Borrowing costs

Soaring borrowing costs increase pressure on indebted UK businesses | Interest rate

Ihis is a photo that marked the end of an era. Morrison boss David Potts, in a black open-necked shirt, standing in a garden at the supermarket group’s headquarters in Bradford, next to a statue of founder Ken Morrison. Former Tesco leader Sir Terry Leahy is chatting with him. They were celebrating a historic deal that last year saw the grocery chain taken off the stock market and into private hands.

Leahy, now an adviser to buyout giant Clayton Dubilier & Rice (CD&R), had helped him outbid US private equity firm Fortress for Morrisons. The deal, which involved burdening the company with debt in an industry known for thin margins and cutthroat competition, was a big bet on growth.

David Potts, CEO of Morrisons (left) and Sir Terry Leahy at Morrisons head office in Bradford

That bet now seems bigger than ever: high inflation, exacerbated by Russia’s invasion of Ukraine, has forced central banks to rapidly raise interest rates. The costs of servicing corporate bank loans – almost ignored in a world of low interest rates – threaten to skyrocket. For UK businesses that have floating rate loans or need to refinance, rising interest rates will have a marked effect on costs and profits.

After the takeover, Morrisons’ debt more than doubled – from £3.2bn in January 2021 to £6.8bn a year later, according to Moody’s. The ratings agency estimates that a one percentage point rise in interest rates will cost Morrisons £30million a year in additional fees. It would significantly reduce profits at a time when sales could also be under pressure, although Moody’s and other agencies believe Morrisons still have strong enough finances to weather the storm.

With Britain set to slide into recession in the coming months, interest rates could push less healthy businesses out of business.

Companies have scrambled to reduce exposure, paying off debt with profits when they could and seeking investors where they couldn’t. Last month, carmaker Aston Martin Lagonda allowed investors – including Saudi Arabia’s controversial sovereign wealth fund – to buy shares at a deep discount in order to reduce what President Lawrence Stroll called a crippling cost of debt.

Aston Martin factory
Aston Martin Lagonda faces crippling debt costs. Photograph: Phil Noble/Reuters

For companies still hoping to refinance, rising interest rates will make things even more difficult. Among them, GFG Alliance, the group of metallurgical companies controlled by Sanjeev Gupta. Gupta has been trying to refinance the companies for more than 18 months, which has raised concerns among thousands of steel jobs in Rotherham and Stocksbridge in South Yorkshire, and elsewhere.

Richard Etheridge, associate managing director of Moody’s, said companies in the UK and Europe were facing high debt levels and tough capital markets. “Those who need to refinance will be most at risk given rising financing costs,” he said.

In 2022, interest rates around the world rose faster than at any time in the past 41 years, according to an analysis carried out last week by S&P Global Ratings, another credit rating agency, led by Nick Kramer.

If Bank of England Governor Andrew Bailey or European Central Bank President Christine Lagarde raise interest rates too soon and energy prices continue to soar, it could “rapidly accelerate defaults.” of payment,” they warned.

Economists have long warned against “zombie companies” are kept alive through debt while paying low interest rates. They could soon face a settling of accounts. Rating agencies focus on large companies, which are able to issue bonds, but there are also concerns about the impact of rising borrowing costs on smaller companies.

Daryn Park, senior policy adviser at the Federation of Small Businesses, said he was concerned that small businesses could not access loans if they needed short-term cash. “If interest rates hit 6%, that will start to drive down the price of many companies,” he said.

One in five small businesses that applied for financing in the third quarter did not find an offer at an interest rate below 11%, according to a survey of FSB members.

There will also be longer-term consequences for small businesses that depend on bank loans to invest in growth. Park said, “If we’re heading into a tighter market, they won’t be able to grow.”

In late 2019, Gary Ballantyne and his wife Lynette founded Viral Entertainment, a company providing virtual reality experiences in Corby, Northamptonshire. The pandemic shutdown that followed soon after caused the company to miss the opportunity to build a financial cushion ahead of the expected recession.

Gary Ballantyne with a client.
Viral Entertainment’s Gary Ballantyne Can’t Get Funding to Expand

“We really have to consider bigger premises because the technology has evolved,” he said. The company now has virtual reality headsets that allow two people to move around a room and interact without being tethered to a computer. “We really need more space but we can’t afford to move because there isn’t enough working capital in the business.”

Ballantyne is confident in the company’s longer-term prospects – analysts predict that interest in virtual reality will explode – but he said that short-term growth of his business was going to be impossible due to the difficulty in obtaining financing. Instead, he’s trying to find other ways to use the equipment they have, like bringing it into care homes to give residents a taste of virtual reality.

Norman Chambers, chief executive of the National Association of Commercial Finance Brokers, said that over the next six months he expected an increase in “distressed borrowing” from businesses in need of emergency funds. He said brokers, who act as intermediaries between companies and lenders for a fee, should “extend loan terms and consolidate where possible”.

However, the banking sector, which provides the bulk of borrowing to UK small businesses, is not yet too worried. In September, UK Finance, the banking industry lobby group, said there remained “high financial leeway among SMEs, and lenders continue to stand ready to support businesses”.

Katie Murray, NatWest Group’s chief financial officer, said on Friday that “loan writedowns remain extremely low.” However, the bank acknowledged that it was seeing an increase in credit risk among its corporate clients, although evidence of actual defaults remained limited.

Stephen Pegge, managing director of commercial affairs at UK Finance, acknowledged tough times were ahead for the UK economy, but said so far the proportion of borrowers under stress was not higher than before the pandemic.

“Banks have been testing for some time whether companies can afford higher interest rates,” he said. “It gives me confidence that things could turn out well.”

bank of england analysis published last year estimated that “only a large increase in borrowing costs” – around four percentage points – would “significantly increase the share of companies with high debt service”. However, this analysis was carried out when the bank base rate was 0.1%. Since then, this rate has risen to 2.25%, and further increases are expected; increases in borrowing costs of four percentage points now seem entirely possible.

This Bank analysis also suggested that corporate debt burdens would be manageable if profits were to fall, but did not examine what would happen if sales fell just as interest rates soared. .

The pace of rising interest rates has “taken a lot of people by surprise,” said Louise O’Sullivan, director of Interpath Advisory, a debt and restructuring advisory firm. During the period of low interest rates since the financial crisis, she added, companies were no longer used to hedging against interest rate risk. And it was now too late, as hedging costs had risen, and companies instead had to try to see how they could keep cash reserves in their operations.

Sandra Kylassam-Pillay, another Interpath director, said the true effects of higher borrowing costs have yet to be seen. “It’s not the rise in interest rates alone that’s affecting businesses right now,” she said. “It’s also inflation and the cost of living – all of which means businesses are under increased stress.”