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In response to improving economic conditions, rising inflationary pressures, and a desire to maintain price stability, the RBA has raised interest rates twelve times over the past thirteen months. Following the most recent interest rise at the May RBA board meeting, the current cash rate is 4.1%, the highest it has been since April 2012. These adjustments signal the central bank’s effort to normalize monetary policy and control inflation. However, such rate hikes can significantly influence the M&A landscape and the valuations of companies involved in M&A transactions.
Impact on M&A Valuations
1. Discount Rate Adjustment
M&A valuations often rely on discounted cash flow (DCF) models, which use a discount rate to calculate the present value of future cash flows. The discount rate incorporates the cost of capital, including interest rates. As interest rates increase, the discount rate also rises, resulting in a higher cost of capital. Consequently, future cash flows are discounted at a higher rate, reducing the present value of those cash flows. This adjustment can lead to lower M&A valuations.
2. Financing Costs and Debt Capacity
Rising interest rates directly affect the cost of borrowing, potentially impacting the financing costs associated with M&A transactions. Higher interest expenses increase the debt service burden, reducing a company’s ability to take on additional debt for acquisitions. This constraint may limit the pool of potential acquirers and affect the overall demand for M&A deals. Additionally, companies may need to revisit their debt capacity and consider alternative financing options to adapt to the changing interest rate environment.
3. Impact on Industry Sectors
Different industry sectors may be affected differently by rising interest rates, leading to varying impacts on M&A valuations. Interest rate-sensitive sectors, such as real estate and infrastructure, have experienced a more pronounced impact due to their reliance on debt financing. Higher borrowing costs can weigh on valuations, especially for companies with substantial debt levels. Conversely, sectors with robust growth prospects and resilient cash flows have been less affected, as their inherent value drivers can mitigate the impact of rising interest rates on valuations.
4. Adjusted Risk Perception
Interest rate rises have influenced the risk perception of investors and acquirers. Higher interest rates have signalled a tighter monetary policy and in turn, increased market volatility, affecting the perceived risk associated with M&A transactions. Investors have become more cautious and demanded higher returns to compensate for the heightened risk. This increased risk perception has resulted in conservative valuation approaches.
5. Shift in Deal Dynamics
As interest rates continue to rise, the M&A landscape has witnessed a shift in deal dynamics. Acquirers have become more selective, focusing on target companies that demonstrate strong growth potential and resilience against the impact of higher interest rates. Conversely, target companies with high leverage or those dependent on debt financing have faced challenges in attracting buyers at favourable valuations. Deal structures have also adapted, with more emphasis on equity-based transactions or alternative financing mechanisms to reduce reliance on debt financing.
The recent interest rate rises in Australia have important implications for M&A valuations. The adjustments to the discount rate, increased financing costs, and adjusted risk perception can impact the attractiveness of M&A deals and influence deal pricing. While rising interest rates have posed challenges, companies can navigate the changing landscape by evaluating alternative financing options, conducting thorough due diligence, and emphasizing the underlying strength of their businesses.
If you have any questions or would like to discuss how to navigate the current landscape in managing and completing transactions, please reach out to a member of our Corporate Team on (03) 9948 1950.
Last updated: 11 August 2023