Inflation and interest rates are two important economic indicators that can significantly impact the Mergers & Acquisitions (M&A) environment.

In the past year, we have seen the United States Federal Reserve System (US FED) increase interest rates, resulting in a domino effect throughout all economies. A few days later, the South African Reserve Bank (SARB) announced its interest rate hike. Just last week, SARB announced an interest rate hike of 50bps, effective 31 March 2023. This is off the back of the FED increasing interest rates the week before, with top economists indicating that the FED will increase rates again in the near future.

In a nutshell, central banks use interest rates as a tool to manage inflation and keep it at a healthy, steady rate.  As such, interest rates and inflation generally move in the same direction, however, with some lags. Basic supply and demand principles are mirrored in this relationship.

Central banks are often mandated to keep inflation at a steady rate. However, this is a challenging job, and they may be required to adjust short-term interest rates to keep inflation within targeted levels. When inflation diverges from the targeted long-term trend, central banks will adjust monetary policy (through adjusting short-term interest rates) to realign inflation with the targeted trend.

When inflation is above the central bank’s target rate, the central bank will employ a more restrictive monetary policy by increasing short-term interest rates.

This increase in short-term interest rates is aimed at slowing down economic growth and, in effect, causing inflation to revert back to the long-term target level.

On the other hand, when inflation is below the steady rate that the central bank has targeted (i.e. people are not spending money/economic growth is slowing down), the central bank tends to employ a loose monetary policy, resulting in a decrease in short-term interest rates.

This decrease in short-term interest rates is aimed at stimulating economic growth, which in turn, results in an increase in inflation back to within the target ranges set.

As mentioned above, increasing inflation ultimately results in an increase in short-term interest rates.

This increases the cost of financing, which has a detrimental impact on transactions funded through debt. It can make it more difficult for companies to fund M&A deals, as their borrowing cost will be higher. This can, as a result, lead to a decrease in M&A activity as companies have less access to capital and might not be able to afford new acquisitions. Companies may be more cautious and less likely to take on investment opportunities.

In addition to the above, as inflation and short-term interest rates reach a peak, it’s generally indicative of a movement to the contraction phase of a business cycle.

During this phase, companies/stocks tend to underperform, and this uncertainty of future economic prospects introduces an additional risk for parties looking to enter into M&A transactions.

The COVID-19 pandemic caused a significant decline in consumer spending and luxury retail sales (which ultimately resulted in decreased Inflation).  This contraction phase of the business cycle had a significant impact on retailers’ financial performance, one being Tiffany & Co. Prior to the challenges faced in the pandemic, Tiffany & Co. was already facing some challenges, which included increased competition and slowing sales growth.

The largest luxury goods company, LVMH Moët Hennessy Louis Vuitton SE, announced a  $16.2bn acquisition deal with Tiffany & Co. in November 2019. However, due to Tiffany & Co’s underperformance and the uncertainty caused by the pandemic, LVMH attempted to renegotiate the terms. LVMH delayed the deal in September 2020, citing a request from the French Government to delay the deal until January 2021. However, Tiffany & Co. disputes this, as the two companies had agreed to close the deal in November 2020. In January 2021, LVMH ultimately confirmed the acquisition of Tiffany & Co., valued at $15.8bn, after multiple negotiations and legal disputes and after almost a year after Tiffany & Co.’s shareholders voted to approve the merger back in February 2020.

The near collapse of the LVMH-Tiffany deal highlights the challenges of completing M&A transactions during periods of economic uncertainty and business cycle contraction. Financial performance can be unpredictable, and companies may underperform, making it difficult to value target companies accurately and negotiate favourable deal terms. This introduces additional risks and complexities for parties looking into M&A transactions.

However, although the correlation between monetary policy and business cycles is apparent, predicting the period of each phase of the cycle and how markets will react is subject to far greater uncertainty.

Ultimately, the relationship between inflation and interest rates is multifaceted and complex and, as mentioned above, can significantly impact the M&A environment.

Companies should be cognisant of these economic indicators, including the effect it is having on the deals space. These economic indicators might affect their ability to finance and complete M&A deals.

It will be interesting to see what the Central Bank’s next moves are concerning interest rates, whether they will stimulate growth or continue to slow it down, and the potential domino effect this will have across the globe’s economies.