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 debt 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.