It seems to be a forgone conclusion that the Federal Reserve will increase interest rates at their upcoming meeting. For years the Fed has repeatedly stated that they will likely raise rates in 2015. Now that December is upon us it appears the day of reckoning has arrived.
There is always a lot of consternation around rate changes, and this time around is no different. Effectively the Fed controls the price of money (interest rates) in an attempt to influence economic activity. The Fed lowers rates to spur economic activity and raises rates to slow it down. So a rate increase should be perceived as a generally positive event, an indication that economic activity is increasing.
But many express concern over a rate increase. If you are looking to finance the purchase of a house or a car you may not be excited about the prospect of a rate increase. If you have a variable rate loan or line of credit you similarly may not be excited about a rate increase. If you are a lender you may not be excited about a rate increase either. If you agree to lend money to someone for 7 or 10 years at a low fixed rate, a rate increase effectively erodes your return.
Many are also concerned about the impact a rate increase has on asset values. Asset values often have an inverse relationship to rates. For example, consider a house. All things equal, a house will sell for a higher price when interest rates are low and a lower price when interest rates are high. Assuming you are like most and finance the purchase of a house, the monthly payment for the same “house” will be lower in a low rate environment. You can buy “more house” on the same monthly budget. But so can everyone else, and the prices of the entire housing market is bid up in a low rate environment.
Some of what we have seen in the past years in the financial markets is a result of the above situation. Asset values have been bid up in stock, bond, commodity, and real estate markets as a result of affordable and accessible capital. Many businesses have also taken advantage of cheap and easy money to expand through acquisitions. 2015 was a record breaking year for M&A across the world and a very active year specifically in collision repair.
Most of these acquisitions were financed in some way, whether through traditional bank financing, public market debt or equity financing, lines of credit, or seller financing. When people ask my opinion on an increasing rate environment, they often express concern in three areas. First, is that if all of these deals were financed, when interest rates rise the companies that grew rapidly and are highly leveraged (have a high level of debt) will no longer be able to afford to grow because the new debt will no longer be affordable. Second people feel that many businesses that are highly levered will not be able to afford the existing debt at higher rates. Lastly many state that they are concerned that an increase in rates will result in less access to capital in addition to more expensive capital.
New Debt No Longer Affordable
While all of these things are certainly possible, I do not believe that a .25% (25 basis points) increase will materially change the M&A market, in the automotive industry, or otherwise. The reality is that most businesses do not collapse because of a .25% change in lending rates. Most acquirers, if they are considering a deal that has a margin of failure of .25% would walk away from the deal. The deal would simply be too risky as there are thousands of variables in business that can have a .25% impact on profitability. Good deals tend to be good deals for reasons other than interest rates. We’ll discuss some of those reasons and how to identify them next week.
Existing Debt No Longer Affordable
Certainly for a highly levered company with a high level of variable rate debt, a .25% increase may prove to be fatal. However, it is in the best interests of most lenders to be relatively involved in the finances of a business. Lenders, especially lenders active in acquisition financing, tend to have specific covenants that require the operating business to maintain certain levels of financial performance. And they check in on those businesses regularly to ensure those covenants are being met. It is also likely the executive team has planned at some level for an increase in rates. Planning and budgeting is a key area to ensure that the business is not caught unprepared for changes is the financial landscape.
No Access to Capital
Remember, banks, especially regional or community banks, still generate the vast amount of their income by providing financial products to consumers and businesses. But a common refrain I hear is that the banks will not lend. But my experience is more that banks will not lend into a bad business case, or a business case they do not understand. The large consolidators continue to grow because they have a clearly articulated growth strategy backed by financial projections and historical performance. They are able to tell a story to their lenders, in numbers, how they will deploy and repay the funds they are borrowing.
What Does the Future Hold?
It is likely that a 25 basis point increase will not decimate the M&A market. Interest rates do have an impact on asset valuations as well as carrying costs. But in general, it is not expected to see a significant drop off in the pace of consolidation as a result of one rate increase.
Over the longer term increasing rates can have a negative impact on valuations and M&A activity in general. The past three years have been very “hot” years, both in pricing as well as number of transactions. There is a timing aspect as well to business exits and there are some that say we may be near a top from a pricing standpoint. But there may be additional runway left. Depending on your specific time horizon, it may be a great time to grow.
If you are interested in determining the price of your business, get in contact with me (subscribers email me direct). There are a lot of variables that go into maximizing the value of your business. But we can help walk you through different scenarios so that you can plan to exit on the best terms. Now may be a great time to sell, but I also believe that now is a fantastic time to grow as well. There is no one single approach that is right for everyone and it really depends on your specific circumstances. And if that doesn’t appeal to you, still send me an email about something that does appeal to you. I read all the emails and respond to most so don’t be shy. I enjoy chatting with others in an industry I’m passionate about.