A good portion of the funding that is needed to complete a merger or acquisition comes from an outside source. Whether it be integrated debt, senior cash flow debt, asset-based financing, mezzanine debt, or unitranche debt, each of these sources of financing rely on one key factor: interest rates. Leverage buyouts and management buyouts are very dependent on a company’s ability to acquire a loan at a good rate. The cost of the loan has a direct bearing on the overall return investors will realize. With higher rates, the discounted cash flow of a company’s future earnings are worth less, and valuation multiples contract.
Rising interest rates and slowing economic growth have an influence on the M&A market. Acquisitive businesses today have strong balance sheets, filled with cash, not only from continuing operations, but also from their ability to issue debt due to the low market interest rates. The United States is still in a moderate recovery, forcing companies to grow and develop through acquisitions that increase their revenue and earnings. This inorganic growth coupled with gradual organic growth allows companies to generate a good level of growth and have long term success.
Middle market business owners especially have a special incentive to keep completing deals in this environment. Large asset managers see the alternative asset category of private equity and direct middle market lending as attractive places to invest. This has increased the level of capital available to middle market businesses. This feeds the level of supply and reduces the cost of capital for the entire middle market business segment.
For there to be a significant impact on the thriving mergers and acquisitions market, federal funding and interest rates across the entire yield curve would have to rise substantially. While the Fed has now started to raise rates, the interest rate environment is still favorable from a historical standpoint. Now is an excellent time for middle market companies to take advantage and attract capital needed for long term success.