Mastering Capital Management Amid Rising Interest Rates: Strategic Insights for 2024
An environment with high interest rates has sparked a renewed focus on the cost of capital. Borrowing costs have gone up, and debt repayment for companies that borrowed at previous, lower rates has become a complicated endeavor. This has introduced a heightened level of complexity in private equity.
Since interest rates started rising in 2022, businesses have had to roll up their sleeves to create real value in a way they have not done in the past decade. Gone are the days when private equity consisted of leveraging plenty of debt to just buy a company and then sell it if the rate of return surpassed the cost of the debt, which meant it was making money. Now, a new layer of higher cost of capital has been added.
In this article, we will address the value of assessing the cost of capital and economic profit on a granular level amid a backdrop of anticipated rate cuts by the Federal Reserve.
In what concerns this newfound cost of capital, businesses need to keep in mind that low interest rates result in lower costs for borrowing, which can lead to cheap capital. This means that if capital becomes inexpensive, it can become prone to be misallocated or leveraged since it requires no effort to obtain in the first place. Additionally, low interest rates create a false idea of a ‘surplus of cash’ in the market that often does not translate into a higher abundance of real, tangible assets such as natural resources or food. It also encourages businesses to take on new debt without the appropriate risk management.
The current macroeconomic landscape compels a thorough assessment of taking on new capital costs through borrowing or spending budgeted funds. Still, regardless of macro conditions, asset acquisition and expansion in times of lower rates must be considered strategically if the time arrives. If the target is suitable, taking on debt can be a yielding maneuver for the bull cycle.
Federal Reserve's Interest Rate Policy
Regarding investor sentiment and overall market conditions, interest rates dictate the path forward for actionable moves for companies. High interest rates also affect inflation through prices because they reflect the higher cost of borrowing money, which can reduce spending and slow down economic activity.
On that note, the U.S. Federal Reserve has been on a quest to lower inflation by increasing interest rates since 2022. In its attempt to slow down spending by raising the cost of loans and contracting the money supply, the Fed intends for demand to go down, bringing inflation to lower levels through less spending. In 2024, the Fed claimed they were going to begin rate cuts by the end of June due to having achieved ‘progress’ at slowing down inflation.
However, despite these monetary policy maneuvers, inflation remains significantly above their 2% target. The latest CPI inflation print showed prices rose 3.5% in Q2 in 2024, so rate cuts are not likely to be lowered by the expected date. Also, lower rates could create faster growth and push inflation higher, something Fed chairman Jerome Powell will not be able to tolerate due to the current severe fiscal deficit. So, he might not be ready to slash those rates yet.
As for the causes of the unrelenting inflation we have been experiencing, according to this post from Econometrics, core services are to blame. Core services are one of the CPI items that have not transitioned or cooled down since COVID-19 and are also a big component of the US economy. Month-to-month inflation for core services has not decreased since their 2022 and ‘23 spike. Adding to this, the government's latest report on consumer prices indicated that inflation remains persistently high in areas such as health care, apartment rents, restaurant meals, and other services, so reaching a 2% goal with those numbers seems like an uphill battle.
Officials believe high borrowing rates will be necessary for most of 2024 to continue curbing spending and inflation. Still, as the Federal Reserve adjusts its interest rate policy, the U.S. economy seems likely to avoid a recession for the remaining 2024. Even through higher prices, polls indicate that the overall sentiment remains positive for the seemingly strong US economy due to a healthy job market, a near-record-high stock market, and a slight decline in inflation in 2024. The critical issue is whether the Federal Reserve will begin rate cuts in 2024.
Strategic Guidelines for Effective Capital Management
Some argue that the economy is currently holding strong due to singular factors like historically low unemployment and a record-high stock market. Still, despite the positive indicators, no participant in this high-interest rate environment can afford to disregard the cost of capital. This is proven by the impact of high productivity rates in businesses. The high cost of loans means increased difficulty in purchasing assets like equipment, inventory, or raw materials.
Here are some recommended actions for businesses to take during a period of costly borrowing:
1. Integrate Cost of Capital Into Strategies
Many executives and investors were surprised by the 2023 interest rate hikes, and they saw the rising cost of capital as a threat. However, it does not need to be that way.
Companies that incorporate the cost of capital into their strategies see tangible benefits. In environments with higher interest rates, measuring the cost of capital at a granular level is key for startups and companies to have a longer runway. Economic profit (EP) should also be taken into account. It considers revenue or excess earnings a company generates above the cost of capital. Research shows that companies adopting capital market disciplines internally and managing with economic profit have higher shareholder returns than industry peers.
2. Locate Value Creation
The most profitable aspect of EP is the knowledge that value creation within companies is highly concentrated. Typically, in large corporations, less than 40% of the capital employed generates over 100% of shareholder value, while 25 to 35% of capital actually destroys value. This holds true across different levels, from industries to specific products, channels, and customer segments.
When companies can locate where EP is generated (and where capital costs outweigh earnings margins), it empowers them to allocate capital strategically, avoiding unproductive areas. This accuracy in capital allocation—a core function of the role of CEOs and boards—becomes even more critical during capital cost increases. Companies can redirect spending to create a real operating advantage.
EP dictates that value creation can be located in specific products in specific brands through certain channels in selected locations. Companies should pinpoint which investments yield the best returns and adjust commercial efforts accordingly, outspending the competition and increasing advertising in targeted areas, leading to higher sales. For example, a pharmaceutical company can know its most profitable products through sales numbers, channels and customer audience. Using this data should sharpen the focus of its sales force through more tailored ads, better product offerings, and distribution channels to enhance profitability and market share.
3. Find Where Economic Profit Grows
In addition to recognizing your most valuable assets, companies should know not only where EP is but also where it is growing and where it can grow in order to make informed decisions about investments. Making ambiguous forecasts can lead to wishful thinking. However, measuring EP at a highly detailed level enables honest discussions about where to invest, whether strategies will succeed, and how much capital will be needed.
This disciplined approach also applies to acquisitions, where companies must overcome a premium of approximately 30% to break even on deals. Understanding where profit pools lie helps identify suitable acquisitions. What will it take to win shares of those profit pools also provides an overview of what is needed for a successful post-merger integration.
Most leaders focus on the income statement when planning and budgeting, such as forecasting sales and direct costs. However, analyzing EP meticulously (by product, customer, channel, etc.) creates business plans that are aligned with resource allocation, enhancing EP predictability and delivery.
4. Capital Strategy Implementation
Integrating the cost of capital into companies' strategies requires overcoming some hurdles. EP is a process that continually identifies and quantifies the issues with the highest value at stake and the best opportunities for each business unit and the business as a whole.
This should not be a one-and-done initiative but more like a tenacious operating habit to be reinforced and communicated repeatedly to managers. It should be restated, especially during strategy reviews, budgets, and performance evaluations.
It is also important to remember that over a longer time frame, numbers in companies can change. A division that was wasting capital in the past can become efficient, and a hot market segment can cool down. As for incentives, managers will keep the cost of capital in their scorecards as a new factor to consider. Rewards based on a good EP alone will naturally reduce that capital cost.
5. Interest Rate Impact on Asset Purchases
The importance of practicing good capital management cannot be stressed enough. On that note, if expansion is part of a company's short-term plans, they should keep in mind that if the Federal Reserve actually lowers interest rates, entrepreneurs should prepare for increases in business prices going forward. This will be caused by influxes of cheaper liquidity in the market, bringing higher levels of competition for the acquisition of business assets.
Lower interest rates will positively impact asset owners since the value of these asset classes will increase. On the other hand, this potential lower-rate environment could negatively impact participants looking to buy new assets in the face of higher purchasing prices. Understanding these price cycles will be key for the overall strategy on whether to buy, sell, or hold assets.
Based on projected interest rate trends, fast-forwarding asset acquisition plans might reap significant benefits. Locking in purchases before further rate cuts could leave entrepreneurs in a net positive space, where they can benefit from lower borrowing costs and potential asset appreciation in a declining rate environment. Also, in a different scenario, acquiring an asset or a business with low interest rates, even if the asset's price has risen, can reduce the interest payments over the life of a loan, accentuating the overall financial viability of the operation.
Final Thoughts
We expect interest rate increases will slow down as inflation continues to even out in 2024. Still, we believe inflation will remain higher than the Federal Reserve´s 2% target. As for risk-on assets such as bonds, stocks, real estate, gold, and Bitcoin, historically, they have been positively impacted by lower interest rates due to new inflows of liquidity arriving in the market, which means higher prices in general. So, if the Federal Reserve starts lowering rates, it will be a good time to invest in these risk-on assets.
For the foreseeable future, businesses should stay vigilant and adaptable as interest rate policies evolve and provide strategic expansion opportunities. The cost of capital remains as critical as ever until the Federal Reserve definitely begins lowering rates. Rate cuts will provide significant breathing space for company loans that are due and past debt repayments.
Bottom line, achieving net positive economic profit seems like a smart and hard-earned lesson and habit to maintain for future business strategy. Even if capital mismanagement is less costly during a lower interest rate environment and capital becomes more lenient, the high standard at which businesses are currently evaluating economic profit should be the norm for any business proceeding going forward.