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Cost of Capital in Middle Market M&A Deals

This article was co-authored by John Rogers, Consulting Manager

In the middle-market M&A universe, the cost of capital represents the rate of return that investors and lenders require when providing financing for an M&A transaction. In any M&A transaction, a buyer’s investment decision for new acquisitions should always generate a return that exceeds the buyer’s cost of capital used to finance the acquisition. Otherwise, the acquisition will not generate a return for investors and lenders. Understanding the trends and requirements of the cost of capital is essential for both buyers and sellers in the middle market to make informed decisions and achieve successful outcomes in M&A transactions. Several factors influence the cost of capital, including interest rates, market volatility, industry dynamics, and the perceived risk of the investment.

Several notable trends are shaping the current cost of capital in M&A deals:

  • Interest Rates: Interest rates play an important role in shaping the M&A environment. When interest rates are low, borrowing costs are reduced, making it easier for buyers to finance acquisitions. Conversely, high interest rates bring an increased cost of capital, which factors into the decision-making process of management teams and business owners considering transactions. Companies may find it more expensive to borrow funds for acquisitions, which can impact deal valuations and the transaction dynamics overall. After multiple increases throughout 2023, the Fed held interest rates steady in December 2023 and has laid the groundwork for potential cuts in 2024 and beyond.

  • Increased Risk Premiums: The overall risk environment has become more uncertain and volatile in recent years. Geopolitical tensions, trade disputes, workforce shortages, and technological disruptions have introduced new risks that investors must account for when determining the cost of capital on an M&A transaction. Consequently, risk premiums have increased, particularly for companies operating in sensitive industries or facing specific challenges. As the perceived risk increases, the cost of capital to finance a transaction increases.

  • Industry-Specific Factors: Different industries exhibit varying levels of risk and return potential, leading to industry-specific trends in the cost of capital. For example, sectors such as technology and healthcare, characterized by rapid innovation and growth prospects, may command lower costs of capital due to their perceived future potential. On the other hand, industries facing regulatory scrutiny or structural challenges may experience higher costs of capital.

  • Alternative Financing: In a time of rising interest rates and risk premiums, cost of capital increases. This trend has a ripple effect on middle-market M&A valuations and how buyers can come up with a financing package that satisfies the needs of the seller. Buyers have turned to more creative deal structures and financing options to bridge this gap, most of which shift the risk from the buyer to the seller in the form of deferred consideration. Some common examples include:
    1. Seller notes: involve the payment of a portion of the deal consideration over time. The seller holds a note (essentially acting in the same function as a bank) and typically receives monthly payments of principal and interest. Seller notes are always subordinate to senior and other financial institution debt, which adds a layer of risk to the seller.
    2. Earnouts: allow the seller to earn additional future transaction consideration if certain financial or other metrics (generally EBITDA or revenue based) are achieved.
    3. Rollover equity: allows the seller to retain a portion of their ownership post-transaction. Rollover equity is typically encouraged and sometimes required by a buyer. From a buyer’s perspective, this reduces the perceived risk and aligns incentives on a go-forward basis.

  • Other Buyer Trends: In addition to employing various deal structures to bridge the financing gap and meet the required transaction value to get a deal done, entities like private equity groups have embraced alternative strategies.
    1. Minority investments: To navigate the challenges posed by a high-interest rate market, private equity groups are opting for smaller stakes in companies. Departing from the traditional model of control investments or management buyouts, these firms are now more inclined to accept a minority stake investment, enabling them to invest the desired capital, but reducing their stake in the business.
    2. Add-on strategy: There is a growing emphasis on add-on acquisitions within the private equity sector, particularly in times of tight credit markets. By focusing on these strategic add-on investments (to the existing platform company), private equity firms aim to capitalize on costs synergies, thereby enhancing overall value and driving revenue growth in a challenging financial environment.

Final Thoughts

In conclusion, the cost of capital is a critical determinant in shaping the strategic decisions and outcomes of middle-market M&A transactions. With traditional reliance on senior and subordinated debt facing challenges due to rising interest rates, buyers are compelled to adopt more innovative deal structures, a shift towards more minority investments, and a heightened focus on add-on acquisitions. These adoptions not only reflect the resilience of M&A markets in the face of financing challenges, but also underscore the importance of having a trusted advisor to help buyers and sellers optimize capital structures, mitigate risk, and maximize value creation.

If you are considering the sale of your business, curious about learning more about the current trends and everchanging landscape of deal structures, or anything else described in this article, feel free to contact us.

This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.