As interest rates rise, bankers weigh in on the lending landscape

A small, minority-owned company won a large construction contract — but had to invest “a couple of million dollars in upfront infrastructure, knowing it would not receive any payments for 120 days,” recalled Valley National Bank President Tom Iadanza. “The contract was a big win for the business, but the terms of the deal would have strained their balance sheet.”

After reviewing the company’s financial statements and the underlying contract, “we extended the financing – which was secured by equipment and accounts receivable – so the business could seal the deal,” he explained. “It’s part of our outreach to minority- and women-owned businesses. We have a dedicated team in New York, New Jersey, Florida and Alabama that provides customized services, financial education and other assistance to under-served small-business owners. It’s a way of helping them to get a start, and as they grow we look forward to continuing to work with their expanding businesses. Everyone benefits from this approach.”

When companies need extra cash for growth or other purposes, they may check in with their local banker to find out about a loan. It sounds simple, but every business has unique needs and borrowing capacity — and the mix gets more complicated in an uncertain economy.

So far, at least, “Our loan-pipeline demand is still pretty strong,” said John Cole, Wells Fargo division portfolio executive for the Metro NY-NJ Division. “Despite the increase in interest rates and concern about how the economy will react, our business customers are well-capitalized and have a good cushion of liquidity.”

But businesses are “being more strategic when it comes to fixed-rate or variable-rate financing,” Cole noted. “Our professionals are working with them to analyze customers’ cash flows and match them with appropriate financing that will address issues like interest rate risk while meeting their needs.”

When interest rates began to march north, many companies tried to get ahead of the curve, added Iadanza. “Our customers apply to refinance their fixed-rate debt as a way to lock in the low rates,” he said. “We’ve seen healthy demand for lines of credit, working capital and inventory and receivables support; and the commercial mortgage segment was particularly active.”

But, he added, “Many companies have been reevaluating their capital needs. They’re concerned about the cost of capital, but they’re also looking ahead at the possibility of a slowdown or a recession. So, we’re seeing a measured slowdown in demand for capital financing, and for manufacturing-related borrowing and financing for importing goods. On the other hand, demand for multifamily and warehouse construction, and acquisition financing continues to be healthy. And with our [2014] expansion into Florida, we continue to see growth among business and consumer activity in that state.”

Iadanza said companies are being more imaginative about responding to the prospect of higher interest rates. “An increasing number of businesses are turning to the derivatives market [such as futures, options, forwards and swaps contracts] to shield themselves from higher rates. More of them are also trying to negotiate interest-rate caps. Whenever it makes sense, we try to accommodate business and consumer customers.”

Legal advisers are also helping out. “More businesses are reevaluating their capital needs and are trying to lock in lower-rate loans,” according to John Cromie, chair of Connell Foley’s Corporate and Business Law practice. “Some companies are trying to convert their outstanding credit lines or variable-rate loans to a fixed term loan, in order to capture the lower rate before it increases. We’re also helping others to try to structure derivatives, like a swap agreement with a financial institution, to manage their credit risk.”

Cromie observed that the firm continues to do a brisk volume of M&A work, especially “with private equity funds that seek strategic growth opportunities ahead of a possible recession. Sellers may see reduced multiples, however, as money center bank underwriters look more closely at credit standards, given that their own cost of capital is on the rise. Additionally, loan covenants and tighter lending limits may have a constraining effect on M&A valuations, similar to the way that home values in some markets are being affected by increased mortgage interest rates. I think we’ll see continued demand for healthy companies with good prospects, however.”

Connell Foley recently assisted in the sale of a North Jersey company that installs, services and repairs heavy industrial equipment. “The company was purchased by a private equity firm that wants to grow strategically,” said Cromie. “And another company in the industrial-construction space just engaged us to find a buyer. This is a good time for sellers, since PE firms are still looking for opportunities, while older owners of companies that don’t have a clear succession plan are increasingly looking for a way to monetize their business interests. So both sides can end up benefiting.”

M&A adaptations

Some professionals, like Laurence  Smith – a member of CSG Law – aren’t so sanguine. He noted that rising interest rates are beginning to affect M&A transactions. “As the cost of capital rises, the amount of debt that can be serviced readily by borrowers, and the level of acquisition financing that lenders are willing to extend, is diminishing, which constrains the amount that can be bid for target companies,” Smith said. “This is especially true for financial buyers,” he said. “But the prices paid by strategic buyers for whom synergies may create additional value are not as directly correlated to interest rates.”

His firm is currently advising an East Coast packaging industry client about selecting an investment bank to help consummate a deal with a potential buyer. “The company’s owners are in their 60s with no real succession plan, and they would like to monetize their investment now,” he explained. “The good news is that the company continues to grow and has almost no debt, but it struggles with internal accounting issues. A large strategic buyer has expressed strong interest, and we’ve advised our client to engage with the proposed buyer in a meaningful fashion once the banker is up to speed and to seek to sign and close a deal by year end.”

Bankers also report subtle, yet significant changes. “There has been a shift for interest rate sensitive businesses that have and will continue to see less demand for their goods or services, observed Edward Galan, senior vice president, regional director, Commercial Lending, Provident Bank. “In a rising interest-rate environment consumers begin managing and eliminating discretionary expenses as disposable income levels diminish. The average consumer will spend more on minimum payments for student loans, car loans, and mortgages. Depending on your service or product, retention and acquisition rates decrease, directly impacting sales and overall profitability. A business’s overall financial health impacts the approach and flexibility when it comes to long term or day to day financing needs.”

Despite concerns about rising interest rates, loan demand remains robust, according to Juan Oelofse, Spencer Savings Bank’s senior vice president director, Commercial & Industrial Lending.

“At Spencer, we have not yet seen a shift in demand for business lending, due to rising interest rates,” according to Oelofse. “We have seen a lot of loan growth, in the first half of this year, driven primarily by companies that reaped the positive benefits of COVID. In the first half of 2022, we completed 70% of last year’s production which in and of itself was also a record year for us. A lot of these small to medium-sized companies, including our clients, are doing really well. I see very few of our business clients that struggled. Many of them – including wholesale distributors, and manufacturers – were very well-positioned to weather the storm and come out better than before.”

He cautioned, though, that rates have only started to increase in the past four to five months, and “the trailing effect on our borrowers only manifests in the next two to three subsequent quarters. A more appropriate time to assess any shift in loan demand would therefore be six to 12 months from now, when we would be able to assess the impact of the higher interest rate environment as well as factors driven by the anticipated recession on our loan growth.”

And although rising interest rates have not significantly affected demand for business loans, “During times of uncertainty, like we have now, there is a natural inclination to dive deeper when reviewing business loans,” said OceanFirst Bank New Jersey Regional President George Destafney. “Stresses like unemployment, supply chain issues, and increasing interest rates need to be fully vetted so we can structure financing that is right for the client and for the bank. I would add, it is more challenging to structure a longer-term loan or line of credit based on current economic factors.”

But OceanFirst is also taking steps to help clients get appropriate loans. “We were able to quickly engage to become an SBA lender in 2020 and assist thousands of our clients to receive Paycheck Protection Program loans,” he noted. “The stimulus funds were great for the businesses who needed it then, but now we are finding that the money has been used and more financing options are needed for the current priorities of our business clients. First and foremost, regular communication is essential whether the company is growing or struggling. Understanding the business’ history, short- and long-term goals and expectations are all important to help our business customers and identify the best financing options for each unique situation.”

At law firm Mandelbaum Barrett PC, shareholder and co-chair of the firm’s Banking and Financial Services practice group Richard Simon has not seen a large shift in borrowers seeking alternative financing or alternative lenders. “Still, we are seeing borrowers seeking refinancing of existing loans to accommodate cash flow needs, such as seasonal bumps in the amount of the loan to accommodate inventory,” he noted. “They are also obtaining additional financing such as financing the income stream from royalty payments under license agreements.”

And Simon identified a developing trend when it comes to asset acquisition and other issues, as some clients “add IP [intellectual property] assets, if available, to borrowing base-collateral packages to provide additional liquidity. Borrowers are also looking to maximize inventory advance availability — often in the form of a seasonal stretched advance rate [the percentage amount of the value of the collateral that a lender is willing to extend as a loan].

Another professional offered other advice for companies. “As interest rates continue to march north, businesses should review their loan documents to determine if higher rates negatively affect any debt covenants, or restrictions,” counseled EisnerAmper Private Client Service Partner Anthony Faugno. “Do not wait for the year-end to review your loan agreements.”

For the most part, though, Faugno said his clients “are not too worried about the increases, since we’re coming off historically low rates anyway. As long as they don’t climb too high, one- or two-point increases shouldn’t present much of a problem.”

A bigger issue is the possibility of a recession, he added. “Companies may want to consider increasing their lines of credit now, while business is still relatively good,” Faugno said. “Even if it means doing so at a slightly higher rate, an increased credit line may help provide some insurance if the economy slows down.”