Analysis

Higher rates may have muted impact on the Middle Market

Federal Reserve’s latest rate-setting policy

The minutes from the Federal Reserve’s latest rate-setting policy meeting depict a central bank that is ready to start raising rates, but in a careful and gradual manner.

Higher rates may have muted impact on the Middle Market

May 5, 2015

A blog post by Roger Nanney, national managing partner for Deloitte Growth Enterprise Services, Deloitte LLP

The minutes from the Federal Reserve’s latest rate-setting policy meeting depict a central bank that is ready to start raising rates, but in a careful and gradual manner. Higher rates would be expected to increase borrowing costs for many US businesses, but there is reason to suspect that private companies in the middle market may be spared from a significant impact.

One reason for this is the way many mid-market companies are financed. Many private businesses use their assets and cash flow to secure expansion capital. With the strengthening economy helping to increase the value of that collateral, such businesses are enjoying extra borrowing capacity. The asset-based lending (ABL) market is very active at present, and all indications are that the momentum will carry on for the balance of this year. In our latest biannual survey of mid-market companies, asset-based financing was cited as the most likely form of financing to be pursued this year, followed closely by cash-flow loans.

A big reason middle market businesses tend to tap the ABL and cash-flow financing markets is because such loans typically have low costs. Lenders are willing to charge less interest because real assets back the loans and often can be liquidated in the case of borrower default. Of course, many such loans are floating rate offerings, meaning their costs will rise as market rates increase. But the fact that they start off at such a low base promises to soften the impact of rate hikes on many middle market companies.

Of course, there are some important caveats. For one, ABL and cash-flow lenders tend to restrict how borrowers can use the proceeds; they generally want the funds to be spent on activities that will directly enhance the borrower’s earnings. The other limitation is what’s called an “airball” – that’s the amount the lender is willing to lend above and beyond the value of the collateral. Asset values may be rising in today’s economy but the dynamics noted still put a cap on the amount that middle market businesses can borrow.

Private businesses that need to look elsewhere for financing are more likely to feel the pinch from future Fed rate hikes. Business development companies (BDCs) have been very active in the middle market space of late, helping to lend money with fewer strings attached. In fact, about 20 publicly traded BDCs now operate in the middle market, up from just a handful a few years ago. The wrinkle in working with a BDC is that the cost of capital tends to be higher – a lot higher in some cases – and their financing is tied to floating rates, so interest related costs will likely adjust even higher if the Fed goes forward with its plans.

But for the majority of private companies looking to borrow in 2015, the interest rate picture will likely remain a backdrop to continued growth. Financing is plentiful and, in most cases, relatively inexpensive. A rate hike or two over the coming months isn’t likely to derail the growth of the middle market anytime soon.

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