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Buying and Selling Companies in a High Interest Rate Environment

After reading the 2023 merger and acquisition (M&A) end of year outlooks published by various multinational consulting firms, we noted that each firm echoed a cautious optimism for M&A markets in 2024. This may be surprising to some since 2023 was a stale year in M&A with deal volume falling by 3%, while deal value fell 19%. Further, 2023 marked the second consecutive year of falling M&A activity. However, the new year seems to have brought a new optimism towards M&A. Estimates suggest that nearly $4 trillion of “dry power” was sitting on private equity firms’ balance sheets at the beginning of the year. This is cash that is not being “put to work” and is, therefore, not earning the return expected by investors. This year, private equity (PE) firms are expected to receive pressure from impatient investors to become more active in the marketplace.

The implications of a high interest rate environment have changed the landscape of M&A. Alternative deal structures are expected to be utilized in place of the high-leverage buyout models which were a staple in the PE industry while borrowing costs were low. These alternative structures include financing through non-bank lending institutions, joint venture and strategic partnerships, and 100% equity funding. One point is clear about the 2024 outlook for M&A, firms do not expect deal structuring to be as straightforward as it was during the 15 years of quantitative easing that followed the Global Financial Crisis.

How Banks Play a Role in the M&A Outlook

Much of the necessity for change can be attributed to tighter lending standards required by banks. Banks in the U.S. are severely underwater on bond positions acquired prior to 2022. Further, many are beginning to question the resilience of commercial real estate, as office building vacancy rates have continued to increase since the pandemic and many loans underwritten in 2019 are going to be reset at much higher rates this year. Clearly, increasing debt service paired with increasing vacancy means that this sector is vulnerable, and banks have had to tighten lending standards to remain liquid in response to potential defaults and collateral devaluation. The most recent Senior Loan Officer Opinion Survey published by the Federal Reserve states that “significant or moderate net shares of banks reported expecting a deterioration in credit quality across most loan types over 2024.”

M&A is expected to rebound this year, but banks are expected to remain selective with financing. This implies that business owners will have to be dexterous and adapt to the new environment with creative solutions to transfer or acquire ownership interests. For this reason, effective planning is more critical than ever for a successful transaction. Two years ago, transferring ownership interests was relatively easy because most transactions could be funded with cheap debt that could be serviced over many years with distributions from the company. Now, bank lending rates have doubled, durations are shorter, and collateral requirements are often higher; this is making it harder and harder for traditional M&A deals to cash flow.

Finding M&A Success in 2024

Where there is change, there is always opportunity. Many business owners are recognizing the advantages of seller financing while rates remain high. Seller financing is a vehicle often utilized when selling to employee stock ownership trusts and related parties. With interest rates high and capital difficult to access, seller financing is certainly a worthwhile consideration for any transaction in 2024. This is not only an effective tool used to receive fixed income for several years after selling, but many owners find that the tax implications are more desirable than those of receiving a lump sum. Joint ventures and strategic partnerships are also rising in popularity as a way of diversifying income streams with less need for high-yield debt. Of course, these methods do not always work for every company. Successful M&A in 2024 will require innovative, creative solutions to bridge the gap between sellers’ expectations and buyers’ access to capital.

At McKonly & Asbury, we understand that there are many factors involved in exiting or acquiring a company. We offer a wide array of valuation, estate planning, and transaction advisory services for our clients’ specific needs. Please reach out to T. Eric Blocher, Partner and Director of Business Valuation Services, if you have any questions.

About the Author

Clay Dimpsey

Clay joined McKonly & Asbury in 2023 and is currently a Financial Analyst with the firm. He is a member of the firm’s Business Valuation Segment, serving a variety of industries.

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