The Edge of a Straight Razor
As expected, the Federal Reserve increased interest rates by another .75%. The prime interest rate will rise to 7.00%, which is up from 3.25%, the rate that ran from March 2020 to March 2022. Businesses with variable-rate loans are getting whacked, particularly those that originated in the past 2-3 years, and especially SBA loans.
In continuing the discussion on stress testing for margin compression (see below), we have been tracking the rate increase impact on an acquisition loan through the lens of the Debt Service Coverage Ratio (DSCR). While lending standards can vary slightly, a ratio of 1.25 (1.15 for SBA) has generally been considered healthy enough to originate a loan. However, as the ratio approaches 1.0, a borrower may be drawing cash from other sources to manage debt payments as they try to maintain covenants and avoid default.
With the new rate increase, our loan that started with a DSCR of 1.25 is now at 1.11. The same loan under an SBA structure will revise at 1.03 at the end of the year, and if there are additional rate increases, will drop below 1.0 come 2023.
...like a snail crawling along the edge of a straight razor.