Get ahead of the cost of capital conundrum

It has increased dramatically over a relatively short period of time – the Secured Overnight Financing Rate (SOFR) has moved from essentially negative in early 2022 to more than five percent today. 

Borrowers who did not have their SOFR hedged – or borrowers who have hedges rolling off – are facing a significantly increased cost burden. Refinancing at a rate that’s five or six percentage points higher than it was a couple of years ago is significant – perhaps not historically, but certainly by comparison with the last decade. This may cause sticker shock for executives faced with their first major transaction at this higher price. 

Inflation is also tracking above the Fed’s target rate and, allied to a remarkably strong U.S. economy, my view is that we’re unlikely to see interest rate reductions in 2024 and only a relatively modest fall in 2025. 

In the current environment, there is also unprecedented supply of capital for the borrowers that are generating enough EBITDA to cover debt servicing costs at these levels. However, with a wall of maturities approaching in 2025-27 in the leveraged loan and high yield debt markets, there will be a subset of those maturities who will be challenged in their ability to refinance their debt at that cost. While I don’t see any peaks in restructuring activity like the global financial crisis or the more recent pandemic, I do expect the current trend of heightened activity to continue for the next two or three years. 

Borrowers that are unable to afford or fund the current cost of refinancing their debt will be forced to restructuring their balance sheet or take action to improve operations, such that they can generate enough EBITDA to cover it. 

The most important thing for company management teams facing this challenging environment of expensive capital is to be realistic about their projected cost of borrowing and recognize the greater strain that this will place on their liquidity requirements. 

With a number of levers at their disposal, I would recommend that they sit down with their advisors well ahead of likely changes in their cost of capital and plan for the appropriate actions to be taken. That could include selling assets to reduce debt levels, pursuing operational restructuring and profit improvement opportunities and, in a worst-case scenario, a potential need to restructure the balance sheet. But, critically, all of these potential approaches must be carefully thought through and planned for well ahead of the event.