A contribution from Xavier Ledru, Head of Corporate Finance, REYL & Cie
The world has drastically changed recently, and not just for the short term.
Central banks have been raising rates at the fastest pace since the 1990s and, to date, most policymakers do not expect a return to 2 % inflation before 2025.
According to Fitch’s latest global economic outlook, the direction of interest rates in emerging and developed markets is beginning to seriously diverge, with the majority of emerging market central banks keeping their rates unchanged or beginning to cut them, while major developed market central banks continue to raise them in the face of persistently high core inflation.
In the ever-evolving landscape of the financial sector, current economic factors significantly influence the strategies of all market participants.
Higher interest rates are currently casting a shadow over the industry, causing global M&A deal makers to navigate uncharted waters. Recalibrating financial dynamics has more than ever become an imperative for success.
Implications for valuations, financing, and deal-making
The resurgence of high interest rates introduces a new layer of complexity for financial sponsors and corporates.
At REYL it is our role to provide strategic and valuation advice to our clients, mid to large businesses in sectors including renewables, Tech, Media and Telecoms, consumer goods, real estate and hospitality. Our corporate finance services, which include mergers and acquisitions (M&A), debt advisory, capital markets, restructurings and private equity, means we have been involved in a number of deals over recent months, advising leading private equity funds in Europe on transactions ranging from EUR 100m to several billions, as well as advising large international corporates.
Our role in the market means we can oversee valuation dynamics, financing challenges, complex negotiations, and operational adjustments which are all demanding greater attention. Market players must adapt their strategies, remain agile, and effectively address these issues.
In terms of financings, high interest rates resonate through the M&A ecosystem, immediately impacting valuations and valuation models. Elevated interest rates affect discount rates used in valuation models, and influence cash flows and cost of capital. As interest rates rise, the cost of capital increases, affecting the valuations of future cash flows and potentially reducing returns on investments. Previously, valuation models based on lower interest rates might have overstated the present value of future earnings, introducing a risk of overvaluation. This is no longer the case.
This also means borrowing costs escalate, making debt financing more expensive for acquirers. The financial profile of leveraged buyouts decreases as costs of servicing debt increases. This paradigm shift forces companies to reevaluate their financing structures, and they are increasingly forced by lenders to rebalance towards more equity-based financing models.
On the other side, sellers face challenges as they bought at high valuations at a time where interest rates were exceptionally low, and buyers seek more favourable terms to mitigate the impact of increased interest expenses. We are in the crux of this strategic conundrum, and this is undoubtedly the main reason why there has been a recent slowdown in deal-making.
Lower valuations may influence buying activity as cash-rich players seeking to deploy capital must suitably compromise with their counterparts to close transactions, in both debt and equity markets.
Deals also take longer to close. According to a recent report by Ansarada, the first quarter of 2023 saw the longest average M&A deal duration recorded since COVID, with deals taking an average of nearly ten months to complete. The average deal duration in the second quarter of 2020 was 10.9 months (333 days).
While the current landscape might appear uncertain and challenging, additional attention must therefore be paid to financial valuation, financing flexibility, and rigorous due diligence.
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