Rising interest rates and a weakening business environment are likely to pose significant challenges to midsized, privately owned companies that have accumulated heavy loads of debt at high multiples in recent years.
The new environment, created in part by the Federal Reserve’s campaign of inflation-fighting rate increases, is a significant reversal compared to the last decade, when low rates and strong corporate growth made debt an easy and attractive financing option.
Two recent reports on the debt environment suggest that some private companies in the middle market, in particular those at the lower end of the credit spectrum, may face increased difficulties bringing in enough revenue or profit to cover rising interest expenses if the Fed keeps raising rates, as is widely expected.
The debt-induced stress squeezing the companies is visible in debt-to-EBITDA and interest coverage ratios, two metrics closely followed by lenders as they evaluate the creditworthiness of companies seeking to borrow money. Both ratios are currently moving toward levels that indicate more pressure on companies is coming.
For a middle-market company, a debt-to-EBITDA ratio of above 6x is concerning as the company has less room for error, said Arthur Penn, the founder of PennantPark Investment Advisors, a middle-market lender.
Companies in PennantPark’s portfolio on average have a debt-to-EBITDA ratio of 4.5x and an interest coverage ratio of 3x, based on the last-12-month figures, he said. When underwriting new deals, the firm tends to structure an interest coverage ratio of at least 1.7x to 2x for cash-flow based loans.
“When your debt-to-EBITDA leverage ratio is six times, or seven times, and then LIBOR goes up from 1% to 4%, or goes up from 1% to 5%, all of a sudden your EBITDA-to-interest coverage becomes very tight,” Penn said. “If you’re 4.5 times levered, your interest coverage ratio will go from three times to two times. But if you’re six or seven times levered, you may just be barely covering your interest.”
“It’s a very interesting time for those who put on more leverage,” he said. “They’ll still make the argument that these are great companies, the loan-to-value (ratio) is low, and sponsors will put in more equity. Those could still be very valid arguments. But by definition, the interest coverage is a lot less than it was.”
At its November policy-setting meeting, the US central bank raised its federal funds rate to a target range of 3.75% to 4%, and Federal Reserve Chair Jerome Powell hinted that he would keep raising rates to a level higher than the 4.6% projected in September. Currently, markets expect the fed funds rate will peak at near 5% next year.
In a recent report, Kroll Bond Rating Agency found that about 16% of middle-market borrowers it surveyed won’t be able to afford interest payments using cash generated from their operations when the federal funds rate hits 5.25%. That level translates into an average increase of 450 basis points on borrowing costs for these companies from the start of this year, the survey found.
KBRA’s report said that while these companies can use hedges to alleviate the effects of higher rates, many of them will struggle to maintain an all-in yield of around 12%—the sum of an average interest rate of 7.5% on a typical private credit loan at the start of the year and the 450 basis point rate increase projected for next year.
The firm examined over 1,900 unrated middle-market companies—a majority backed by private equity investors, and operating in the software, business services and healthcare sectors. The pool used by its analysis appears tilted toward companies that are smaller in size and earlier in their growth stage compared to the broader private credit market. While this portfolio represents a small sample of the private credit market—and may not comprehensively reflect the broader market—the analysis indicates what type of pressure some borrowers in this market are likely to face as rates keep rising.
At the same time, there are other signs showing some privately owned midsize companies may not have enough cushion to absorb increased debt costs following several rate hikes from the Fed.
In Q3, these companies recorded 1.6% EBITDA growth compared with the same quarter last year, yet EBITDA margins contracted by 1.9%, according to a report by middle market investment bank Lincoln International.
The average interest coverage ratio of these companies dropped to 2.2x in Q3, slightly down from 2.4x in the previous quarter, the report said. However, when taking into account the increases in interest rates and spreads in Q3, the average ratio drops to closer to 1.6x, it said. An interest coverage ratio below 1 means a company cannot meet its interest payments.
Against this background, some private lenders are taking a closer look at borrowers’ ability to repay debt when they underwrite loans to fund new buyout deals, said David Hayes, a partner at law firm Reed Smith.
“Last year, companies could easily get 6.5 times in leverage, but in the current market, I’m seeing companies struggle to get deals at five or 5.25 times of leverage,” he said. “You’re almost talking a full-turn lower in leverage.”
At the same time, lenders are tightening contract terms. For instance, Hayes said he saw more deals in recent weeks incorporating a fixed-charge coverage ratio covenant, which measures companies’ ability to service all of its near-term liabilities.
“In traditional leveraged buyouts, if you are dealing with senior secured lenders on the first or second lien, you are only using leverage ratio,” he said. “But I’m seeing in newer deals, to help a portfolio company get financing, the fixed charge coverage ratios are creeping in.”
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