How Interest Rates Affect M&A Volume (And How to Explain It in an Interview)

"How do interest rates affect M&A activity?" is one of the most common market questions in banking interviews. The short answer is that higher rates usually slow M&A down, and lower rates usually speed it up.

The interviewer won't stop at the short answer, though. They want to know why, whether you can show it with numbers, and whether you understand that rates are only part of the story. This post walks you through all of that, with worked examples you can use on the spot.

The Short Version

Rates affect deal volume through three main channels:

• Cost of financing: debt gets more expensive, so leveraged deals get harder to make work.
• Valuations: higher discount rates push down what buyers are willing to pay, while sellers still anchor to older, higher prices.
• Deal math: cash deals funded with debt become less accretive, or even dilutive.

On top of that, rising rates often come with economic uncertainty, which makes CEOs and boards more cautious. Let's go through each channel.

Channel 1: Debt Gets Expensive, and LBOs Feel It First

Private equity firms fund a big chunk of every buyout with debt. That debt is what juices their equity returns, so when it costs more, the whole model gets squeezed.

There's an important detail here. Leveraged loans are typically floating rate, priced as a benchmark like SOFR plus a spread. When the central bank raises rates, the interest bill on those loans rises almost immediately.

A Worked LBO Example

Let's keep the numbers simple and hold everything flat so you can see the rate effect in isolation.

• Target EBITDA: $100M
• Purchase price: 10x EBITDA = $1,000M
• Financing: $600M debt, $400M equity
• Cash available for debt service each year (after capex and taxes, ignoring the interest tax shield for simplicity): $60M
• Exit after 5 years at the same 10x multiple: $1,000M

Scenario A: 5% interest rate

• Annual interest: 5% × $600M = $30M
• Cash left to repay debt: $60M − $30M = $30M per year
• Debt repaid over 5 years: $150M, so remaining debt = $450M
• Equity at exit: $1,000M − $450M = $550M
• MOIC: $550M / $400M = 1.375x, or roughly a 6.6% IRR

Scenario B: 9% interest rate

• Annual interest: 9% × $600M = $54M
• Cash left to repay debt: $60M − $54M = $6M per year
• Debt repaid over 5 years: $30M, so remaining debt = $570M
• Equity at exit: $1,000M − $570M = $430M
• MOIC: $430M / $400M = 1.075x, or roughly a 1.5% IRR

Same company, same purchase price, same exit. Just changing the interest rate wipes out most of the return. (Real deals assume EBITDA growth, so the absolute returns would be higher, but the gap between the scenarios is the point.)

Interest coverage tells the same story. EBITDA divided by interest falls from 3.3x to about 1.9x, and lenders get nervous at levels like that. They respond by lending less, which means the sponsor needs more equity, and that drags returns down even further.

What the Sponsor Does Next

To get back to an acceptable return, the PE firm has a few options:

• Bid less for the company
• Use less leverage and put in more equity (which lowers returns)
• Walk away

All three mean fewer deals get done.

Channel 2: Valuations Drop, and Buyers and Sellers Stop Agreeing

Higher rates raise the cost of capital, and a higher cost of capital means future cash flows are worth less today.

A Quick DCF Example

Take a business with $100M of free cash flow growing at 2% forever. Using a simple perpetuity formula (FCF divided by discount rate minus growth):

• At an 8% WACC: $100M / (8% − 2%) = ~$1,667M
• At a 10% WACC: $100M / (10% − 2%) = $1,250M

A two-point increase in the discount rate cuts the value by 25%. Nothing about the business changed.

The Bid-Ask Spread Problem

This is where volume really dies. Buyers update their models and offer the lower number. Sellers remember what similar companies sold for a year or two earlier and refuse to accept it.

When the gap between what buyers will pay and what sellers will accept gets too wide, deals simply don't happen. Bankers spend a lot of time in these periods on creative structures, like earnouts or seller financing, to bridge that gap.

Channel 3: Accretion/Dilution Gets Harder

This one connects directly to a technical question you might get in the same interview.

A quick rule of thumb: an all-debt deal is accretive if the after-tax cost of debt is lower than the target's earnings yield (the inverse of the P/E you're paying).

Worked Example

Say the acquirer pays 15x earnings for the target. The earnings yield is 1 / 15 = 6.67%. Assume a 25% tax rate.

• Debt at 4%: after-tax cost = 4% × (1 − 25%) = 3.0%. That's well below 6.67%, so the deal is accretive.
• Debt at 9%: after-tax cost = 9% × (1 − 25%) = 6.75%. That's just above 6.67%, so the deal is now slightly dilutive.

Same target, same price. Higher rates flipped the deal from clearly accretive to dilutive. Boards don't love announcing dilutive deals, so they hold off or switch to stock as the currency.

Strategic Buyers vs. Financial Sponsors

Rates don't hit every buyer equally, and pointing this out in an interview shows real understanding.

• Private equity is the most rate-sensitive because its model depends on leverage.
• Large strategic acquirers with strong balance sheets, lots of cash, or highly valued stock can keep doing deals. They may even find better opportunities when PE competition backs off.
• Stock-for-stock deals sidestep the financing issue entirely, though they come with their own problems if share prices have fallen.

A Real Cycle to Reference

You don't need precise figures to make this point, just the shape of the cycle:

• 2021: Rates were near zero and M&A had a record year globally, driven heavily by sponsors and cheap debt.
• 2022 to mid-2023: The Fed raised rates from near zero starting in March 2022, reaching a range of 5.25% to 5.50% by July 2023. Deal activity fell sharply, and leveraged buyouts were hit especially hard.
• September 2024: The Fed began cutting rates, and the conversation shifted to whether a dealmaking recovery would follow.

Mentioning this timeline makes your answer feel grounded in actual markets rather than theory.

Rates Aren't the Whole Story

Here's the nuance that separates good answers from great ones. Rates matter a lot, but they aren't the only driver.

• Volatility and uncertainty often matter more than the level of rates. Buyers can price a deal at 6% if they're confident it stays at 6%. What freezes markets is not knowing where rates are headed.
• CEO confidence and the broader economic outlook drive strategic deals.
• Equity markets matter, since strong stock prices give acquirers a valuable currency and make sellers feel richer.
• Regulation and antitrust scrutiny can block or delay large deals regardless of financing conditions.
• Credit availability matters alongside price. If banks pull back but private credit funds step in, leveraged deals can still get financed.
• Dry powder: PE firms with lots of uninvested capital face pressure to deploy it eventually, which can push activity up even when conditions aren't ideal.

How to Answer in an Interview

Keep it structured and under a minute. Something like this:

"Generally, higher rates reduce M&A volume, and lower rates increase it. There are three main reasons. First, financing costs rise, which hurts leveraged buyouts the most, since leveraged loans are usually floating rate and higher interest leaves less cash to pay down debt, which lowers returns. Second, higher discount rates push valuations down, which widens the gap between what buyers will pay and what sellers expect. Third, debt-funded deals become less accretive. That said, rates aren't the only factor. Uncertainty about where rates are going, CEO confidence, equity markets and regulation all matter too, and strategic buyers with strong balance sheets are less affected than private equity."

Then be ready for follow-ups:

• "Walk me through how higher rates affect an LBO." Use the interest and debt paydown logic above.
• "Would you rather do a cash or stock deal right now?" Tie it to the cost of debt versus the acquirer's P/E.
• "What's happening in the M&A market today?" Read the financial news in the days before your interview so you can talk about the current rate environment with confidence.

The Bottom Line

Rates move M&A volume by changing what deals cost, what companies are worth, and whether the numbers work for the buyer. Learn the three channels, practice the LBO and accretion examples until you can do them in your head, and always add the nuance that uncertainty and confidence matter as much as the rate itself.

Nail that, and you'll turn a standard market question into a chance to show you actually think like a banker.