The Zero Interest Rate Policy (ZERP) environment has come to an end, representing a new set of playbooks for PE firms to break out of the old filing cabinet from 1990. The resurgence of high interest rates is putting pressure on firms with stagnant or declining revenue growth that previously relied on high leverage and favorable financing conditions to stay afloat. These observations are not unique in any way. Rates go up, cash flow after debt service goes down, and bad companies have to re-orient or crumble. How do you attempt a turnaround of these companies? The effective turnaround first hinges on securing talent adept at restructuring with less runway to survive. This challenge is compounded by a talent pool that often lacks experience in managing in an environment of rising interest rates and cheap cash.
Since 1990, interest rates have experienced significant fluctuations influenced by various economic conditions and policy decisions. In the early 1990s, the Fed reduced interest rates to combat recession, reaching a low of 3% in 1992. Throughout the mid to late 1990s, the economy boomed, leading the Fed to gradually increase rates to prevent overheating, peaking at around 6.5% in 2000. The early 2000s saw rates slashed again in response to the dot-com bubble burst and the 9/11 attacks, dropping to 1% by 2003. Rates then steadily rose to 5.25% by 2006 before the 2008 financial crisis forced the Fed to cut rates to near zero. This ultra-low rate environment persisted for several years to support economic recovery. It wasn't until late 2015 that the Fed began to incrementally raise rates, reaching 2.5% by 2018. However, the COVID-19 pandemic in 2020 prompted another dramatic cut to near zero to mitigate economic fallout. As of recent years, rising inflation pressures have led to a more aggressive rate-hiking cycle, bringing interest rates to levels not seen in over a decade.
This recent reversal of interest rates has a significant impact on the core PE business model:
1. Increased Borrowing Costs and Tighter Credit: Higher interest rates make debt financing more expensive, reducing returns on LBOs. This increased cost of capital makes deals less attractive and decreases the overall volume of transactions. Additionally, higher rates often lead to tighter credit conditions, making it more difficult to finance new deals and refinance existing debt. This stifles growth and can lead to liquidity issues for portfolio companies.
2. Exit Challenges: Elevated interest rates can make initial public offerings (IPOs) less attractive and reduce the willingness of strategic buyers to pay high prices due to their own increased borrowing costs. This can lengthen the holding period for investments and complicate exit strategies.
3. Cash Flow: Tighter DSCRs lead to less reinvestment in the revenue drivers of the business. Staff, CAPEX, software—all the oil that makes a business tick—is now under stress, possibly leading to a death spiral.
Maintaining a healthy Debt Service Coverage Ratio (DSCR) becomes crucial in this environment. Broken covenants and debt spirals are real risks if rates were not hedged prior to the COVID-19 pandemic. Financial outlooks can dramatically differ based on whether a company locked in low rates or is now facing the brunt of LIBOR + x% basis adjustments. Operational adjustments have their limits, and once critical structures begin to crumble, the implications can be severe.
With yields in perpetual decline over the last 40 years and cash being cheap, the amount of effort and skill needed to manage the treasury and cash flow also diminishes. Prior to this hiking cycle, the incentives for businesses to hire talent who excel at fundraising and growth took precedence over operators who excel at prudent treasury management and focusing on efficiency.
In addition to finding executives with practical knowledge of how to operate in this environment, signing that talent is an even bigger hurdle. Why would a high-quality candidate risk their reputation by attaching their name to a company burdened with LIBOR + 8% paper?
A practical solution to these issues is hiring outside consultants who do not dilute equity. These consultants can step in to run the necessary playbooks and set up the full-time executives for success moving forward. This approach allows firms to leverage the expertise of seasoned professionals without the long-term commitment and reputational risk for incoming executives. Additionally, it provides a buffer period during which the company can stabilize and improve its financial health, making it a more attractive and less risky proposition for high-quality candidates.
In conclusion, the high-interest rate environment presents a formidable challenge for PE firms aiming to commit to a turnaround. Increased borrowing costs and tighter credit conditions make leveraged buyouts less attractive and complicated exit strategies, while stressing cash flow and DSCRs. While these conclusions are obvious, the less obvious is how to hire operating talent in this environment. This scenario necessitates a shift in focus towards securing talent skilled in restructuring and prudent treasury management, a competency that has diminished in priority over the years of low interest rates. MBA programs must adapt to this new reality, equipping graduates with the knowledge and skills to navigate rising rates. Meanwhile, PE firms can mitigate immediate risks by hiring specialized consultants who bring expertise without long-term commitment, setting the stage for sustainable recovery and attracting permanent operating executives without the baggage of a risky turnaround on their resume. This strategic approach not only addresses the immediate operational and financial challenges but also positions firms for future success in a more volatile economic landscape.