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We need to talk about debt
Money is no longer ‘free’ and much has been written in the mainstream media about the looming mortgage cliff for residential borrowers. The same challenges hold for companies who will find it increasingly difficult and costly to refinance, borrow additional money and fuel growth. Early planning, clarity when it comes to capital strategy, and regular corporate funding discussions across the whole of an executive leadership team are key to optimising liquidity management and making sure lenders don’t call all the shots when times get tough.
Perhaps a slightly obtuse analogy, but parallels can be drawn between many corporate debt facilities and US congressional election cycles. Both are incredibly short – two-years in the case of those elected to the US House of Representatives, and three for your typical liquidity facility. What’s more, both are relatively ineffective for a significant part of that time. US elected officials will spend most of their second year in office campaigning for re-election. Discussions to refinance a revolving working capital facility, often undrawable in its final six-months, need to kick-off around the 18-month mark to avoid borrowings becoming current.
Consider the year 2020. Markets were awash with cash as central banks sought to protect against the unknown impacts of the COVID-19 pandemic. Looking to sensibly shore up their position, corporates took on a raft of additional liquidity facilities and refinanced existing debt at previously unheard-of pricing levels. It’s easy to lose sight of the fact that this was the better part of four-years ago. If they haven’t already, these facilities – entered into at ultra-low rates over the years of lockdown – will soon be due for renewal. However, this time around discussion with lenders will take place against a vastly different backdrop.
It’s hard to avoid talk about peak interest rates, as central banks try (and try again) to tame a stubborn global outbreak of inflation. The only consensus seems to be that the work of these institutions is not yet done, with several rises yet to come over 2023. What we do know however is that as at today, reference rates are around ten times what they were in 2020. Adding to the challenge, lender margins have blown out – reflecting broader macro-economic challenges that are pressuring corporate earnings and increasing default risk. This is particularly true of economically sensitive sectors and those where cost increases cannot be readily passed on to consumers. In these cases, even investment grade corporates have seen a doubling of their debt issuance pricing. Lower rated issuers may even find themselves struggling to refinance at all – instead facing complex, dilutive, and potentially value destructive equity market transactions as the only alternative.
As noted above, the “practical” tenor of a corporate debt facility is often less than two years. A rough extrapolation reasonably suggests that at least one-third of corporate borrowers will be (or should be) in refinancing discussion at any point in time. Consider that if your company has multiple facilities and a well spread maturity profile, there really shouldn’t be any point in time that refinancing isn’t an active topic of discussion between executive leadership and corporate boards. Despite this, the more common approach over the years of ‘easy credit’ has been for debt maturity charts to be mechanically rolled over for audit committee papers. It’s only a sudden realisation when lying awake in bed one night, or a probing question from a director that sparks quick action. By this point it will be lenders – or time – that dictate the outcome of a transaction.
Instead, having a deep understanding of debt structures and consistently monitoring them allows for more considered planning, more favourable refinancing terms and – if necessary – restructure of existing facilities to ensure they don’t become a management distraction. While CFOs and Treasury teams will lead the charge on the delivery of solutions, make no mistake – this is a whole of business issue and operational leadership cannot wash their hands of the challenge. Their understanding and input will be key in facilitating the finance teams’ ability to successfully deliver funding solutions that are fit for purpose, support the achievement of wider strategic objectives, and maintain the confidence of debt and equity markets alike. The following are only a selection of the topics that should regularly be under consideration:
- Do you have the right type of facility? While carrying excessive debt may have had minimal adverse impost in a lower rate environment, a more flexible, revolving facility that aligns with fluctuating working capital requirements be now be more appropriate than a term loan.
- Conversely, have recent challenges resulted in a tranche of debt becoming more ‘structural’ and permanent in nature – and if so, is it time to explore longer term debt options such as corporate bonds?
- Do existing loan terms align with wider organisational strategy and work well for your business from an operational perspective – for example, can you freely execute on expansion, M&A, or asset divestment plans?
- Are financial covenants under pressure? Lower earnings, increased debt and higher interest costs will all be conspiring to devour headroom under interest and debt service cover ratios.
- Do you need to consider amending the amortisation profile of existing loans to reduce near term repayments and free up cash for other purposes?
- Do project construction timelines and income profiles still align with financing structures, or have recent events and pandemic impacts resulted in a divergence?
- Do you have a sufficiently spread maturity profile?
- Is the time right to introduce green, or sustainability linked finance to your debt portfolio? Not only will this support an ESG agenda, but it may also open access to specifically earmarked parts of lender balance sheets. Significant additional work may however be required across all areas of a business to obtain and operate such facilities.
- If you have a sizable amount of variable-rate debt, would you sleep easier and benefit from rate certainty – even if that means forgoing potential future rate decrease? If so, negotiating interest swaps or other derivatives may be appropriate.
I don’t intend to canvass here whether you should wait for interest rates to peak before signing your company up to its next loan agreement – if indeed you have that luxury. Rather, my point is don’t ever take your eye off the funding ball. Remain nimble, have clarity in your capital structuring goals and make sure that your organisation is positioned and sufficiently equipped to manage whatever comes your way. The intersection of refinancing into tightening monetary policy, record inflation and macro-economic uncertainty carries far greater risk and can blow refinancing timelines out significantly. Companies can be crushed if they get it wrong. But, if you are far enough ahead of the curve you can take decisions that support growth and adjust other corporate settings accordingly.
Even with the ‘excitement’ of what currently passes as normality, a good deal is still a good deal. With asset prices falling, it might be the right time to execute on a game changing element of your corporate strategy – even if the funding isn’t quite as cheap as it may have been. The adage that if you’re standing still then you’re moving backwards is one to heed. But that also means being on the front foot when it comes to funding and capital structure. Don’t fall for the old trap of “set and forget”, especially at times like this…
The views expressed in this article are the views of the author. This article provides general information, does not constitute advice and should not be relied upon as such. Professional advice should be sought prior to any action being taken in reliance on any of the information.