debt lenders are highly transparent about their due diligence approach and their post-closing loan management making it easy for companies to engage with.

Elections have consequences and positive ones at that for the acquisition financing middle market. While much media attention is paid to the direction of the yield curve and the Fed’s likely rate cuts, scant attention is paid to the more important drivers of the acquisition financing market – business psychology and regulatory climate.