How recent interest rate rises have impacted the debt funding market
Tuesday May 23, 2023
Tom Cox explores the impact recent economic turmoil has had on the debt funding market
To combat surging inflation driven by the wholesale energy market and wider supply chain dislocations – which were arguably exacerbated by the market reaction to the Government’s ‘mini-budget’ in October 2022 – the Bank of England (BoE) has hiked interest rates to 4.50 per cent, representing the most accelerated rise in borrowing costs since 1989, with further rate rises a distinct possibility. As a result, borrowers are likely to face increasing scrutiny from lenders in assessing debt capacity in 2023.
In a previously low interest rate environment, the idea of rates approaching 5 per cent was viewed as cataclysmic for many, but the reality is that firms’ must continue executing on their growth strategy and delivering value for their clients in order to mitigate the increasing drag on underlying cashflows.
Nevertheless, the BoE’s chief economist Huw Pill recently commented that the UK must also look to avoid an elongated inflation spiral driven by wage price inflation without a cut-back on discretionary spending. UK plc must accept the outlook is more challenging and focus on targeted investment to stimulate growth.
While credit markets may be harder to navigate, they will continue to offer an avenue for capital raising for many corporates and with this in mind, our team are on hand to advise of clients on how best to familiarise themselves with the current funding landscape.
Aside from the far-reaching implications rate rises will have on consumers’ behaviour and personal finances, prolonged rate rises will also temper the appetite of many firms – especially those in the lower and mid-market – to continue investing for growth through debt funding.
While the International Monetary Fund recently commenced that increases in borrowing costs are likely to be “temporary” once sustained excess inflation is brought under control, and longer-term rates should revert to lower levels than the long-term average in order to combat low productivity and ageing populations, the short-term impact on investment could still be profound.
To many a stagnation in debt funded growth investment may seem like a natural outcome – higher interest rates make the option more expensive, while the difficult operating landscape may encourage businesses to save what cash they have and retrench their operations.
However, past experience shows us that firms that continue to invest during an economic downturn are most likely to weather the storm in the long run. With this in mind, it’s important for business owners to familiarise themselves with the current funding landscape and understand how best to navigate it.
Appetite for funding
The events of the past six months have understandably led to reduced willingness amongst some lenders to invest through debt funding. This is acutely impacting SMEs – with inflation impacting both operational costs and consumer propensity to spend, investment in mid-market firms is a less attractive proposition.
However, these firms should not let recent events deter their growth ambitions. Regardless of the economic climate, there will always be appetite amongst debt providers to invest in businesses with defensive characteristics, strong demand fundamentals and ambitious growth plans. Business owners should keep this in mind when developing their funding propositions to pique the interest of lenders, and they should take steps to review the defensibility of their operations and the supply chains that serve them.
Given the recent market volatility, it’s important that this process includes rigorous stress testing. Borrowers that can demonstrate the fiscal and operational flexibility to mitigate the impact of prolonged rate levels or even further rises will seem a safer bet for institutional lenders.
Surveying the options
Despite this willingness amongst lenders to continue investing, market volatility has resulted in borrower uncertainty. For firms looking to mitigate the risk of further rate rises, there are a range of options available.
We’ve seen a surge in demand for debt insurance and hedging products in the last six months that can help businesses to limit their exposure to market shifts. Similarly, we expect to see an uptick in the demand for fixed rate debt products on offer, and also more discussion around hedging strategies that have been remote from board room discussions for a long time. At the same time, we are also seeing increasing consideration being given by clients to hybrid structures which blend cash flow and asset-based lending, to deliver funding targets by leveraging the best of both products give the incremental drag on cashflows from pure leveraged instruments.
With such a range of products available in the market, it’s important that borrowers undertake thorough research to find the best match for their ambitions. This can often be an intensive process with several competing options in play – yet is also key in ensuring a firm is best placed to deliver on its growth strategy.
For firms struggling to navigate this procedure, we would recommend calling in the help of an independent debt adviser with a knowledge of the range of options available. In the face of continued inflation and market uncertainty, such advice can often be what makes a difference for business owners looking to find a most suitable funding partner.
Past experience shows us that firms that continue to invest during an economic downturn are most likely to weather the storm in the long run.Tom Cox FRP Corporate Finance