The Refi Crunch

No not your house but your employer

During the pre-COVID era of zero interest rates, companies took advantage of the favorable borrowing conditions to go private. Many others took on debt to go on an acquisition binge. This was the end of the long secular decline in interest rates that sparked M&A and LBOs in the ‘80s. That game is over. As the economic landscape shifts and interest rates rise, these companies face significant challenges when it comes to refinancing their debt. We can review the difficulties companies taken private during the zero interest rate pre-COVID era face in today's higher interest rate environment and guess whether this could lead to bankruptcies.

One of the primary challenges for companies taken private during the zero interest rate era is the increased cost of servicing their debt in a higher interest rate environment. We hear this about the federal government, but this hurts corporations, too. With interest rates elevated, companies face higher interest payments on their existing debt. This can strain their cash flow and profitability, especially if they have a significant amount of debt maturing in the near term. Add on top of this the need for firms to roll over debt they accrued before the rate run up, and the 5-7 year timeline for refinancing comes due soon. Firms face a market with interest rates well above the average for 2017-2021.

Rising interest rates also make it more difficult for companies to refinance their existing debt from the supply side. In a higher interest rate environment, lenders are more cautious and demand higher interest rates or impose stricter lending terms. This can make it challenging for companies to find lenders willing to refinance their debt on favorable terms, particularly if they have a high level of leverage or poor credit quality. All of those privatizations involved turnaround plans, which usually focus on cost cutting, but who has seen their margins wrecked by inflation. Who had pricing power? This adds an extra wrinkle.

Companies taken private during the zero interest rate era may have structured their debt with longer maturities to take advantage of low interest rates. Once again, this gets into the issue of how long was long term. A problem, as interest rates rise and stay higher, is that they may find themselves with a maturity mismatch, where their debt matures before they are able to refinance it on favorable terms. Most privatizations have a plan to IPO after the efficiency gains, tech improvements and market expansion. If they cannot, they either sell to some other private buyer or refi. Problems pop up with that monthly nugget even for corporations when facing 8% rather than 4%. This can create liquidity pressure and increase the risk of default or bankruptcy.

Higher interest rates can also impact the valuation of companies, especially those with high levels of debt. As interest rates rise, the cost of capital increases, which can lead to lower valuations for companies with large debt burdens. This can make it more challenging for companies to raise equity capital or attract investors, further exacerbating their financial difficulties. It is also not like these firms have generated so much cash that they could go to the market and buy their now cheaper bonds at well below face value.

There is an element of risk. What is the market’s appetite for high yield risk? Things look very stagflationy right now. Rising interest rates can contribute to increased market volatility and uncertainty, which can further impact companies' ability to refinance their debt. In an uncertain market environment, investors may become more risk-averse and demand higher returns leading to higher rates, making it more difficult for companies to access capital. This creates a vicious cycle where higher interest rates lead to lower valuations and reduced access to capital, further building companies' financial challenges.

While the challenges posed by the transition to a higher interest rate environment are significant, whether they will lead to bankruptcies is murky. The analysis does point to evaluating it as a case by case problem. It is not just numbers but where the debt market is going, what product or service the firm provides, and the firm’s competitors. Some companies may be able to navigate the transition by quickly managing their debt obligations, improving their operating costs, and exploring alternative financing options. For companies with weak fundamentals or high debt burdens, the combination of rising interest rates and limited access to refinancing increase the risk of bankruptcy. We will see bankruptcies. The sad truth is we are also in a political cycle where winners and losers will be decided with political considerations. Books have been written on the Latin American experience with high interest rates and high inflation, and as America becomes more Latin, we should take copious notes as to what transpired.