The economy may be slowing. But there’s good news for investors who are worried about rising interest rates, says First National Bank’s Boyd Pethel.

“Even though we saw four upticks in 2018, the interest rates are still extremely low,” says Pethel, who oversees metro commercial banking for FNB’s Cleveland, Pittsburgh and mid-Atlantic markets. “If you look at the average rates compared to where they have been historically, they are still below the average, even going back as far as World War II. It puts into perspective just how low today’s rates are.”

The Federal Reserve may not only delay further rate hikes in 2019, he says, we could be looking at an interest-rate cut. What does this mean for dealmakers?

This week, Pethel discusses the outlook for M&A investors, creative financing solutions and how to protect against market volatility.

Let’s make a deal

Pethel says deal activity is being driven by two factors: The cost of capital — especially senior debt — is cheap, and interest rates are still historically low.

“You have a lot of capital out there, other means of capital besides debt,” he says. “You also have private equity dollars and junior capital sources like mezzanine financing on the sidelines looking to be deployed; and you’ve got banks hungry for the right kinds of opportunity. All those things lend themselves to an active deal flow landscape.”

Companies looking for additional debt would be wise to get their financial houses in order before getting too far down the road.

“You should work with a good accounting firm and provide full transparency as it relates to financial performance on a historical basis, and then full engagement as it relates to the due diligence process when looking at the opportunity,” Pethel says. “That could be an acquisition, a plant expansion or an equipment purchase.”

In any M&A activity, you want to have your banker, your accountant and your attorney on the same page, says Pethel.

“If I’m a business owner, the best thing I can do is make sure that my partners are working aligned and collaboratively,” he says. “Everybody is going to know a piece of the equation better. The banker hopefully understands the debt side. The attorney understands documentation, how we cross the t’s and dot the i’s, and deal structure. The accountant is going to understand the tax impact side and how it affects the audit. The best scenario is when those partners are working together for the good of the client.”

Creative bank financing

The future as it relates to the economy, interest rates and the yield curve changed at the end of 2018.

“When the expectation is that rates are going higher, that is generally proof that things are going in the right direction and we’re healthy enough where we can bump rates up a bit,” Pethel says. “That has changed. When we got into December and toward the end of the calendar year, that yield curve began to flatten and it’s very flat today. The expectation via the financial market forecast is that rates will continue to stay flat.”

The benefit of a flat yield curve is that financial products become less expensive.

“Let’s say you’re expanding the plant, buying some equipment or embarking on an acquisition,” Pethel says. “You can actually lock in your rate to begin X number of months from now. We’ll lock that rate in for six, nine, 12 months or as far as two years from now. That’s just one of many examples where a bank could be creative and strategic as it relates to mitigating interest rate volatility.”

In instances where the need for capital extends beyond the lender’s comfort zone, mezzanine financing can be an effective solution, Pethel says.

“If the need for capital exceeds that maximum leverage amount for a bank, the bank can bridge that gap by introducing mezzanine capital that is going to provide that additional turn or two of leverage,” he says. “The borrower will finance that end of it. It’s going to come with a higher coupon — it’s going to be a bit more expensive. But it’s not going to be as expensive or dilutive as equity.”

As you think of the capital stack, debt is always going to be the least expensive option.

“Companies looking to acquire another company or a sponsor only want to put so much equity into a deal,” Pethel says. “A bank only wants to put so much debt into a deal. Sometimes there is a gap between those two that can be bridged with mezzanine financing. If I were to point to an arena where we’ve seen it used the most, it’s in that M&A space.”

Related post: First National Bank’s Boyd Pethel talks about the importance of financial transparency.