The Impact of Falling Rates on Acquisition Financing

Posted on: September 30th, 2024

acquisition-financing

Acquisition financing is driven by a multitude of forces both macroeconomic and microeconomic in nature. Analyzing the creditworthiness of a company seeking acquisition financing is primarily an exercise in fundamental analysis wherein financial performance, balance sheet strength and competitive positioning is judged. Yet behind the specific focus on the quality of the company, acquisition financing providers hold a general view on the overall credit markets and the timing of the credit cycle.

This general credit view helps them decide if it is a good time to be bullish or bearish and informs their view on leverage levels and risk profiles. The recent interest rate spike in 2022 was unprecedented in its swiftness and caught many acquisition financing lenders by surprise. The rapidity of the Fed was taken not only as a sign of incipient inflation but also as a precursor to a recession. Many lenders became highly conservative during this period and the acquisition financing market became tighter with only high-quality deals getting done.

Positive Impacts of Lower Interest Rates on Acquisition Financing

As interest rates increased, debt service increased significantly leading to tighter debt service coverages and an increase in debt service covenant breaches. Companies not only had to pay more money for acquisition financing loans, but they also had to navigate a more challenging economy during this period. As the Fed now reduces interest rates and there is no sign of an imminent recession, there are several positive impacts for companies seeking acquisition financing.

Broader credit risk acceptance – the market will be less focused on funding only the best deals but will have more of a risk appetite for average and above average deals.
Higher Leverage Multiples – acquisition financing lenders will loosen up their structures and be able to fund at historical multiples given the lower interest rate environment.
Higher valuations – reduced interest rates will increase the valuations of the underlying companies allowing them to raise larger amounts of capital.
Positive Credit Outlook – rather than thinking the sky is falling, credit officers are more likely to think we are at the front end of a new credit cycle and more likely to do deals and take risks.

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.