To Recapitalize or Not to Recapitalize: How To Hedge Against Rising Interest Rates

By Karen Haywood Queen/Published April 7, 2015 for ForbesBrandVoice

With the Fed signaling that it may raise interest rates for the first time in nine years, now is the time for middle market companies to explore the pros and cons of recapitalizing, releveraging, and refinancing. Businesses can take advantage of the current low rates while hedging against rising rates.

“Interest rates typically aren’t near zero the way they are now,” says John Merrick, professor of economics and finance at the Raymond A. Mason School of Business at William & Mary. “One would expect that rates would normalize over time. The possibility of the Fed raising rates in the coming year is quite appropriate.”

On March 18, the Fed indicated that a rate increase is possible in June or later this year. Likely, any rate increase will not be steep. “The Fed raises rates in a slow and methodical way,” Merrick says.

Companies that have not already moved to take advantage of lower rates should consider taking action now. Businesses with financing tied to short-term interest rates stand to pay more when interest rates rise.

“The opportunity to refinance at reasonable interest rates is there,” Merrick says. “There’s still time to act but you shouldn’t be waiting for a better opportunity. You shouldn’t be hanging with a big exposure in your funding.”

That logic can also apply to recapitalizing, which reorganizes a company’s capital structure to replace debt with equity, and releveraging, which adds more borrowed capital to existing debt. “I really don’t view adding leverage and recapitalizing as different. They’re just different points along the same continuum,” says Neil Wessan, managing director and head of CIT Capital Markets.

The main advantage of recapitalization or adding leverage is reducing the cost of capital relative to what a company is currently paying, he adds. Since interest rates are low for now, it’s possible for companies to significantly reduce the cost of borrowing.

Hedge Against Rising Interest Rates

Companies looking for flexibility now may consider hedging against rising interest rates. According to Wessan, businesses aren’t focusing enough on the importance of hedging. “Companies should take advantage of relatively cheap mechanisms available to protect themselves today, rather than waiting for interest rates to move,” he says.

Interest rate swaps are one way to hedge against rising interest rates. A company making such a deal enters into derivatives where it “pays a fixed rate and receives a floating rate,” Merrick says. “If interest rates go up, they win on that contract.” That would hedge the company against rising interest rates on the loan.

Even as rates have remained low, terms and conditions of borrowing have loosened in recent years, which means companies that already have good rates may still be able to refinance to obtain better terms and conditions that provide more flexibility.

Whether it’s to make an acquisition, build a new plant, or pay a dividend to shareholders, “The primary consideration should be matching the requirements and plans of the company against what’s available in the capital markets to make it more efficient,” Wessan says.

Knowing When to Wait

Recapitalization, refinancing and adding leverage have many benefits for middle market businesses. But despite pending interest rate increases, there are times when it may be better to hold off.

For example, a company’s current credit situation may mean it does not qualify for today’s low rates. But if the company expects to release a new product soon or anticipates other developments that will improve cash flow, waiting—even with a pending interest rate hike—could be prudent, Merrick believes. Qualifying, even at a higher rate, is better than being turned down. “If they’re having trouble selling themselves to a bank as a good bet, then it may be good to wait until something changes in the company to tell a better story and make them seem much more credit worthy,” he says.

Another reason to wait: if a company is considering a sale in the near future, Wessan says. A company needs to have enough time to spread out the costs associated with refinancing for it to be economical.

Ultimately, the decision to recapitalize or add leverage is an economic one. Wessan notes: “If you can recognize the cost savings in excess of the upfront charges you pay for the refinancing, I think it’s worth considering.”