On July 12, 2017, the Bank of Canada raised its overnight lending rate to 0.75 per cent from 0.5 per cent. This was the first such increase in almost 7 years, after a prolonged policy of fiscal stimulus in the wake of the economic recession.

While the need for an interest rate hike in the current economic climate is certainly contentious, the fundamental effects of rising interest rates are well known. At a macro level, borrowing and spending cash becomes more expensive, and saving becomes relatively attractive. The effect of an interest rate hike on M&A activity has been discussed on this blog previously. However, in 2017 we now have a present-day testing ground in the United States, whose Federal Reserve raised the current federal funds rate to 1.25% in June. The June announcement was the latest in a series of rate hikes that began in September 2015, when the Federal Reserve increased rates from 0.25% to 0.5%.

The U.S. experience

The effect of these rate hikes on U.S. M&A activity has been… negligible. According to MergerMarket’s Deal Drivers Americas 2016 report, the overall drop in M&A activity in 2016 has primarily been attributed to global political and economic uncertainty, as well as the high standard set by a record-breaking 2015. The same publication cited the cost of money – still low by historic standards – as a factor that had actually promoted dealmaking. One top U.S. banker explained the market’s apparent ambivalence towards the interest rate hikes as follows:

Interest rate hikes signal that an economy is alive and well, and recovering, which gives confidence to dealmakers to engage in transactions. Even though interest rates are going up, they’re going up at such a gradual rate that they are not impacting the fundamental cost of funding.

One commentator on Forbes offered a parallel explanation:

Many companies in the market to buy are armed with strong balance sheets that are loaded with cash, not merely from continuing operations, but also from having taken advantage of low market interest rates to issue debt. The more cash potential acquirers have on hand, the less need there is to borrow to complete a deal.

Implications for Canada

The U.S. experience above suggests that the Bank of Canada’s interest rate hike won’t cause any dramatic changes in Canadian M&A activity. The cost of capital will remain low for the near future. That being said, the rate hike is an historic signal that the economy may be shifting gears. With the long-term prospect of more expensive loans, buy-side dealmakers should be cognizant of alternatives to debt-financed transactions. Furthermore, future buyers should consider building their “war chests” now, in anticipation of opportunities that may arise in a market where funding is more expensive. Sell-side players should be aware that they may encounter downward price pressure, especially in larger transactions where debt finance is difficult to avoid.

The author would like to thank Eric Vice, Summer Student, for his assistance in preparing this legal update.

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