Multi-Unit Franchisee Magazine Issue IV, 2011 | Page 76

ExitStrategies
By Dean Zuccarello

Project Financing
Should the fix be in?

I

nterest rates right now are low—very low. They’ve been
low for a while. And they’re expected to remain low for the
foreseeable future. So, when you go to your bank and they
have only a floating-rate loan to offer you, no problem,
right? Maybe… but you better make sure you’ve considered all
the angles before you pass up the opportunity to convert that
loan to a fixed rate.
Entrepreneurs securing new project financing are well aware
that banks today typically offer only floating-rate products. Although some lenders may not offer fixed-rate loans themselves,
they typically will facilitate converting the loan to a synthetic
fixed rate by helping borrowers purchase an interest rate hedge
known as a swap. A third party will make the floating-rate payments on the loan, and agree to accept payments at some fixed
rate from the borrower. A swap boils down to a
transfer of interest rate risk from you, the borrower, to your swap counterparty. You can think
of it as insurance—you get rid of interest rate
risk by paying an up-front fee and somewhat
higher initial rates. They win if interest rates
stay low; you win if rates rise.
So when closing a new loan, should you a)
buy the insurance and take the fixed rate, b) roll
the dice with the bank’s floating-rate product,
or c) buy a swap for only part of your debt
and go with a blend of fixed- and floating-rate
debt? Of course, nobody knows what will happen with interest rates in the future, but what
you can do is be aware of the current lending
environment, stay informed on the interest rate
outlook, and understand the potential risks and
rewards of each strategy.
The current environment

Interest rate outlook

In our opinion, with interest rates so low, there is nowhere for
them to go but up. The only question is when. Current low
rates on a long-term investment such as 10-year Treasurys are
one indicator that the market expects rates will stay low for an
extended period. Big financial firms and hedge funds bet money
every day on what future rates will look like. Taking a peek at
a composite of their bets—known as the forward curve—also
says the “smart” money expects rates to stay unusually low for
the next several years. There are plenty of reasons to support
that belief. The slow recovery (or lack thereof), the Fed’s easy
monetary policy, and low inflation all lead
us to believe that interest rates will stay low
until the economic environment changes
significantly. That said, the fundamentals of
today’s economy and the increased risk for
extraordinary political and economic events
are incubating inflationary pressures that
we believe are likely to push interest rates
up over the long term, perhaps quite high.

In our opinion,
with interest
rates so
low, there is
nowhere for
them to go
but up.
The only
question is
when.

Why are most lenders offering only floatingrate financing? The simple answer is that they’re not willing to
make long-term loans that are fixed at today’s low interest rates.
Floating-rate products charge interest at a set spread over an index—and whether that index rate is Libor, prime, Treasury, or
another index, rates are all at or near record lows. Libor rates
have been under 1.00 percent for several years, prime is at 3.25
percent, and the 10-year Treasury recently dipped to just 2.14
percent in the week of August 8—and that’s after the S&P rating downgrade!
While borrowers should rightly be glad of these record-low
rates, the downside is that banks are placing unusually large
spreads on their floating-rate products. Whereas a few years
ago they could charge 3 percent over 3-month Libor and still
earn a decent return, today that would be generating only a 3.28
percent total interest rate—a number at which banks just can’t
make money. As a result, spreads have grown artificially high to
make up for the low index rates. Our opinion at Cypress is that

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spreads will possibly come down once base-level interest rates
rise back into normal ranges.

Risks

Don’t let the last decade of relatively low
rates lull you into a false sense of security.
Those 10-year Treasurys that are hovering around 2 percent today were above 15
percent in the early ’80s and above 9 percent in the early ’90s. Imagine adding 7 or
13 percent to your floating-rate debt if the
rates of 1991 or 1982 return in 2015. While
that might be unlikely, it is wise to consider
what your exposure to rising interest rates
could be, and how badly it might hurt.
Let’s imagine a franchisee with $1.375 million EBITDA, $1
million in rent, and a $5.5 million loan. That’s a 4-to-1 debt/
EBITDA ratio, and at an effective interest rate of 5 percent on
that 10-year loan, our franchisee is sitting at a reasonable 1.39x
fixed-charge coverage ratio. But if rates rise to 10 percent, that
coverage ratio drops to 1.25x, and at 12 percent to 1.20x. Now
he could quite possibly be in violation of his loan covenants, and
a hiccup in EBITDA (or further increase in interest rates) could
threaten his ability to pay his bills.
While you may not be able to guess what interest rates will
be five years from now, you should understand the particular
impacts of potential rate increases on your business. If you have
very low debt levels relative to EBITDA, perhaps you can absorb a big hike in interest expense. It still won’t feel good but
it won’t put you under. On the other hand, if you are pushing
the limits of your borrowing capacity, you probably can’t afford

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