Rising real interest rates are pushing up the cost of commercial and industrial loans, making it harder for middle-market businesses to meet payrolls and finance their expansion, according to the RSM US Middle Market Business Index (MMBI) Funding Special Report, presented by RSM US LLP (RSM).

The survey found that middle-market firms are paying between 10.9 percent and 15.5 percent for financing, and these rates are pushing the risk premiums on loans close to double digits. Additionally, 34 percent of smaller middle market firms ($10 million to $50 million in revenue) have loans from commercial banks with rates below 5 percent, and 24 percent have loans with rates between 5 percent and 7 percent. The report explains that those loans will have to be rolled over in the coming years at higher rates, posing an additional threat to cash flow.

"The increasing cost of doing business through higher rates is leading to a greater sense of risk across the middle market and the economy," said Joe Brusuelas, chief economist with RSM US LLP. "One of the particular challenges during this cycle is that as inflation eases, real interest rates increase. That creates a situation in which commercial and industrial loans are much more expensive, on top of tighter lending by commercial banks."

Firms Look to New Financing Sources and Face Higher Premiums
The survey results show that middle-market firms are casting a wider net for financing. Fifty-six percent of organizations in the survey sought traditional bank lending over the previous 12 months, down from 74 percent in a similar RSM survey in 2015. Additionally, 53 percent of the surveyed executives indicated they would be less likely to obtain financing from a commercial bank than in the past.

When asked about where they are getting funding, 36 percent of middle-market executives said they have turned to the shadow banking market. Thirty-three percent reported using equity sources such as private equity, 30 percent said digital banking and financing sources, 29 percent have used government lending and 60 percent said private lending. Roughly 39 percent reported using retained earnings and cash to meet financial requirements. The higher premiums attached to nontraditional bank lending are another sign of substantial financial stress affecting the real economy.

For firms that need to finance payroll and business expansion through traditional bank lending, the overall rate is 10.9 percent. However, 21 percent of middle market businesses surveyed now pay less than 5 percent on their existing loans taken from commercial banks, and 22 percent are paying 5 percent to 7 percent, implying substantial reset risk and diminished cash flows as those loans are refinanced in the coming years.

Companies using nontraditional lenders pay a mean average annual percentage rate of 13.7 percent, with those in the larger revenue category ($50 million to $1 billion in annual revenue) paying 14.7 percent and smaller middle-market firms paying 10.5 percent.

For businesses that turn to equity sources of lending such as private equity, the mean average APR is 15.5 percent. Larger firms are paying 17 percent and smaller companies are paying approximately 8.8 percent.

Significant Impacts in Private Equity
The impact of rising real interest rates is significant in the private equity ecosystem, with private equity firms paying four and five times the rates of 18 to 24 months ago to leverage the capital they have. Private equity firms are being more thoughtful in the way they apply leverage and debt financing in deals. With the changed financing environment and increased scrutiny on deals, some middle-market transactions are taking longer to close as a valuation gap has emerged.

"Nowhere has the impact of rising rates been more pronounced than in private equity," Brusuelas said. "Over the past decade, long-term real rates, using 10-year Treasury Inflation-Protected Securities as the benchmark, have averaged 0.26 percent compared with rates that have exceeded 2 percent this fall. The increase in real interest rates is particularly painful for private equity firms that use leverage to make deals."

The RSM report also notes a shift in deal focus. While M&A activity is increasing, there has been a shift from large acquisitions to strategic, smaller acquisitions designed to expand footprint or market share.

Financing Challenges Felt Across Industries
The report details how the current financing environment is challenging middle market companies across the manufacturing, consumer products, life sciences and real estate industries.

Highlights include:

• Manufacturing: For many manufacturing firms, the playbook from three years ago, when low-rate loans were available, no longer applies. Manufacturers will continue to invest, but the cost of those investments has gone up – along with the price of being wrong.
• Consumer Products: The new environment is taking a toll on innovation, whether a company is going to invest in a new plant or a new line of products. One way these companies are innovating is through add-on acquisitions.
• Life Sciences: Early-stage companies with high valuations raised a lot of cash during the pandemic and many still have a year or two of runway, but they need to conserve funds.
• Real Estate: The gap in valuations will start to narrow once buyers fully believe the Federal Reserve's rate hike campaign is finished.

Further industry insights can be found in the full report.