Inflation and Rising Interest Rates: Considerations for ESOP Companies

Supply chain disruptions, labor shortages and increased transportation costs are all contributing to record-high inflation. Coupled with the recent increases in the Federal Reserve’s target interest rates and continued inflationary headwinds, ESOP companies face several implications that its stakeholders—including employees, management, advisers and lenders—should consider.

A rising interest rate and inflationary environment will likely have a downward impact on valuations. For starters, the increased cost of debt results in higher discount rates (thanks to higher risk premiums and required rates of return) used in valuation techniques, which drives down valuations. Also, as interest rates increase, investors tend to shift their focus to the bond market, where they can find meaningful returns with less risk. This leaves less capital flowing to equity markets, leading to subsequent declines in stock valuations. The increased cost of interest expense erodes cash flow, which can also negatively impact stock valuations.

When inflation rises, many companies at least temporarily experience margin compression as they work to pass the increased costs to their customers. Generally speaking, the quicker a company can pass price increases to their customers, the better the company’s cash flow will be, minimizing the impact on its valuation.

Finally, higher inflation changes consumer behavior, which means companies could suffer a drop in revenue as customers cut back on purchases and prioritize necessities such as food and gas.

A decline in a company’s stock price has positive and negative impacts for different stakeholders. All else being equal, a lower share price would likely decrease repurchase obligation payouts since the value of the shares repurchased would be lower. This reduced cash outflow can be beneficial to a company’s cash and leverage position, partially offsetting the drop in the stock price.

Another potential effect of falling stock prices is an increase in diversification for the employee base, as shareholders seek investments with higher potential returns outside of the ESOP. Additionally, as inflation increases the cost of living, employees may have immediate cash needs and opt for an earlier retirement payout.

Companies could benefit from an updated independent repurchase obligation study that evaluates the impact of the current interest rate market dynamics and ensures liquidity is sufficient to cover all near-term obligations.

The value of synthetic equity, such as warrants and stock appreciation rights, or SARs, would also be impacted by a change in a company’s valuation. Companies should consider the impact that a decline in the value of any management incentive plan could have on key employees and their incentives to drive performance. Warrants are typically issued at the time of the transaction in order for the seller notes to have an all-in return that is commensurate with where the notes sit in the capital structure. If the warrant value declines, this could result in a return that is less than the risk the noteholders are taking.

The M&A market in 2021 was exceptionally strong, with an 86% increase in total transaction value and a 35% increase in transaction volume compared to 2020 . Inflation and the monetary policy response have the potential to dampen M&A activity broadly, including deal activity for ESOP companies.

The tightening monetary policy response to inflationary pressures is likely to result in lower valuations of any M&A target across all sectors. On one hand, this presents a unique opportunity for ESOP companies that are cash rich and generating strong free cash flow to make acquisitions at attractive entry valuations. Additionally, rising interest rates may make it more costly to finance an acquisition with debt, benefitting ESOP companies with strong cash positions or the ability to borrow at more favorable interest rates. However, lower valuations may cause owners who are considering a sale to pause and wait for market conditions to rebound.

Given that the Fed has indicated it will continue to raise interest rates aggressively in the near term, it may be wise for companies to evaluate their market risk exposures, including their fixed and floating debt mix. Hedging removes the uncertainty around a business’ cost to borrow. Interest rate swaps, for example, could be an appropriate consideration. Borrowers should evaluate their expected time frame to de-lever when exploring their hedging options.

Given ESOP’s tax-efficient structure, these companies often prepay their debt, and it may not be prudent to hedge 100% of the senior bank facilities. That’s why in periods of heightened volatility, a layered or tranched hedging strategy may be a reasonable option.

The current environment may be the right time to refinance seller notes or other high-interest debt with traditional (and potentially fixed-rate) debt ahead of looming interest rate increases. Conversely, higher rates on senior financing may bring the cost of debt closer to that of subordinated debt. For ESOPs with lower-priced, friendly seller debt, a refinancing strategy may be more attractive in today’s environment than one with more expensive seller financing.

When evaluating various strategies to offset the headwinds driven by higher inflation and rising interest rates, it’s important for ESOP companies to consider the potential impacts. Communicating with your key partners and trusted associates—employees, industry peers and your financial providers—can help you navigate this evolving economic climate.