When money has a price

For much of the past two decades, firms, investors and policymakers lived off the easy money of historically low interest rates.

That era has ended. Short of another black swan event, it is not coming back.

Business models built around zero interest rates—and services firms with exposure to those businesses—are adapting to the return of a positive term premium in the price of money.

The end of easy money, and the significant leverage that it encouraged, is stimulating a period of rediscovery and reformulations around a view of financing that was once commonplace.

Put simply, money once again has a cost, and that cost is affecting how businesses operate.

To understand what is happening, we look at the weighted average cost of capital—or the average cost a firm expects to pay as it finances and expands its business. It’s a useful metric that shapes risk appetite and influences corporate capital expenditures and hiring decisions.

For our analysis, we look at firms with $1 billion to $10 billion in revenues, drawn from the Russell 3000—the beating heart and soul of the American real economy.

This estimate provides a quarterly, real-time look at investment and hiring conditions across the economy.

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 the Federal Reserve’s rate cuts are likely to affect fixed business investment, hiring and the economy.

We then use our measure of the cost of capital and extend it across select industries to map out where to go.  

What rate cuts mean to business

The financial engineering that blossomed in the time of negative real interest rates funded many marginal businesses. Many of those businesses’ survival depended on a continuing influx of cheap capital.

That cheap capital is now history.

And it came at a cost: An entire generation of managers, investors and policymakers knows little beyond zero interest rates and is now searching for a way forward.

To thrive in the post-pandemic economy, firm managers need a different understanding of commercial conditions under structurally higher interest rates.

The intellectual exhaustion involved in determining what’s next should come as no surprise. The Fed’s terminal rate, after all, appears to be closer to 3% than the 1.5% average terminal rate between 2000 and 2020 or the 1% average nominal policy rate between the financial crisis and the pandemic.

To remedy that exhaustion, we look to the weighted average cost of capital, a term in common use before the days of historically low interest rates. 

Why are we placing so much emphasis on this idea?

The rate shock unleashed by the Fed to reestablish price stability resulted in an approximately 31% increase in the weighted average cost of capital from the financing trough in 2020 to now.

That shock has unnerved enough investors and entrepreneurs to the point that extreme risk aversion has crept into American commerce.

The two black swan events of the past 20 years—the financial crisis and the pandemic—have created a negative mindset, where too many investors are simply waiting for the proverbial other shoe to drop as they sit on large cash positions. The result is a refusal to make the type of investments in their firms and people to remain competitive.

The $17.7 trillion sitting in banks is a testament to that risk aversion. 

But there are powerful reasons not to sit tight. As the Fed reduces its policy rate, yields along the curve will ease, creating the conditions to unlock cash flows and release pent-up demand.

When this happens, firms will weigh the return on investment against the weighted average cost of capital as they make investment and hiring decisions.

The cost of investment

The weighted average cost of capital is what a firm expects to pay as it finances and expands its operations.

A business will not invest in platform services that revolve around equipment, intellectual property and software unless the return on investment exceeds the weighted average cost of capital. Otherwise, such an investment would destroy the firm’s enterprise value.

Put another way, as interest rates decline, the incentive for firms to make long-term strategic investments increases, which in turn bolsters fixed business investment, boosts productivity and leads to more hiring.

Large firms traditionally have a greater appetite for risk and better access to capital, which gives them a first-mover advantage in making these investments.

It’s a different story for small and medium-size firms, which do not always have the personnel to identify such large policy changes and are often risk averse.

But in the ultracompetitive landscape that is emerging, middle market firms cannot afford to wait.

Falling behind the productivity curve is not an option, because large firms, having invested in improving efficiency, will move down and capture market share.

Our objective is to identify the current weighted average cost of capital for middle market firms across a variety of industries in America’s real economy.

Ideally, middle market firms would take advantage of this insight to make the sort of productivity-enhancing investments that the capital allocation process aims to produce.

State of play

The increased cost of financing illustrates how the monetary transmission mechanism works and identifies the profound impact of the rate shock of the past two years.

Industries that are sensitive to interest rates, like tech, financial services and real estate, experienced the greatest shock.

But it wasn’t just those industries. Telecommunications, automobile manufacturing and technology hardware were hit as well, and as rates ease, they are poised to be among the winners over the next two years.

At the same time, industries that rely more on discretionary spending, like consumer products and transportation, may not experience the same benefit.

But overall, the benefits to the economy will be significant.

Not only will firms with an elevated weighted average cost of capital benefit from lower interest rates, but businesses with high debt-to-asset ratios will also disproportionately benefit as a wave of refinancing begins.

Most importantly, the magnitude of the rate shock has not yet been completely absorbed by asset classes like private equity, which will emerge transformed as the era of easy money ends.

A recent article by Bloomberg, noting that private equity firms are resorting to debt to pay out investors during the current drought of mergers and acquisitions, describes the profound shift in that formerly preferred asset class.

Gone are large multiples and a quick turn on portfolio companies. In its place is a bottom-up approach that relies far less on macroeconomic conditions and far more on commercial transformation from the inside out.

Leverage, in the end, will return to its traditional role of financing expansion.

A roadmap

In many respects, the years ahead will look much like the era before the financial crisis, with stable inflation, interest rates and demand.

This economic landscape will put a premium on managers who know how to optimize the operations of a business rather than simply maximize the carrying capacity of its balance sheet.

Financial engineering will take a back seat to a firm’s core enterprise value.

In other words, it’s a return of the classic capital allocation process. What’s old is new again.

To be sure, the use of leverage will remain an important part of the value creation playbook for sponsors and executives. But that playbook will become harder to implement as the cost of capital increases and capital markets demand a more disciplined approach to asset valuations and exits.

The winners will be those who can improve operating efficiencies and effectively allocate their firm’s capital across the enterprise.

We believe firms need to develop capital allocation skills, tools and processes that focus on quantifying returns across their industry value chain.

Industry-specific enterprise value roadmaps will be an important compass for navigating this new economic landscape, where a higher cost of capital and operating efficiencies will dominate the shareholder value equation.

Of course, adopting this value creation playbook will take time, and managers will have to learn new skills.

The focus of these commercial tools should be maximizing shareholder value and optimizing returns on capital—much like the days before the financial crisis.

In short, we are going back to the future.

The takeaway

The relationship among the public, businesses and those who guide monetary policies is complex.

The Fed’s pivot to lower interest rates will have an unmistakable impact on the broader economy.

Years of zero interest rates extracted a powerful analytical price across the American commercial community, creating a generation of bull market geniuses who now appear adrift in a sea of uncertainty.

It is only natural that the end of that era will generate substantial transition costs as firms seek to position themselves to compete.

Their next step should be to develop expertise in maximizing free cash flows and enterprise value.

Money has a price, as seen in the weighted average cost of capital. Those who acknowledge, and respond to, the transformation that is underway will reap the rewards.