Impact of macroeconomic factors on M&A

by Raghu Marwah and Parul Goel

Mergers and acquisitions (M&A) have a major effect on the world economy as a whole. As a significant tool, M&A helps organisations expand into new markets, diversify business activities, and achieve cost synergies through economies of scale. A whole host of macroeconomic variables, including interest rates, inflation, market sentiment, and economic growth, are critical in influencing M&A activity.

Interest rates

Interest is the monetary charge for the privilege of borrowing money, typically expressed as an annual percentage rate. (Source: Investopedia)

In case of low interest rates, borrowing becomes cheaper, and it becomes feasible for companies to finance transactions through leveraged buyouts. Higher interest rates discourage companies from engaging in such transactions, as the valuation goes for a toss (becomes of little to no value) because the discount rate used for valuing the company is affected by prevailing interest rates. In such scenarios, companies start opting for a different capital structure consisting of more equity than debt. Companies with strong reserves and surplus tend to pursue acquisition in such a scenario.

Inflation

Inflation is the rate of increase in prices over a given period of time. (Source: International Monetary Fund)

As inflation rises, businesses' input, labour and operating costs rise as well. Profit margins may decline as a result, which may lower the valuation of prospective targets and make them less desirable acquisitions. Different industries respond to inflation differently. Because they can pass costs on to customers, utilities and consumer staples, for instance, might do better than discretionary industries.

Market sentiment

Market sentiment refers to overall perception of investors towards a market.

Valuations can rise as a result of positive sentiment, which also motivates businesses to make aggressive acquisitions in order to expand their operations. Conversely, negative sentiment can lead to decreased values and increased risk aversion, which hinders M&A activity and makes funding more difficult. Furthermore, regulatory agencies may scrutinise planned mergers more closely during pessimistic times, making clearance procedures more difficult.

Economic growth

Economic growth refers to an increase in the size of a country's economy over a period of time. The size of an economy is typically measured by the total production of goods and services in the economy, which is called GDP. (Source: Reserve Bank of Australia)

Times of economic growth are usually when businesses enjoy good profitability ratios, increasing market confidence to pursue deals in a bid to gain market share and to profit under prevailing market conditions.

Strong economic growth drives higher valuations of acquisition targets and facilitates access to capital. However, during times of economic recession, stability and cost-cutting concerns tend to dominate.

In essence, M&A activity is highly cyclical, often peaking during periods of economic expansion and lower interest rates, and slowing during downturns. Macroeconomic factors create a foundational backdrop that companies must navigate, making them crucial considerations in M&A strategy and timing.