RSM US Survey Data Details Impact of Rising Financing Costs on Middle Market Firms and Potential Risks to Economy

CHICAGO – (October 23, 2023) – 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% and 15.5% for financing, and these rates are pushing the risk premiums on loans close to double digits. Additionally, 34% of smaller middle market firms ($10 million to $50 million in revenue) have loans from commercial banks with rates below 5%, and 24% have loans with rates between 5% and 7%. 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% in a similar RSM survey in 2015. Additionally, 53% 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% 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% said digital banking and financing sources, 29% have used government lending and 60% said private lending. Roughly 39% 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%. However, 21% of middle market businesses surveyed now pay less than 5% on their existing loans taken from commercial banks, and 22% are paying 5% to 7%, 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%, with those in the larger revenue category ($50 million to $1 billion in annual revenue) paying 14.7% and smaller middle market firms paying 10.5%.

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

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% compared with rates that have exceeded 2% 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.

The survey data that informs this index reading was gathered from 416 respondents between July 5 and July 25, 2023.

About the RSM US Middle Market Business Index 
The RSM US Middle Market Business Index (MMBI) is based on research of middle market firms conducted by Harris Poll, which began in the first quarter of 2015. The survey is conducted four times a year, in the first month of each quarter: January, April, July and October. The survey panel consists of approximately 1,500 middle market executives and is designed to accurately reflect conditions in the middle market.

Built in collaboration with Moody’s Analytics, the MMBI is borne out of the subset of questions in the survey that asks respondents to report the change in a variety of indicators. Respondents are asked a total of 20 questions patterned after those in other qualitative business surveys, such as those from the Institute of Supply Management and National Federation of Independent Businesses.

The 20 questions relate to changes in various measures of their business, such as revenues, profits, capital expenditures, hiring, employee compensation, prices paid, prices received and inventories. There are also questions that pertain to the economy and outlook, as well as to credit availability and borrowing. For 10 of the questions, respondents are asked to report the change from the previous quarter; for the other 10 they are asked to state the likely direction of these same indicators six months ahead.

The responses to each question are reported as diffusion indexes. The MMBI is a composite index computed as an equal weighted sum of the diffusion indexes for 10 survey questions plus 100 to keep the MMBI from becoming negative. A reading above 100 for the MMBI indicates that the middle market is generally expanding; below 100 indicates that it is generally contracting. The distance from 100 is indicative of the strength of the expansion or contraction.