Fed Rate Hikes and SBA Loans for Small Business M&A

In our November 2022 episode of Private Market Insights, we covered the impact of the FED rate hikes and SBA loans on the broader small business ecosystem and the M&A activity moving forward. With the FED raising interest rates by 75 basis points the day before this conversation (and by 50 basis points in December 2022!), this was a timely topic in the SMB world, and we expect it will continue to be important for our ecosystem going forward as well.

Our guest was Jared W. Johnson, Vice President at First Internet Bank, who has extensive first-hand experience in SBA loans for business acquisition. FIB specializes in nationwide lending solutions for small businesses, with Jared serving as a business acquisition specialist that provides customized solutions to clients nationwide.

As an SBA lender, he is well-positioned to understand the impact of a rising rates environment on lending solutions, and the overall SMB acquisition process. Jared was recently named SBA BDO of the year by Coleman Publishing and regularly deals with business acquisition financing between $350,000 and $10,000,000. We invited him to offer us his insights from the lender perspective, a very important role in the process of leveraged SMB acquisitions.

Check out the full episode here, or on your favourite podcast platform:

Impact of the Fed rate hikes on SMB acquisitions

Interest rates have a pronounced effect on SBA lending and dealmaking in the SMB space. As rates increase, businesses can become less willing to take on additional debt, and bank lending to SMBs tightens. In contrast, low rates make borrowing more attractive and can encourage M&A activity as buyers have greater access to capital.

Jared noticed that buyers accustomed to 2021 and early 2022 interest rates have experienced some shock upon finding out that rates now are close to 10% for an SBA loan. However, he expects the market to adjust since neither buyers or sellers have any impact on FED decisions. There is general hope that the FED will slow the rate or intensity of rate hikes to assess their effect on curbing inflation. While high interest rates may have a cooling effect on the industry’s activity, Jared doesn’t expect that impact to be substantial. Even with the uncertainty of 2022, the number of transactions in our market remains high. Certainly, it is not the same situation as in 2020, when the pandemic led to a significant drop in both lender and seller activity. 

Current context and potential risks

On the buyer side, the Covid-induced pause in the middle of 2020 was a turning point for many current buyers who come from corporate America. As many transitioned to remote work and enjoyed strong investment returns, this change in circumstances offered entrepreneurs a change in perspective on their careers, with many deciding to pursue SMB acquisitions. At the same time, after an initial pull-back from the market, sellers got back to their initial plans.

On the macro scale, Jared expects that the recent increase in home sales due to very low rates means that another great recession is unlikely. With many new homebuyers locked into attractive interest rates, the core financial situation of regular Americans is in better shape than in 2008. That being said, Jared pays attention to two possible risks:

  • The first is that the banks could start getting nervous with economic uncertainty leading to tighter credit approvals, which in turn could dampen activity in our market. Additionally, tighter access to traditional loan structures could prompt an increase in “more creative” financing solutions, which increases the riskiness of the system overall. Some lenders get into the SBA world thinking these loans are like mortgages, which they are not.
  • Another real risk is the potential for continuous FED rate increases, which can lead to a stale SMB acquisition market, with both buyers and sellers waiting out for better financing conditions. Frustratingly, this is a real possibility despite a weak 2022 for stock market and real estate investors. The combination of reduced wealth and high rates could have a double-cooling effect. However, buying a business still has one of the highest returns one can get, even with a 9% to 10% interest rate.

All in all, despite the current interest rate hikes, the situation seems stable for now. Jared is confident that buyers will continue to access SBA loans for business acquisition, a sentiment that aligns with current broker expectations as well. Jared mentioned that the biggest change we’re likely to see is a reduction in seller price multiples so that acquired businesses’ cash flows can cover debt payments.

Advice for buyers and sellers

The lender plays a very important part in acquiring an SMB through an SBA loan, a process that is both long and emotional. Jared notes that buyers and sellers must go through a variety of steps to close a transaction, each of which can present challenges. Within this context, Jared recommends working with SBA lenders who have deep experience in the industry. Lenders who are unable to adjust to shifting conditions may lack the speed or flexibility to get your deal done quickly. Changing a lender at the last minute can create a situation where sellers lose momentum and the deal dies. With emotions running high, sellers are often looking for an escape hatch at the end of deal negotiations, and any sign that a buyer is unable to close the deal could kill it completely. 

Jared discussed how buyer and seller emotions change throughout the acquisition process. In his experience, momentum is strongest for sellers when they get their business listed and offers start flowing in, while for the buyers the initial agreement seems to excite them the most. From that moment on, there are ups and downs, and sellers can get nervous as the initial excitement dissipates. Selling a small business is a life changing decision, which naturally creates fear and doubt. New questions may arise for them: Will they be able to retire? Is this the right price? These feelings only accelerate during the due diligence process as accountants, lawyers, and other experts dissect the business and its operating history. 

Bonus: Potential changes in the lending process with huge impact on the SBA world

Among the most fascinating insights from Jared came at the beginning of the episode as a side note, when he talked about the rules lenders need to follow to make sure the loans they provide are eligible for financing. This guidance changes periodically, in cooperation with the lenders. Some of the current proposed changes could have a sizable impact. 

Specifically, it is highly possible that the new rulebook will remove current language that prohibits the use of an SBA 7a loan to fund a partial acquisition or buy out. The current rules require a buyer to acquire 100% of a target company, creating material constraints on the number and types of transactions that can be financed through this method.

This is particularly true in industries that have professional licensing requirements. As an example, for a construction, HVAC, or electrical contracting company, the SBA rules preventing partial acquisitions reduces the pool of potential buyers. Any buyer that lacks the proper licenses going into the transaction would face a potential interruption in the company’s ability to do business in the event that its license lapses upon the owner’s exit. If partial acquisition rules are relaxed, the current owner could maintain a portion of the company’s equity in an acquisition, maintaining their license and therefore avoiding such interruptions. Currently, the parties are trying to assess the real impact of this major change. Important questions remain, including: who would have to be a guarantor in a partial buyout? What can be done with the funds – can they go to the seller or do they have to be put into the business? 

This article only covers the highlights of our conversation with Jared, so be sure to check out the full episode, including a lively Q&A with members of the community. Our goal is to ensure that entrepreneurs have access to the services and knowledge they need as they evaluate SMBs as part of their acquisition process. Tune in to our next episode on our Spaces every month, ask questions and let us know what topic and/or guest you would like us to bring to the next conversation!

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