As financing costs surge, the real economy faces a reckoning

Nowhere has the impact of rising real interest rates been more pronounced than in the private equity ecosystem.

For an industry that relies on financing, it’s hardly surprising that firms are having to adjust in the face of sharply higher capital costs.

Don Lipari, the industry and private equity leader for RSM, said that private equity firms are paying four and five times the rates of 18 to 24 months ago to leverage the capital that they have. Deals, as a result, have become much harder to close.

“The current lending environment puts tremendous pressure on sponsors to ensure the deals they close are the right deals,” he said. Otherwise, he added, sponsors risk disappointing their limited partners down the line. 

A recent RSM US Middle Market Business Index survey of senior executives found that rising interest rates are imposing a higher cost of financing on companies.

“That increase in real interest rates is particularly painful for private equity firms that rely on leverage to make deals,” said Joe Brusuelas, RSM chief economist.

Over the past decade, Brusuelas said, long-term real rates, using 10-year Treasury Inflation-Protected Securities as the benchmark, have averaged 0.26% compared with rates that have exceeded 2% this fall.

This all has an unmistakable effect on dealmaking, the lifeblood of the industry.

“The pace of dealmaking has definitely slowed,” said Kennedy Chinyamutangira, a senior manager in RSM’s audit practice with a focus on hedge funds and private equity funds. “Private equity firms are being a lot more thoughtful in the way they apply leverage and debt financing in deals.”

This shift doesn’t mean that the market is dead. But it does mean that private equity firms, and companies in the industries they serve, have to adapt to a changed financing environment.

The trend is playing out in the consumer products industry.

“There is more scrutiny on deals,” said Mike Graziano, a director in RSM's national transaction advisory services practice specializing in consumer products. “A couple of years ago, you could take a business that was underperforming, you could tell a story and get funding. That’s not happening anymore. Lenders want to see profitability before they put their dollars at risk.”

On the sell side, we are seeing a hurry-up-and-wait approach. Large deals are occurring, he said. But it’s the ones in the middle market that have a little bit of fleas on them that have to get shaken away—those are the ones that are taking more time to close.

A main reason it’s taking longer is that a gap in valuations that has emerged.

“The market went from a 10-year seller’s market to a buyer’s market in the span of a quarter,” Graziano said. “It’s taking time for sellers to understand this.”

Graziano gave the example of HVAC repair. It’s a fractured industry with many smaller operators that compete in the same geographic area. A private equity firm will look to consolidate these businesses with the goal of saving money on back-office functions while expanding product offerings.

But a lot of owners in the HVAC business know each other. When one of them sells to a private equity firm, the price gets out.

“When you know that your friends got a certain price two years ago, it’s hard for you to swallow 50% of that,” Graziano said.

At some point, he said, the market will adjust, as it always does. Sellers will have to come to terms with the lower price, or at the least change their deal structure with provisions like earnouts, or meeting certain financial thresholds.

“Ultimately, private equity needs to start thinking about operational excellence around acquisitions because they will have to hold their assets for longer,” Brusuelas said. “The basic assumptions around which private equity firms operated are in the process of changing.”

Another difference that has emerged as the industry adapts to a new environment is in the kind of deals being pursued.

“We saw a very quiet M&A market in the first and second quarters, but that is starting to pick up again,” said Karen Galivan, an RSM tax partner focused on consumer products. “But instead of large acquisitions, there are a lot of strategic smaller acquisitions to expand either footprint or market share.”

Through it all, buyers and sellers need to understand that higher real interest rates are not going away, Brusuelas said.

“It is essential that all who work in private equity or have exposure to that ecosystem understand that the zero-rate era that often featured real negative rates is over,” Brusuelas said.

Going forward, Brusuelas added, real rates are likely to float between 1% and 2% in an optimal environment. Firms need to be prepared for higher rates. 

Even with these headwinds of higher rates, Lipari expressed confidence that private equity firms could navigate a challenging environment. “My money is with the sponsors,” he said.

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Manufacturers have faced a host of challenges in recent years, starting with the tariff wars and continuing through the shocks of the pandemic.

But the new regime of higher interest rates imposed by the Federal Reserve has presented an altogether different challenge.

With the Fed having increased its policy rate over the past 18 months to the highest level in 22 years, manufacturers, like other businesses, are paying more for financing as they seek to make investments that will keep them competitive.

In the short term, it’s a significant challenge.

“Firms that did not lock in long-term rates, or even medium-term rates, are experiencing significant increases in debt-service costs,” said Jason Alexander, enterprise leader for RSM’s industrials practice. “A lot of companies are finding that loan terms are a lot more restrictive and unfavorable than they were in the past.”

A recent RSM US Middle Market Business Index survey of senior executives found that across industries, including manufacturing, rising financing costs are making it harder for businesses to meet payroll or finance new projects.

The new environment has come as quite a shock to those executives who have not had to deal with a high-interest rate environment in the past. As a result, executives are having to pivot their strategies to emphasize the operational end of the business.

“A lot of companies are having to focus on working capital and looking at margins and cash flow in a more granular way,” Alexander said. “In the past, when money wasn’t costing as much as it is now, and you could borrow in the short term to cover expenses, you had a lot more flexibility.”

That flexibility is gone now. So executives have to be more selective in pursuing longer-term investments.

This is not to say that manufacturers do not have options that can help them work through this period. Alexander gave three examples:

1. Focus on what is working: Companies need to take a hard look at the areas of their business that are most economically beneficial, Alexander said. This will help generate the most cash in the short term, while still allowing for longer-term investments.
2. Be data driven: A lot of organizations, Alexander said, have not made the necessary investments over the long term that will be the table stakes to remain competitive. Machine learning and artificial intelligence are just two examples. “If you don’t have the appropriate information technology infrastructure, and you don’t have the ability to aggregate your data on the shop floor, you’re going to be at a competitive disadvantage,” Alexander said. In today’s business climate, organizations need to be data driven. Without better and more informed decisions, the cost of being wrong will only increase.
3. Invest in people: To harness this data requires a creative, informed staff. It’s one thing to have the IT infrastructure in place, Alexander said, but it’s meaningless without the people who can help interpret that data and execute on the decisions.

All of these initiatives require money, and that’s where the higher cost of capital has started to take a bite. To secure this financing, companies are looking beyond traditional banks.

“There is a growing private credit market where private equity and nontraditional lending sources have stepped in, especially where commercial banks have backed off,” Alexander said. “In a lot of cases, that financing is significantly more expensive.”

The RSM survey asked middle market executives across industries what annual percentage rate their organization had paid over the past 12 months. For loans from commercial banks, companies were paying a mean average of 10.9%. For nonbank lenders, that rate was 13.7%. For equity sources, which include private equity, venture capital and mezzanine financing, that rate was 15.5%.

For many manufacturing firms, the playbook of three years ago, when low-rate loans were available, no longer works. In the end, manufacturers will continue to invest, but the cost of those investments has gone up—along with the price of being wrong.

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Two years ago, amid the pandemic lockdown, consumer products companies faced the unusual challenge of securing enough goods to meet surging demand. Supply chains were broken, and companies scrambled to meet demand.

Today, these firms face a different challenge, according to the RSM US Middle Market Business Index survey for the third quarter.

With consumer spending shifting to services, and away from goods, firms are having to reduce inventories amid a slowing economy just as financing costs are surging.

Major retailers identified this shift to services in the summer of 2022, and they scaled back their purchasing, said Mike Graziano, a director in RSM's national transaction advisory services practice specializing in consumer products. Inventories, they realized, needed to get to a more sustainable level.

For the middle market wholesalers selling into the big box retailers, it was a radical change.

As a result, executives face tough choices as they try to identify the best investments. It’s no easy task amid the whipsaw change in technology and the economy. In 2022, the metaverse was the must-have technology that would drive growth. Then, seemingly overnight, the focus was artificial intelligence. All the while, businesses are now actively rethinking their supply chains, and shifting away from China.

That leaves the question: Where does a company invest?

“In 2018, you probably could have taken out a loan and invested in all three,” Graziano said, “but today you can’t.”

It’s all part of the squeeze hitting middle market businesses, according to RSM’s survey. Senior executives across industries said they were paying more to secure financing, and that was limiting their ability to invest in the future.

Metaverse? AI? Supply chains? Today, it’s pick one.

The change has reined in expectations, said Karen Galivan, an RSM tax partner focused on consumer products.

“When we talk about technology in the middle market, it’s important for executives to remember that they don’t need the Cadillac solution, but they need a trustworthy and adaptable solution,” she said.

Then there is the more urgent matter for some businesses of simply keeping the lights on.

During the pandemic, some companies were propped up by the robust spending and the surging demand for goods. Today, that support is fading, and executives are struggling to identify the area that will best position them over the long term.

Companies cannot just plan for the next six months; they have to plan for the next six years. But when lending costs are as high as they are, it makes strategic decisions harder.

The role of commercial banks as first-choice lenders has eroded, the survey found. Not only are they having a harder time keeping up with technological advances, frustrating some businesses, but they are also being more selective in the companies they lend to, as the Fed survey of loan officers found.

It can be a frustrating time for middle market businesses.

“The bank's communication regarding interest rates and changes in policies is often unclear or delayed, making it difficult for us to plan and manage our finances effectively,” one executive in the retail trade said in the survey.

In the end, the new environment is taking a toll on innovation, whether a company is going to invest in a new plant or a new line of products, Galivan said.  

“I liken it to potato chips,” she said. Before the pandemic, she added, “there was always some crazy potato chip flavor that would come out. Today, companies are not doing that as much. It just costs too much.”

On top of this, Galivan said, the tax legislation around research and development have changed, and companies cannot immediately expense research and development costs anymore. You have to amortize those over five years in the United States, or 15 years for foreign operations.

One way they are innovating, she said, is through add-on acquisitions.

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Ever since the Federal Reserve began raising interest rates last year and the markets cooled, life science companies that relied on abundant and low-cost financing are suddenly facing a radically changed environment.

A recent RSM US Middle Market Business Index survey of senior executives found that across industries, including life sciences and technology, rising financing costs are making it harder for businesses to manage their cash runway or finance new projects.

It’s a similar story in with technology startups that burn through significant amounts of cash as they pursue what can be moonshot strategies. While these firms face a risk of failure, the rewards can be significant when it works.

Today, as financial stress mounts, a split has emerged in the life sciences sector, said Adam Lohr, a senior analyst for life sciences at RSM.

In one camp are the more established companies that are on their way to commercialization and have a pathway toward profitability. In the other camp are the early-stage companies with significant cash requirements to develop their pipelines and bring innovations to market. Both face challenges.

“We keep talking about the easy money being gone,” Lohr said. “Most life science companies burn cash for years as they move through trials and seek FDA approval. Higher rates, risk aversion and market volatility have made it a very difficult time for them.”

These companies, which can have a 10-year runway to commercialization and even longer to profitability, are used to getting regular cash infusions from private investment or public offerings. That money just hasn’t been there following the pandemic. Now, for early-stage startups or those approaching commercialization, survival is more challenging.

The issue, for many, is simply staying in business: How do life science and technology startups keep moving their core technology forward while also managing their cash flow? 

It can be done, Lohr said. 

Early-stage companies, he said, raised a lot of cash during the pandemic at very high valuations. So there are still many that have a year or two of cash runway to pursue their next milestone. But that doesn’t mean they don’t feel the pressure.

To get through this phase, they need to conserve cash. 

What’s not negotiable, he said, is skimping on the science. Everything else can give way to support the core mission of the business.

Outsourcing noncore business functions including information technology, human resources and finance divisions is often a viable solution. The goal, Lohr said, should be to support the company’s essential employees that have deep expertise in science or technological development to propel the company to the next phase of development.

Then there are the strategic partnerships. Companies can look to contract out research, clinical trials or their manufacturing, to focus more intently on their core innovation. 

That’s because, at this point, the money isn’t available the way it was even two years ago. But the good news is that there are other ways that companies can extend their shelf life.

Lohr outlined three options:

1. Licensing: In some cases, a startup may have a tool or technology that complements or supports the needs of another firm. It may make a good fit for a licensing arrangement where the cash-starved firm generates revenue, while bolstering the firm paying for a technology it needs.
2. Acquisition: A firm buys out a startup, gaining its intellectual property and talent. This is perhaps the most direct solution.
3. Partnership: Short of an acquisition, this approach crafts a deal where a firm essentially makes an investment or enters into a collaboration agreement with another firm, gaining access to, for example, an individual drug as opposed to an entire company.

Beyond these strategies, startups are now looking at flat or down round investments, in which a startup gains an investment at a valuation that is the same or lower than it was before.

And it’s a hard adjustment. For operators used to having a much higher valuation set during a more buoyant era, it can be difficult to realize that their business is worth less.

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The real estate industry relies on consistency and predictability when it comes to financing transactions or new projects.

Over the past year and a half, as the Federal Reserve has increased interest rates to their highest level in decades, real estate companies have had to contend with a new environment of higher costs and greater uncertainty. 

Their response has been to take more of a wait-and-see approach.

“We’ve seen a significant slowdown in transaction activity,” said Scott Helberg, a senior analyst in RSM’s Chicago-based national real estate industry practice.

Higher interest rates squeeze margins and reduce potential opportunities for being able to buy assets, he said.

In the end, the math has to work, and these days that has become more difficult, he said.

“If I told you that a real estate deal is offering a 3% return when a money market is paying 5%, there won’t be a deal,” he said. “Time and again, anecdotally from our client base, you could be looking at acquiring an asset, but when interest rates increase during the due diligence period, the economics may shift to kill a deal.”

A recent RSM US Middle Market Business Index survey of senior executives found that across industries, including real estate, rising financing costs are making it harder for businesses to meet payroll or finance new projects.

Now, with commercial banks pulling back on their lending, real estate companies have had to become more creative in filling out their capital stack when they are looking to acquire an asset.

So they are looking to sources beyond commercial banks such as debt funds—private equity firms issuing their own debt to fill that gap—or mezzanine loans and preferred equity. These types of notes are secured by the borrower differently, often by the partnership and not by the property itself.

These alternative sources of capital also cost more for the borrower.

“That’s another reason you are seeing a squeeze on asset transactions,” Helberg said of the turn to alternative sources of financing. 

But there are other factors at play in the decline in transaction activity. 

On the seller side, there is a reluctance to recognize that property values have dropped as interest rates have increased.

“There is a gap between the bid and ask prices,” Helberg said. 

It’s a dynamic playing out in other industries, where owners of companies are slower to realize that a company is worth less.  

It will take time for this gap in valuations to narrow. The first step for buyers is to fully trust that the Federal Reserve is finished with its rate hike campaign. 

That time may be approaching. RSM chief economist Joe Brusuelas has forecast that the Federal Reserve has reached, or is about to reach, the peak in its cycle of the rate increases.

As real interest rates rise and inflation falls, the cost of doing business increases, particularly in real estate. Brusuelas said that the priority for the Fed should be to remove some of that uncertainty.

“The direction of policy needs to focus on stabilizing those real rates,” Brusuelas said.  

In the meantime, Helberg said, acquirers have become more selective in their deals and are getting more creative, whether it’s the type of property they are buying or the method of financing they use.

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