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M&A Advisors Predict Interest-Rate Stress in Lower Middle Market

May 11, 2017, 07:26 AM
Filed Under: Mergers & Acquisitions

Nearly two-thirds of M&A experts predict that a rising interest environment will impact their ability to finance transactions. 

That's according to a survey of 315 business brokers and advisors in 37 states commissioned by the Pepperdine Private Capital Markets Project and the Graziadio School of Business and Management at Pepperdine University.

The Q1 2017 Market Pulse survey was conducted by the International Business Brokers Association and M&A Source and found that almost half (47%) of advisors expect a decrease in valuations, and about 40% predict a decrease in the buyer pool. The study looked at businesses in the lower middle market, with annual revenues from $2 million to $50 million.

“By raising interest rates, the Federal Reserve is signaling that the economy is improving and lender risks are decreasing. An interest rate increase should encourage lenders to initiate more loans, allowing them to gain a higher yield on their capital,” said Craig Everett, PhD, Director of the Pepperdine Private Capital Markets Project. “However, rising interest rates also mean borrowing will become more expensive. That raises the total cost of a transaction, which is why advisors are somewhat pessimistic about getting deals financed at the current values,” Everett continued. “Either way, buyers and sellers who are looking to complete a transaction should accelerate their efforts now, before lending costs increase and values decrease because neither of these conditions are conducive to completing a transaction.”

Seventy-seven percent (77%) of respondents said that deal structure is an important negotiation factor in most transactions. That is followed by negotiations over closing date, and an employment contract or non-compete contract for the seller.

Among other findings, respondents reported that the average time to close is getting longer for deals in the lower middle market.

“Deals are getting done at strong values, but they’re taking longer to get done. Much of that could be driven by investors doing more diligence to make sure the business is worthy of the premium they’re willing to pay,” said Scott Bushkie, CBI, M&AMI,  President of Cornerstone Business Services, Inc. “Others could be due to outside third parties needing time to do their work."

The researchers found that cash remains king for most businesses considering a sale. During the first quarter, owners got 77% or more cash at close. The majority of the balance came from seller financing, along with some earn outs to close the valuation gap. According to the report, sellers in the largest sector kept a portion of equity, consistent with recapitalization being a key reason for sale in this sector. Seller financing played a larger role this quarter, representing 12% to 20% of deal structure. 

“We’re seeing recapitalization show up as a leading reason for sale more often. That tells me two things. One: We’re doing a better job of educating sellers on what a recap is and how it could benefit them. Two: I believe we’re seeing younger sellers take advantage of the good seller’s market today, cashing out the majority of their equity while working with experienced partners who will help them grow the business and get a second bite at the apple down the road,” said Kyle Madden, Partner, KLH Capital.

Respondents completed 272 transactions this quarter.

Click here to download a free copy of the report.

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