For much of the past two decades, businesses, investors, and policymakers have lived on the easy cash provided by historically low interest rates.
Business models built around zero interest rates are adapting to returns from higher costs of capital.
Those days are over. It will not return unless another black swan phenomenon occurs.
Business models built around zero interest rates and service companies with exposure to them are adapting to the return of a positive term premium in monetary prices.
The demise of easy money and the high leverage it encouraged is stimulating a period of rediscovery and reinvention of once taken-for-granted ways of thinking about financing.
Simply put, money costs money again, and those costs are impacting how businesses operate.
To understand what’s going on, we look at the weighted average cost of capital, or the average cost a company is expected to pay to raise capital and expand its operations. This is a useful indicator that shapes risk appetite and influences a company’s capital investment and hiring decisions.
Our analysis focuses on Russell 3000 companies with annual revenues between $1 billion and $10 billion, which are the heart of the U.S. real economy.
These estimates should provide a real-time picture of investment and employment across the economy on a quarterly basis.
As the weighted average cost of capital falls, the conditions conducive to growth should improve.
In the process, we gain a better understanding of how Federal Reserve interest rate cuts can affect capital investment, employment, and the economy.
Next, use the weighted average cost of capital proxy and extend it to a select number of industries to consider a roadmap of where to go.
What the rate cut means for businesses
The financial engineering that blossomed in the era of negative real interest rates provided financing to many marginal companies. Many of those companies relied on continued inflows of cheap capital.
That cheap capital is now history.
But it came at a price. One of those costs is that an entire generation of executives, investors, and policymakers knew little about moving beyond zero interest rates and are now looking for a way forward.
To thrive in the post-pandemic economy, business leaders will need a different understanding of business conditions under structurally high interest rates.
It’s no surprise that intellectual fatigue occurs when deciding what to do next. After all, the Fed’s final interest rate appears to be closer to 3% than the 1.5% average from 2000 to 2020, or the nominal 1% average policy rate from the financial crisis to the pandemic.
To remedy this exhaustion, we focus on the weighted average cost of capital. This is a term that was common before the era of historically low interest rates.
Why do we attach so much importance to this idea?
The weighted average cost of capital has increased by approximately 31% from the 2020 funding trough to date as a result of the interest rate shocks imposed by the Fed to restore price stability.
The shock rattled investors and entrepreneurs to the point where extreme risk aversion crept into American commerce.
The two black swan events of the past two decades, the financial crisis and the pandemic, have left far too many investors sitting with large cash positions waiting for the proverbial other shoe to drop. It created a negative mindset. As a result, companies and talent refuse to invest to remain competitive.
The $17.7 trillion sitting in banks is evidence of that risk aversion.
But there are strong reasons not to sit still. When the Fed lowers policy rates, yields fall along the curve, freeing up cash flow and creating conditions for pent-up demand to be released.
Companies will then weigh return on investment against the weighted average cost of capital when making investment and hiring decisions.
definition
Weighted average cost of capital is the amount a company expects to pay to raise capital and expand its operations.
Companies do not invest in equipment, intellectual property, and software-based platform services unless the return on investment exceeds the weighted average cost of capital. Otherwise, such investments will destroy the enterprise value of the company.
In other words, lower interest rates increase incentives for companies to make long-term strategic investments, which in turn increases capital investment, increases productivity, and leads to more employment.
In the hyper-competitive environment of today’s economy, midsize businesses cannot afford to wait to invest in productivity improvements.
Large companies traditionally have a higher appetite for risk and have access to capital, giving them a first-mover advantage when making these investments.
For small businesses, the story is different. Small businesses don’t always have the resources to identify such large-scale policy changes and tend to be risk averse.
However, as hypercompetition continues to intensify, mid-sized companies cannot afford to wait.
Falling behind the productivity curve is not an option. Otherwise, large companies that have invested in efficiency gains will fall back and gain market share.
The purpose of this study is to determine the current weighted average cost of capital for middle market companies and various industries in the U.S. real economy.
Ideally, mid-market companies will use this insight to address the productivity-enhancing investments that their capital allocation processes are intended to generate.
State of play
The increase in funding costs shows how the monetary transmission mechanism works and reveals the significant impact of the interest rate shocks of the past two years.
Rate-sensitive industries such as high-tech, financial services, and real estate experienced the biggest interest rate shocks.
But it wasn’t just those industries. Telecommunications, auto manufacturing and technology hardware have been hit as well, and with interest rate easing, these companies are set to be among the winners over the next two years.
At the same time, industries that rely on discretionary spending, such as consumer products or transportation, may not see similar benefits.
But overall, the benefits to the economy will be significant.
Not only will companies with rising weighted average costs of capital benefit from lower interest rates, but companies with higher debt-to-asset ratios will also benefit disproportionately once the refinancing wave begins.
Most importantly, the magnitude of interest rate shocks has not yet been fully absorbed by asset classes such as private equity, which will emerge differently as the era of easy money ends. .
A recent article by Bloomberg points out that the current merger and acquisition drought has left private equity firms relying on debt to pay investors, marking a major shift in the previously favored asset class. It tells you everything you need to know about.
Gone are the companies with high multiples and quick exposure to portfolios. Instead, a bottom-up approach is being adopted, relying less on macroeconomic conditions and much more on commercial transformation from the inside out.
The use of leverage will eventually return to its traditional role of financing expansion.
road map
In many ways, the next few years will look a lot like the pre-crisis era, with stable inflation, interest rates, and demand.
In this economic climate, the emphasis is on managers who know how to optimize business operations, rather than simply maximizing their ability to maintain their balance sheets.
Financial engineering will take a backseat to a company’s core corporate values.
In other words, it is a return to the classic capital allocation process. What is old becomes new again.
Indeed, leveraging will continue to be an important part of value creation strategies for sponsors and management teams. But that strategy will become increasingly difficult to implement as the cost of capital rises and capital markets demand a more disciplined approach to asset valuation and exits.
Read more RSM insights on private equity, interest rates and the broader economy.
Winners will be those that can improve operational efficiency and effectively allocate corporate capital across the enterprise.
We believe that companies need to develop capital allocation skills, tools and processes that focus on quantifying benefits across industry value chains.
We believe industry-specific enterprise value roadmaps provide a critical compass to navigate this new economic landscape where higher costs of capital and operating efficiency dominate the shareholder value equation.
Of course, adopting this value creation strategy takes time and requires managers to learn new skills.
The focus of these commercial tools should be maximizing shareholder value and optimizing return on capital. It’s very similar to the era before the financial crisis.
In short, we are going back to the future.
Take-out
The relationship between the public, businesses, and those who direct financial policy is complex.
The Fed’s move to lower interest rates will have an undeniable impact on the overall economy.
Years of zero interest rates extracted powerful analytical prices across the American commercial community, creating a generation of bull market geniuses who now appear adrift in a sea of uncertainty.
It is no surprise that the end of that era will incur significant transition costs as companies seek to establish a competitive edge.
We believe a second priority is promoting and developing expertise to maximize free cash flow and enterprise value.
Money has a price, as seen in the weighted average cost of capital. Those who recognize the transformation that is taking place will be rewarded.
