Commercial Insights

Downside protection: Are You Ready for Higher Interest Rates?

With the economy in recovery and interest rates still low, owners of middle-market companies may find themselves at a crossroads. For one thing, cheap debt won’t last forever. This is a great time, then, to evaluate your balance sheet for opportunities. At the same time, M&A activity is indicating that we’re in a sellers’ market, so it’s an excellent time to consider possible exit strategies. Let’s look at how to take advantage of these windows of opportunity.

Optimize your capital structure

“Years of low interest rates have given companies the ability to borrow very cheaply,” says Rit Amin, Co-Head of Corporate and Leveraged Finance at Regions Securities, LLC. “For some, it may have been tempting to take on more debt than might be ideal.” Amin suggests taking a hard look at your balance sheet to take advantage of continued low rates, and make sure your company has the financing in place to manage through an increasing-rate environment.

• Beware floating rates. Most bank and institutional middle-market loans are floating-rate debt, meaning that it will become more expensive to pay down these loans as interest rates start to rise. If you have floating-rate debt on your balance sheet, you may want to convert some or all of it into a fixed-rate structure for the long term, or reduce your liabilities by paying them off early.
• Take advantage of additional leverage If, however, your balance sheet is under-leveraged, locking in inexpensive debt can be used to fund strategic or organic growth for your business.

Seek strategic growth opportunities

If you’re looking to grow market share by acquiring competitors or making other expansion investments, this might be a great time to do so, says Rob Tyndall, managing director, Mergers & Acquisitions at Regions Securities LLC. “Companies that are conservatively leveraged may have the opportunity to make growth investments using increased, low-cost debt capital, but only until rates begin increasing” he explains. “If you’re a healthy company that’s well capitalized, you can consider being aggressive with strategic or add-on acquisitions, capital investments, and other ways to grow. The energy sector in particular currently has distressed situations where some companies can be acquired at good values, and a healthy consolidator may buy up market share at historically low cost.”

Position your company for a sale

On the other hand, there are also excellent opportunities for sellers, as corporate buyers, private equity funds, and other investors are eager to take advantage of the lower rates. “There appears to be an attractive window of opportunity to sell a business or a portion of the business if that’s of interest,” Tyndall notes. “That window will shut at some point.” He points to a few favorable trends that might make a sale attractive, including:

• Shifting demographics: As the baby boomers age, it’s reasonable to expect a wave of companies coming on the market, Tyndall points out. “To some extent, there’s an opportunity to get ahead of that wave and be a scarce asset in a seller’s market,” he adds.
• Historic levels of corporate cash and private equity: Buyers and investors are eager to put this capital to work in strategic acquisitions and growth investments.
• Limited window of low-cost debt: Already, banks are pulling back on leveraged lending. Consider the impact of rising interest rates on your balance sheet.
• Leveraging the growth curve. With the economy well on the mend, many midsized companies have built an extended, strong track record of profitability and growth, along with a favorable outlook for the future. “That enables sellers to attract a higher valuation from buyers who are more confident acquiring companies with longer profitable track records of growth,” says Tyndall. He adds that the “sweet spot” for a sale is when you’ve captured some growth for yourself while leaving significant, achievable growth for the buyer—two to four years of strong, historical performance and one to three years of credible forecasted, profitable growth.

As times change, your growth strategy needs to evolve. Whether you’ve established your balance sheet to see your company through the economic downturn or stayed the course with a conservative strategy, now is the time to take a second look at your debt and equity structure, and plan for the future.