The Verit View – October 2013
Valuation Ripples – The Recent Sharp Rise of U.S. Long-Term Treasury Interest Rates
Verit Advisors’ view is that the recent rise, and the anticipation of further rises, of long-term interest rates presents valuation headwinds for private companies. Concurrently, short-term interest rates remain extremely low and are likely to remain low for a considerable period of time. This creates an interesting opportunity to consider financing ownership transition, growth, or liquidity transactions utilizing low cost bank financing.
The Recent Spike in Long-Term Interest Rates
30-year and 10-year treasury bond interest rates have recently spiked up over one percentage point and are near 2013 highs, currently trading in the 3.7% area for the 30-year and the 2.7% area for the 10-year. The recent increases in rates have largely held thus far despite the surprise announcement on September 18th that the Federal Reserve would not reduce the amount of large scale asset purchases (also known as quantitative easing) which had succeeded in driving 30-year and 10-year treasury yields to 30 year lows this year around 2.5% and 1.5% respectively. Long-term treasury interest rates appear at an inflection point and could possibly be at the beginning of a long-term uptrend in interest rates after a 30 year plus downtrend.
Implications for Private Business Valuation
The impact of rising long-term interest rates for business valuation is analogous to rowing a boat upstream. Valuation methodology for private businesses typically consists of an income approach and a market approach. A rise in long-term interest rates directly impacts the valuation results from an income approach discounted cash flow analysis unless offset by other critical assumptions, such as an increase in expected future earnings expectations. A 1.0% rise in long-term treasury rates would, in the near term, typically translate into a 1.0% rise in the long-term cost of capital which would place downward pressure on value. A business with a 10.0% cost of capital which experiences an increase in its cost of capital to 11.0% would experience an approximate 10% drop in value from an income approach calculation. A business moving from a 15.0% cost of capital to 16.0% would experience an approximate 6.0% drop in value. A series of long-term annual increases in long-term interest rates could place continuous downward pressure on business valuation.
Positive Financing Environment for Middle Market Borrowers
The Federal Reserve controls short-term treasury rates. 90-day treasury rates are effectively near zero percent and have been for nearly five years. Current market participants do not expect the Federal Reserve to raise short-term interest rates until at least 2015 and interest rate increases would not likely take place until after the cessation of quantitative easing. Banks are eager to lend to deploy capital and raise earnings. The competitive landscape creates pricing pressure, benefiting borrowers. With the combined data points of an interest rate environment that supports valuations, although with potential headwinds, and a lending environment with access to competitively priced capital, we believe it makes sense to consider financing ownership transition, growth, or liquidity transactions.
As always, it is Verit’s vision to bring a fresh approach and customized solutions to advise private business owners on ownership transition.