Debt is part of life but higher interest rates warrant caution

Although Polonius may have been speaking wisely when he advised, in Shakespeare’s Hamlet, “Neither a borrower nor a lender be,” he was talking about borrowing among friends. When it is strictly business, certain situations warrant ignoring the advice of the king’s chief counsellor, there being much to recommend borrowing and lending.

However, in a high interest rate environment, caution should be exercised by business owners when taking on debt.

Michael Lalor, head of debt advisory at Focus Capital Partners, points out that interest rates have increased at pace in the past year following a prolonged period of zero or negative rates since the global financial crisis. However, he notes that the rates themselves are not remarkable.

“Between 2000 and 2008 one-month Euribor rates at times were actually at levels similar to today – and higher,” says Lalor. “What is different this time is the pace of rate rises to curb inflation and the fact that we are coming out of a prolonged period of low rates.”

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As far as Lalor is concerned, borrowing is simply part of the business landscape.

“Debt has been and will remain an important part of any financing solution,” he says. “Like any cost to a business, provisions should be made for the potential of increased cost and mitigation strategies.”

So how can business owners adapt to such changing circumstances as pertain at the moment and ensure that companies can meet their debt service obligations?

“Consideration may be required to their business model in a higher-rate environment, whether that’s addressing their cost base, as we’ve seen in the tech sector, or perhaps a restructure of debt facilities to include other capital solutions, including equity,” says Lalor.

It is important for company owners to understand why their enterprise requires debt and to ensure that the terms of any debt facility meet the business’s objectives. Lalor suggests, for example, that a capital expenditure programme may need to be costed, with a realistic timeline for delivery.

“In this case it’s less preferable that this requirement should be financed through a short-term uncommitted facility,” he says. “Also, debt alone may not be sufficient to conclude a specific project and a combination of equity and other capital solutions may be required. Where solutions across the capital stack are required, a blended cost of capital is important to calculate.”

When it comes to figuring out what an acceptable level of borrowing is for a business, there are key checks to be considered: Can the business repay or service the loan over a defined period? Is the leverage of the business appropriate for its profitability? And, for asset lending, the gearing – the ratio of a company’s debt to equity.

“Senior lending covenants are between 55 and 60 per cent currently,” says Lalor. “If debt levels go beyond these senior debt metrics, then you’re potentially looking at other capital solutions such as unitranche, mezzanine or convertible loan notes which can be more expensive. Again, careful consideration should be given to the cost of this capital.”

Lalor has seen the corporate lending landscape change considerably over the past decade, driven by the emergence of private credit.

“The sources of capital have never been more diverse and nuanced,” he says. “Lender interest can be dependent on loan size, pricing, risk profile, geographies, sectors, ownership structure and, more increasingly, ESG [environmental, social and governance] considerations, to name a few.”

David Martin, debt advisory partner at EY Ireland, agrees. “Given the focus by lenders on all things ESG, outlining a business and associated sustainability strategy or plan is increasingly important in any debt-raising process.”

According to Martin, a return to the lower interest rate environment of recent years appears unlikely for the foreseeable future. This means companies must spend more time assessing and structuring their debt raising so they do not over burden their business from a risk perspective, cause any facility agreement covenant breaches or leave themselves with little or no free cash flow to run their business.

Thinking about risk is vital. Martin sees a cautionary tale in our not-too-distant past, adding: “The results of taking on too much debt are well documented in Ireland.”

A review of the capital structure of a business and the leverage ratios it has, or is anticipated to have, is essential where borrowing is concerned.

“Only when a business understands the implications of new leverage and is satisfied that the leverage it is taking on is appropriate for them should they proceed to approaching lenders,” says Martin.

Ensuring a business can meet its repayment obligations and operate within its lender’s covenants are also key.

“This should be worked out not only when things are going well but also understanding that if a business does not meet its projections, can it meet its repayment obligations, through sensitivity analysis,” says Martin.

“When a business has a funding requirement it should also consider the refinancing risk, security requirements and look at a hedging strategy.”

This is to ensure funding requirement are not only being met only by debt, which can lead to an over-leveraged business.

Among prevailing trends reflected in the Irish lending market is a caution Polonius could well identify with.

“What is noticeable in the current environment is that the banks and numerous nonbank lenders who operate in the marketplace expect a well-thought-out plan to be presented to them,” says Martin. “This shows a business has asked themselves the difficult questions before they seek funding and demonstrates their professional attitude to debt raising.”

He concludes: “Historically many businesses saw their debt solution as a bank versus nonbank lender solution. However, we are seeing the international convention of banks and nonbank lenders working together come into the market more, demonstrating that different debt solutions can coexist for the benefit of Irish business.”