Managing Your Capital Structure in a High Interest Rate Environment
As widely anticipated, the Federal Reserve held policy rates steady at its FOMC meeting in September, with the federal funds target remaining in a range of 5.25% to 5.50%. At the same time, the Fed delivered a hawkish message with respect to economic growth and the future path of policy rates. As businesses adjust to higher interest expenses, the most common questions we are hearing from finance teams are: will yields come down, when, and at what level will they settle?
Treasury Yield Curve Jan-23 vs. Aug-23
There are longer-term factors that will cause higher rates to persist:
1. Shrinking of the Fed balance sheet - Reduced only 11% to date, from peak of $9.0 trillion in March 2022 to $8.0 trillion in August 2023 (prior to the pandemic it was $4.0 trillion)
2. Increased federal debt - 95% of GDP, up from 80% at the start of 2020
3. Persistently high inflation - While moving lower, inflation is expected to remain above the Fed’s stated goal of 2.0% for several years
As cheap money becomes a story of the past and higher rates persist, the question to ask is:
What are the costs I can’t quantify of a higher interest rate environment, and how should this impact my capital structure?
Part of the value of maintaining a relationship with Prudential Private Capital is the diversity of “non-bank” capital we provide across 3 types of debt. Here are reasons companies are currently accessing our capital:
Senior Long-Term Fixed Rate Debt - Typically utilized by investment grade and higher below investment grade credit quality companies, our long-term (5-15+ years) fixed rate debt complements bank debt
- Capacity: Commercial bank lending appetite is contracting and becoming more costly as banks reduce risk-weighted loans to preserve capital; our senior debt capital can preserve or increase your total debt capacity
- Attractive Relative Cost: Current long-term debt costs are attractive relative to short-term debt due to the inverted yield curve
- Certainty of Cost: Fixed borrowing rates provide certainty of financing cost for long-term, strategic investments
Senior Floating-Rate Debt – Typically utilized by smaller companies (below $50M of EBITDA) with higher leverage targets and a desire for flexibility
- Low Amortization: Annual amortization requirements of 1-5% per year allow cash flow to be preserved for growth
- Covenant Lite: Fewer covenant restrictions than traditional bank debt allow greater relative operating flexibility
Mezzanine Debt – Typically utilized by companies for transformational events (large acquisitions, shareholder buyouts, etc.) that exceed the risk levels of senior debt investors
- Equity Value Enhancement: When used in place of raising equity, the cost of mezzanine is less dilutive to existing shareholders due to the lower return requirements associated with debt-like features (current return, liquidation priority)
- Cash Preservation: There is no amortization until maturity and part of the total coupon is paid in kind, preserving cash for higher priority items
If you would like to learn more about our types of capital and what may be a fit for your business, contact us here.