May 2023 Update
Fed Increases Federal Funds rate by 0.25% to 5% to 5.25%
The May rate hike by the Federal Reserve is the 10th interest rate increase in just over a year putting the Fed Rate at a range of 5% to 5.25%. The Prime rate immediately increased 0.25% to 8.25%, which also increased the maximum SBA 7a loan rate to 11.25% (the maximum allowable SBA 7a loan rate is Prime + 3%). Few SBA lenders are presently charging the maximum allowable rate, and most are in the 9% to just over 10% range. As of May 4th, we have one SBA lender offering 7.5% to 7.75% SBA 7 a loans, with 10 year fixed rates which is the best rate we are aware of. The SBA lending market remains very competitive with banks looking to do more SBA loans to replace their shrinking residential real estate loans and consumer loans. So yes the rates are higher than in 2021, but banks are still lending and the market is competitive.
To put this in perspective, while the Prime Rate has indeed jumped from a historic low of 3.25% in 2020 to 8.25% as of May 2023, a Prime Rate of 8.25% is not unusual as you can see from the charts above and below.
The graph below shows the Historical US Prime Rate through May 2023.
How Do Increases in Interest Rates Affect Business Acquisitions?
As professional business brokers, we follow the prime rate and SBA loan rates closely. From March 2020 through March 2022 we enjoyed a prime rate at a historic low of 3.25%, which translated to a maximum SBA loan rate of just 6%. The last time the Prime rate dropped to 3.25% was in December 2008 and before that in 1955. Interest rates from 2020 through early 2022 years were truly at historic lows; consequently, so were SBA loans and other business loans.
10 successive interest rate hikes by the Fed from March through May of 2023 raised the Prime Rate from 3.25% to 8.25%, with SBA loan rates increasing from 6% to between 9% and a maximum rate of 11.25%, which begs the question, will these rate increases affect business sales and business values?
The Maximum allowable SBA loan rate stands at 11.25% (Prime+3%) as of May 2023. With that said, none of the SBA PLP (Preferred Lender Program) banks we work with are charging this rate and most banks are charging from 9% to 10.25%, with one lender offering rates as low as 7.5% to 7.75% as of May 2023. The picture is not as bleak as the media is painting for small to mid-size business sales and acquisitions. As business brokers, we know this from our over 20 years of experience selling businesses with SBA financing. Yes, the increased interest rates increase debt service and lower the buyer’s net after debt service, but a solid transaction will still pencil out at the right price and terms.
The Acquisition Financing Perspective: Impact of a 1-Point Increase to SBA Loans
Psychologically, we all react negatively to increases in interest rates. When we see news of the Fed raising interest rates by 0.75% in one bump, the immediate response is to assume the loan you are contemplating is going to cost a lot more money and maybe the deal you are working on won’t pencil out anymore. In fact, this is far from true.
The table below compares the effect of a 1-point (1%) increase in lending rates on $1 million, $5 million, and $10 million loans business acquisition loans. As you can see in the example below, a 1-point increase in SBA lending rates on a $1 million loan reduces the net after debt service by just $6,341 annually.
Acquisitions and purchases of small to mid-sized businesses were steady when SBA rates were as high as 9%, and even above 10%, in the not-so-distant past, and we have been here before so to speak. With that said, there may be a knee-jerk reaction to the “sudden” change and this may slow or pause acquisition activity for a while. But, if one looks at the impact of a 1-point increase in lending rates, it isn’t all that dramatic; and rate increases don’t make solid deals fall apart. The increased interest rates do increase debt service and reduce the Net After Debt Service on deals, and yes, it may result in reduced values on some transactions where the debt service is tight, but businesses with strong cash flow and growth will not be adversely affected.
Of course, it is disappointing and frustrating to see interest rates on the rise, and yes, debt service is going to increase; but, one has to remember that interest rates are increasing from historic lows and returning to historically normal levels. A solid deal will still pencil out and make economic sense; and if it doesn’t, it was likely a weak deal to begin with.
Small and Mid-Sized Business Sales Survive Rate Increases Better than Wall Street
Business media may be full of stories about Wall Street M&A activity slowing as the rates increase, but these are highly leveraged deals, with very tight cash flow, and counting on optimistic growth projections to generate the cash flow necessary to service the debt and make a profit. These deals will fall apart because there simply is no margin for increased lending costs, slower economic growth, or increased operating costs. It is likely, therefore, we will see increasing media attention as to the decline of Wall Street, Fortune 500, and tech business sales and acquisitions.
Small and mid-sized businesses are generally not directly affected by these economic factors. Firstly, small & mid-size business acquisitions are not done on razor-thin deal margins. The banks won’t underwrite the deal and a small business buyer would never take that level of risk. Secondly, Wall Street and big companies are subject to the wild swings of the stock market as well as the overall economy. Many small businesses continue to thrive when the general economy slows. Case in point, while the general economy struggled in 2020 due to COVID, many of the businesses we sold had strong years in both 2020 and 2021. Small business financial performance doesn’t necessarily follow the stock market.
The bottom line is that if the deal and company are solid, it will survive the upcoming higher interest rates, and the effect will be minimal.
For more information about selling your business contact us. Pacific Business Sales specializes in the sale of industrial businesses including manufacturing, technology companies, 3PL, construction, healthcare, e-commerce, and aerospace companies. Our team of professional business brokers will guide you through the process of selling your business, working closely with you to ensure the best outcome.