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Prepare for a new normal

Author: Zoe Clarke

Published: 09 Nov 2023

snow mountains peaks sky cloud ICAEW Corporate Financier comment interest rates

Interest rates are rising, but what’s on the horizon? EY’s Zoe Clarke looks at what the forecasts mean for both private and public mid-market M&A.

Much like waiting for a bus, you wait a long time for an interest rate rise and then they all come at once – 14 to be precise since the end of 2021 (at the time of going to press). At the start of August the UK base rate increased to 5.25%, following the Bank of England’s Monetary Policy Committee (MPC) meeting. At its September meeting the MPC decided it would remain at 5.25%. Rates started climbing at the end of 2021, after historic lows that had prevailed for more than 12 years since the MPC slashed the base rate to 0.5% in March 2009, following the global financial crisis of 2008.

Many believe we are now close to the upper limit of base rates. In September the Governor of the Bank of England, Andrew Bailey, told the Treasury Committee: “I think we are much nearer now to the top of the cycle on interest rates, on the basis of current evidence.”

The Bank of England has also to date been clear in its stance on managing market expectations about a near-term rate reversion. As a result, borrowers are experiencing another consequence of the battle with inflation that does not look like it will dissipate any time soon – higher interest costs.

So what exactly does this mean for borrowers? Existing borrowers will already be feeling the monthly cash-flow effect of recent rate rises, unless they have protected themselves against increasing interest rates with hedging. Many borrowers will not have done so. And most senior loan borrowers’ credit ratios, however, will be based on the last 12 months (LTM) rates and measures. As a result, the full impact on covenants, headroom and debt serviceability will not be felt yet. In practical terms, an LTM covenant measure taken at the end of September 2023 includes interest expenses based on the rates from October 2022 to July 2023 – including from back when rates had just risen to 2.25%.

While the SONIA (Sterling Overnight Index Average) forward curve projections of UK base rates have it peaking at around 5.5%, the delayed impact of higher rates on LTM metrics means that debt serviceability is not expected to reach peak tightness until the middle of next year. A typical unhedged SONIA + 4% leveraged bank loan in the summer of 2024 would be expected to have a full year’s interest burden of nearly 10%, based on the most recent forecasts. 

Difficult future

For businesses this is analogous to the situation consumers find themselves in, currently treading water with fixed-rate mortgage products. While many corporate and leveraged borrowers have managed the initial impact, regardless of where rates may be heading, in terms of covenant headroom most of the pain is yet to be felt. Borrowers will need to plan ways to protect their covenant compliance. If not they must start preparing for conversations with lenders about covenant waivers and/or resets.

For businesses planning to borrow or refinance in the short term, what does this mean? Borrowings might well be needed to finance M&A opportunities arising, and so it is particularly relevant to M&A advisers. With the UK economy experiencing sticky inflation and with the base rate at its highest in more than 15 years, will lenders be forced to change their approach?

In the mid-market leveraged finance world, while there has been some talk of a slight easing in direct lending margins, this is entirely dwarfed by the impact of base rate rises on the overall interest cost. Increased leverage levels over the past decade mean a rise in interest costs may result in prospective borrowers facing tightness in debt service coverage. That might be explicitly documented in facility agreements, or implicit, but either way it will impact lenders’ internal parameters. 

Particularly for debt funds operating at the higher end of the market, this may cap the total amount of leverage they are able to provide. That decision will likely be taken regardless of borrowers’ willingness to pay higher interest costs in order to maintain appropriate serviceability levels.

Corporate outlook

Private equity is finding it tough raising money to fund deals. And corporate borrowers aren’t off the hook. Previously, borrowers looking to bank debt as a source of low-cost funding enjoyed the near-zero base rate environment, essentially paying only the lending margin in interest expense. The impact of recent rate rises will be felt relatively harder as the variable portion of interest cost accounts for a more significant element of the total interest expense.

Here we are likely to see covenant headroom on new loans reduce to more historical levels. Advisers are expecting a ‘new normal’ to emerge, but that is yet to shake out. Both CFOs and lenders are having to keep a closer eye on interest cover ratios for the first time since 2008.

So how do businesses plan for this? Cross their fingers? The impact of higher rates on the business needs to be looked at and then with advisers a plan of action mapped out to deal with the new normal we are entering, which should become clearer.

Zoe Clarke is a partner in EY’s capital and debt advisory practice

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