Survey Predicts Interest Rate Stress in Lower Middle Market
The most recent Market Pulse survey shows that roughly two-thirds of M&A experts predict that a rising interest rate environment will have a significant effect on their ability to finance transactions. The interest rate is going up in the lower middle market.
The Market Pulse survey interviewed 315 business brokers and advisors in 37 states and was commissioned by the Pepperdine Private Capital Markets Project and the Graziadio School of Business and Management at Pepperdine University. The International Business Brokers Association (IBBA) and M&A Source are responsible for the Q1 2017 Market Pulse survey.
Decrease in Valuations
Almost half of the respondents said that they expect a decrease in valuations (47%), with about 40% anticipating a drop in the buyer pool. The study analyzed 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,” noted 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,” he remarked.
Everett went on to say that in any event, buyers and sellers seeking to complete a transaction are best to speed up their efforts—before lending costs increase and values decrease—neither of which is conducive to completing a successful transaction.
Deal Structure Critical
The survey also found that 77% of respondents said that deal structure is a critical negotiation factor in most transactions. The next most influential factor is negotiation over closing date, followed by an employment contract or non-compete contract for the seller.
Other findings show that respondents reported that the average time to close is lengthening for deals in the lower middle market. These types of transactions are closing with strong values; however, they are taking longer to complete. Experts say that this time increase may be the result of additional due diligence being conducted by investors to be certain that the target business is worth the premium they’re willing to pay. And other factors may include outside third parties requiring additional time to complete their work.
Cash Still King
The survey also confirmed that cash was still king for most businesses considering a sale. The first quarter saw owners with 77% or more cash at close, with most of the balance from seller financing and some earn outs to close the valuation gap. The Market Pulse survey also noted that sellers in the largest sector kept some of equity, which is consistent with recapitalization being a key reason for sale in this sector. Seller financing played a significant role in Q1, constituting from 12% to 20% of deal structures.
Recapitalization is becoming more of a top rationale for sales, the survey found. This means that business consultants like Andrew Rogerson in Sacramento are experts at educating their sellers on interest rate, what a recap is and its benefit to their transactions. In addition, recapitalization may be impacted by younger sellers taking advantage of today stronger seller’s market. These business owners are cashing out much of their equity while partnering with experienced owners who will help them grow their businesses to potentially reap a second payday in the future.
Andrew Rogerson specializes in helping business owners sell businesses in northern California and across the West. His services include business valuations, marketing the business, negotiating the transaction, as well as third-party lending, due diligence, and escrow.
Andrew is the author of four insightful books on business ownership entitled, Successfully Start Your Business, Successfully Buy Your Business, Successfully Buy Your Franchise, and Successfully Sell Your Business. For more information visit Rogerson Business Services.