The effect of Interest Rates on M&A deal flow, and how W&I may be the catalyst to rejuvenation.

The M&A market is starting to show green shoots of prosperity, with there being a slight uptick in deal volume compared to this time last year. This is particularly noticeable in the lower-mid market where target businesses with EVs of less than ￡150 million continue to prop up overall deal volume.

Whilst flow remains constant, average deal size is significantly down. Why is this? One factor that can be attributed to this is the significant increase in capital cost due to interest rate rises. Interest rates are intimately linked to M&A deals as nearly all buyers finance all or a significant portion of targets with debt. With the cost of debt doubling in the last five months of 2022 and further increases realised in H1 of 2023, acquisitions have become far more expensive. Furthermore, debt providers have imposed far stricter lending guidelines imposing barriers to entry for less established and more leveraged buyers. These stricter lending guidelines and lender due diligence processes have increased scrutiny on obligation default, often delaying the loan approval period and causing issues often under time sensitive auction processes.

A further consequence is the diligence cost for the buyers, with historically lower returns and higher costs, buyers want to make sure that they are investing in the right assets, often commissioning more detailed/expensive diligence from advisors to flush out any uncertainties. Resulting in costs across the board spiralling to higher levels.

We are now in an established buyer’s market, resulting in deal dynamics starting to shift back to more historic deal terms to help bridge valuation gaps. Increasingly more deals are now incorporating Deferred Payments, Earn-outs and Post closing adjustments to try an offset as much risk as possible within targets where there is little investor shakeup within the first 18 months.

Sellers now are increasingly looking to pass on risk to buyers via the removal of escrow accounts for breaches in warranty by capping their liabilities at $/￡1. So, what can buyers do to gain comfort in these situations to help alleviate some of the growing pains of interest rates? Luckily, W&I offers a solution which in current market conditions is paradoxical to the rise in debt costs. The rates on W&I insurance are slowly declining as the market softens. Buyers should consider using this risk protection product as it provides valuable protection and mitigates potential risks associated with the transaction as a whole. It acts as a safeguard by transferring the risk of breaches in representations and warranties made by the seller to the insurer. This coverage allows buyers to enhance their deal terms, reduce uncertainty, and provide additional security during the transaction. By utilising W&I insurance, buyers can gain confidence in the quality of the target company’s financials, legal compliance and other representations therefore facilitating a much smoother and secure acquisition process especially in times when more detailed diligence is likely to flag more unknown issues.

What does the future hold? Both the BofE and Federal reserve have hinted that no further interest rate hikes are expected however this is of course dependent on how the macroeconomic environment reacts to the curbing efforts on inflation. I believe the general sentiment is that following a period of consistent interest rates toward the later stages of this year, and a decline in rates over the next 18 months, M&A deals will significantly pick up and the market will rebound.?

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