Tyler Durden1
New member
- Feb
- 6
- 6
Investment Banking
No doubt a rise in interest rates affects M&A volume. The general structure of a M&A buyout can be conducted in two broad categories, being a leverage buyout or all cash / equity funded transaction. Both are affected in different ways as follows.
Leverage Buyout
Typically, to keep it simple let’s assume the acquiring firm pays 10x earnings for a target. The deal is structured 60 / 40 debt equity split. So if earnings are 10 MM and the EV of the target is 100 MM (10 x 10) so with these assumptions that is 60 MM debt and 40 MM equity (excl. fees for the purpose of the example). Assume the interest cost on the debt is 10% resulting in an interest bill annually of 6 MM. On this basis the transaction supports reasonable interest cover of ~1.7x (10 / 6). What this implies in simple terms is that for every dollar the company has to pay in interest, the company has 1 dollar and 70 cents available to pay that bill.
Think of returns as an implied interest rate earned each year which compounds each year. In the above example, 40 MM is put in day 1 and turns into 81 MM which means the money compounds at 15.2% year on year. Because investments take many years to materialise and many different things can happen, think of it as a KPI used so investors and management can tell if the investment is a good one or not.
So lets now move this base case around a bit and fund the transaction on an 80 / 20 debt equity split resulting in 80 MM debt and 20 MM equity. Assuming the debt costs the same the annual interest bill increases to 8 MM and interest cover drops down to ~1.3x (10 / 8). This is too tight as there is not much margin for error. If the company missed revenue by a small amount even, the business may not be able to pay its interest bills. It’s a big risk.
View attachment 145
Although the target company is paying more interest and not making the same out of cash after paying its bills, the returns are better as the amount of initial invested equity is reduced compared to that of the previous case…20 MM instead of 40 MM.
Moving the base case along further, if the interest cost went up to 12% on debt of 60 MM based of a 60 / 40 debt equity split the annual interest bill would be 7.2 MM and debt coverage ratio of ~1.4. the more expensive the interest rate the riskier the buyout of the target company is. If the company can not pay its bills the business could enter bankruptcy / chapter 11 in the US. Think of airlines in the US…they are always in the news for these reasons.
View attachment 146
Cash / Equity
Funding the transaction in all cash or equity picks up exactly there the above paragraph left off. There is no debt to pay interest on but the investment does need to be profitable. If interest rates are increasing or forecast to increase, then customers of the target company might find it hard to justify paying the price to purchase products or services. If that is the case, the target company may have to reduce prices which will reduce the cash made each year that is put in the bank. Therefore, something must give in order to make the case for the returns. These factors can be numerous such as revenue / cost synergy creation etc. the list goes on. However, if none of these factors are material then it needs to fall to price paid for acquiring the target company.
In this below scenario of all cash offer, the business generates a 12.1% return on 100 MM invested capital based off a 2.5% company growth rate.
View attachment 147
However, if the company was able to sell more products or services because customers are able to afford them, the target company would make more cash each year. If that is the case the company is more valuable to a new acquirer. It is also true that it has saved up more cash because it has made more.
View attachment 148
Summary
With both structures of transactions, it is clear to see interest rates have an impact on the outcome of a deal and the potential for price adjustments. It does not mean M&A deals are not worth doing. It merely means that doing the deals under the same terms as a low interest rate environment when one is not present is not worth doing as the acquiring company could be effectively over paying and taking on too much risk on the future macroeconomic backdrop to make the investment case. If vendors are still wanting high multiple that are not inline with the parameters just mentioned, then that can create a competitive tension that can affect the viability of transactions being executed. This activity on mass can on its own lead to a reduction in deal activity and volume. However, there are other deal components that counterbalance this out. In layman’s terms, vendors may be in a situation where there is a greater importance on doing a deal at a lower price than not doing a deal at all and waiting for another day. These reasons can be plentiful but range from coming towards the end of their investment horizon for the target company, the target company is no longer core to the strategic direction of the rest of the business group, the business group needs to realise cash to help fund debt pay down or other M&A activity the business group may be involved in. So with all this said, interest rates will have an impact on the volume of deals but this can be off set given wider considerations of organisations in the marketplace. Will interest rate increases spook investors and stifle deal activity more than wider strategic initiatives by business within the marketplace remains to be seen. There are many unknows which is why some speculators get it right and make great returns in times like these and some get it wrong by overpaying for target companies that do not deliver the required performance required orbed them down with long running issues for many years to come causing a lot of distraction effectively removing them from doing other potentially additive strategic deals at a later date. In the latter example, the opportunity cost outweighs is a negative trade. Very simplistically put scenarios to demonstrate the arguments but one thing is for sure…time will tell where deal volume lands. Some will get it right and some will get it wrong. How many is the question…
Leverage Buyout
Typically, to keep it simple let’s assume the acquiring firm pays 10x earnings for a target. The deal is structured 60 / 40 debt equity split. So if earnings are 10 MM and the EV of the target is 100 MM (10 x 10) so with these assumptions that is 60 MM debt and 40 MM equity (excl. fees for the purpose of the example). Assume the interest cost on the debt is 10% resulting in an interest bill annually of 6 MM. On this basis the transaction supports reasonable interest cover of ~1.7x (10 / 6). What this implies in simple terms is that for every dollar the company has to pay in interest, the company has 1 dollar and 70 cents available to pay that bill.
| Assumptions | ||||||
| Debt Split | 60% | |||||
| Equity Split | 40% | |||||
| EV MM | 100.0 | |||||
| Debt MM | 60.0 | |||||
| Equity MM | 40.0 | |||||
| Interest Rate | 10% | |||||
| EBITDA | 10.0 | |||||
| EBITDA Growth | 2.50% | |||||
| EBITDA x | 10.0x | |||||
| Cash Flow (MM's) | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 |
| Buyout | -100.0 | |||||
| Debt | 60.0 | |||||
| Equity | 40.0 | |||||
| EBITDA MM | 10.0 | 10.3 | 10.5 | 10.8 | 11.0 | 11.3 |
| Interest | -6.0 | -6.0 | -6.0 | -6.0 | -6.0 | -6.0 |
| Repayment | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 |
| FCF | 4.0 | 4.3 | 4.5 | 4.8 | 5.0 | 5.3 |
| Interest Cover | 1.7x | 1.7x | 1.8x | 1.8x | 1.8x | 1.9x |
| Opening Debt | 0.0 | 60.0 | 60.0 | 60.0 | 60.0 | 60.0 |
| Drawdown | 60.0 | |||||
| Repayment | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | |
| Closing Debt | 60.0 | 60.0 | 60.0 | 60.0 | 60.0 | 60.0 |
| Opening Cash | 0 | 4.0 | 8.3 | 12.8 | 17.5 | 22.6 |
| Closing Cash | 4.0 | 8.3 | 12.8 | 17.5 | 22.6 | 27.9 |
| Net Debt | 56.0 | 51.8 | 47.2 | 42.5 | 37.4 | 32.1 |
| Returns | ||||||
| Equity | -40.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 |
| Less Debt | -32.1 | |||||
| EV | 113.1 | |||||
| Total | -40.0 | 0.0 | 0.0 | 0.0 | 0.0 | 81.0 |
| IRR | 15.2% |
Think of returns as an implied interest rate earned each year which compounds each year. In the above example, 40 MM is put in day 1 and turns into 81 MM which means the money compounds at 15.2% year on year. Because investments take many years to materialise and many different things can happen, think of it as a KPI used so investors and management can tell if the investment is a good one or not.
So lets now move this base case around a bit and fund the transaction on an 80 / 20 debt equity split resulting in 80 MM debt and 20 MM equity. Assuming the debt costs the same the annual interest bill increases to 8 MM and interest cover drops down to ~1.3x (10 / 8). This is too tight as there is not much margin for error. If the company missed revenue by a small amount even, the business may not be able to pay its interest bills. It’s a big risk.
View attachment 145
Although the target company is paying more interest and not making the same out of cash after paying its bills, the returns are better as the amount of initial invested equity is reduced compared to that of the previous case…20 MM instead of 40 MM.
Moving the base case along further, if the interest cost went up to 12% on debt of 60 MM based of a 60 / 40 debt equity split the annual interest bill would be 7.2 MM and debt coverage ratio of ~1.4. the more expensive the interest rate the riskier the buyout of the target company is. If the company can not pay its bills the business could enter bankruptcy / chapter 11 in the US. Think of airlines in the US…they are always in the news for these reasons.
View attachment 146
Cash / Equity
Funding the transaction in all cash or equity picks up exactly there the above paragraph left off. There is no debt to pay interest on but the investment does need to be profitable. If interest rates are increasing or forecast to increase, then customers of the target company might find it hard to justify paying the price to purchase products or services. If that is the case, the target company may have to reduce prices which will reduce the cash made each year that is put in the bank. Therefore, something must give in order to make the case for the returns. These factors can be numerous such as revenue / cost synergy creation etc. the list goes on. However, if none of these factors are material then it needs to fall to price paid for acquiring the target company.
In this below scenario of all cash offer, the business generates a 12.1% return on 100 MM invested capital based off a 2.5% company growth rate.
View attachment 147
However, if the company was able to sell more products or services because customers are able to afford them, the target company would make more cash each year. If that is the case the company is more valuable to a new acquirer. It is also true that it has saved up more cash because it has made more.
View attachment 148
Summary
With both structures of transactions, it is clear to see interest rates have an impact on the outcome of a deal and the potential for price adjustments. It does not mean M&A deals are not worth doing. It merely means that doing the deals under the same terms as a low interest rate environment when one is not present is not worth doing as the acquiring company could be effectively over paying and taking on too much risk on the future macroeconomic backdrop to make the investment case. If vendors are still wanting high multiple that are not inline with the parameters just mentioned, then that can create a competitive tension that can affect the viability of transactions being executed. This activity on mass can on its own lead to a reduction in deal activity and volume. However, there are other deal components that counterbalance this out. In layman’s terms, vendors may be in a situation where there is a greater importance on doing a deal at a lower price than not doing a deal at all and waiting for another day. These reasons can be plentiful but range from coming towards the end of their investment horizon for the target company, the target company is no longer core to the strategic direction of the rest of the business group, the business group needs to realise cash to help fund debt pay down or other M&A activity the business group may be involved in. So with all this said, interest rates will have an impact on the volume of deals but this can be off set given wider considerations of organisations in the marketplace. Will interest rate increases spook investors and stifle deal activity more than wider strategic initiatives by business within the marketplace remains to be seen. There are many unknows which is why some speculators get it right and make great returns in times like these and some get it wrong by overpaying for target companies that do not deliver the required performance required orbed them down with long running issues for many years to come causing a lot of distraction effectively removing them from doing other potentially additive strategic deals at a later date. In the latter example, the opportunity cost outweighs is a negative trade. Very simplistically put scenarios to demonstrate the arguments but one thing is for sure…time will tell where deal volume lands. Some will get it right and some will get it wrong. How many is the question…
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