As the era of easy money and low-cost financing ends, middle market businesses are facing a reckoning.
Rising real interest rates are pushing up the cost of commercial and industrial loans, making it harder for these firms to meet payrolls and finance their expansion, according to a new survey from RSM US LLP. The result is a risk to economic growth across the real economy and, potentially, a recession.
More than three-quarters, or 77%, of senior executives at firms that replied to special questions from the July RSM US Middle Market Business Index survey anticipate an increase in interest rates in the coming months. The overwhelming majority, or 82%, said that rising rates carried a negative risk to their operations.
The new regime is particularly challenging for a generation of executives that came of age during historically low interest rates.
And it’s hitting smaller companies the hardest. The survey found that small and midsize firms now pay anywhere from 10.9% to 15.5% for financing. Such rates are pushing the risk premiums on loans close to double digits—a dynamic that was hard to imagine even two years ago.
In addition, about a third, or 34%, of smaller middle market firms, or those with $10 million to $50 million in annual revenues, have loans paying below 5%, and 24% have loans between 5% and 7%. Those loans will have to be rolled over in the coming years at higher rates, which poses an additional threat to cash flow.
Not surprisingly, lending has tightened notably in recent months, as reported in the Federal Reserve’s Senior Loan Officer Opinion Survey. As a result, middle market firms needing cash are casting a wider net for financing and looking to the shadow banking sector or those firms outside of traditional sources.
More than half, or 56%, of firms in the RSM survey sought traditional bank lending over the previous 12 months. At the same time, though, more than a third, or 36%, turned to the shadow banking market, 33% to private equity sources, 30% to digital banking and financing sources, 29% to government lending and a whopping 60% to private lending. Roughly 39% reported using retained earnings and cash to meet financial requirements.
At least one-third of survey participants appeared to be moving into nontraditional bank lending, which does not have the regulatory framework and safety net of traditional bank lending. As a result, the higher premiums attached to such lending are a further sign of substantial financial stress affecting the real economy.
The survey aggregated the responses of 416 senior executives from a range of middle market companies and was conducted from July 5 to July 25.
For more insights on the real economy, check out RSMUS.com.
Since the survey, nominal rates have only increased while inflation continues to abate. This divergence has pushed real rates up, which inhibits risk-taking and business expansion. Currently, real rates using 10-year Treasury Inflation-Protected Securities are about 2% and are likely to rise. This rate stands well above the 0.26% that was common over the past decade.
In our estimation, it will soon be time for the Federal Reserve to stabilize real rates to prevent a downturn in an otherwise solid economy. Such an outlook means possible rate cuts in the first half of next year, given the rise in nominal and real rates, which may continue rising on the back of solid economic data.
The data
Our survey illustrates that the nearly two-year campaign by the Fed to tame inflation is now resulting in financial stress across the real economy that will, in turn, cause hiring and economic activity to slow, which is the explicit goal of the Fed’s policy.
The risk of policy mistakes has now shifted from the Fed not acting aggressively enough to restore price stability to the potential for overkill leading to a premature end to the business cycle.
A recession need not be the end game for the Fed’s push to restore price stability. But if the central bank does not end its rate hike campaign soon and focus on stabilizing real rates, it risks unnecessarily causing a recession.
Our special question survey data clearly illustrates rising financial stress. For firms that need to finance payroll and business expansion through traditional bank lending, the overall rate is 10.9%, with firms in the smaller revenue bucket ($10 million to $50 million) facing a mean average 7.7% rate and firms in the larger revenue bucket ($50 million to $1 billion) 13.2%.
Overall, 21% of firms now pay less than 5% on their existing loans, and 22% are paying from 5% to 7%, implying substantial reset risk and diminished cash flows as those loans roll over in the coming years.
Firms using nontraditional lenders pay a mean average annual percentage rate of 13.7%, with firms in the larger revenue category paying 14.7% and smaller middle market firms paying 10.5%. Firms that have turned to digital bank and finance sources of liquidity pay an average mean APR of 12.3%, with smaller firms facing a 15.3% rate and larger firms at 11.4%.
For those businesses that eschew traditional and nontraditional lenders and turn to equity sources of lending, the mean average APR is 15.5%, with the larger revenue firms paying 17.0% and lower-revenue companies paying approximately 8.8%. This does not include warrants or any conditionality attached to such private lending sources.
Those using government sources pay a mean average of 11.4%, with smaller firms paying 5.7% and larger firms paying 13.1%.
Those businesses that use credit card financing face an average of 15.0%, with smaller firms paying 13.6% and 15.3% on average.
Who adjusts?
To put things in perspective, especially for those not familiar with middle market financing, this is an instructive way to think of it: Using the secured overnight financing rate (SOFR ) as the benchmark, 5.25% would be the baseline rate for lending. Then, based on a bank’s assessment of a firm’s balance sheet quality in the context of market conditions, a risk premium is attached. If we assume the perspective of a traditional bank lending to a firm with $50 million to $1 billion in revenues, the bank will seek a risk premium that fits the individual firm and broad economic factors. The 13.2% mean average APR noted in the survey data implies a 7.95% risk premium attached to financing.
That is well above the norm over the past 20 years when loans were available at historically low interest rates.
That raises two questions: Who adjusts, and how?
Recent research indicates that after a tightening shock of 100 basis points, research and development spending declines by about 1% to 3% and venture capital investment declines by about 25% in the following one to three years. Given that the Federal Reserve has increased the policy rate by 550 basis points over the past two years, the risk to the lending conditions across the real economy is nontrivial.
It is clear that firms that have relied upon low-cost leverage, sometimes at negative real rates, will face clear challenges in financing payroll and expansions as rates remain high compared to recent standards and real rates continue to increase.
Manufacturing, housing, technology and life sciences firms will all likely face significant adjustment periods to the current and upcoming period of higher nominal and real rates.
Private equity, in particular, will face challenges as the economic landscape has shifted from one that supported the low-cost, high-leveraged risk-taking model for many years to a new environment of higher rates and higher cost of capital that now favors operational efficiencies and execution.
Zero interest rate policy can mask a wide array of operating inefficiencies in the real economy. An environment with higher rates and higher inflation, on the other hand, reveals them. In the longer term, the winners in private equity will most likely be firms that can create enterprise value among their portfolio companies by focusing on operational expertise and optimized cash flows. The prior risk-seeking regime that sought balance sheet engineering and relied on debt maximization and deal structuring will, in contrast, face considerable headwinds.
The takeaway
The zero interest rate era has ended. A new era with higher nominal and real interest rates is upon us. Middle market firms report paying, in some cases, double-digit rates to finance payroll and business expansions—far higher than in the past 20 years. Adding to the risk is the large volume of loans made during the previous era that need to be rolled over at significantly higher rates.
This poses a challenge to companies that rely on significant leverage, such as private equity firms or low interest rates, to support speculative and risky business activity.
This will require a policy response from the central bank—likely in the first half of next year—to stabilize real rates and ensure the economy does not unnecessarily sink into a recession.
