Many bankruptcy attorneys, financial advisors, and investment bankers who work in the distressed business industry believe that when interest rates increase to more historic levels the industry will enjoy a much-needed resurgence after five years of depressed engagement volume and fees. Clearly the Federal Reserve is in the process of gradually increasing the federal funds rate, a base rate that directly impacts—and to a large degree drives—all lending rates in the U.S.
However, anticipated interest rate increases may not create the significant surge of engagements for distressed business professionals that some are expecting. No doubt increased interest rates will create more pressure on struggling companies, as would price hikes for raw materials, labor, or any other cost increase. However, the distressed business professional service niche has always been a highly cyclical business in which unforeseen catastrophic events, such as the residential housing financing collapse or technology sector collapse, trigger significant and unexpected booms in distress business.
This article explains how this author views the expected interest rate increases and offers predictions for how they are likely to affect distressed business professionals over the next few years.
Figure 1 shows annual interest rates from January 1990 to January 2017 (most recent 28 years) for the federal funds rate, three-month LIBOR, and the prime rate. Focusing on just the federal funds rate, the data show:
As most are aware, it is highly likely that the federal funds rate will increase by at least 2.0 percentage points as it moves toward the historical average over the next two or three years. It’s unlikely the Fed will increase rates by more than 0.25 percent in any one quarter, so as a practical matter, federal funds rate increases are not likely to exceed 1 percent in any calendar year. Therefore, it will likely take until 2019 for the federal funds rate to return to 3 percent, its recent historical average, or even higher.
Credit Expansion, Contraction
The level of activity of the distressed business niche can be thought of as a function of loan credit activity. There are three general conditions of loan credit activity:
Loan credit expansion, during which new loans are being created and the market for new financing is heating up. During this cycle, loan underwriting standards are lowered, interest pricing drops, and covenants become more and more liberal for borrowers. This creates conditions more favorable for distressed business professionals, as some percentage of those deals will encounter trouble; the more aggressive the lending market becomes, the less margin for error there is for staying out of financial distress. The greater the credit expansion, the better it will be for future distressed work flow.
Loan credit contraction, during which lenders reclassify some existing loans as “exit credits” and actively ask companies to refinance, sell, or liquidate because the lender has decided to no longer extend credit to that borrower. This is the best condition for the distressed business professional. High loan credit contraction occurs when a catastrophic event impacts overall lending or an industry collapse prompts lenders to push out troubled industry credits. The greater the credit contraction, the better the opportunities will be for immediate distressed work flow.
Loan credit stability, during which some new loans are created but at a slow pace. The economy, if it is expanding at all, is doing so slowly and cautiously. Companies are cautious about capital spending, hiring, expansion, and acquisitions. Lenders hold on to portfolio size for fear of losing market share and exit only very bad credits, such as in cases of fraud or high cash burn. This is the worst condition for the distressed business professionals because there is a low level of immediate work and a low level of distressed backlog being created for future work. This was essentially the state of the market from 2011 to 2015. Only since late 2015 and early 2016 has loan credit started to expand again.
Figure 2 illustrates these three general conditions and how a distressed business professional might view each.
The U.S. government, primarily the Fed, intervened in capital markets in three ways that were unusual and unprecedented after the turmoil of the Great Recession. In the author’s view these interventions dramatically altered the historic U.S. business cycle of expansion followed by contraction.
First, the Fed’s long-term suppression of the federal funds rate has continued for more than eight years, keeping this rate under 1 percent. The problem with keeping the rate so low for so long is that it becomes increasingly difficult to escape this artificially low interest rate world. As previously mentioned, the Fed seems to have started down a path to return interest rates to historical norms by 2019. But that is still two long years away.
Second, the Fed injected huge amounts of capital into the marketplace during the recession in the form of bailouts for banks (TARP), the automotive industry, and American International Group Inc., and its purchase of Treasury bonds for so-called quantitative easing (QE). Although most of the bailout money has been repaid, the Fed still holds $4.5 trillion of Treasury bills and mortgage-backed securities, which is five times its investment in assets before the Great Recession. Until those assets are sold back into the market, the impact of this government intervention will continue.
Third and least discussed is the Office of the Controller of the Currency’s (OCC’s) unpublicized approach to troubled real estate loan classification for large U.S. banks during the immediate post-Great Recession period of 2010 to 2012. Clearly the OCC didn’t follow its own policies regarding marking commercial real estate loans to market during that time. If it had done so, it’s likely that all big banks would have been financially wounded a second time (triggering the risk of a second round of TARP loans) because there was essentially no market for commercial real estate property and loans for at least two years. This was probably a wise decision because it avoided a second-stage banking industry crisis. This relief was phased out by 2013 to 2014.
So only one of these three U.S. government intervention actions, OCC relief, has been fully reversed, and another, a return to historic interest rates, should be completed by 2019. That leaves one intervention, government capital in the market, still to be addressed. The author believes that the distressed business niche won’t significantly expand until this last intervention is on a clear path toward correction.
FCC Ratio Covenant Defaults
Increased interested rates mean two things for borrowers: increased costs and increased fixed charges in the calculation of fixed charge coverage (FCC) ratio covenants. The FCC ratio is typically defined as EBITDA divided by fixed charges. Fixed charges are typically defined as principal and interest debt service plus capital expenditures (capex) plus income tax payments.
The impact of increased interest costs on borrowers will be much more pronounced for companies that are capital intensive—those having large investments in either fixed assets or working capital—or highly leveraged. These are companies with relatively high debt for their sales levels. Although increased interest costs adversely affect all borrowers, especially those already on lenders’ distressed company watch lists, borrowers can mitigate the impact by reducing costs elsewhere in the business. Since the increase in interest rates will occur gradually over a two- or three-year period, higher interest costs aren’t likely to create much new distressed business work.
However, the impact on FCC ratio covenants is a different matter. Not only does the increased interest cost reduce earnings (but not EBITDA), but it also increases fixed charges for the FCC ratio calculation, as there is no way to offset the impact of the fixed charge. Most lenders require a minimum FCC ratio of 1.1 times to 1.25 times. An FCC ratio of less than 1.0 means EBITDA is insufficient to service all fixed charges (i.e., debt service, capex, and income taxes), which in turn means that going concern value of the borrowing company is being eroded.
Figure 3 provides two examples of how a 1.0 percent increase in interest rates would impact two different companies of the same sales size and same EBITDA margins, where one company has a much greater loan size (due to some combination of capital intensity and higher leverage) than the other.
This one-point interest rate increase hasn’t yet put the heavy capital company into a cash-bleeding situation, as EBITDA is still higher than fixed charges. However, it has reduced the FCC ratio from 1.20X to 1.10X and likely put the company into a loan default, assuming there is an FCC covenant in place. Of course, this is only the first 1 percent increase in interest rates, and a total increase of 2.0 percentage points or more will occur over time as interest rates trend back toward historic levels. This means that interest rate increases will become a compounding problem as far as FCC ratio covenants are concerned and will create potential liquidity tightness for borrowers, who will find themselves with little cushion in their FCC ratio covenants.
The Bottom Line
The increased risk for heavy capital borrowers from the cumulative impact of pending interest rate increases over the next few years is quite significant. But that impact will mostly manifest itself through FCC ratio covenant defaults rather than in pushing borrowers from cash flow positive to cash flow negative positions. Interest rate increases will be somewhat positive news for distressed business professionals, but they shouldn’t expect a flood of new opportunities from these pending rate hikes.