Business owners and capital providers have operated and invested through a range of challenges in recent years, including the COVID-19 pandemic, supply chain disruptions, tight labor markets, and inflationary pressures. While some businesses struggled to stay afloat, many businesses have been able to weather the storm and even thrive. Through it all, there was a general backstop within the marketplace. An abundance of capital coupled with near-historic low interest rates engendered a “risk-on” mentality to persevere despite the challenging environment.

The low interest rate era over the last 15 years ushered in record highs and activity across markets. In the private market, we witnessed incredibly robust debt capital markets. Creditors were increasingly willing to lend more at competitive pricing with minimal strings attached. The strong debt markets allowed business buyers to increase their use of leverage in purchases, resulting in strong competition for assets and ultimately higher valuations. In the public markets, growth was rewarded — as the cost of capital, also known as the hurdle rate or opportunity cost for a new project — was depressed in the low-rate environment. In short, when base interest rates and costs of capital are low, operators have a wider universe of value-creating opportunities available. Operators can take big swings, running after growth initiatives that might otherwise be value destroying in a higher rate environment. When nearly all projects are value-creating, growth is what separates the pack. An example is the relative performance of technology related stocks in the years leading up to 2022. Those companies demonstrated potential for significant long-term growth and were rewarded for it, despite poor profitability (or lack thereof) for many.

Roughly a year ago, markets began to pivot. The Federal Reserve transitioned its position on inflation (remember the word “transitory”?) and committed to fighting inflationary pressures by raising interest rates and reducing the size of its balance sheet. Along the entire maturity curve, U.S. treasury yields increased, revealing the markets response to the new environment. Over the past year, base rates have continued to rise at an unprecedented clip. For some context, the federal funds rate range and 10-year treasury rate yield was 0-0.25% and ~1.6%, respectively, at the start of 2022.[1] Today, the funds rate range and 10-year is at 4.75-5.00% and ~3.6%.[2] These are rates we have not consistently seen since before the global financial crisis in 2008-09. The rise in rates has an incredible (and often underappreciated or maybe just forgotten) impact on corporate finance and operating decisions.

We would be remiss not to at least mention the recent banking crisis. The failure of Silicon Valley Bank is directly related to the rapid rise in rates and is one example of the knock-on effects in the market pivot. Banks and other market participants have not had to operate in a rising and higher rate environment for decades, and for some, their entire careers have been built in a low-rate environment (yes, I fall in that camp). For others, they have shelved their high-rate playbooks and it is time to dust them off or better yet, digitize them for the new world in which we live.

So at a fundamental level, what is the impact of rising interest rates? Higher rates increase the overall cost of capital, which represents the blended cost of debt and equity. In 2022, the cost of capital increased from 5.75% to ~10%.[3] In other words, higher rates have translated to more expensive debt and equity, making business owners more capital constrained today. Higher costs of capital decrease the availability of capital, reduce viability of projects, and ultimately reduce valuations. As higher rates take hold in the market, management teams must reevaluate capital decisions based on new hurdle rates, and business buyers must reevaluate how to finance their purchases.

Public markets have priced in the new rate environment, most evident in the same growth-focused technology companies mentioned earlier. Their inflated valuations relied on low costs of capital that made dollars today relatively cheap compared to dollars tomorrow (i.e., you could pay more today for future growth). Cost of capital represents your opportunity cost, so as rates and the cost of capital rise, dollars today are worth relatively more than dollars tomorrow – because you could have invested in another opportunity today at a higher return. Therefore, the focus moves from long-term total growth to near-term profitable growth, which is exactly what you are seeing play out in public company strategy.

In the transaction world, there was epic activity in 2021. Relatively cheap capital costs and a system flush with liquidity, not to mention some hangover demand left from lockdowns, led to record-setting volumes and valuations. However, in 2022, the Fed’s consecutive rate hikes slowed down transaction activity over the course of the year. Market participants increasingly decided to wait out the uncertainty in the path of interest rates.

Taking a step back and looking at the broader history, 2022 remained a solid year for dealmaking, ranking among the top five years all time for deal value and volumes, underpinned by the incredible amount of liquidity held by capital sources.[4] Private market deal valuations remained strong and rose overall in 2022 but showed evidence of softening late in the year. Private markets tend to lag public market movement. Business buyers are quick to adjust to the new environment, while sellers tend to hold onto known ground. The bid-ask spread, or the difference between buyer offer and the seller’s minimum price, gaps out during market movements. Similar to public market valuations performance in 2022, we expect to see some further softening in underlying private valuations due to higher rates.

The start of 2023 has been a turning point in capital markets. There is a regime change underway. With a growing consensus on the new normal, zero rate policy looks to be a thing of the past. The market has accepted we are likely to be in a rate environment that resembles the pre-global financial crisis moving forward, with longer term treasury rates closer to 4% rather than 1%. Higher sustained rates will have profound effect on decision- and dealmaking. Operators will need to demonstrate prudency in capital allocation, seeking opportunities that can clear their new, higher hurdle rates. Investors are more likely to reward profitable growth, rather than growth at all costs. Lenders will underwrite more conservatively given the change in debt service costs. Deal diligence and negotiating will likely be a bit pricklier than in previous years. Rather than pure speed to market, there will be more attention on staging of deals and finding the right business buyer.

In closing, this is not meant to be all doom and gloom. Investors and capital allocators still sit on near-record highs of liquidity (est. $2 trillion in global private equity cash reserves)[5], which will motivate business buyers to put money to work and support valuations. Private market businesses continue to perform well, and we still see signs of appetite from lenders and private equity investors. The unknown factor for 2023 is the potential for an economic downturn. The market is questioning whether the rise in rates will ultimately slow business activity enough to tip us into a recession. Time will tell. For now, we believe the market remains constructive for dealmaking.

Follow along as we explore additional topics related to the impact of rising interest rates. Contact if you would like to further discuss the current environment.

[1] Federal Reserve Economic Data

[2] Ibid.

[3] Damodaran Online: US Total Market Cost of Capital (without financials)

[4] White & Case M&A Explorer

[5] S&P Global Market Intelligence