Navigating the Complexities of Today’s Capital Markets

By: M. Ryan Weir, Jr., Director
Capital Advisory Investment Banking Group

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In the current economic climate, navigating the capital markets is becoming increasingly more complex. Several themes have contributed to the challenging landscape including inflation and rising benchmark rates, a regional bank liquidity crisis, and broader recessionary concerns. This near-term volatility has given rise to an acute focus on interest rate risk management and the necessary exploration of alternative capital solutions.

Inflation and Rising Benchmark Rates
In response to persistent inflation, the Federal Reserve continues to raise its benchmark interest rates with the explicit goal of tempering inflation and stabilizing the economy. This tightening monetary strategy has had, and will continue to have, profound implications on operating companies and their access to capital.

Following a prolonged period of near-zero interest rates, the Federal Reserve implemented ten consecutive rate increases since March 2022, thereby moving the target range for the federal funds rate in the May 2023 Federal Open Market Committee (FOMC) meeting to between 5.00-5.25%. The prime and standard overnight financing rate (SOFR) benchmark rates, which are directly correlated, consequently rose to 8.25% and ~5.00%, respectively.

This shift in the rate environment presents yet another set of hurdles operating companies face when already battling the lingering impact of the pandemic, rising costs, supply chain issues, and an incredibly tight labor market. As companies navigate their way through this (hopefully temporary) new reality, rising interest rates will undoubtedly impact performance and ultimately access to capital.

The Fed outlook is mixed: while a pause is expected, some Fed governors are suggesting the work is not done quite yet. Meanwhile, the markets are pricing in 2-3 cuts this year (perhaps a stretch) and, given that derivatives price off market anticipation, strategies employing interest rate swaps and similar structures are relatively attractive to floating rate borrowers.

Companies have a number of strategies at their disposal to hedge against exposure to rising interest rates. One of the more obvious solutions is swapping variable-rate debt for fixed-rate debt. This allows the issuer to lock in the current interest rates, thereby insulating their debt service obligations from future rate hikes. However, this strategy requires careful scrutiny as it can be costly if interest rates unexpectedly drop.

Alternatively, businesses might explore the use of other common financial derivatives such as caps and collars. These instruments offer some protection against future interest rate fluctuations although, like any financial contract, they do require a certain level of financial acumen and may involve additional costs. Often, a borrower may elect to swap rates on only a portion of the loan amount, versus the total amount.

A brief explanation of hedging tools is outlined below:

• Interest Rate Swaps
An interest rate swap is a contract between two parties to exchange interest payments. One party agrees to make payments based on a fixed interest rate, and the other agrees to make payments based on a variable (or floating) interest rate. The principal amount (the loan amount) doesn’t change; rather, just the interest payments that were swapped.

Cost/Benefit: If a borrower is worried about interest rates rising and has a loan with a variable interest rate, the Company might enter into a swap wherein the Borrower pays a fixed rate and receives a variable rate from the counterparty. If rates go up, payments from the increasing variable rate received from the swap help offset the higher interest cost on the fixed rate loan; however, if variable rates decrease, the Borrower is still obligated to pay the counterparty the higher fixed rate in the contract.

Risks: The key risk with swaps is a decrease in interest rates that results in higher payments (again, the Borrower is obligated to pay the agreed upon fixed rate) and a potential liability if the swap is terminated as a result of a refinance or sale of company (the value of the contract is marked to market and may result in a liability on the Company’s balance sheet).

• Interest Rate Caps
An interest rate cap is a derivative that provides a hedge against rising interest rates by setting a maximum or “cap” on a variable interest rate.

Cost/Benefit: A cap provides protection in a rising interest rate environment because the interest rate won’t go above the contractual level; however, caps come with an upfront cost (the premium) that’s paid whether or not interest rates rise. If rates stay the same or go down, the premium paid is forfeited.

Risks: Upfront cost – much like insurance, the contract affords no benefit if there’s no “claim” activity.

• Interest Rate Collars
An interest rate collar is a combination of a cap and an interest rate floor (which sets a minimum interest rate). It effectively “collars” the nominal interest rate by creating a hard range perimeter.

Cost/Benefit: An interest rate collar provides protection against rising rates (with the cap) and against falling rates (with the floor). This tool is beneficial to a Borrower focused on locking in a range of potential interest rates for budgeting purposes.

Risks: The risks are similar to those of caps and swaps. If interest rates don’t move as expected, Borrowers potentially pay more in interest or upfront costs to protect against a risk that doesn’t materialize.

Each of these strategies comes with its own set of costs, benefits, and risks, and the best choice depends on each specific situation, expectations for future interest rates, and tolerance for risk.  In some circumstances it may be best to ride the presumed rate cut “wave” down or use this time as an opportunity to de-lever.

Private Credit Takes Share/Resurgence of Mezzanine Debt
Shifting to capital, the banking industry, traditionally the bedrock of financial systems worldwide, recently finds itself at the epicenter of an escalating (and manufactured) crisis. Regional banks in particular are struggling with unprecedented challenges and, as a result, the current economic uncertainty has ushered in what Blackstone dubbed the “golden age” of private credit. As traditional sources of financing (banks) become less accessible, private credit continues to grow its reputation as a viable, and competitive, source of capital for closely-held companies.

In stark contrast to the struggles of traditional banks, private credit lending is experiencing an unparalleled upswing. Private credit lenders are non-bank institutions that offer loans to companies that are not bound to the traditional regulatory requirements of banks. Traditionally, these lenders have operated behind the scenes, often serving niche markets or higher-risk borrowers. But as traditional banks hesitate under the weight of the current uncertainty, private credit lenders are moving in to fill the void by providing essential liquidity when traditional banking channels struggle.

The rise of private credit lending can be attributed to several factors. Firstly, private credit lenders are not bound by the same regulatory constraints as banks. They offer more flexible terms and conditions and move quickly to close deals. In an environment where time and adaptability are critical, agility is a significant advantage.

Secondly, in this era of rising rates, private credit lenders can offer attractive risk-adjusted returns to investors. Private credit financings typically price in the SOFR plus >6.00% context resulting in low-double digit (unlevered) returns. Investors in private credit funds are finding this asset allocation strategy a relatively prudent approach in the current economic environment as it provides near equity-like returns at a far more attractive attachment point in the capital structure. This dynamic is fueling a surge of capital flowing into the alternative asset sector.

But what does this shift mean for the borrowers? The relevance of private credit lending will reshape how companies and real estate investors access credit. Private credit financings are more complex to navigate than traditional bank financing and tend to include more esoteric structural features that many issuers may not recognize. With an increasing number of providers and strategies that vary significantly, the market is still inefficient from a price/structure perspective (i.e. ten different providers will offer ten different solutions at ten different prices).

It is important for borrowers to weigh all the alternatives including review of competing providers, evaluate options, and ultimately sort through the market inefficiencies to secure the liquidity best suited for a specific industry and/or growth objective.

The Resurgence of Mezzanine Debt
Over the past few years, private credit lenders have dominated the leveraged loan market, primarily focusing on innovative financing forms such as unitranche deals, which amalgamate senior and junior debt into a singular loan; however, due to escalating interest rates and more stringent lending conditions, mezzanine (“mezz”) financing, positioned within a company’s capital structure between senior debt and common equity, is enjoying a renaissance. The ongoing instability within the traditional bank market is expected to generate even more opportunity for mezzanine lenders.

This resurgence of mezzanine financing continues to drive significant inflows into the sector with private credit managers accumulating billions of dollars in dry powder for future deployment. According to Pitchbook, global mezzanine funds raised a total of $30.1 billion in 2022, almost double the amount in 2021, and the highest since 2016. Capital generated by mezzanine funds contributed to 16% of the total funds raised across all private debt strategies in the past year. This surpasses distressed debt and is second only to direct lending making it one of the most sought-after debt sub-strategies.

This accumulation of dry powder corresponds with growing demand for mezzanine financing from private equity firms and their portfolio companies, as other credit markets, such as the syndicated loan market, maintain a “risk-off” posture.

Structures from second lien term loans to Holdco Payment-In-Kind (“PIK”) notes to structured preferred equity all fall into the mezz category and several factors are contributing to the increased demand. One major catalyst is the dwindling access to senior debt and unitranche loans due to MFN or “most favored nation” clauses restricting new debt issuance on more attractive terms than those offered to existing lenders. This restriction makes it challenging for borrowers to bring in new senior debt without repricing an entire first-lien facility and potentially losing the cost advantage of legacy debt in a rising rate environment. Furthermore, the rise in popularity of mezzanine financing is also attributable to the willingness of mezzanine lenders to permit PIK interest, and to offer a larger PIK component, thereby allowing operating companies to decrease fixed charges and build or conserve cash.

Role of an Advisor/Conclusion
Issuers facing capital markets volatility must be diligent in their approach to managing liquidity. The use of a conflict-free advisor to develop a sound go-to-market strategy, evaluate options, force providers to compete, and mitigate risk is crucial to executing successfully. More importantly, a capital markets professional that sits on the client-side of the table serves only the best interest of the Borrower and as an important market advocate plays a crucial role when identifying the right financing solutions and ensuring continued access to capital for growth and/or liquidity.

About Matrix Capital Markets Group, Inc.
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