By Simon Lockard
Introduction:
Interest rates play a large part in the frequency and negotiation leverage of M&A deals. In this paper, I will discuss what interest rates are, who determines them, how they are determined, and the justifications for lowering or increasing interest rates. Then, I will discuss the period between 2020 and 2024, which had the greatest year in M&A volume history and the worst year in a decade. Then, I will discuss how lowering or increasing interest rates affects the volume, terms, and party leverage in both the deal and financing agreements that are part of a deal. Finally, I will discuss how the current lowering of interest rates might affect deal flow volume and negotiations in the future.
What are Interest Rates and How Are They Determined:
Interest rates are the additional rate the lender determines that they require a debtor to pay when taking out a loan.[1] Federal Interest rates represent the floor for the rate at which lenders are willing to loan money to debtors in the United States because this is the rate at which commercial banks loan money to each other. The Federal Open Markets Committee (the “FOMC”) sets the Federal Interest rate.[2] The FOMC is the policy-making body of the Federal Reserve. The FOMC meets eight times yearly to discuss the target interest range they want to set based on the current economic conditions.[3] The FOMC can lower or raise interest rates at their discretion. The FOMC can lower interest rates when it wants to reduce the cost of capital and make borrowing money cheaper. Making money more affordable to borrow incentivizes investment and spending, which boosts the economy. On the other hand, the FOMC can raise interest rates to increase the cost of capital and make lending more costly, which makes investments riskier. This disincentivizes spending and investment and cools down the economy during high inflationary periods.
The Effect of Interest Rates on Mergers and Acquisitions:
Mergers and Acquisitions (“M&A”) are the process of combining previously independent, freestanding businesses into one business organization.[4] As discussed above, interest rates strongly impact the flow of M&A deals. Interest rates play a significant role in M&A because most deals are financed using a combination of debt and equity.[5] Equity is the process of raising money through selling a company’s interest, which takes the form of stock certificates.[6] Debt is the process of borrowing money to be paid back with interest.[7] Increases and decreases in interest rates affect the cost of obtaining debt and the likelihood of getting approved for debt financing. Increased interest rates make the cost of taking on debt more expensive, decreasing the possibility that the borrower will be able to make a return on their investment and making lending riskier for the lender.[8] Lenders usually impose stricter lending requirements and increased diligence to account for the increased risk. These extra impositions make approval for financing deals riskier for the borrower, take longer and are more costly. The increase in the cost of debt and the additional lending requirements placed on debtors make taking on debt significantly more expensive and time-consuming, which can cool the appetite of businesses looking to merge or acquire.
High interest rates affect the relationship between lenders and borrowers and buyers and sellers within each deal. High interest rates will increase the target companies’ capital costs and discount rates, lowering the company’s business evaluation. The decrease in the company business valuation hurts the seller and makes them more reluctant to sell their company at a price which they feel is too low which decreases the volume of potential sellers in the M&A market. Additionally, when the cost of capital is too high, it prices some potential buyers out of the market, which decreases competition for deals and gives the buyers remaining in the market increased leverage over a seller who wants to sell their company now.
In conclusion, the increase in interest rates suppresses the M&A market because it makes lending riskier and more expensive, forces lenders to impose stricter and more tedious lending requirements, drives down the valuation values of target companies which makes them more reluctant to sell, and decreases competition because fewer buyers are willing to pay the high cost of capital need to acquire a company.
The Effect of Interest Rates on M&A From 2020-2024:
In 2020, fearing the coronavirus’s effects on the economy, the Federal Reserve stepped in with several actions to keep credit flowing and mitigate the damage done to the economy.[9] One of their actions was to cut the federal interest rate to a range of 0 to .25 percent, lowering the cost of capital to almost zero, meaning there was virtually no penalty for borrowing money. Slashing interest rates and lowering the cost of capital resulted in the busiest year for M&A ever in 2021, with a global deal volume exceeding 5 trillion dollars.[10] The total number of transactions in 2021 was 46,361.[11]
However, in response to hyperinflation, the Federal Reserve abruptly raised interest rates in 2022 and 2023 back up to 5 to 5.25 percent to cool the economy and try to stop runaway inflation. This rise in interest rates decreased the volume of M&A by over 36 percent, causing it to be at its lowest in a decade, with a global volume of only 3.8 trillion dollars in 2022 and 3 trillion dollars in 2023.[12] Additionally, the number of transactions decreased to 43,552 in 2022 and only 33,018 in 2023.[13] Business attorneys stated that interest rates increasing debt cost compounded with inflation cutting into profits and increasing operating expenses for companies led to a mismatch in valuation expectations between buyers and sellers, which paralyzed the market in 2023.[14]
Further, the sharp decrease in deals conducted by private equity firms in 2023 was a significant factor in the poor performance of the overall M&A market. Private equity firms are investment partnerships that use money from investors to buy equity in private companies.[15] In 2022, Private equity firms accounted for 38 percent of all global M&A value.[16] From 2021 to 2023, private equity deal flow decreased by over 45 percent.[17] One of the main factors for the sharp decline in private equity deal flow was the interest rate increase, making the cost of debt too expensive. In today’s current M&A market, private equity uses large amounts of leverage (debt) in their M&A transactions. It is common for debt to be 40 to 60 percent of the deal consideration for private equity M&A transactions.[18]
How M&A Deals Are Affected by the Increases in Interest Rates:
As discussed above, the increased cost of capital associated with higher interest rates has led to a widening risk tolerance gap between buyers and sellers.”[19] Sellers want the hands-off “walkaway” deal structure common in the 2021 boom.[20] However, “the increased cost of capital… put pressure on buyers to preserve their margins, and as a result, buyers… now [demand] more stringent risk controls, particularly when potential risks emerge in due diligence.”[21] Due diligence is the “careful investigation of the economic, legal, fiscal and financial circumstances of a business or individual.”[22] Buyers are currently unwilling to absorb all of the risks associated with an M&A transaction without recourse, like in 2021, when competition for deals was extremely high.[23] These increased risk provisions by buyers have resulted in increases to deals dying post exclusivity during the due diligence phase.[24]
Additionally, increased interest rates have resulted in less competitive transactions because fewer buyers are willing or able to engage in a bidding war over a company when the cost of capital is so high. This environment creates a more buyer-friendly market that gives buyers more leverage over sellers who cannot pit buyers against each other to drive up the price or lower their risk exposure. Therefore, while buyers have decreased leverage when negotiating financing with lenders (i.e., banks and private lenders), buyers have increased leverage when negotiating deal terms with sellers.
The combination of buyers’ lower risk tolerance and increased leverage in the market has resulted in them being able to negotiate deals with buyer-friendly deal terms.[25] Typical buyer-friendly deal terms buyers propose in high-interest rate environments include deferred payments, earnouts, and post-closing adjustments.[26]
Deferred payments are when the buyer agrees to not pay the entire purchase price for the company at once but have a portion paid out over time on an unsecured basis.[27] Deferred payments are good for the buyer because they avoid paying everything at once, which would be extremely costly when interest rates are high. Deferred payments are bad for the seller because they lose the value they could get from investing the money they deferred. If the seller cannot pay them later down the line, the remaining amount will likely not be able to be recouped by the seller.
Earnouts are when the buyer pays a lower cost at closing in exchange for future payments to the seller based on the performance of the business after the deal has closed.[28] Earnouts are favorable for buyers because they allow them to pay less upfront when the cost of money is high. They only must spend additional funds on the seller if the company is successful, which takes much risk off the buyer if it becomes a bad investment and unprofitable. Earnouts hurt the seller because they are losing out on the ability to invest the money they are promised in the future in the present, and a lot of the risk of the company failing post-closing is put onto them when they are no longer in charge of the company.
Post-closing adjustments allow the buyer to adjust the closing price after closing based on the performance of the company and their analysis of the company they bought after the fact.[29] Post-closing adjustments are advantageous for the buyer because they place the risk of the company being overvalued on the seller and allow the buyer to recoup value if it turns out that the company they bought is not as valuable as they had suspected.
How Lowering Interest Rates Will Affect Mergers and Acquisitions:
In September 2024, the Federal Reserve started to lower interest rates by cutting the interest rate range from 5 to 5.25 percent to 4.75 to 5 percent.[30] Then again, in November 2024, the Federal Reserve cut interest rates from 4.5 to 4.75 percent.[31] Financial analysts at JP Morgan project another rate cut by the end of 2024 and additional rate cuts in 2025.[32] While further rate cuts are likely to occur, Federal Reserve’s chairman Jerome Powell has indicated that it is doubtful that the rates will return to near zero as they were in 2020 and 2021.[33]
Additionally, since the reelection of Donald Trump, financial analysts have projected that the Federal Reserve will likely move slower with future interest rate cuts out of the fear that Trump’s economic policy will have an inflationary effect on the economy.[34] Economists believe that Trump’s policies could result in “faster economic growth and a tighter labor market that, along with the higher import costs, would put upward pressure on prices.”[35] Additionally, the economists believe the fear of potential inflation will likely result in the Federal Reserve making fewer interest rate cuts in 2025 and instead opting to extend their rate cut period into 2026 so they have time to adequately assess the inflationary implications of Trump’s policies once he actually starts implementing them.[36]
However, even if the rate cuts are slower than anticipated, they will be positive for M&A volume because they will lower the cost of capital, which will both decrease the risk for deals and increase competition among buyers, which, combined with the lower cost of capital, will drive up prices for companies looking to be sold which should decrease reluctance of sellers and increase overall deal volume.[37] Additionally, the decrease in interest rates will likely see sellers having increased leverage in negotiations with buyers because their companies will be valued higher, and competition will increase now that investing has become viable for investors unwilling to invest when interest rates are higher. This increased leverage will likely result in sellers pushing back against buyer friendly deal terms and demanding deals terms which leave them with less post-closing exposure. Further, interest rate decreases should increase private equity’s willingness to buy in the market. In anticipation of interest rate drops, private equity has saved and is currently sitting on a record amount of cash which they refer to as dry powder.[38] As interest rates drop private equity is much more likely to both spend the money they are currently holding and be willing to take on more debt to help finance transactions. Benjamin Clinger, a private equity partner at Kirkland and Ellis, states, “PE firms use cash to fund growth, service debt, or distribute cash to shareholders. With lower rates, [PE firms] can borrow more and pay more (for assets). That should help bridge valuation gaps with sellers.[39]” As discussed above, in 2022, one of the main reasons the deal market was paralyzed was the mismatch in the expectations of sellers and buyers on what the price of a company should be. Increased interest rates increased risk and the cost of capital, which made buyers’ demand lower prices in deals. This demand from buyers was met with resistance from sellers who were unwilling to sell their company for significantly lower than what the company was valued at in 2021. However, the recent interest rate cuts have “encouraged optimism for increased deal flow and may help narrow the gap between buyers and sellers.”[40]
Overall, the current interest rate decreases are likely not enough to cause a massive uptick in deal flow, but if the current projections persist, we should see gradual and healthy growth going forward. The Federal Reserve’s decision to continue to lower interest rates will likely facilitate more deal volume because buyers will be more willing to take out financing, which should result in more balanced and less stringent deal terms. Sellers should be able to drive up the price of their company through increased competition and valuation amounts that come from lowered interest rates which will drive increases in overall deal volume. Currently, through September 2024, M&A volume for both private equity and corporate deals has been up 17 percent from last year.[41] EY-Parthenon’s macroeconomic outlook also projects M&A activity to rise by 10 percent in 2025.[42] Further, private equity deals are expected to increase by 16 percent in 2025.[43] While these increases are promising, it is improbable that deal volume will return to the levels seen in 2021. For reference, deal flow increased by over 91 percent in 2021 due to historically low interest rates, low inflation, and a robust economic outlook.[44] However, the current increases and projections show that deal volume will likely rebound from the ten-year low we saw in 2022 and 2023.[45]
Conclusion:
Over the past five years, there has been much volatility in the M&A market. When interest rates were near zero, there was the most significant yearly M&A volume in history. After the abrupt interest rate increases, a severe retraction in deal flow resulted in a ten-year low. The rise in interest rates hurt buyers because it made the cost of capital more expensive, making investments riskier. This increased risk allowed lenders to have stricter loan requirements and longer diligence processes, making securing financing for M&A a longer and more costly process. Additionally, the rise in interest rates hurt sellers because it decreased the value of their companies and reduced competitive bidding which resulted in them being out leveraged by buyers when negotiating deal points. The state of the market in 2022 and 2023 was inhospitable for both buyers and sellers and led to everyone being reluctant to enter the deal market. I project that, while we are unlikely to return to the deal volume of 2021, the continued lowering of interest rates will have a positive effect on increasing deal volume because it will lower the cost of capital which will reduce the risk of investment and make buyers more willing to take on debt. This decrease in risk and willingness to take on debt should increase the number of buyers in the market. The increase of buyers in the market should increase competition and balance out the leverage disparities between buyers and sellers which should result in more frequent, efficient and expensive deals. Finally, more frequent, efficient, and expensive deals should drive up deal volume and help the M&A market rebound from the lows seen in 2022 and 2023.
[1] Michael Adams, Understanding the Federal Funds Rate, Forbes Advisor, https://www.forbes.com/advisor/investing/federal-funds-rate/ (last visited November 22, 2024).
[2] Id.
[3] Dawn Papandrea, How Federal Interest Rates Work, U.S. News (Nov. 7, 2024, 3:33 PM), https://money.usnews.com/loans/articles/how-federal-interest-rateswork.
[4] John D. Maynard, Maynard: Mergers and Acquisitions 2 (5th ed. 2021)
[5] Kison Patel, How to Finance a Business Acquisition, DealRoom, https://dealroom.net/blog/how-to-finance-a-business-acquisition (last visited October 11, 2024).
[6] Findlaw Legal Team, Debt vs. Equity – Advantages and Disadvantages, Findlaw (Jun. 6, 2024), https://www.findlaw.com/smallbusiness/business-finances/debt-vs-equity-advantages-and-disadvantages.html#:~:text=%22Debt%22%20involves%20borrowing%20money%20to,shareholders%20stock%20in%20your%20company.
[7] Id.
[8] James R. Glover, M&A Market Update: The Impact of Interest Rates, Koley Jessen (May 12, 2023), https://www.koleyjessen.com/insights/publications/m-a-marketupdate-the-impact-of-interest-rates.
[9] Sarah Milstein, What Did the Fed Do in Response to the Covid-19 Crisis?, Brookings (Jan. 2, 2024), https://www.brookings.edu/articles/fed-response-to-covid19/.
[10] Frank Bergamo, Navigating the Impact of High Interest Rates on M&A Markets, HBK (Jan. 19, 2024), https://hbkcpa.com/insights/navigating-the-impact-of-rising-interest-rates-on-the-ma-market/.
[11] Al Barbarino, M&A Attorneys Anticipate Rebound Despite Challenges, Law360 (Jan. 1, 2024, 8:02 AM), https://www.law360.com/articles/1734230/m-a-attorneys-anticipate-2024-rebound-despite-challenges.
[12] Id.
[13] Id.
[14] Id.
[15] James Chen, Private Equity Explained with Examples and Ways to Invest, Investopedia (April 10, 2024), https://www.investopedia.com/terms/p/privateequity.asp.
[16] Atif Azher, Private Equity (Transactions): Global Overview, Lexology (March 11, 2024),https://www.lexology.com/library/detail.aspx?g=d44db972-e313-44a0-9639-11c13ca0fe91#:~:text=Private%20equity%20deals%20accounted%20for,per%20cent%20by%20value%2C%20respectively.
[17] Mark Hoeing, Private Equity in 2024: Where do we go from here, Commonfund (February 14, 2024), https://www.commonfund.org/cf-private-equity/private-equity-in-2024-where-do-we-go-from-here.
[18] White, Michael, How the Availability of Leverage Impacts Valuation, Founders Advisors (July 11, 2023), https://foundersib.com/2023/07/11/how-the-availability-of-leverage-impacts-valuation/#:~:text=In%20today’s%20M%26A%20market%2C%20the,60%25%20of%20the%20deal%20consideration.
[19] Gregory S. Fine, 2025 Private Equity Trends Outlook, The National Law Review (Nov. 19, 2024), https://natlawreview.com/article/2025-private-equity-trends-outlook.
[20] Id.
[21] Id.
[22] LexisNexis Authors, What is Due Diligence?, LexisNexis, https://www.lexisnexis.com/en-us/professional/risk-management/glossary/due-diligence.page?srsltid=AfmBOoruKaNbY8zY3mDl9Bks8Pl20s6yNE6r2b1kguwkIv2xF1XK1YK- (last visited November 23, 2024).
[23] Id.
[24] Id.
[25] James R. Glover, supra note 8.
[26] Id.
[27] Id.
[28] Id.
[29] Id.
[30] Cristina Dwyer, Federal Reserve Meeting September 2024: Interest Rate Cuts, J.P. Morgan Wealth Management (Sep. 19, 2024), https://www.jpmorgan.com/insights/outlook/economic-outlook/fed-meeting-september-2024.
[31] Federal Reserve, Selected Interest Rates, Federal Reserve (Nov. 22, 2024), https://www.federalreserve.gov/releases/h15/.
[32] Id.
[33] Louis Lehot, Outlook on M&A Activity for Q4 2024, Foley & Lardner LLP (Sep 26, 2024), https://www.foley.com/insights/publications/2024/09/outlook-m-a-activity-q4-2024/.
[34] Ann Saphir, Trump’s election victory puts Fed on a path for fewer rate cuts, Reuters (November 6, 2024, 9:42 AM), https://www.reuters.com/markets/rates-bonds/federal-reserve-seen-shallower-rate-cut-path-after-trumps-election-2024-11-06/.
[35] Id.
[36] Id.
[37] Id.
[38] Dylan Thomas, Private Equity Dry Powder Growth Accelerated in H1 2024, S&P Global (Jul. 12, 2024),
[39] Patrick Smith, More Deals and Larger Deals: Big Law Dealmakers Weigh in on Rate Cut Impact, Law.com (September 23, 2024, 05:00 AM), https://www.law.com/americanlawyer/2024/09/23/more-deals-and-larger-deals-big-law-dealmakers-weigh-in-on-rate-cut-impact/.
[40] Gregory S. Fine, supra note 19.
[41] Gregory Daco, M&A Outlook Signals Firming U.S. Deal Market Activity in 2025, EY Parthenon (Nov. 21, 2024) https://www.ey.com/en_us/insights/mergers-acquisitions/m-and-a-outlook.
[42] Id.
[43] Id.
[44] Id.
[45] Brian Levy, 2024 Mid-Year Outlook Global M&A Industry Trends, PWC (Jun. 5, 2024), https://www.pwc.com/gx/en/services/deals/trends.html.
