How interest rates affect your business

When it comes to the cost of borrowing, burgeoning UK ventures have rarely had it so good. Base interest rates are at historically low levels, having been on a downward trend since the late 1980s. But this could be about to change.

Setting up a business bank account

Setting up a business bank account

When it comes to the cost of borrowing, burgeoning UK ventures have rarely had it so good. Base interest rates are at historically low levels, having been on a downward trend since the late 1980s.

The UK base rate stood at a weighty 15 per cent in October 1989, yet the last change made in August 2005 by the Bank of England saw the rate moved south from 4.75 per cent to 4.5.

However, with the US rate now above that at 5.25 and a further rise likely, the gap between the US and UK is being stretched (UK rates are rarely above those in the US) and many analysts suggest the UK base is due a lift before the end of this year.

Private equity – will it feel the pinch?

Leading figures in the private equity space are cautioning that deals are being financed by too much debt, a risky situation for borrowers that affects both private equity houses and the companies that use them to back their bids.

Experts worry that investors may be over-borrowing, storing up huge problems for the future should rates rise.

Philip Marsden, director at Vantis Corporate Finance, explains: ‘When rates go up, finance becomes less available and it becomes more expensive to make acquisitions with debt.

In the private equity and venture capital arena, companies making acquisitions have depended on high levels of debt being available, with the banks lending on multiples of EBITDA (earnings before interest, tax, depreciation and amortisation).

Now, that multiple will inevitably come down when interest rates go up and that in turn directly affects the mergers and acquisitions market.’

High rates equal strategy shifts

For growing companies, Marsden identifies two key effects of a rising rate environment. ‘There’s the market side, where rising rates affect demand for a growth company’s goods and services, putting the squeeze on spending.

As rates rise, growing companies might have to consider the robustness of their forecasts, asking themselves how they are going to contend with lower sales.’

Conversely, when interest rates fall, economic expansion usually follows and this will also have an effect on a company’s strategy.

Does the business have enough staff to deal with a swift rise in sales if growth follows suit? Can the business speedily gear up in terms of capacity, or capitalise on acquisitions in a land grab in its sector?

‘The second real effect is on the company directly,’ continues Marsden. ‘If rates rise and the company has been heavily dependent on bank borrowing or asset-based lending, everything becomes more expensive for that company.’

If rates do start to push higher, bankers – ever risk averse – start to become nervous about the quality of a company’s debts and also about the cover for those debts. ‘The profit-to-interest ratio (interest cover) falls and a company might have to pull back by reducing working capital or stocks.’

Winners and losers

There is a flip side to the coin, however. Ventures with lower borrowings or cash on the balance sheet can find themselves in poll position to outflank rivals in a high rate environment. ‘

There are always winners and losers and companies with high levels of debt can often become targets for cash rich players,’ elaborates Marsden.

For those companies unfettered with debt, ‘It is possible for them to buy companies much more cheaply, because there is even less debt-financed competition for targets out there in the market.’

A rising rate scenario shouldn’t send growing companies with a liking for debt-funded deals into panic, however, so long as they are growing profits, generating strong levels of cash and sporting healthy interest cover.

Floated on AIM in late 2004 with the acquisition of Azur, and determined to play a role in the consolidation of the IT services market, Maxima is a venture that doesn’t fear rate rises despite the fact it has dipped into debt to help fund subsequent acquisitions.

The most recent of these was the £4.8 million acquisition of QED Business Systems, a deal with an equity element, but primarily funded by bank debt under facilities with Barclays.

Cash generation in the year to May was strong, even though there was a net cash outflow of £12.1 million on acquisitions, and year-end net debt was £3.1 million even after a September share placing that raised £4.8 million.

‘For us, bank debt is the cheapest way of doing acquisitions,’ explains finance director Linda Andrews, ‘because our level of profit means that our interest cover is pretty substantial and also because our shares are undervalued [Maxima floated at 110p and the shares are currently trading at 160p].

‘So, the only way that higher interest rates would affect our strategy would be if they kept rising and rising and our share price failed to move.

This is because we think that at the right price, equity has to be the preferred route for doing deals.’

Rising rates would not really play into Maxima’s hands in terms of targets amid the acquisitive landscape, ‘as most of the targets we are looking at actually have cash, with one in particular having £2 million on its balance sheet,’ adds Andrews.

A venture that does have an astute interest rate strategy relating to acquisitions is Lavendon, which rents out ‘powered access’ equipment such as cherry-pickers and scissor-lifters.

The group is a European market leader and has a history of high debt. This has been brought under control of late thanks to strong operational cash flows.

Last year, net debt reduced by £27.3 million to £61.7 million, helping to slash the interest bill by £1.4 million to £4.4 million.

Needless to say, rate fluctuations are watched carefully, as debt is used to fund acquisitions, of which the most recent was AMP, an operator of a fleet of powered access machines in the South West.

The consideration for AMP was £3 million in cash, with an extra sum of between £300,000 and £2.6 million payable in relation to profits. Lavendon used its bank facilities to fund the deal, and has also assumed £2.8 million of AMP debts.

‘Where we can,’ explains finance director Alan Merrell, ‘we try and protect ourselves with a mix of fixed and variable interest rates on our debt, and we take out various interest rates swaps, which gives us a fair degree of protection.

‘So, let’s say we were carrying £100 million of debt, we would have £50 million of that at fixed rates with our banks. If rates move up by a quarter of a per cent then the fixed element would not be affected, even though the variable would be.’

And in terms of rates strategy and debt-funded acquisitions, he says, ‘if we think that rates are on an upward trend, which means that we’ll be paying more for that debt, then we would try and reflect that in the price that we are prepared to pay for the acquisition.’

Interest rates and initial public offerings

Consternation surrounding the prospect of rising rates – used by monetary policy makers to peg back growth – usually constrains the IPO scene and, at the very least, pulls back pricing. Pulled stock market floats and less ambitious pricing are a feature of high rate environments.

‘When interest rates rise, the Stock Exchange is typically held back because the demand outlook becomes more questionable and the City queries where the growth is going to come from,’ explains Vantis’ Marsden.

‘Interest rate rises tend to hold back the amount of funding available for offerings and at the very least, separate the wheat from the chaff. More highly geared, less attractive companies will find a degree of indigestion in the market.

 

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