Sometimes little can change in a year but a lot can change in a week. Despite the macro events of this year, the UK SME lending market had continued to enjoy relatively benign conditions through 2022 albeit with an increasing undertone of concern over the summer months about growing inflationary pressure. But when the Chancellor stood up to deliver his surprise statement 10 days ago, UK lenders and borrowers saw the kind of rapid realignment of risk sentiment not experienced since the early days of lockdown in March 2020.
When the Government announced £45bn of unfunded tax cuts last Friday, the market assumed a big and arguably unsustainable increase in UK borrowing. The sell-off started, international capital flowed out of the pound and a classic investor flight-to-safety took hold. The Bank of England eventually took action to stabilise gilt markets and sterling. For everyone the interest rate outlook changed overnight.
The consensus is now that the Bank of England base rate will move to 6% by mid-2023. For borrowers, that outlook is feeding directly to the SONIA reference rate that most commercial floating rate loans are priced on.
The daily SONIA last week was 2.18%, it started the year at 0.19% and has doubled in just a little over 3 months. As an indication of where markets believe rates are heading – to fix SONIA exposure today the 3-yr swap rate is 5.1%. That same swap was 3.6% a month ago, and only 0.6% a year ago.
So, in practical terms – if you’re a £2m EBITDA borrower with a 3.0x leveraged facility on an unhedged floating rate, that rate could rise to 5-6% in the near term when you were paying just over 1% three months ago. The result is around 15% of your annual EBITDA is about to be eaten up by the rate movement. If a worsening trading outlook may impact EBITDA by another 10-15%, many businesses could be in cash flow covenant breach territory.
On the supply side, some debt funds will have floating-rate funding costs from wholesale finance facilities but have lent to borrowers on fixed rates for 3-5 year loans. Most will have sensibly partially hedged their funding costs but there will still be some inevitable pain to work through as the price of risk resets.
How are lenders reacting and what’s the outlook?
Currently, it’s principally a re-pricing issue – for now lenders are stating that there continues to be appetite to lend to resilient sectors and at slightly dampened but still historically high leverage levels. There is no suggestion that issued term sheets are being pulled by lenders currently.
We expect that most of the fixed rates that private credit lenders offered until this summer are likely gone. Lenders are telling us that they’re not interested in taking the pricing risk for borrowers right now.
The result is that a return to mandatory interest hedging in term sheets is expected. Some lenders are already demanding it for new transactions. What does that look like? It could be a requirement for at least 50% of debt service costs to be hedged for 2-3 years, similar to what was required 2012-16 in the leveraged market before interest rates fell and remained at historical lows.
All lenders will want to see much greater tolerance of SONIA rate moves in borrower debt serviceability forecasts. Cash-flow sensitivities presented to lenders will need to be much more robust and defensible.
The game changer will come if or when higher rates feed into the real economy over the next 3-6 months. If borrowers come under pressure and lenders begin to see stress on their portfolios. As in the past, the first reaction will be to reduce credit appetite for new deals and adopt a wait & see approach. A pricing issue may well turn into a credit squeeze.
Whilst we’re in a period of heightened uncertainty right now, our team believe that a market stabilisation at a new normal will occur over the next 6 weeks, particularly once the Chancellors’ fully costed plan and accompanying OBR report is released on 23rd November. The cost of risk is resetting but there is also optimism that the Bank of England base rate will settle at around 4% through next year, not the 6%+ being talked about at the moment.
In any case the way ahead for the SME debt market is choppy – for companies there is unlikely to be a benefit in waiting to raise debt or refinance. The pricing premium present now may well dissipate as the interest environment stabilises but any future credit tightening could have a much bigger impact on getting deals done.
If you are looking at raise new debt facilities or need to consider restructuring existing debt exposure, our fundraising advisory team will be able to assist you in finding the right option for your business. Get in touch with our team on 01491 579 740.
Sometimes little can change in a year but a lot can change in a week. Despite the macro events of this year, the UK SME lending market had continued to enjoy relatively benign conditions through 2022 albeit with an increasing undertone of concern over the summer months about growing inflationary pressure. But when the Chancellor stood up to deliver his surprise statement 10 days ago, UK lenders and borrowers saw the kind of rapid realignment of risk sentiment not experienced since the early days of lockdown in March 2020.
When the Government announced £45bn of unfunded tax cuts last Friday, the market assumed a big and arguably unsustainable increase in UK borrowing. The sell-off started, international capital flowed out of the pound and a classic investor flight-to-safety took hold. The Bank of England eventually took action to stabilise gilt markets and sterling. For everyone the interest rate outlook changed overnight.
The consensus is now that the Bank of England base rate will move to 6% by mid-2023. For borrowers, that outlook is feeding directly to the SONIA reference rate that most commercial floating rate loans are priced on.
The daily SONIA last week was 2.18%, it started the year at 0.19% and has doubled in just a little over 3 months. As an indication of where markets believe rates are heading – to fix SONIA exposure today the 3-yr swap rate is 5.1%. That same swap was 3.6% a month ago, and only 0.6% a year ago.
So, in practical terms – if you’re a £2m EBITDA borrower with a 3.0x leveraged facility on an unhedged floating rate, that rate could rise to 5-6% in the near term when you were paying just over 1% three months ago. The result is around 15% of your annual EBITDA is about to be eaten up by the rate movement. If a worsening trading outlook may impact EBITDA by another 10-15%, many businesses could be in cash flow covenant breach territory.
On the supply side, some debt funds will have floating-rate funding costs from wholesale finance facilities but have lent to borrowers on fixed rates for 3-5 year loans. Most will have sensibly partially hedged their funding costs but there will still be some inevitable pain to work through as the price of risk resets.
How are lenders reacting and what’s the outlook?
Currently, it’s principally a re-pricing issue – for now lenders are stating that there continues to be appetite to lend to resilient sectors and at slightly dampened but still historically high leverage levels. There is no suggestion that issued term sheets are being pulled by lenders currently.
We expect that most of the fixed rates that private credit lenders offered until this summer are likely gone. Lenders are telling us that they’re not interested in taking the pricing risk for borrowers right now.
The result is that a return to mandatory interest hedging in term sheets is expected. Some lenders are already demanding it for new transactions. What does that look like? It could be a requirement for at least 50% of debt service costs to be hedged for 2-3 years, similar to what was required 2012-16 in the leveraged market before interest rates fell and remained at historical lows.
All lenders will want to see much greater tolerance of SONIA rate moves in borrower debt serviceability forecasts. Cash-flow sensitivities presented to lenders will need to be much more robust and defensible.
The game changer will come if or when higher rates feed into the real economy over the next 3-6 months. If borrowers come under pressure and lenders begin to see stress on their portfolios. As in the past, the first reaction will be to reduce credit appetite for new deals and adopt a wait & see approach. A pricing issue may well turn into a credit squeeze.
Whilst we’re in a period of heightened uncertainty right now, our team believe that a market stabilisation at a new normal will occur over the next 6 weeks, particularly once the Chancellors’ fully costed plan and accompanying OBR report is released on 23rd November. The cost of risk is resetting but there is also optimism that the Bank of England base rate will settle at around 4% through next year, not the 6%+ being talked about at the moment.
In any case the way ahead for the SME debt market is choppy – for companies there is unlikely to be a benefit in waiting to raise debt or refinance. The pricing premium present now may well dissipate as the interest environment stabilises but any future credit tightening could have a much bigger impact on getting deals done.
If you are looking at raise new debt facilities or need to consider restructuring existing debt exposure, our fundraising advisory team will be able to assist you in finding the right option for your business. Get in touch with our team on 01491 579 740.
Despite all the doom and gloom, could it be a good time to exit your business ?
Unless living under a rock, it is impossible to ignore the dire predictions of economic collapse in the UK over the coming months. Hot on the heels of the pandemic and supply chain challenges, we now face epic fuel bills at home and at the pumps, in turn driving high inflation and the first increases in interest rates for years. With the Bank of England now predicting a recession, surely only a complete lunatic would consider now a “good time” to sell a business.
For those of us who are old enough to have been Corporate Finance advisers through the recession of 2002/3 and the financial crisis (and its protracted aftermath) between 2009 and 2012, as well as the pandemic, it is not necessarily as simple as that.
On the one hand, the decision to sell a business is not purely a function of where the wider market is at. Ill health or even simple fatigue can lead owner-managers to want to hang up their boots even when the timing is a bit off. In 2022, in the wake of Brexit, Pandemic and now Cost of Living crises, who could blame a business owner for wanting to trade less than perfect market conditions for the opportunity to step back. Indeed simply the thought of yet another challenging and uncertain period might make an exit more, not less, appealing. The gamble as to whether tax rates will rise or fall is also often part of that equation…….
In every set of economic conditions there are businesses that thrive. Even in the depths of lock-down, technology businesses were selling for premium valuations as the market rushed to digitalize. Traditionally, a recession can drive investors and acquirers to look with interest at companies serving the public sector and in the current downturn, one might surmise that businesses delivering supply chain resilience or efficiencies, e commerce logistics, ESG solutions, digital transformation and security and some aspects of health tech are likely to continue to be of interest.
Individual business valuations will continue to be a function, not of some academic equation or of a general malaise, but of supply and demand. As has been the case since the financial crisis of 2009-20012, there will be a focus on quality and with very significant amounts of “dry powder” (cash) in private equity funds and on corporate balance sheets, those businesses that have scale and face resilient parts of the economy, will continue to generate interest, competition and decent prices. B2b software, data and IT services businesses are a core focus for many funds and competition for strong businesses in those sectors will almost certainly continue to be fierce. For sub-scale, struggling or “old economy” businesses, the ability to generate an exit is likely to be much more limited, albeit a recession always brings out some opportunists looking for a bargain and if a recession were to be prolonged, some would shift focus to take advantage.
UK mid-market private equity funds have spent the last year fund-raising and have enormous amounts of capital left to deploy. Inflation makes it more, not less, important for them to deploy it and they will be working hard to identify resilient, growing companies and to fight off the competition to get to a deal. It is likely that in the teeth of a recession, commercial and financial due diligence will be even more painful that normal but there are imperatives for buyers as well as for sellers.
An increase in the cost of debt might deter some deals, but in reality there has been a reluctance to over-leverage which is a hang over from the mass casualties of over-leverage in the lead up to the crash of 2009. For most debt providers, there will just be a swift reversion to their standard lending criteria, with a recent slight loosening of the parameters looking like a blip rather than a trend. Even with debt margins increasing, debt is still significantly less expensive than equity and still historically cheap. Many new debt funds have been launched in the last few years. While the banks might retrench and wait it out (as usual), the debt funds arguably have as much of an imperative to lend as private equity do to invest. The same flight to quality and neurotic diligencing is a more likely response than them leaving the market en-masse.
For dollar denominated acquirers, the UK has been an attractive hunting ground for some time and the current dollar/sterling exchange rate extends that dynamic, albeit no-one ever bought a business just because it is cheap. Since the financial crash, acquirers have become increasingly and properly strategic in their identification and pursuit of acquisition targets. However interesting and cheap a deal might be, if it isn’t on the Board’s shopping list it is unlikely to gain any traction.
In practice, none of this is new. For good businesses, sales will still go ahead and at strong valuations. For less good ones they will continue to be difficult. With good preparation, good advice and a good dose of realism, I predict that many entrepreneurs will head for the exit in the next couple of years, whatever the economy is doing. The draw of a quieter, easier life will just be too great !
Despite all the doom and gloom, could it be a good time to exit your business ?
Unless living under a rock, it is impossible to ignore the dire predictions of economic collapse in the UK over the coming months. Hot on the heels of the pandemic and supply chain challenges, we now face epic fuel bills at home and at the pumps, in turn driving high inflation and the first increases in interest rates for years. With the Bank of England now predicting a recession, surely only a complete lunatic would consider now a “good time” to sell a business.
For those of us who are old enough to have been Corporate Finance advisers through the recession of 2002/3 and the financial crisis (and its protracted aftermath) between 2009 and 2012, as well as the pandemic, it is not necessarily as simple as that.
On the one hand, the decision to sell a business is not purely a function of where the wider market is at. Ill health or even simple fatigue can lead owner-managers to want to hang up their boots even when the timing is a bit off. In 2022, in the wake of Brexit, Pandemic and now Cost of Living crises, who could blame a business owner for wanting to trade less than perfect market conditions for the opportunity to step back. Indeed simply the thought of yet another challenging and uncertain period might make an exit more, not less, appealing. The gamble as to whether tax rates will rise or fall is also often part of that equation…….
In every set of economic conditions there are businesses that thrive. Even in the depths of lock-down, technology businesses were selling for premium valuations as the market rushed to digitalize. Traditionally, a recession can drive investors and acquirers to look with interest at companies serving the public sector and in the current downturn, one might surmise that businesses delivering supply chain resilience or efficiencies, e commerce logistics, ESG solutions, digital transformation and security and some aspects of health tech are likely to continue to be of interest.
Individual business valuations will continue to be a function, not of some academic equation or of a general malaise, but of supply and demand. As has been the case since the financial crisis of 2009-20012, there will be a focus on quality and with very significant amounts of “dry powder” (cash) in private equity funds and on corporate balance sheets, those businesses that have scale and face resilient parts of the economy, will continue to generate interest, competition and decent prices. B2b software, data and IT services businesses are a core focus for many funds and competition for strong businesses in those sectors will almost certainly continue to be fierce. For sub-scale, struggling or “old economy” businesses, the ability to generate an exit is likely to be much more limited, albeit a recession always brings out some opportunists looking for a bargain and if a recession were to be prolonged, some would shift focus to take advantage.
UK mid-market private equity funds have spent the last year fund-raising and have enormous amounts of capital left to deploy. Inflation makes it more, not less, important for them to deploy it and they will be working hard to identify resilient, growing companies and to fight off the competition to get to a deal. It is likely that in the teeth of a recession, commercial and financial due diligence will be even more painful that normal but there are imperatives for buyers as well as for sellers.
An increase in the cost of debt might deter some deals, but in reality there has been a reluctance to over-leverage which is a hang over from the mass casualties of over-leverage in the lead up to the crash of 2009. For most debt providers, there will just be a swift reversion to their standard lending criteria, with a recent slight loosening of the parameters looking like a blip rather than a trend. Even with debt margins increasing, debt is still significantly less expensive than equity and still historically cheap. Many new debt funds have been launched in the last few years. While the banks might retrench and wait it out (as usual), the debt funds arguably have as much of an imperative to lend as private equity do to invest. The same flight to quality and neurotic diligencing is a more likely response than them leaving the market en-masse.
For dollar denominated acquirers, the UK has been an attractive hunting ground for some time and the current dollar/sterling exchange rate extends that dynamic, albeit no-one ever bought a business just because it is cheap. Since the financial crash, acquirers have become increasingly and properly strategic in their identification and pursuit of acquisition targets. However interesting and cheap a deal might be, if it isn’t on the Board’s shopping list it is unlikely to gain any traction.
In practice, none of this is new. For good businesses, sales will still go ahead and at strong valuations. For less good ones they will continue to be difficult. With good preparation, good advice and a good dose of realism, I predict that many entrepreneurs will head for the exit in the next couple of years, whatever the economy is doing. The draw of a quieter, easier life will just be too great !
