The financial world is changing for the first time since 2009.
It seems, for the near future, that the era of cheap money is over and asset prices will now reflect a higher cost of money as the Federal Reserve along with other central banks raise rates to fight inflation.
While 4-5% Fed rates may seem manageable compared to the almost 20% rates during Paul Volker's era in the 80s, it is not. If terminal rates end at 5% when it was just 0.25% in 2021, it works out to be a 20x increase in overnight rates.
What does this mean for the rest of the economy, or for our intents and purposes, the business sale market?
Here's what I see:
1. Enterprise Values will be impacted by higher rates and borrowing costs. While rates alone may not affect small businesses as much as larger corporations (due to an already high discount rate or expected ROI of 25-40%), it will be significantly felt as business buyers face tighter lending standards and higher interest.
2. Risk profile for most businesses is increased due to poorer economic outlook. High interest rates take time to run its course through the economy. This time, its a double whammy of higher cost of money and structural (supply side) inflation. The economy works in a sort of butterfly effect where it takes up to 5 or more levels through to finally show up in a big way in the numbers. For example, higher rates cause people's mortgage payments to increase or real estate investment activity to slow > People and investors spend less > Businesses see sales slow or decline > Businesses start to lay off their workforce > laid off people spend less > feedback loop into less sales for businesses.
3. Financial instability rising in several segments in the financial markets. e.g. Home lending and mortgages, auto loans, consumer and business insolvencies.
These are the unfortunate outlook that faces everyone of us for 2023 as central banks fight inflation. Their fight is important because we do not want inflation to be entrenched and become a disaster for the economy.
What can business buyers and seller do?
Buyers will need to be more selective of the industry and specific risk of the business they are buying. They must not max out the debt service ratio and purchase a business with more downpayment. Earnings to debt payment needs to have a bigger buffer in case the business experiences any drop in sales. This mean where before they could buy the biggest business with a downpayment, they will have to settle for a smaller one so that the debt load is lower.
Sellers need to get more comfortable with vendor takeback and deferred payments to help get the deal across the line. Their valuation expectations need to be adjusted lower. To get the most cash out of the sale, they should make sure their working capital and assets are well optimized so that they are not leaving tens or hundreds of thousands on the table.
Another option for both parties is to remain at status quo to ride out the rough 12-18 months ahead of us. Minimize risk, protect other assets, and ride out the tough times expected to come in 2023.