Is The Fed’s Stance On Interest Rates Hindering The M&A Market?

The near-consensus among prognosticators a year ago was that the Fed would lower the Federal Funds Rate multiple times in 2024 after hiking rates 11 times in 2023 to combat inflation. Six months into 2024, we’re still waiting for the Fed’s first rate reduction. As a lower middle market private equity fund focused on acquiring niche B2B manufacturing and distribution businesses with enterprise values between $10-50 million, we wanted to offer a few thoughts on how the Fed’s continued reluctance to lower rates might influence the M&A landscape in the coming months, with the thinking that the Fed might not lower rates until late 2024 or early 2025.

Higher Borrowing Costs and More Discerning Lenders Resulting In Lower Multiples

Rising interest rates translate to a higher cost of capital for both debt financing and equity returns. This translates to a more cautious approach from acquirers and their lenders. In addition to senior debt being pricier, we’ve seen a reduction in the amount of leverage lenders are willing to approve for a given transaction, as evident in reported capital structures. Through June of 2024, private equity manufacturing platform acquisitions consisted of 26% senior debt compared to 33% in 2023, with the difference made up by an increase in more expensive subordinated debt and a significant increase in equity. The increased cost of capital negatively impacts rates of return investors are able to underwrite to, which results in lower valuations. Indeed, since 2022, average EBITDA multiples for lower middle market manufacturing buyouts have reportedly decreased by 7-20 percent.

Unsurprisingly, this resulted in valuation gaps, which gave way to an overall slowdown in the lower middle market. Specific to MCM Capital, which focuses on $1.5-6 million EBITDA companies, we saw an 11 percent decrease in relevant deal flow. In the past six months as the Fed has continued to hold rates, we’ve seen relevant deal flow decline by another 8 percent. Many business owners we speak with also mention uncharacteristically poor performance during the past 12-18 months as their customers aim to keep inventories low due to heightened borrowing costs.

One way to bridge valuation gaps is with creative deal structures based on company performance shortly after a transaction. These structures are most applicable to leveraged recapitalization transactions where the business owner plans to retain a minority portion of the equity in the business and are more common during times of economic uncertainty when it becomes increasingly difficult for buyers and sellers to properly allocate risk within ordinary deal structures. Three of the more common tools for bridging valuation gaps, particularly when a company may either be underperforming in a down market or is on the cusp of landing a significant new program include:

• Contingent Consideration: a contractual provision providing the seller of a business additional compensation if the business achieves certain pre-defined performance thresholds.
• Equity Clawback: gives one party the right to repurchase a certain amount of equity at a predetermined value if certain conditions are met.
• Performance Based Stock Awards: Equity awards typically given to members of the management team provided certain performance criteria are met

Despite increased capital costs and uncertainty causing M&A deal activity to stall, there is still strong demand for quality assets in the lower middle market. At MCM Capital, we acquired two niche manufacturers, Tech NH Inc and AIM Processing in 2023 and will look to continue acquiring niche B2B manufacturers and value-added distribution based businesses possessing sustainable competitive advantages and talented management teams in 2024 and beyond regardless of the interest rate environment.

For further discussion on this topic, please reach out to Chris Hren at 216-514-1848 or chris@mcmcapital.com