Should you pause on growth in 2023?
December 14, 2022 •Oak Street Funding
After the December 14 meeting, the Federal Reserve announced an increase of 50 basis points to a target range of 4.25% to 4.5%. The FED has raised rates seven times this year as shown below:
- January – rates maintained
- March – rates increased 50 basis points
- May – rates increased 50 basis points
- June – rates increased 75 basis points
- July – rates increased 75 basis points
- September – rates increased 75 basis points
- November – rates increased 75 basis points
- December – rates increased 50 basis points
These rising rates have caused some business owners to rethink their plans to finance an acquisition or buyout. In a recent webinar, Marc Chandler, Chief Market Strategist with Bannockburn Global Forex and Alicia Chandler, President of Oak Street Funding, addressed these concerns and provided insights.
Implications of the FED rate increases
The implications of the rising rates will have a varied impact on the insurance, CPA, and RIA industries. According to Marc Chandler, Chief Market Strategist with Bannockburn Global Forex, “The cumulative effect of the tighter monetary and fiscal policies has not yet worked its way through the economy. The Federal Reserve will likely continue to raise interest rates through at least the first quarter of next year. As a result, the recession that may have been avoided in 2022 looks bound to come to the US (and Europe).”
Because of this, insurers may see a decrease in the number of policyholders as households drop coverage in an effort to save money. Insurance agents will need to market their non-monetary value to retain clients who may seek a less expensive option due to rising costs. CPAs will likely see rising costs and fewer opportunities to increase revenue from 2022. A few clients may forego services to save money while others will continue to seek advice on managing their P&Ls and navigating complicated taxes. In the RIA industry, concerns about lower trading activity on the stock market have led to a sudden drop in M&A activity. Clients will likely take a more cautionary approach to their investments and diversification will become even more important to mitigate risk.
The Federal Reserve has committed to slowing the economy down and legislators are tightening the fiscal policy. “In 2021, the U.S. had a budget deficit of 10.5% of GDP. This year, it is likely to fall to 4.5%,” said Marc Chandler. Additionally, the last three recessions in the U.S. were preceded by a doubling of oil prices and we are again seeing high oil prices around $90 a barrel, up from $50 a barrel in January 2022. “Unfortunately, the Federal Reserve cannot control the supply side, so they are tightening the demand side by raising interest rates to lower demand. Economists call this demand deconstruction and I believe this will lead to a recession in the latter half of 2023,” said Marc Chandler. This will impact CPA and RIA clients who will seek advice on managing their investments or P&Ls to mitigate loss. Insurance agents will need to market their non-monetary value to retain clients who may seek a less expensive option due to rising costs.
Impact on Lending
With this in mind, some business owners are wondering if they should pause on plans to finance succession or acquisition. Valuations have not yet showed signs of decreasing and according to Bain & Co, 2022 M&A should fall short of a record-breaking 2021, but it will likely still be one of the strongest markets of the past 20 years. This is likely because M&A remains one of the top ways to add new services or products to strengthen market position. Business owners who want to continue with plans for M&A in 2023 can explore creative ways to financing deals.
“To combat the rising interest rates, we’ve seen more creative seller notes or earnout structures. We’re adjusting our underwriting process to address these adjustments and help our clients adapt to the current environment,” explains Alicia Chandler. For example, previously when rates were lower, a standard acquisition payout might look like the following.
Example of a standard acquisition payout
Today, we have seen more deals where the seller is willing to accept a longer-term seller note or earn out, or even accept less up front with a larger potential earnout on the back side as shown below.
Example of an acquisition payout with longer-term seller note
Instead of a three-year payout structure, the seller may be willing to accept a five-year payout. Additionally, the seller can take an earnout instead of a set payout. This means the seller payments are based on the performance of the business. Thus, if the business meets agreed upon performance metrics, the seller receives a payment. This helps ensure there are funds available to pay the seller.
How to prepare for 2023
With creativity and perseverance, prudent business owners will continue to leverage debt to build equity. Business owners should not freeze just because interest rates are higher. In preparing for 2023, business owners can:
- Evaluate opportunities for M&A and continue to pursue growth when the benefits of the merger or acquisition outweigh the cost of debt.
- Continue to plan for succession. There will always be a reason to put your plans on hold but stick to the plan to be prepared should a crisis arise. Consult with advisors and financial partners to ensure the plan accounts for as many scenarios as possible.
- Maintain financial records. When it is time for an acquisition or working capital loan, having clean, accurate financial records will make the lending process smoother. A recession may require a tightening of the books which is even more reason to be diligent in record keeping.
- Build a strong relationship with financial partners. If you do not plan to leverage debt in the near future, it is still important to build a strong relationship with your financial partners. Then, when you are ready to pursue an opportunity, you will have eliminated the time searching for a funding source.
Disclaimer: Please note, Oak Street Funding does not provide legal or tax advice. This blog is for informational purposes only. It is not a statement of fact or recommendation, does not constitute an offer for a loan, professional or legal or tax advice or legal opinion and should not be used as a substitute for obtaining valuation services or professional, legal or tax advice.