How Interest Rates Impact Practice Values

One of our newsletters from last summer discussed the role of interest rates in M&A primarily from the standpoint of acquisition activity. We think now is a good time to reprise the subject, only this time we'll focus on their relationship with practice values.

Interest rates and valuations have an inverse relationship; the lower the interest rate, the higher the value. We've witnessed record highs for practice valuations the past few years, and there is no doubt they've been aided by the low interest rate environment in which we've lived since the recession.

While mortgage rates and 30-year treasury rates have risen, both the Prime Rate and the Federal Funds Rate have remained unchanged since 2008. Many large corporations can borrow at rates slightly above the Federal Funds Rate, effectively making capital available to them for free. In analyzing practice values, those at the high end of the range are influenced by hearing aid manufacturers who either purchased the practice directly or funded a third party acquirer. While it's commonly believed that manufacturers are paying cash for practices - and they do make hefty cash payments at closing - in reality they utilize leverage (e.g. debt) to fuel their transactions.

As borrowing becomes more expensive, valuations begin to feel pressure as buyers can no longer afford to pay as much. Simply put, the more they have to spend on interest, the less they have left over to spend on principal payments. Think of the last time you bought (or re-financed) a house. An interest rate change of only 1-2% can result in a swing of several hundred dollars per month in your mortgage payments - and that's on a 30-year mortgage. Imagine the impact on a 5-, 7-, or 10-year note.

Everyone wonders how long acquisition activity and valuations will remain at their current levels, and while there are several contributing factors, interest rates play a critical role in the overall M&A landscape. Interest rates are certain to rise, the only question is when. Last week, the Federal Reserve suggested that rates would remain near zero for the foreseeable future, meaning that no change is likely before the end of this year.

When rates begin to rise, they are likely to do so gradually, but steadily. The impact may be felt as early as 2015 or as late as 2017. Regardless, as it happens, buyers will no longer be able to afford the multiples they are paying today. Bottom line: if you're contemplating a transaction as either a buyer or a seller, the longer you wait the tougher the environment will become.