In today's inflationary markets, the cost of capital remains high. Estimates suggest that the cost of equity is around 9% to 14.5%,influenced by factors like a 4% to 9% risk-free rate and market risk premium. This high cost of capital is expected to persist until at least 2024 due to factors such as inflation and labor markets. In early 2022, the weighted-average cost of capital for S&P 500 companies was below 6%,indicating a significant increase in capital costs since then. The current economic environment emphasizes the impact of inflation on company valuations, making it crucial for businesses to adapt their financial strategies accordingly.

The weighted-average cost of capital (WACC) is a crucial financial metric that calculates a company's cost of capital by proportionately weighing its use of debt and equity financing sources. It represents the blended cost of capital across all funding sources, including common shares. Estimates indicate that in early 2022, the WACC for the average company in the S&P 500 was below 6%, but it has since increased significantly due to various factors, with current estimates suggesting a cost of equity around 8%to 9.5% in today's inflationary markets. This metric is essential for businesses to determine the minimum return they need to earn on their existing assets to satisfy their investors and creditors.

In the current economic landscape, lower middle market companies face even greater challenges compared to S&P 500companies. Lower middle market firms, which typically have annual revenues under $5 million, operate in a segment just above small and medium-sized businesses (SMEs). Despite the difficulties, there are bright spots in this sector, with company founders and financial sponsors recognizing opportunities to transact with smaller businesses. Capital costs are notably high across the board.

April 15, 2024