In May, US inflation reached a 40-year high of 8.6%, a symptom of major macroeconomic turmoil that the Federal Reserve (Fed) is working fast to combat. Myriad forces are contributing to rising prices in the US, some global—including Russia’s invasion of Ukraine, which has led to soaring energy prices, and ongoing supply chain disruption linked to ongoing COVID-19 lockdowns in China—and others local and within policy-makers’ control.
The loose monetary policy that the Fed pursued during the pandemic—generating cheap credit, which spurred red-hot dealmaking in 2021—is being wound down. Monetary tightening and interest rate hikes are in play. In mid-June, the Fed raised rates by 75 basis points, and expects to do the same in July before a 50bp increase in September. Looking ahead, members of the Federal Open Market Committee (FOMC) project that the Fed’s policy rate will reach 3.4% by the end of 2022 and could rise to 3.8% next year.
The implications of this rapidly evolving inflation and interest rate environment for dealmakers are potentially very severe. Some players are better insulated than others: well-capitalized groups—especially private equity firms, who possess record-high levels of dry powder—are positioned to withstand negative shocks and continue transacting even as financing conditions become less favorable.
But for less-liquid organizations the mixture of global uncertainty, volatility in equity markets, rising interest rates, higher operating costs and weakened cashflows makes for an unpleasant cocktail. Debt financing will become increasingly costly, and the rate of real returns on investment will fall while inflation remains elevated.
Echoing these sentiments, according to a June 2022 Datasite survey of 500+ senior dealmakers, 46% of these dealmakers believe deals will rely on a greater ratio of equity to debt. Even further, 34% of those dealmakers surveyed think that inflation will lead to more all-cash deals. However, while deal structures might change, only 20% of the dealmakers expect less M&A overall, showing some market resilience for the times ahead.
In the face of these challenging circumstances, comprehensive (and lengthy) due diligence will become critical, purchase-price offers will slip and contingent considerations such as earnouts will become more common. All in all, US M&A is likely to look somewhat subdued this year and next, especially when compared to the stellar figures posted in 2021 and H2 2020.