Raising debt when the future is uncertain
Raising debt when the future is uncertain
The economist Paul Samuelson joked that the stock market has predicted nine of the past five recessions, and it is a quip that has also been aimed at Bank Credit Committees, who naturally err on the side of caution and dampen their institution’s lending appetite when bad news is on the horizon.
Recent political events have upped the ante, with (the now former) chancellor Kwasi Kwarteng’s mini budget sending already nervous markets into a ball of confusion. The mini budget was swiftly followed by higher interest rates and ultimately the resignation of Liz Truss as Prime Minister. It is fair to say if you were appearing in front of a Bank’s Credit Committee, you’d be hard pushed to confidently tell them their fears of hard times ahead were just a flight of fancy.
Seeing how debt markets have reacted has been fascinating, however. We are continuing to provide advice to our clients on successful debt raises during this period, navigating them through the political turmoil and delivering innovative debt solutions. As a result, we have witnessed several emerging trends first hand:
Credit Committees are increasing scrutiny
The bar has been raised in terms of credit quality for lenders – they want to know their money is relatively safe, so if your business wants to borrow, you will need to be well prepared to answer questions about any perceived weaknesses. Lenders take comfort in recurring and repeat revenues, so you need to consider how best to present your company. Showing a high quality of earnings is one way to do that; for example, articulate the key barriers to switching, provide analysis of the length of your customer relationships, demonstrate how spend may be improving year on year, or show proof of low customer churn.
Focus on cash cover
The ultra-low interest rate environment seems to be over in the short to medium term, and lenders are having to adjust to rising interest costs. Twelve months ago, the risk-free rate that lenders use to add their margin onto (now known as SONIA, formerly LIBOR) was less than 0.5%. Now, a three-year swap will cost closer to 5% - and that’s before the lenders’ margin. Lenders therefore need to ensure they don’t saddle companies with too much cash pay interest burden and will model rising rates of interest. In some instances, this will also constrain debt capacity.
However, lenders have been quick to find ways to support borrowers in the higher interest rate environment and there continues to be a diverse range of debt funding options available. For example, non-bank or fund lenders are incentivised to put money to work, which means they are actively finding ways to help borrowers. During our recent discussions we have noted that lenders are focused on:
Flexibility to preserve cash for growth
Given their additional cost, fund lenders are seeking to find innovative solutions to reduce cash drain on businesses that want to invest in growth. Examples include the deferral of a portion of cash pay interest (called Payment-in-Kind, or “PIK”) and/or deferral of fees on committed facilities.
Downside risk sensitivities
Given the market headwinds, prospective lenders are increasingly challenging downside risk sensitivities. They want confidence that the borrower is robust enough to manage and avoid a future covenant/liquidity challenge. The more confident a lender is that the borrower has considered all the risks, for example by building inflationary costs into their forecasts, the more likely they are to provide additional headroom and flexibility in loan documentation.
Interest rate hedging
Following several years where compulsory hedging of interest rates was quietly dropped from lender documents, lenders are now seeking reassurance that borrowers have an effective hedging strategy.
Although the cost of borrowing is rising, lenders still want to support borrowers, especially those with a perceived lower exposure to the cycle, and competition remains intense in a diverse lender pool. Therefore, there has never been more onus on borrowers to:
- Approach appropriate lenders that would likely have an appetite for their credit and that can deliver their funding objectives; and
- Maximise traction with lenders by investing the time in preparing the business for a debt process and selling their credit story to lenders.