The Pendulum in Motion: Prudence and the Credit Markets

Market, economic and business cycles and the resulting fluctuations should come as no surprise to anyone, yet the point at which the pendulum rests is often unclear to market participants leading to unfortunate consequences for the unprepared. The recent problems with subprime mortgages have had spillover affects to the overall credit markets illustrating that the pendulum has shifted, and portending more challenging times. While it is difficult to predict the economic cycle, and it is challenging to make predictions about the future availability and cost of liquidity, it is worth considering how to prepare for the likely uncertainty ahead.

The euphoria of available credit and favorable terms characteristic of the last few years have certainly benefited many businesses. For companies that have taken advantage of attractive debt financing, whether for buyout debt or permanent leverage, there may be real benefit from this market cycle. However, for those who have significant debt on their balance sheets, it is well worth considering the following:

Model It Well
Financial models are an essential part of determining the appropriate level of debt financing. They provide the framework for developing covenants and repayment schedules. Our view is to always model several downside and recession scenarios particularly if your business is cyclical. On a macro level, look at how interest rates affect the economy and therefore your business. We believe it prudent to model greater than 2x interest coverage in a variety of scenarios and allow for meaningful (20%+) covenant cushion in light of changes in the economy.

If you haven’t taken a close look at the models underlying your debt financing recently, it is worth a relook. If you are going to the market now, be prepared for much more stringent requirements. If you need to go back to your bank whether for covenant relief or additional financing, understand that it will be hard to ask for forbearance without penalty and lenders will increasingly be exceptionally demanding and stringent.

Hedging : Apply the 50% Rule
While one can speculate on the direction of interest rates, it is more productive to consider the cost of hedging your debt. Since we never advise our companies to take on leverage to the point of assuming default risk, most of our companies have adequate interest coverage. Still, many of our companies find it is prudent to hedge at least 50% of their debt providing some cushion to earnings and cash flow in the event of fluctuating interest rates.

Adjust Cost Structure
Always keep a close eye on your cost structure and make sure you have flexibility to make adjustments as required. When in high growth mode, more attention is paid to revenue drivers and ramping expenses to meet growth, rather than identifying those areas that are more fungible. Fixed costs, i.e. longer term leases, capital costs and certain personnel expenses are difficult to adjust, but thought and attention to the key cost drivers are critical in the event of slight downturns or a slowing of growth or the prospect of cyclical downturns.

Consider Cash Use
Carefully evaluate use of discretionary cash and closely manage planned capital expenditures so you can pull in the reins if necessary. We believe in aggressively amortizing debt, particularly buyout related financing. In general, accumulating cash is not beneficial unless you return cash to shareholders, are looking to make acquisitions or are buying back stock.

Be Ready for Opportunities
Take advantage of markets when they are good and be ready for the windows when they appear. If you added leverage prudently in the recent favorable credit markets, you will very likely have benefitted. As the pendulum swings back and credit markets tighten, there will be a unique window of opportunity for strategic buyers, as financial buyers will no longer have the ability to leverage transactions with such generous terms. It is good to have financing capacity and cash so as prices go down, you can be nimble and act quickly, pre-empting competition. Use stock as currency in looking at strategic opportunities. If you are not yet public and the market are favorable, be ready to access public capital.

At GA, we advise prudence when taking on debt and in managing it. It is well worth the effort to re-evaluate capital structure in light of the new environment not only to make sure you can weather an expected storm but also to continue to be prepared as opportunities are sure to arise even in more challenging times. To discuss your capital structure and debt financing in greater detail, please contact your GA team.