For months the news has been full of premonitions of a recession contrasting against hopes the Federal Reserve Board will be able to negotiate a soft landing. While these are the stories that appear in the headlines, middle market borrowers are trapped in a very difficult working capital management and financial performance position.
The increased Fed Funds rate has caused the rates borrowers pay to rise to levels not seen since the 1980s.
For example, a borrower who was paying 4% interest in 2021 may now be paying 9%. If a middle market borrower has $50 million of debt, the annual interest costs increased from $2 million to $4.5 million. Most borrowers do not have the level of capacity in their EBITDA performance to meet loan covenants and service debt with that level of increased interest expense.
Recently the Fed has signaled the potential for interest rate cuts in 2024. Most prognosticators, such as MorningStar, are expecting the Fed Funds rate to be cut beginning in the second quarter of 2024 and possibly reach 4.00% to 4.25% by the end of 2024. Most are not expecting rates to return to the 2021 and 2022 levels for at least several years – into 2026 or later.
With that interest rate environment as the backdrop, companies that built balance sheets relying on debt are suffering. Middle market companies typically have used an asset based line of credit to fund working capital coupled with term debt to fund fixed assets. Companies and their lenders have not focused on maintaining higher levels of equity and have been comfortable using more leverage during the long period of low interest rates that occurred prior to 2023.
With the increased interest rates, companies are searching for ways to reduce their operating cycle, which means having their customers and vendors support more of the cash conversion cycle. Using days sales invested in accounts receivable and inventory offset by days sales provided by payables, provides the number of days sales the company needs to finance with debt or invest additional equity.
If a company has $100 million of sales and the operating cycle moves by 5 days, that could change the working capital needs by $1.4 million. If an ABL structure can support half of that need, equity would need to fund $0.7 million. And, if an additional $0.7 is provided by the ABL lender at a 10% interest rate, additional debt would cost $70,000 of additional interest expense annually.
These are material numbers that impact the income statement and the balance sheet of a company.
Lenders are being confronted with:
weakening fixed charge coverage ratios,
increased borrowing needs,
working capital and cash management stresses on ABL structures,
reduced excess availability.
Equity has been pushing back on investing additional dollars. Individual owners and private equity owners have been pushing back on requests from lenders to have ownership solve the liquidity and performance problems. Lenders are being asked to reduce excess availability requirements or lower FCCR ratios.
With the 2023 year-end financial statements being published shortly, there will be additional stresses on financial ratios as the testing for fixed charge coverage and related ratios will be reported.
Monthly borrowing base certificates have been showing reduced excess availability for months.
Lenders cannot accept the excuses companies bring forward. This is the time for companies to develop tools to better analyze their performance. For example, evaluate customer profitability not just at the gross margin level, but also considering the cost of credit terms and required inventory levels.
Middle market borrowers and their lenders are experiencing stress related to interest expense that should not be expected to reduce in the foreseeable future. Borrowers and lenders need to adjust to the current interest rate environment rather than hoping to wait out the rate increases in 2022 and 2023.