Higher interest rates are impacting the M&A market. The new landscape brings radical modifications for buyers and sellers — on both enterprise value expectations and the price tag to get deals done.
“With a higher cost of capital, the multiples of EBITDA a buyer is going to pay may be lower because the cost consummate is higher,” says Robert Berdanier, Managing Director at Riveron. “One huge element of deal cost is the interest a buyer is going to pay to lever a deal. That reality is affecting deals on many levels.”
Smart Business spoke with Berdanier about the effect interest rates are having on the M&A deal environment and how sellers can maximize their position.
How do higher interest rates impact M&A deals?
Transactions happen in any marketplace, at any time, no matter the interest rate environment. Differentiated categories of businesses drive varied enterprise values based on their investment risk and return opportunity. Capital intensive businesses, such as manufacturing, are more interest-rate sensitive. These industries often rely on various lending products to fund operations prior to generating margin. In contrast, service businesses have higher margins as the input costs tend not to be as rate sensitive. Each has a unique investment thesis with different capital requirements, and the result is a different multiple of EBITDA.
Interest rates will always influence the split between equity and debt in any deal. If the seller wants a higher multiple than market conditions dictate, it will force the buyer to more closely evaluate the deal structure. Possible outcomes include requiring more equity and less debt to achieve the result that they want. This is because carrying the debt costs will drive where resources post-close are allocated. The lender will always want to be paid first, which leaves less money for sustaining the business and generating a return for the acquirer. This leaves the buyer with the choice of executing the deal with more equity and less debt in the hopes of generating a significant internal rate of return on the invested capital. Inserting more equity means more risk capital is on the line. Certain buyers use debt to execute deals with minimal equity (skin in the game) to preserve capital, to do other deals, or re-invest in the current acquisition as it matures. The cost of debt can therefore become an increasing cause of concern in any deal environment.
What has this done to the structure of deals?
Three years ago, the deal market was competitive enough that sellers could stick to their price and refuse any alternate structures. Buyers are now using seller notes and asking the seller to accept a portion of the purchase price in a series of deferred payments that is subordinate to the senior debt holder. Buyers are also increasingly using earn-outs to bridge the gap between cash tendered at closing and the agreed upon selling price. An earn-out is a noncash closing instrument used to defer payment by offering to pay the seller more once the company achieves certain performance goals. In either case, it means the seller does not get the entire purchase price at closing and creates the risk that the agreed-upon enterprise value might not be realized. Even strategic buyers, much like financial buyers, are using seller notes or an earn-out in this market to mitigate risk and lessen the need for increased leverage.
How can sellers maximize their position?
To get maximum value for their business in this environment, sellers need to prepare for an in-depth examination once an offer has been accepted. Buyers are conducting more exhaustive due diligence, so sellers should create a strong model, be clear regarding assumptions and understand the thesis of the business and its critical risks. They should look for potential liabilities, have a good budget process in place, clean up their internal controls and have a strong finance team, as well as a mature ERP system.
To accomplish this, sellers should collaborate with good advisers — an experienced deal attorney, tax adviser, financial adviser and a banker. Bring them in as a team and insist that they are all integrated, talk to each other and understand the goal for the transaction. If they’re true professionals, they’ll align their advice based on what the seller wants the outcome to be. ●
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