The Consequences Of Prolonged High Interest Rates? “Higher For Longer” Shifts Value Within The Capital Structure – Corporate and Company Law

Through our Viewpoints series, Riveron experts share their
opinions on current topics, business trends, and industry news.

Monetary policy wields significant influence over the economy,
and its impact is often most felt through the movement of interest
rates. As the cost of capital rises, it becomes more difficult for
companies to justify investments in capital expenditures or new
hires. For highly leveraged private equity investments, this can be
especially detrimental, as the increased debt servicing burden puts
further strain on equity returns and business growth.

Exploring interest rate trends

Torsten Slok, Chief Economist at Apollo, recently remarked, “If the Fed cuts
interest rates too early, it increases the likelihood that we will
see a repeat of the 1970s. The Fed has no other option than to keep
interest rates higher for longer.”

Image Source: Bloomberg, BLS, Apollo Chief
Economist

The higher-for-longer policy stance has proven detrimental to
many over-levered companies, as rising interest expenses erode
available cash flow, leaving little or no distribution for
shareholders.

Higher interest rates effectively shift value within the capital
structure, favoring senior debt holders over junior equity
holders(see illustration below). While equity holders bear the
brunt of higher rates, lenders may benefit from higher returns,
particularly if the company has substantial equity.

Image Source: Penta Mezz

Obstacles and opportunities: How companies are affected by
interest rates

In this environment, companies that lack earnings or cash flow
are especially vulnerable, as they struggle to meet elevated debt
servicing costs. On the other hand, companies with strong earnings
or pricing power can often outperform, as they are better
positioned to absorb the increased debt servicing burden. The
broader goal of higher interest rates is to moderate growth and
make value investing more appealing compared to growth or
distressed investing.

This is the intention behind the Federal Reserve’s decision
to maintain higher interest rates: to curb excessive risk-taking,
particularly in capital structures lacking earnings or cash
flow.

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