Interest rate increasing: are you going lower debt / full equity?

November 01, 2022

by a searcher from London Business School in London, UK

Interested in your views on how are you treating the current debt costs. Are you trying to secure leverage with the aim to refinance it in the medium-term once everything stabilizes or are you going full equity?

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Reply by a searcher
in New York, NY, USA

It is important to keep in mind the cost of capital varies heavily between equity and debt. If you are giving up debt and increasing your equity stake solely thinking of trying to minimize costs, I would suggest that's not a productive way of thinking from a value creation or a risk management perspective. Instead, the purpose of increasing the equity stake should be either to improve the probability of closing or to manage the fixed costs of the business in a downturn (interest will be one of your largest fixed costs in most small business LBOs). There are a few other cases where the calculus is muddier (esp in earlier stage companies or where a turnaround is required) but for most search deals I think it's important to remember that interest costs are relatively fixed expenses but even in higher rates debt is cheap compared to most forms of equity. Managing the balance is the task of prudent capital allocation. Otherwise, I would politely ask for you to introduce me to your equity investors who are underwriting to an 8% base case return as I may have some business for them...

Reply by a searcher
from Columbia University in Santa Monica, CA, USA

I personally wouldn't want to put too much faith in interest rates coming down again to make a deal work - current interest rates are still on the low end from a longer-term historical perspective, and no one really knows what will happen going forward. I would just leave some buffer in the debt service coverage ratio by increasing the equity % in the deal and maybe using fixed interest rate options in the short term for more certainty if that's an option that's available to you.

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