How Inflation and Rising Interest Rates Indicate the Market Is Strong for Opportunities and Why

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Last year saw the best merger and acquisition (M&A) market in decades. Its effects have carried into 2022 for sure, but this most opportune window might be closing sooner. If you wait until your company grows in hopes of getting a more significant value, you might pass on the right price tag at the right time.

You probably have some fear and doubt in your mind, seeing we’re in the midst of rising inflation and higher interest rates. However, this blog discusses how and why now is the best time to sell your business. And hopefully, it will all make sense in the end.

Opportunities open for lower middle market

The record-smashing accelerated pace of M&A activity in 2021 drove 24% more deals than in 2020. Dealmaking also remains robust this year but without expectations of hitting new highs. Capital is still abundant – nearly $2 trillion raised and on deposit with private equity (PE) funds. PEs must deploy all that money to generate returns and be rewarded with more investors’ interest.

So the buying of companies continues.

However, the pressure mounts for PE groups in the face of growing macroeconomic headwinds. Surging inflation is felt as the disruptive effects of the pandemic play out, including global supply chain slowdowns. With the demand for goods and services outpacing production and prices increasing, the Federal Reserve raises interest rates to control inflation.

How does this economic climate create opportunities for the lower middle market?

Acquirers use debt to partially fund acquisitions – usually 50% – so that additional cost of capital can be passed on into the deal via lower valuations. But while rates are increasing, they are still historically low. We haven’t seen interest rates affect M&A activity just yet. And when they do, the larger deals (those at the $500-million mark and up) will experience the effects first. Interest rate hikes are unlikely to impact smaller sales (less than $200 million) for some time.

With $2 trillion of cash on balance sheets and on deposit with consumers and an additional $2 trillion of debt, PEs have $4 trillion of dry powder that needs to be spent. If the larger markets are volatile, that money will come down to the lower middle market. The lower-middle-market deal volume will continue to be strong because of this.

Why sell your business now – timing is key

We have established that smaller companies will be unaffected by interest rate hikes. The challenge then lies in inflation taking a chunk out of their profits due to the higher cost of labor, materials, and fuel. Decreased profits result in lower overall earnings before interest, taxes, depreciation, and amortization (EBITDA), which means their business is valued lower than it would be in times of normal prices.

So while profits are still positive, valuations remain strong, and the demand from acquirers continues to be high, smaller business owners can look to M&A to sell their business. Consider that current inflationary trends may stay that way for a while. If you wait until this corrects a couple of years from now, the valuations won’t be as strong because that money will have been spent, and there won’t be as much demand.

Why consider M&A in these times

Ride an all-time high

Again, we go back to what we said at the beginning: the M&A market reached new heights in 2021, and the outlook remains positive this year. And with high inflation and interest rates posing a risk for megadeals, acquirers will be setting their sights on the lower middle market – exactly where you come in.

Valuations are still strong, but instability can make it harder to get top dollar 

You won’t want to take the ride at the tail-end of an all-time high, though. Some clients think that if they wait until the company is larger, then they’ll get a bigger value. Unfortunately, this is oftentimes not the case.

Consider that current valuations may not exist at the end of 2022. Even as M&A peaked last year, robust M&A activity can be more challenging to sustain over time with the steady rise of interest rates, fuel costs, and prices of goods and services. Margins will be declining because of that, resulting in lower valuations.

Another effect to watch out for is waning acquisition interest. Buyers’ interests change frequently. So something they like today may not be something they’re interested in tomorrow.

Opportunity cost is a real thing

If your business has been doing well, and the market valuations are strong (as they are today), take a hard look at the opportunities available. But, again, we cannot stress this enough – if you wait, those will likely not be there.

Think about what you can lose. To illustrate:

A client last year walked away from a solid deal, thinking their business would grow substantially and valuations would hold strong for them. However, halfway into this year, the company is not performing as expected. Buyers are also less interested in the sector as it is tied to new home construction, which may be slowing due to rising interest rates.

In other words, the grass is not always greener, so you must be opportunistic and take advantage of the market conditions, even if you think you aren’t ready.

You don’t have to do it alone

Don’t let your fear of change or the unknown stop you from moving your business forward. Aside from the opportunities mentioned above, support is available when needed.

If you think you aren’t ready, working with an advisor like Align allows you to become “ready.” We assist smaller business owners as they prepare for the process and guide them step-by-step. This alleviates their fear and gives them the confidence to know they’re being proactive and strategic at the right time, getting the maximum value possible with the right buyer.

Aside from finding the right buyer, AlignBA experts ensure you leave behind a lasting, impactful legacy or achieve the freedom to start your next chapter.

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