Refinancing risks focus borrowers’ minds on early lender discussions

The refinancing market for SME corporates faces a liquidity squeeze and margin hike in the next 12 months as banks reassess the higher-for-longer interest rate environment and the impact of fiscal policies by the new Conservative government.   

While banks’ market share of the corporate lending market has been in a steady decline for years, they remain the dominant lender group in the UK SME market. Therefore, understanding how they will approach the coming phase of the economic cycle will help borrowers navigate the complexity of the current refinancing market. In the coming weeks and months, a number of catalysts will influence the environment for SME refinancing and new lending. These include: 

• the Bank of England’s (BoE) monetary policy path to tame inflation;
• lenders’ assessment of how industries will perform in a stagflationary environment; and
• impact of the government’s strategy to finance its energy stimulus package and promised tax cuts.

This article will examine these issues, followed by our assessment of the refinancing market in the coming period.

Living with higher inflation during a recession 

The UK economy has immediate and longer-term structural challenges. The outlook for the economy and inflation has deteriorated since the summer, due to a raft of interrelated headwinds. These include soaring energy costs, the decline in household spending and real wages, weaker export prospects, a weakening global economic outlook, poor investment conditions and fading business confidence and cashflows. All these headwinds were caused by the worldwide response to Covid-19 and amplified by the war in Ukraine.

Interest rate expectations and corporate and household spending behaviour are important signals for the economy’s outlook, which feed into banks’ lending decisions. The annual rate of CPI inflation ticked down to 9.9% in August, according to the Office for National Statistics (ONS), driven by easing petrol prices. However, UK inflation is expected to surge higher again next month. Markets expect the Bank of England’s Monetary Policy Committee (MPC) will increase the Base Rate by 50 basis points on Thursday (22 September). However, the risks for an upside jumbo 75 bps hike surprise remain. Another signal that rates are too low is the pound’s weakness, which fell to $1.14 last Friday (16 September), the lowest level since 1985. Economists Capital Economics forecast the BoE will push the Base Rate to 4% next year. 

UK retail sales fell sharply in August, by 1.6%, according to separate ONS data published last Friday. Sales were three times weaker than forecasts, underscoring concerns that the UK may already be in a recession. The British Chambers of Commerce (BCC) expects a UK recession by the end of 2022, with inflation spiking to 14% in Q4 and anaemic GDP growth to continue into 2024.

Vulnerable sectors 

Clearing banks will assess their loan books in relation to how the above headwinds will impact different industries throughout the UK economy. Weakening consumer spending will continue to limit disposable incomes, hurting the outlook for industries reliant on discretionary spending (e.g., retail and leisure, hospitality, etc.). The fate of Vue International, the UK’s third-largest cinema chain, exemplifies the weakness in this segment of the economy. A consortium of Vue’s lenders, led by Barings, Farallon Capital Management, Invesco and PGIM, have negotiated a £700 million debt-for-equity restructuring deal to recapitalise the international cinema chain’s balance sheet.

In addition, sectors reliant on high energy consumption and/or imports, such as manufacturing (e.g., rubber, plastic production, basic metals, minerals, chemicals and food), construction materials (e.g., ceramic products, cladding, glass, precast concrete, steel, etc.) and transportation (e.g., cross-border goods haulage) will all see operating costs spiral at a time when demand softening accelerates. Vulnerable sectors may find it harder to secure a bank refinancing or may be offered uncompetitive terms over the coming 12 months as banks weigh the future earnings outlook of customers amid softened demand and higher costs. 

Energy stimulus and tax cuts

Soaring energy bills will make it harder for some corporates, and households, to afford loan repayments. The BoE has crafted a new stress test for UK banks’ ability to withstand a rise in defaults linked to sky-high energy prices in a deep economic recession scenario, according to the Guardian. The stress test follows the new UK governments promised £150 billion energy stimulus package to cap the price of gas and electricity bills for households and businesses this winter. However, economists suspect this stimulus package – to protect companies from falling into financial stress and distress – may be insufficient to stave off the anticipated recession. The fiscal intervention will unlikely stimulate consumer spending, with households remaining in a broad-based cost-of-living squeeze.

The UK government has yet to reveal how the energy stimulus package will be financed. In addition, the government has promised to abolish the national insurance increase in 2023 and the corporation tax rise. Over the past 15 years, central banks have functioned as the primary investor in government gilts, issued to finance stimulus packages to support the recovery from the global financial crisis (GFC), Covid-19, and the more recent energy and inflation crisis, exacerbated by the war in Ukraine. During the pandemic, the UK government stood behind more than £80 billion in loans to UK corporates to protect the UK economy. But the government will now find balancing the need to provide stimulus to support the economy through the energy price crisis and prudent fiscal management much more difficult.  

Central banks are now tightening financial conditions and reducing their balance sheets to dampen demand and tame inflation. Consequently, they are no longer buyers of government gilts, at a time when government debt servicing costs are spiralling. This macro backdrop creates upside risks to the financing costs for the incoming UK energy stimulus package. If the stimulus package is gilt-financed, the yield the government achieves will feed into the pace and destination of further interest rate hikes. This will also play a part in the lending decisions of clearing banks today. This catalyst includes upside risks to where Base Rate will eventually peak, which could be higher than the current forecast consensus. In turn, this will impact borrowing costs for corporates looking to refinance.  

Refinancing outlook for borrowers

The UK macro environment and domestic political change have added to the uncertainty over where Base Rates and the economy might be over the next six, 12 and even 18 months, leaving the economy at something of a precipice. For banks and the broader lending market, it is difficult to price debt today, as the outlook for the economy has a number of plausible divergent trajectories from here.  

The consequences of this environment, so far, is relatively predictable. Banks are lending more cautiously (e.g., increasing margins, decreasing LTVs, slowing the due diligence process, etc.), while many borrowers, particularly smaller companies, are intuitively pausing refinancing discussions. However, this “wait and see” strategy, while understandable, is unlikely to prove judicious in hindsight as refinancing deals currently take longer to close with the risk of not securing a new line of credit from the incumbent lender now higher.

For corporates with credit facilities maturing within the next six to 12 months, it is crucial to know where you stand with your existing lender. If for whatever reason, the incumbent lender is not going to be supportive at the next refinancing date, the sooner this is known increases the probability of securing successful refinancing with an alternative lender. Waiting only serves to kick the can down the road and reduce the time available when the refinancing is eventually undertaken. Corporates in vulnerable sectors will want to be proactive and deal with their refinancing early.

For those businesses who may wish to refinance or extend existing debt – from trade finance facilities to overdrafts, revolving credit facilities, to long-term fixed rate loans – BTG Advisory has a wide network of lenders, from high street clearers to specialist funders in the sector. We are well placed to help with regular finance requirements to assess worst-case options if your company is near insolvency risk. Please do get in touch with our team today, if you need help.