With the federal funds target rate above 5% for the first time since 2006 and interest rates on various financing options increasing accordingly, private equity firms and portfolio companies are slowly adapting to higher interest rates. These rate increases mark the end of a generation of inexpensive and readily accessible debt financing and the return of tighter capital and financing markets, with higher coupons and more onerous terms. Companies in need of financing, however, are still able to take advantage of various financing techniques to optimize their capital structure. We discuss five of those options below.

• Liability Management: As interest rates rise, the prices of lower interest rate instruments that a company may have outstanding are likely to decrease. Companies with excess cash thus have an opportunity to do a cash tender offer for their outstanding securities, or repurchase their securities or term loans on the open market, at a discount to par value. For companies funding the repurchase with new debt, purchasing outstanding debt at a discount may mean that less new—and likely more expensive—debt needs to be issued. These options allow a company to de-lever and to manage upcoming maturities at attractive, opportunistic prices.
• Amend and Extend: In an “amend and extend” transaction, the borrower seeks to extend the maturity date on its existing credit facility rather than refinance it at then-current interest rates. The extended maturity can be anywhere from two to five years, and is sometimes accompanied by other changes, such as tighter or additional covenants, additional security or collateral and an amendment fee for the extending lenders. These amend and extend transactions can help a borrower buy time before it needs to refinance or repay its outstanding credit facility and can be accomplished more quickly than a full refinancing, provided that lenders are willing to consent to the transaction. One downside, however, is that an amend and extend transaction may require all lenders to consent to the extension of the maturity date, potentially making the transaction more difficult and expensive to complete. In that case, and if unanimous consent is not forthcoming, a portion of the loan may need to be repaid, or one or more replacement lenders—who are willing to consent—may need to join the facility.
• Utilize Both Fixed and Floating Rate Debt: In a high or increasing rate environment, companies should consider the optimal mix of fixed and floating rate debt. While fixed rates can act as a hedge against future increases in interest rates, they also carry the risk of locking in high rates if issued at or near the peak of an interest rate cycle. On the other hand, floating rate instruments become more expensive as interest rates rise, but also confer costs savings when rates begin to decrease. Companies should take into consideration how rates are expected to change over the life of their outstanding debt, and utilize both fixed and floating rate instruments, including synthetically through interest rate swaps, to optimize their cost of capital and exposure to interest rate changes. For example, for floating rate instruments issued when reference rates were near zero and that have a periodic reset every five or more years, the current interest rate environment offers an opportunity to refinance with a fixed rate instrument that may reduce the cost of financing and act as a hedge against future increases in interest rates. Redemption premiums or “no-call” features should also be considered when determining whether to issue fixed or floating rate debt, as they can effectively limit future refinancings if and when interest rates drop.
• Deferred Payment Terms: Certain financing structures may allow a borrower the flexibility to defer interest payments on their debt. These include “payment-in-kind” or PIK instruments and “hybrid” instruments. PIK instruments allow the borrower to pay interest in kind (i.e., through the issuance of additional debt) rather than in cash. The interest that is paid in kind is capitalized and added to the principal balance of the loan or bonds. PIK instruments can be structured to meet the borrower’s needs, with true PIK instruments requiring payment in kind until maturity and PIK-toggle instruments allowing the borrower to elect to pay in kind, subject to the satisfaction of any applicable conditions. Hybrid instruments, popular with financial institutions, typically allow for the deferral of interest payments for some period of time, which can provide a company with significant flexibility. In the event that the company is not making interest payments, the company would be subject to a dividend stopper and the missed interest payments must be made in the future.
• Equity Financing: While potentially dilutive and more expensive from a weighted average cost of capital perspective, equity financing can allow a company to raise capital without ongoing cash costs, e.g., in the case of common stock or non-cumulative preferred stock, and with no maturity date. Similarly, convertible securities may provide companies with a low interest rate (particularly as compared to the interest rate on other debt) and with the possibility of future dilution (which can be managed with derivatives or share repurchases). The proceeds from any equity financing could be used to repay higher interest rate debt. For public companies with shelf registration statements, these transactions can be done quickly, allowing the company to hit market windows when the opportunity presents itself.

The Private Equity Report Fall 2023, Vol 23, No 3