The Acquisition Financing Market in a Period of High Rates

Posted on: September 21st, 2023

acquisition-financing

Interest rates have increased at breakneck speed over the past year with the fed funds rate increasing from near zero to 5.1% over a fifteen-month period. The acquisition financing market has adjusted to this new interest rate reality in both direct and indirect ways. Acquisition financing Interest rates have increased commensurate with the higher cost of funds for all lenders. This is essentially a direct passthrough of higher cost from the lender to the borrower. The more subtle and indirect changes in market occurred in the credit sensibility of the lenders. The speed of the interest rate increases was so precipitous and suggested that the Fed was late to the game and making up for lost time.

This is true insomuch as the Fed was late to acknowledge the threat of incipient inflation brewing in late 2021. The slope of the interest rate hike that occurred over the 15-month period from March 2022 to June 2023 is the steepest it has been since the late 1970’s. Other interest rate increases, like the one in 2004, were smaller hikes and unfolded more gradually over a longer period. Due to the size and speed of the Fed’s rate spike fury, acquisition financing lenders were spooked, as this action created financial market uncertainty. Acquisition financing lenders were already highly conservative through the pandemic, given many expected a recession in 2019 and 2020. They were in portfolio triage mode throughout the pandemic supporting their borrowers.

Acquisition financing lenders had a good handle on the credit side of the market coming out of 2021 and were ready to put money to work. The pace of the rate hikes caused acquisition financing lenders to question their positions on economic growth and created a “what does the Fed know that we don’t know” moment. As a result, the market cooled and created a flight to quality for higher quality deals. As the economy performed better than expected, acquisition financing uncertainty has dissipated and good deals are getting done, albeit at lower multiples and higher pricing. The growth in assets under management for private debt funds and their counter cyclical investment appetite has undergirded the supply side, creating new avenues of acquisition financing capital for acquisitive companies.

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.