It was a photo that marked the end of an era. Morrisons boss David Potts, in a black open-necked shirt, standing in a garden at the supermarket group’s Bradford headquarters, beside a statue of founder Ken Morrison. Standing chatting to him is the former Tesco supremo Sir Terry Leahy. They were celebrating a landmark deal that last year saw the grocery chain taken off the stock market and into private hands.
Leahy, now an adviser to the buyout giant Clayton Dubilier & Rice (CD&R), had helped it outbid rival US private equity firm Fortress for Morrisons. The deal, which involved loading the business with debt in a sector known for slim margins and cutthroat competition, was a big bet on growth.
That bet now seems bigger than ever: high inflation, exacerbated by Russia’s invasion of Ukraine, has forced central banks to raise interest rates rapidly. The costs of servicing corporate bank loans – all but ignored in a world of low interest rates – are threatening to balloon. For British businesses which have loans at a variable rate, or need to refinance, rising interest rates will have a marked effect on costs and profits.
After the takeover, Morrisons’ debt pile more than doubled – from £3.2bn in January 2021 to £6.8bn a year later, according to Moody’s. The rating agency estimates that a one-percentage-point increase in interest rates will cost Morrisons £30m a year in extra fees. That would significantly dent profits at a time when sales could also come under pressure, although Moody’s and other agencies think Morrisons still has strong enough finances to weather the storm.
With Britain expected to slip into recession in the coming months, interest rates could push less healthy businesses into bankruptcy.
Companies have been scrambling to reduce their exposure, paying down debt with earnings when they can and looking for investors where they cannot. Carmaker Aston Martin Lagonda last month allowed investors – including Saudi Arabia’s controversial sovereign wealth fund – to buy shares at a deep discount in order to reduce what chair Lawrence Stroll said were crippling debt costs.
For companies still hoping to refinance, rising interest rates will make things even harder. They include GFG Alliance, the group of metals businesses controlled by Sanjeev Gupta. Gupta has been trying to refinance the businesses for more than 18 months, which has raised concerns for thousands of steelmaking jobs in Rotherham and Stocksbridge in South Yorkshire, and elsewhere.
Richard Etheridge, associate managing director at Moody’s, said companies in the UK and Europe faced high indebtedness and difficult capital markets. “Those who need to refinance will be most at risk given the step-up in funding costs,” he said.
In 2022, interest rates around the world have increased faster than at any time in the past 41 years, according to analysis last week by S&P Global Ratings, another credit rating agency, led by Nick Kraemer.
If Bank of England governor Andrew Bailey or European Central Bank president Christine Lagarde raised interest rates too soon and energy prices kept soaring, it could “accelerate defaults quickly”, they warned.
Economists have long warned about “zombie firms” being kept alive by debt while paying low interest rates. They could soon face a reckoning. Ratings agencies focus on bigger companies, which are able to issue bonds, but there are concerns about the impact of higher borrowing costs on smaller firms as well.
Daryn Park, senior policy adviser at the Federation of Small Businesses, said he was concerned that smaller companies would be unable to access loans if they needed short-term cash. “If interest rates hit 6%, it will start to price out a lot of businesses,” he said.
One in five small businesses which applied for finance in the third quarter failed to find an offer at an interest rate below 11%, according to a survey of FSB members.
There will also be longer-term consequences for smaller businesses which rely on bank loans to invest in growth. Park said: “If we’re heading towards a tightening market, they are not going to be able to grow.”
In late 2019, Gary Ballantyne and his wife Lynette founded Viral Entertainment, a company offering virtual reality experiences in Corby, Northamptonshire. The pandemic closure that followed soon after meant the company missed out on the chance to build up a financial cushion before the expected recession.
“Really we need to be looking at bigger premises because the tech has moved on,” he said. The company now has virtual reality headsets that allow two people to roam a room and interact with each other without being tethered to a computer. “We really need more space but we can’t afford to move because there isn’t enough working capital in the business.”
Ballantyne is confident in the longer-term prospects of the business – analysts predict interest in virtual reality is set to boom – but he said short-term growth for his business was going to be impossible because of the difficulty of getting finance. Instead he is trying to find other ways to use the equipment they have, such as taking it in to care homes to give residents a taste of virtual reality.
Norman Chambers, managing director of the National Association of Commercial Finance Brokers, said that over the coming six months he expected an increase in “distressed borrowing” from companies in need of emergency funds. He said brokers, which act as intermediaries between companies and lenders for a fee, should “lengthen loan terms and consolidate where possible”.
However, the banking sector, which provides the bulk of borrowing for smaller British businesses, is not yet too worried. In September, UK Finance, the banking industry’s lobby group, said there remained a “high degree of financial headroom across SMEs, and lenders continue to stand ready to support businesses”.
Katie Murray, finance boss at NatWest Group, said on Friday that “loan impairments remain extremely low”. However, the bank did acknowledge that it was seeing increased credit risk among its corporate customers, even if evidence of actual defaults remained limited.
Stephen Pegge, managing director for commercial at UK Finance, acknowledged that there were tough times ahead for the UK economy, but said that, so far, the proportion of borrowers under pressure was no higher than before the pandemic.
“Banks have been stress-testing whether businesses can afford higher interest rates for some time,” he said. “That gives me confidence that things could be OK.”
Bank of England analysis published last year reckoned that “only a large increase in borrowing costs” – about four percentage points – would “markedly increase the share of businesses with a high debt-servicing burden”. However, that analysis was carried out when bank base rate stood at 0.1%. Since then that rate has increased to 2.25%, with further rises expected; increases of in borrowing costs of four percentage points now seem very possible.
That Bank analysis also suggested that companies’ debt burdens would be manageable if earnings were to fall, but did not look at what would happen if sales fell just as interest rates were soaring.
The pace of interest rate rises had “taken a lot of people by surprise”, said Louise O’Sullivan, director at Interpath Advisory, a debt and restructuring consultancy. During the period of low interest rates since the financial crisis, she added, businesses had become unused to protecting against interest rate risk. And it was now too late, as hedging costs had surged, and companies were instead having to try to see how they could keep cash buffers in their businesses.
Sandra Kylassam-Pillay, another director at Interpath, said the true effects of higher borrowing costs had yet to be seen. “It’s not the increase in interest rates in isolation that is affecting corporates at the moment,” she said. “It’s also inflation and the cost of living – all of that means businesses are under increased stress.”
