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January 2025 | 

Navigating 2025: Debt, AI, and Deal-Making in Focus

Navigating 2025: Debt, AI, and Deal-Making in Focus

As 2025 unfolds, economic decision makers face a complex financial landscape shaped by persistent challenges and emerging risks. Wharton finance faculty point to three pivotal trends demanding attention: addressing the hidden perils of integrating artificial intelligence into financial systems, recalibrating expectations for mergers and acquisitions activity amid evolving market dynamics, and navigating the implications of the mounting U.S. national debt. These insights highlight the interplay of fiscal responsibility, technological innovation, and strategic growth as key factors shaping the economic outlook for the year ahead.

AI in Finance

Itay Goldstein, academic director of the Advanced Corporate Finance program, says the potential risks arising from the fast-paced adoption of generative AI in finance should be on everyone’s radar. As opposed to algorithmic AI (or machine learning), which has been widely used in finance for decades to analyze, optimize, and solve predefined problems, generative AI creates original content by learning patterns from existing data. It is often described as agentic, meaning it takes independent actions and makes decisions rather than merely supplying information for humans to act upon.

“The risks of AI are coming from the delegation of decisions,” says Goldstein. “If AI is used for trading, or for forecasting, where the information that they provide is available to humans to make decisions, that's something different. But usually when you talk about AI, you think about delegating different decisions, and this is what we don't understand as much.”

He continues, “AI functions are being introduced more and more by the current big players in the financial system, but the risks are not easy to define or to quantify. When you delegate decisions from humans to non-humans, we don't fully understand how those non-humans are going to act or how AI models really work.”

One such risk is the potential for herding, “where AI systems end up doing the same thing. So, we're going to see a lot of homogeneity and uniformity in the financial system,” says Goldstein, “which brings risk because it means that things can move sharply from one direction to the other. I've been involved in a study where we think that interactions between AI can actually generate some kind of collusion where they learn over time that what is best for them is not to act very competitively, and this is hurting the quality of the market.”

Another potential downside of the use of AI in finance is risk concentration, in which widespread adoption of AI leads to a more interconnected financial system. These deepening interconnections between institutions amplify the risk that one failure could ripple across the entire system. “Business leaders need to understand the recent developments of AI and finance because these might change the ways that finance is being conducted in practice. It's going to affect everyone, whether they work in a financial institution or whether they need to raise money from financial institutions.”

M&A Activity

Robert W. Holthausen, Nomura Securities Company Professor of Accounting and Finance and academic director of Wharton’s Mergers and Acquisitions program, says, “Predicting markets is a potential fool’s folly, but it never hurts to delve into some of the forces we are currently seeing at play in the M&A market. On the good news front, we know several things. First, over the last year, M&A activity has increased relative to 2023. Through the first three quarters of 2024, global M&A activity is up by 27.6 percent by dollar deal value and 13.3 percent by count. This suggests a far more robust M&A market than we saw in 2023. Private equity activity has also begun to increase in the last two quarters of 2024. Through the first three quarters of 2024, PE deal values are up 24.0 percent and the number of deals is up 10.4 percent. Having a vibrant PE market is an important part of a robust M&A market because PE deals usually represent a significant proportion of deal activity (roughly 40 percent).”

Second, says Holthausen, interest rates in 2024 are down relative to 2023, “and the big banks, who withdrew from deal lending in 2023, are back in action. In May of 2023 for example, B-rated debt was priced at 11.0 percent and as of mid-September, that rate had fallen to 9.7 percent. With the Fed’s 75 basis-point reduction in the benchmark federal-funds base rate since September, we expect this rate to fall further. We have seen similar reductions in the borrowing rate in Europe given the actions of the European Central bank. This all leads to the availability of debt financing as well as reductions in the cost of capital companies use to price deals, which typically leads to greater deal flow.”

Third, consumer confidence and CEO confidence have increased since the U.S. election. “The November jobs report bounced back from the disappointing numbers in October, leading to increased consumer confidence. Further, many believe that the incoming Trump administration will foster a more favorable tax and regulatory environment for businesses, which could help increase deal flow.”

With all that good news, shouldn’t we believe that deal flow will increase in 2025 relative to 2024? Holthausen says, “Perhaps, but there are uncertainties that may impact M&A activity negatively.  First, the inflation data for November indicates that inflation has not been tamed with an increase in the CPI of 2.7 percent over the last year when the rise was only 2.6 percent in October and core prices (excluding food and energy, which are more volatile) were up 3.3 percent. This was the largest increase in the CPI since April and reduces the likelihood that we will see the Fed cut rates as aggressively in 2025 as we might have previously expected, since we aren’t near the Fed’s 2 percent target for inflation and the economy is still adding a significant number of jobs.”

“Second,” he continues, “if we look at Trump’s nominees for important positions at the DOJ and FTC (the nation’s antitrust enforcers), they are all on record as worrying about ‘big tech’ and suggest that antitrust enforcement, at least in that sector, will not be lax. Further, JD Vance is on record as an advocate of some of the things that Lina Khan has accomplished in her role as commissioner of the FTC. While overall, I expect the antitrust environment to be more deal friendly than it was during the Biden administration, it remains to be seen exactly what the new administration’s stance will be on M&A.”

Holthausen says that one thing that is less directly related to M&A activity, but which also increases uncertainty (which is never good for deal flow), is “exactly how the Trump administration’s tariff policy will play out and how it will impact businesses and consumers. Moreover, the incoming administration’s deportation policies that may be invoked could increase labor costs. Both have the potential to increase inflation yet again and are likely to lead to winners and losers in the economy. Add to that mix the global uncertainties given recent events involving Ukraine, the Middle East, and the Far East and we have a series of headwinds that could counter all the positive signs we have seen. It remains to be seen where this will all settle out, but I do expect some increase in deal flow in 2025 relative to 2024.”

Addressing the U.S. Debt

When Wharton finance professor Joao Gomes testified last year in front of Congress, he pulled no punches. Although he says he is “an optimist by nature,” his testimony and report (The Impending Crisis: Assessing the Dangers of Excessive US Debt) explain the urgency of addressing the national debt. “I’m not super-worried about the debt right now. I am really worried about where it’s projected to go.”

Gomes told Knowledge@Wharton, “I see the debt problem as bigger and more urgent than the climate challenge. It will come earlier. We will face a fiscal crisis in the next 10 or 15 years. Ten will be almost the outer bound that I would put on that, and when it happens, it will touch all of us. I really mean all of us — every part of the economy, from the banking system and our bank deposits to our paychecks, to Social Security and Medicare. … There is only so much money we can spend addressing [long-term challenges] without thinking, ‘Well, that’s going to create a much bigger problem in the short term.’”

He continues, “One of the things we saw both in 2008 and 2020 with COVID was both of those episodes were something that didn’t have anything directly to do with the government. It was not a fiscal crisis with the treasury. But the economic crisis that unfolded — the debt might have gone up 15 percent to 20 percent of GDP in both episodes because the government felt a need to send stimulus checks, to bail out banks, to do various types of things. So, it could work that way. But if it is a pure fiscal crisis, in the sense that folks wake up one morning and say, ‘We just don’t have confidence in the U.S. government anymore,’ we will have a serious economic crisis on our hands. In that scenario, we might have to tighten our belts by the equivalent of $2 trillion. Just think about the spending cuts that that entails and the damage that would do to the economy. … I continue to hope that we will find our way out of this. But if it unfolds, it is a very scary scenario.”

Gomes says the best way out is growing the tax base to increase government revenue. “More people in the workforce, people working longer, more productivity, more entrepreneurship — those things should be basic priorities for us. That’s the one hope that we have, and we have to still have a significant amount of growth. Absent that, the demographic pressures make our problems very, very challenging. … The Social Security Trust Fund runs out in 2033. That’s the latest that I would envision this conversation taking place. At that point, it’s not a conversation for bankers, for hedge funds, for fund managers. It’s a conversation for 50 million people who are going to think about, ‘What happens to my check?’ We may have that conversation earlier, but I think no more than 10 years from now.”