Navigating the Impact of Rising Interest Rates on the M&A Market

Mergers and acquisitions (M&A) activity is a key economic indicator, a measure of the strength of the U.S. economy as it reflects the strategic moves of companies aiming for growth, efficiency, or competitive advantages. Interest rates exert substantial influence on M&A dynamics; as they rise, a ripple effect is felt throughout the financial world, and the M&A market is not immune.

Over 325,000 mergers and acquisitions worth approximately $34.9 trillion have been announced in the United States since 1985. With a global volume exceeding $5 trillion, 2021 was a record-setting year for mergers and acquisitions. Since that record high, global M&A volumes have plunged to a decade low in 2023 to about $3 trillion due to higher interest rates, economic uncertainty, and market volatility. While M&A volumes may be at a decade low, the United States had a substantially smaller decline (8%) than Asia Pacific (20%) and Europe (32%). Signs of a rebound in the United States are already in progress. The fourth quarter saw a 19% surge in deal volumes year-over-year with energy deals playing a major role in this growth.

To navigate this evolving and often capricious M&A landscape, here are five key factors that businesses should be aware of as well as a few strategic insights.

1. Interest Rates

Interest rates play an important role in shaping the M&A environment. When interest rates are low, borrowing costs are reduced, making it easier for companies to finance acquisitions. Conversely, high interest rates bring an increased cost of capital, which factors into the decision-making process of management teams and business owners considering transactions. In December 2023, the Fed held the key interest rate steady and has laid the groundwork for several cuts in 2024 and beyond. Nearly 90% of the Fed’s policymakers see interest rates lowering by the end of 2024 and none of them see them increasing. Experts expect that rate cuts will start in Spring 2024 and be implemented periodically over the next two years.

2. Financing

One of the immediate effects of rising interest rates is the increased cost of financing for M&A deals. Companies may find it more expensive to borrow funds for acquisitions, which can impact deal valuations and the transaction dynamics overall. Rising rates can slow M&A activity as businesses reassess the feasibility and financial implications of potential deals. While experts expect M&A to see a resurgence in the new year, more significant deals may need to be deferred until the financing conditions become more favorable.

3. Valuations

As interest rates climb, valuation models may need to be adjusted. Interest rates drive discount rates, and higher discount rates reduce values calculated from cash flow models, affecting how companies assess the value of potential acquisition targets. The shift in valuation metrics can lead to more conservative deal structures and negotiation strategies. According to experts, “the resettling of valuations could lead to smaller and more midsize M&A deals, especially in the near term, as asset sale kickoffs on Datasite this fall were much higher than mergers.”

4. Industry variations

The impact of rising interest rates on the M&A market is not consistent across all industries. Certain industries, such as technology and healthcare, may be less sensitive to interest rate fluctuations due to their growth potential and strong fundamentals. Data from Dealogic shows that M&A deals in the healthcare sector surged 22% to $341 billion in 2023. That number is expected to rise in 2024. Artificial intelligence is fueling the technology sector, with its market size expected to reach $407 billion by 2027. Not only will AI continue to be a key area for M&A growth, but it could bring about a 50% faster completion of M&A processes.”

On the other hand, industries with high capital intensity and a heavy reliance on debt financing, such as real estate and utilities, may experience a more significant impact. The real estate market faces several headwinds including a notable shift in the financial landscape marked by decreased credit availability and higher interest rates combined with many employees not returning to the office as frequently or at all. According to PwC, 78% of US real estate lenders say the debt for acquisitions and refinancing is undersupplied. The Feds expected rate cuts in 2024 might pave the way for a resurgence in the real estate debt market.

5. Adapting to the changing landscape

Companies looking to engage in M&A activity can employ a variety of strategies to adapt to this ever-evolving landscape. Some basic approaches include:

• Focus on operational efficiency: Streamlining processes, optimizing costs, and improving productivity can contribute to maintaining profitability amidst a continually changing environment.
• Be more selective: Prioritize acquisitions that align with long-term strategic goals and generate synergies.
• Explore alternative financing structures: For flexibility in a rising interest rate environment, look at alternative financing structures including equity-based deals or partnerships. Companies may also want to consider using a combination of debt and equity to fund acquisitions depending on the specific circumstances of a transaction.

The impact of rising interest rates on the M&A market underscores the importance of adaptability and strategic planning. While higher interest rates can pose challenges, they also present opportunities for companies to reassess their financial strategies, enhance operational efficiency, and make more informed M&A decisions. By navigating the evolving landscape with flexibility, businesses can continue to leverage M&A as a tool for growth and innovation in an environment where economic conditions are rapidly changing.

To learn more about how to leverage M&A for your business, contact Jeff Bergamo at (941) 957-4242.