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Mergers & Acquisitions

Shifts in M&A Deal Flow as a Result of Rising Interest Rates

At a Glance

Main Takeaway

Federal interest rates significantly affect the transaction type companies use during M&A deals when acquiring or selling a business. As interest rates shift, there is often a corresponding change in cash versus stock offerings in M&A deals. By the end of 2022, the Federal Open Markets Committee (FOMC)  increased the federal funds target rate to 4.50%, where it currently stands. When the FOMC meets next, on February 1, 2023, it is projected they will raise the federal funds target rate by another 25 basis points.

Next Step

Due to interest rate hikes, business owners may see more M&A transaction structures with cash and stock offerings. These shifts in M&A deal flow make it necessary for sellers and buyers to understand the benefits and risks of using cash, versus stock, during an M&A deal to minimize tax liability for a successful merger or acquisition. With higher interest rates, the source of funds and their associated carrying costs affect decision-making for M&A deals.

 

Shifts in M&A Deal Flow

The 1980s saw a surge of all-cash mergers and acquisition deals, with nearly 60% of the value of deals over $100 million paid in cash in 1988 and less than 2% in stock. A decade later, only 17% of large deals were paid in cash.

The reversal in the late 1990s remains the current standard for structuring cash and equity transactions as real interest rates made steady declines during market stabilization. In 2021, sellers sought to mitigate the risk from soaring valuations by rolling higher than-ever equity percentages in M&A deals compared to cash, with some offering more than 50% equity in the transaction.

With rising interest rates making it increasingly expensive to borrow cash, more M&A deals involve mixed transactions with cash and equity payments. Mixed transactions have unique risks and rewards. Understanding the legal, accounting, and tax implications accompanying mixed deals is critical to structuring M&A offerings that protect both entities involved.

 

All-Cash Transactions: Pros and Cons

Despite the increasing popularity of mixed M&A transactions, all-cash deals remain the standard, with 73% of total completed deals in 2020 made entirely in cash. The following are the pros and cons of buying and selling entities under all-cash transactions:

 

Buying Entity

Pro: Guaranteed purchase price

A buying entity acquiring another company in an all-cash transaction faces fewer risks regarding value fluctuation and future debt. Because the transaction does not contain stock, which fluctuates in value, the all-cash buyer is guaranteed a purchase price. However, in a high-rate environment, the cost of carrying cash is as high as in an inflationary environment.

 

Pro: No dilution of ownership

When a buyer engages in an all-cash acquisition, the buying entity maintains its current ownership status of the company. Acquisitions involving stock entitle new stockholders to a percentage of future profits and a say in future decision-making. It can also affect board memberships or chairmanships.

 

Con: Liquid asset losses

An all-cash M&A transaction can quickly deplete the buying entity’s cash reserves. If the buyer runs into a cash flow problem, they may find it challenging to convert the long-term growth of acquired fixed assets into cash from operations. If the buyer tries to compensate by quickly selling off the recently acquired company or its assets, they will likely receive less than their purchase price unless that is part of the incentive of the transaction.

 

Con: Potential future debt

Buying entities that finance all-cash acquisitions with bank loans are at risk for future and increasing debt. When an entity increases its debt as a percent of total assets, it also increases its annual debt service. This can lead to cash flow problems, particularly since yearly interest payments are required if the company wishes to avoid defaulting. Entities with high debt are also riskier bets for lenders, and the seller may see a decreased debt rating. In a higher interest rate environment, debt will have higher costs, and variable debt can cause additional interest rate risk.

 

Selling Entity

Pro: Clear and straightforward

The most significant benefit for sellers in an all-cash M&A transaction is the straightforward nature of the deal. The seller does not have to vet the buyer or consider a continued working partnership. When another company buys your business with cash, you decide whether or not you want to sell the company outright.

 

Con: Loss of ownership

An all-cash M&A deal means the seller has no remaining equity in the company. While some business owners may want the freedom this offers, it can also mean letting go of a business you built. Additionally, the seller does not benefit from the company’s future growth without shared equity.

 

Con: Taxation complications

All-cash M&A deals typically trigger a tax event for sellers, who will likely have to report the funds and pay capital gains on the profits. When selling a business, you must notify the IRS of gains from the sale of the individual assets of your company, which can be complex and time-consuming.

 

Mixed Transactions: Pros and Cons

Mixed transactions, also called mixed offerings or mixed payments, involve a combination of cash and non-cash payments, typically stock equity. The following are the benefits and drawbacks of mixed transactions for buyers and sellers:

 

Buying Entity 

Pro: Cash preservation

If the buying entity does not have adequate cash for a transaction, offering a mixed M&A deal allows the buyer to acquire the company while preserving their reserve cash for future growth or debt prevention. Buyers can use the preserved funds to support organic growth and other wealth-building initiatives.

 

Con: Change in Ownership Structure

When a buying entity offers equity and cash, it dilutes some of its current ownership. Rather than assume complete control of the selling entity, as would happen in an all-cash transaction, the buyer must now share this control with the stock owners—the more equity involved in the transaction, the greater the risk of diluted ownership.

 

Selling Entity

Pro: Greater share in rewards

Rather than walk away, as generally happens in an all-cash M&A deal, the seller continues to benefit from the growth of the business after a mixed transaction. If the sold business thrives, so do the shareholders who sold the business.

 

Pro: Tax benefit

While all-cash transactions trigger a tax event for the selling entity, incorporating equity into a mixed deal can lessen the seller’s tax burden, sometimes allowing for deferred payments. Generally, the more stock offered in a hybrid transaction, the less the tax liability for the selling entity.

 

Con: Risk of stock value decrease

Equity transactions carry the risk that shares will drop in value before the deal’s completion. If share values plummet, the seller may see a decrease in the M&A transaction’s value, particularly if they have structured the M&A as a fixed exchange ratio. For this reason, sellers must conduct greater due diligence with mixed offerings than all-cash deals, looking closely into the buyer’s financial, legal, and tax history. It is as important for a seller to do their due diligence as the buyer.

 

M&A Planning with Windes

The shifting economic climate and rising interest rates make it increasingly critical for sellers and buyers to know the benefits and drawbacks when structuring an M&A transaction.

Windes, a professional M&A advisory firm in Long Beach, California, offers M&A strategy services for private businesses in Orange County, Los Angeles, and nationally. We can help guide your M&A strategy by walking you through every step of the deal, including due diligence and EBITDA analysis.

Connect with the Windes M&A Team to discuss your M&A goals and learn how we can help you achieve a successful merger or acquisition for your business.

 

Talk to the Windes M&A Team

We tailor our due diligence services based on your specific situation and will provide the advisory and tax services you need to negotiate, structure, and complete the transaction with the most positive outcome.

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