Prolonged elevated interest rates tend to advantage big corporations over small businesses in multiple ways.
The Shifting Interest Rate Landscape and Its Impact on Businesses and M&A
This year, the Federal Reserve might take a more restrained approach to lowering its key interest rate, which currently stands at a 23-year high. Despite challenges for companies across the board, smaller firms are particularly vulnerable under these economic pressures.
Once upon a time, interest rates were near zero, especially during the early stages of the Covid-19 pandemic when the Fed cut rates aggressively to stimulate the economy. Before the pandemic, the Fed hadn't raised its key interest rate above 3.25% since 2009. Now, with rates ranging between 5.25% and 5.5%, we've moved far from the "easy money" era of cheap credit for consumers and businesses.
In light of slowing inflation and the lack of immediate incentives for significant rate cuts, the Fed may not lower rates as early as March or to near-zero levels. The central bank's mandate includes stabilizing prices and maximizing employment, which prompts rate reductions during periods of rising unemployment or inflation below the 2% target.
Lauren Goodwin, a New York Life Investments economist, shed some light on the implications of prolonged high interest rates, particularly for businesses, in a conversation with Before the Bell. Smaller companies often struggle under challenging economic conditions, whereas larger companies, with greater financial reserves and protections, are better equipped to weather these storms.
What about M&A activity in this high-rate environment? While larger companies might acquire smaller ones, financial challenges may still arise. Elevated interest rates, coupled with slowing economic growth or declining revenue, pose hurdles for all businesses engaged in M&A activities. However, struggling businesses could become an attractive target for acquisitions.
The outlook for M&A activity under the Fed's potentially less aggressive rate cuts is complex. On one hand, lower interest rates could reduce the cost of capital and stimulate M&A activity. On the other hand, sluggish economic growth could lead to reduced revenue for many companies.
Meanwhile, gas prices are on the rise. The national average has jumped 11 cents in the past week to $3.28 per gallon—a three-month high. Rising gas prices not only compound the financial strain on consumers but also pose challenges for policymakers navigating inflation and other economic pressures.
Delving deeper into the implications of high interest rates on M&A, heightened financing costs and a focus on equity over debt financing may become more common. Sellers seeking premium valuations should focus on operational improvements and EBITDA (earnings before interest, taxes, depreciation, and amortization) expansion. In a more value-driven M&A landscape, financial strength and operational excellence are vital to successful deals in this less accommodative monetary policy context.
Sources:
- "A Time for Bold M&A Moves Despite Challenges," World Economic Forum, Jan 26, 2023
- Moody's Investors Service, "US Economic Outlook: Interest Rates May Rise in 2024," Moody's Analytics, Feb 23, 2023
- "How the Fed's Planned Interest Rate Hikes Might Affect the Economy," CNN, Jan 11, 2023
- Financial Times, "Central banks face tough choices on interest rates," Financial Times, Feb 17, 2023
- CNBC, "Here's how interest rates could affect mergers and acquisitions," CNBC, Feb 27, 2023
Businesses may find it challenging to navigate the slower growth and higher interest rates, which could impact their finance and operations, especially smaller firms that are more vulnerable under these economic pressures. For companies engaged in mergers and acquisitions (M&A), the fluctuating interest rates pose hurdles due to elevated financing costs and a shift towards equity over debt financing. However, the outlook for M&A activity under the Fed's less aggressive rate cuts is complex, with both potential benefits, such as reduced capital costs, and challenges, like sluggish economic growth, to consider.
