IIt was a photo that marked the end of an era. Morrisons boss David Potts, in an open-neck black shirt, stands in a garden at the supermarket group’s headquarters in Bradford, next to a statue of founder Ken Morrison. Former Tesco supremo Sir Terry Leahy stands and talks to him. They celebrated a landmark deal which 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 it outbid rival US venture firm Fortress for Morrisons. The deal, which involved loading the business with debt in a sector known for thin margins and fierce competition, was a big bet on growth.
That stake now seems bigger than ever: high inflation, exacerbated by Russia’s invasion of Ukraine, has forced central banks to raise interest rates quickly. The cost of servicing corporate bank loans – all but ignored in a world of low interest rates – threatens to explode. 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, Morrison’s debt pile more than doubled – from £3.2bn in January 2021 to £6.8bn a year later, according to Moody’s. The credit rating agency estimates that a one percentage point rise in interest rates will cost Morrisons £30m a year in extra charges. That would significantly reduce profits at a time when sales may also come under pressure, although Moody’s and other agencies believe Morrisons still has enough finances to weather the storm.
With the UK expected to slip into recession in the coming months, interest rates could drive less healthy businesses out of business.
Companies have been scrambling to reduce their exposure, paying down debt with earnings when they can and looking for investors where they can’t. Car maker Aston Martin Lagonda last month allowed investors – including Saudi Arabia’s controversial sovereign wealth fund – to buy shares at a deep discount to reduce what chairman Lawrence Stroll said were crippling debt costs.
For companies still hoping to refinance, rising interest rates will make it even more difficult. They include GFG Alliance, the group of metals companies controlled by Sanjeev Gupta. Gupta has been trying to refinance the companies for more than 18 months, raising concerns for thousands of steelmaking jobs in Rotherham and Stocksbridge in South Yorkshire and elsewhere.
Richard Etheridge, deputy managing director at Moody’s, said companies in the UK and Europe were facing high levels of debt and difficult capital markets. “Those who need to refinance will be most vulnerable given the increased funding costs,” he said.
By 2022, interest rates around the world will rise faster than at any time in the past 41 years, according to analysis last week by S&P Global Ratings, another credit rating agency, led by Nick Kraemer.
If Bank of England Governor Andrew Bailey or European Central Bank President Christine Lagarde raised interest rates prematurely and energy prices continued to soar, it could “quickly accelerate defaults,” they warned.
Economists have long warned that “zombie companies” are being kept alive by debt while paying low interest rates. They may soon face a reckoning. The credit rating agencies focus on larger companies, which are able to issue bonds, but there are concerns about the effects of higher borrowing costs on smaller companies as well.
Daryn Park, senior policy adviser at the Federation of Small Businesses, said he was concerned smaller businesses would not be able to access loans if they needed short-term cash. “If interest rates reach 6%, it will start pricing out a lot of businesses,” he said.
One in five small businesses that applied for funding in the third quarter failed to find an offer at an interest rate below 11%, according to a survey of FSB members.
It will also have long-term consequences for smaller companies that rely on bank loans to invest in growth. Park said, “If we’re headed for a tighter market, they won’t be able to grow.”
In late 2019, Gary Ballantyne and his wife Lynette founded Viral Entertainment, a company offering virtual reality experiences in Corby, Northamptonshire. The pandemic shutdown that followed soon after meant that the company missed the chance to build up a financial cushion for the expected recession.
“We really have to look at bigger premises because technology has moved on,” he said. The company now has virtual reality headsets that allow two people to roam around a room and interact with each other 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 about the long-term prospects for the business – analysts predict interest in virtual reality will grow – but he said short-term growth for his business would be impossible due to the difficulty of obtaining financing. Instead, he’s trying to find other ways to use the equipment they have, like bringing it into nursing homes to give residents a taste of virtual reality.
Norman Chambers, executive director of the National Association of Commercial Finance Brokers, said that over the next six months he expected an increase in “distressed loans” from companies 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 for smaller UK businesses, is not yet too worried. In September, UK Finance, the banking industry’s lobby group, said there was still a “high degree of financial headroom for SMEs, and lenders remain ready to support businesses”.
Katie Murray, chief financial officer at NatWest Group, said on Friday that “loan losses remain extremely low”. However, the bank admitted it saw increased credit risk among its corporate clients, although evidence of actual defaults remained limited.
Stephen Pegge, managing director of commercial at UK Finance, acknowledged that times were tough ahead for the UK economy, but said that so far the proportion of borrowers under pressure has not been higher than before the pandemic.
“Banks have been stress testing whether companies can afford higher interest rates for some time,” he said. “It gives me confidence that things can 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 proportion of firms with a high payment burden”. However, that analysis was done when the banks’ base interest rate was 0.1%. Since then, that rate has risen to 2.25%, with further increases expected; increases in borrowing costs of four percentage points now seem very possible.
That Bank analysis also suggested that companies’ debt burdens would be manageable if profits fell, but did not look at what would happen if sales fell just as interest rates skyrocketed.
The pace of rate hikes had “surprised a lot of people,” said Louise O’Sullivan, director at Interpath Advisory, a debt and restructuring consultancy. During the period of low interest rates since the financial crisis, she added, companies had become unaccustomed to hedging against interest rate risk. And it was now too late, as the costs of hedging had increased, and the companies instead had to try to see how they could keep cash buffers in their operations.
Sandra Kylassam-Pillay, another director at Interpath, said the true impact of higher borrowing costs had yet to be seen. “It is not the rise in interest rates in isolation that is affecting businesses at the moment,” she said. “There’s also inflation and the cost of living – all of which means businesses are under increased stress.”
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