Inflation is a hot topic as the Covid-19 pandemic has eased and more businesses have re-opened, providing consumers with more opportunities to spend money. Stimulus payments have accelerated the trend, and with the re-opening largely coinciding with the end of the school year and the start of the summer travel season, it should be no surprise that prices are starting to rise.
That ought to cause those looking at the hot merger and acquisition market we are now experiencing to have some concerns. Classic monetary policy would dictate that rising inflation is best addressed by raising interest rates; making saving more attractive will make spending less attractive, which will slow down price increases.
This is all fine and well for the economy overall, especially for retirement-age folks on fixed incomes looking to defend against rising prices. But rising interest rates make debt financing more expensive, which makes high multiples in acquisitions difficult to achieve in a cost-effective manner. As the buyers’ cash costs more, sellers’ deal prices go down, and the M&A market slows.
But how well do the classic policy prescription and the outlook on M&A dovetail with the economy we are all in today?
Reasons to Be Optimistic
One reason to view the traditional model with some skepticism is the nature of this particular upswing. This is not cyclical, by any means. In fact, one could take the view that emerging from a pandemic shock that itself put the brakes on the global economy as a whole is not actually inflationary; it might just be reflationary, getting us all back to where we were before.
A second reason to have some optimism for the M&A markets lies with the types of inflation the economy is experiencing. Supply chains were massively disrupted during the pandemic, and much of the inflationary pressure we are seeing seems tied to lingering issues in those chains, rather than any real systemic price increases.
Lumber is the most commonly cited of these. Three months ago, everyone was talking about a lumber shortage and resulting price hikes that, at the time I am writing this, seems to have largely reversed. Automobiles is another category; mass transportation becomes problematic in a pandemic, so more people buy more cars. As the pandemic recedes, demand is likely to soften, reducing inflationary pressure.
Third, everyone that pays attention to Federal Reserve Board pronouncements is already familiar with statements in recent years that seem to indicate the Fed is not as intent on preventing inflation as it may have been in prior business cycles. This may be due to a feeling that the “natural rate of inflation” was underestimated in prior years. Or it may be due to a feeling that since fewer (relative) dollars are tied up in fixed income investments, inflation presents less of a risk (overall) to retirees and other high savers.
Finally, finance markets may be able to absorb a fair amount of rate pressure before M&A financing becomes expensive enough to impact the market. Most M&A financing today is not directly provided by traditional banks; non-bank lenders, hedge funds, family offices, and sovereign wealth funds all contribute enormous amounts of capital to M&A markets, and may be able to continue lending at low rates, absorbing thinner margins, than we have experienced in previous cycles.
Right now, it is not at all clear what the magnitude of inflationary pressure will be, whether the Fed will feel it necessary to exert enough pressure on rates to have a material impact on markets, or what that level of pressure actually is.
All of which should give M&A market participants hope: the sky may be falling, but not all at once, not everywhere, and maybe not as fast as everyone fears. And where there is hope, there is always opportunity.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Brooks Giles is a partner and deputy general counsel at Katten in the firm’s Corporate Department in Chicago. He helps equity investors and business owners buy and sell operating businesses, and many of his transactions involve the purchase of private companies by private equity firms.