Unlocking Financial Multiples: Why They’re Holding Strong Amid Rising Debt Costs

A businessman is holding a pen and drawing a chart on a background.

Although headlines suggest a slowdown in M&A activity, the lower middle market continues to be very active. For entrepreneurs who have been considering “taking some chips off the table” or transitioning ownership of their businesses, despite rising debt costs, financial multiples remain strong in the lower middle market.  

The Rising Cost of Debt: What this means for Entrepreneurs

The cost of debt, encompassing interest payments and associated expenses, is a critical factor that influences a company’s financial decisions. In a low-interest-rate environment, borrowing is more affordable, and companies often leverage debt as an attractive source of financing to fund growth initiatives, acquisitions, or capital expenditures. However, when interest rates climb, the cost of servicing debt escalates, exerting pressure on a company’s financial health and profitability. 

Higher interest expenses can lead to reduced cash flows, potentially limiting a company’s ability to invest in expansion or allocate resources to strategic endeavors, which, in turn, can affect its overall competitiveness and growth prospects. 

This dynamic underscores the significance of monitoring and managing the cost of debt effectively within a shifting landscape. This also reinforces the drive to partner with an advisory team that can provide strategic insights for mitigating the impact of higher interest rates, optimizing debt structures, and identifying alternative financing solutions to sustain long-term growth.

How Does the Cost of Debt Influence M&A?

While debt is cheaper than equity, cost of debt plays a pivotal role in shaping M&A activity in the lower middle market. Lower interest rates can make debt financing more attractive, potentially fueling an increase in M&A transactions, while higher borrowing costs may lead to more cautious deal-making and a slowdown in M&A activity in this segment.

For asset-intensive companies reliant on asset-based lending, a substantial increase in the cost of debt has caused valuation multiples to dip slightly relative to the past few years, reducing potential premiums. 

Despite the pressure on valuation multiples due to higher debt costs, the resilience of quality businesses suggests that they can weather these changes and still command strong premiums when market conditions stabilize. The ongoing activity in the lower middle market indicates that quality companies are not being unduly penalized and continue to be rewarded for their strength and performance.

Financial Multiples and Lower Middle Market M&A

Understanding the intricacies of how multiples affect a deal is crucial for both buy side and sell side M&A. Financial multiples are used as a barometer to evaluate the value and potential of an investment opportunity.  When a disproportionate amount of media attention suggests a slowdown in mergers and acquisitions, this unfortunately paints an inaccurate picture of the lower middle market which is often left out of these larger data sets which focus primarily on bulge bracket organizations.

As a result, it’s easy to be captivated by headlines that are only concerned about the  market dynamics of  the biggest movers. The lower middle market continues to show resilience despite challenges faced by the broader global economy and increased costs of capital. 

At the end of the day, valuations are still very much in line with historical data and quality well-run companies are receiving good valuations and selling for good prices. 

In times of economic volatility and uncertainty, the lower middle market is often able to exhibit a nimbleness that enables businesses to pivot, adjust strategies, and explore niche markets that might be overlooked by larger players. This adaptability is a testament to the entrepreneurial spirit and determination of these businesses.

What is the Impact of Valuations on Financial Multiples?

Valuations using multiples is a component of the market-based approach and involves estimating a company’s value by applying financial ratios – multiples – observed from comparable companies, making it a commonly used but challenging method due to the need for suitable peer company comparisons.

In the context of valuations, the current market reflects historical averages, with a noticeable emphasis on sourcing quality deals in the lower middle market. Quality companies are commanding good prices in this market environment. For businesses facing challenges, it may be prudent to consider exit planning before entering the market. Ultimately, valuations remain consistent with historical data.

Valuation in the Lower Middle Market

In the current lower middle market M&A landscape, financial multiples play a significant role, especially in light of rising debt costs, as they provide valuable insights into the relative valuation of companies and help stakeholders make informed decisions in an environment influenced by increasing borrowing expenses. Valuation in the private markets is often defined by a business’ EBITDA.

What is EBITDA?

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) multiples are commonly used in the valuation of businesses as they provide a straightforward means to assess a company’s operating performance and potential profitability, allowing for comparisons with industry peers, serving as a measure of overall financial performance.

Using EBITDA helps normalize financials by removing non-operating expenses, such as interest and taxes, and non-cash expenses like depreciation and amortization. This normalization allows for a more accurate comparison of the operating performance of different businesses, making it easier for potential buyers, sellers, and investors to assess the true earnings potential of a company. EBITDA is essential for planning exit strategies, such as selling a business or seeking investment. Business owners and investors often aim to maximize EBITDA to enhance the attractiveness of the business to potential buyers or investors, ultimately leading to a higher valuation.

Financial Multiples and Cost of Debt

The rising cost of debt due to a high-interest-rate environment has significant implications for investment decisions, especially in the realm of private equity (PE). In a climate of increasing debt costs, PE firms may need to inject more equity into their investments to maintain the desired internal rate of return (IRR). This means they must invest more of their own capital, potentially reducing the attractiveness of certain deals.

Private equity investors often use leverage to enhance returns. When the cost of debt increases, the attractiveness of leverage diminishes, leading to a reduced IRR. This prompts PE firms to ask themselves how much more capital they are willing to invest and whether it is feasible to continue reinvesting their own capital to meet their IRR targets. 

Competition and Surplus Capital in Search of Investment Opportunities 

When the cost of debt is high, investors seek higher returns to offset borrowing expenses, which can drive up valuation multiples as they compete for more attractive opportunities. This intensifying competition can push multiples to elevated levels, as investors are willing to pay a premium for assets with growth potential, despite the cost of debt, in their pursuit of desirable returns. The combination of these factors reflects the intricate balance between risk and reward in financial markets and influences investment decisions.

As long as investors are willing to pay a premium for investments, multiples will persist at elevated levels. Even during cycles of uncertainty, with the support of a strong M&A advisory team, buyers and sellers can unlock opportunities, make better decisions, and prioritize M&A transactions that align with their financial goals. 

What to Expect from the Lower Middle Market into 2024

In the face of rising debt costs, the resilience of the lower middle market continues to be an underreported story. We’re seeing that quality businesses continue to thrive, debunking the notion of a slowdown in M&A activity. 

When heading to market, the interplay between financial multiples and the cost of debt is crucial, particularly in private equity, where the rising cost of debt can prompt strategic adjustments. As the landscape continues to evolve, for business owners it is a significant advantage to partner with an advisory team that understands market dynamics and have witnessed these cycles before. Doing so serves to unlock the transformative power of M&A.

If you are ready for the next chapter of your entrepreneurial journey, reach out and let’s begin together.