Thursday November 11, 2021

Tom Cox, Debt Advisory Partner, and Philip Watkins, Restructuring Advisory Partner, explore the key implications of rising interest rates for UK businesses looking to rebuild after the pandemic

Rising inflation, and the gradual return to normality after the COVID-19 pandemic, has prompted The Bank of England to signal it will likely raise interest rates in the coming months.

The Bank has forecasted that inflation will continue to rise and could peak at 5 per cent in Spring 2022, before reducing again – far above the target 2 per cent inflation rate set by the Government.

Despite the rapid rebound in activity levels that have been experienced in 2021 there is little doubt that the pandemic has caused long-term harm to the economy that will take time to resolve, so changes to interest rates in response to inflation will be closely monitored by many.

Importantly, any rise in interest rates is likely to be marginal in the short-term, and will only increase gradually. But while rate rises may seem a small cost for companies to bear, it will add further pressure to businesses already balancing multiple challenges.

In some industries such as retail and hospitality, several businesses were operating with weakened balance sheets even before the pandemic, and are now having to navigate multi-faceted challenges, including escalating supply chain shortages, increasing energy prices, rising inflation and competitive labour markets exacerbated by Brexit, which are all driving wage inflation. It’s a challenge for firms across numerous sectors, so any potential interest rate rise is likely to compound these headwinds while also putting the brakes on consumer spending.

And while it’s likely to be a relatively small rise when compared to historic long-term rates, bearing in mind we have not had a 1.00 per cent base rate since February 2009, it puts into focus an economy that has become attached to the super low rate environment and as such speculation regarding longer term rate rises have been met with widespread concern. This in itself reflects the fragile balance of the economy and nervousness around the speed of recovery.

In reality, the current base rate has been at an all-time low of 0.1 per cent since the pandemic began, so any change will be felt more strongly across the economy. This is particularly true for businesses that are planning for growth, investment and expansion as they look to rebuild. So what can businesses do to mitigate the impact of any potential rise in interest rates?

For all businesses, developing a strategy to build resilience is critical. Business leaders must add flexibility and contingencies to their financial forecasting, particularly for those affected by combined COVID-19 challenges and navigating a number of moving parts in both input costs and operational models.

Access to finance also remains central to any operator’s forward plans, particularly for smaller firms. A cash injection can be crucial in providing the financial headroom to invest for the future. But in a rising rate environment, lenders may be more cautious as debt service tightens, and may require greater levels of due diligence.

During the pandemic financial pressure was arguably felt most acutely by smaller firms with demands for emergency liquidity. The Bank of England estimates a third of the UK’s small businesses are now classed as highly indebted, more than double since before the pandemic, with 33 per cent of SMEs holding debt levels of more than 10 times their cash balances, versus 14 per cent before COVID-19. Rate rises will therefore impact cashflows more acutely.

With the impending step down in the Recovery Loan Scheme in January 2022 (reduced from a maximum of £10 million to £2 million of government guaranteed loans for eligible borrowers) businesses may be concerned about their long-term financial structure where stakeholder resources are more limited.

But options remain open, with private equity investors having shown an insatiable appetite to support buy and build strategies in the last 12 months which can deliver both cost and revenue synergies that preserve long term value for existing stakeholders or a return to owners for their efforts over many years, despite the recent crisis.

At the same time the private credit market continues to deliver options for owner managers who may not have the appetite to dilute equity, but lack the resources to adequately recapitalise their balance sheet in order to maximise chances of a recovery. The diligence focus of such lenders may be more invasive given the events of the last two years but with differing attitudes to risk and the ability to deliver more flexible financing structures in light of future volatility, sourcing a financing partner beyond the traditional high street banking market may be well advised.

Preparation is key, and business leaders and private equity sponsors must ensure they are positioned and well advised to embark on a debt raising process, particularly when an interest rate increase is likely in the months ahead.