Impact of rising interest rates on lending in the IT sector

7 December 2022 / Insight posted in Article

The prevailing economic situation in both the UK and worldwide has caused the Bank of England to raise base rates considerably in recent months to counter inflation and calm the markets following former Chancellor Kwasi Kwarteng’s mini-budget in September, with rates having risen from 0.5% to 3% since the start of 2022. Rates being at a 14-year high would suggest that banks and other debt providers may have to prudently manage their lending activity, with a knock-on effect on M&A activity where many transactions require leverage.

While rising interest rates do mean the cost of debt is going up for businesses across the board, finding willing lenders may become the bigger challenge. As lenders’ cost of capital increases, their lending criteria tightens. This will likely lead to a “flight to quality” as lenders look to increase the proportion of lower-risk clients in their book.

This should protect good operators in the IT sector. IT companies are typically cash-generative, tend to have high levels of long-term contracted recurring revenue and are not capex-intensive, which is going to be increasingly attractive to lenders. Where operators are providing business-critical functions, such as IT managed services and cyber security, they will be particularly attractive to lenders.

We spoke with John Palmer, Director of Corporate Lending at Shawbrook, who commented: “Despite economic headwinds and the recent market volatility, Shawbrook remains committed to providing debt facilities to businesses looking to grow through M&A. The IT sector in particular is attractive to lenders due to recurring revenue models, high levels of cash generation and strong equity valuations. While the cost of borrowing has increased on the back of increases to the Bank of England base rate, well-run operators in the sector can still attract flexible debt offers from lenders.”

“The IT sector in particular is attractive to lenders due to recurring revenue models, high levels of cash generation and strong equity valuations.”

More than ever, it is going to be necessary to ensure that the historical and forward-looking financial information provided to lenders is of a high quality. Credit panels will be paying particular attention to the quality of management teams and the recurring nature of revenue.

Indeed, our analysis of Q3 deals in the UK IT services sector shows that there hasn’t been a significant slowdown in M&A activity. However, there could still be a slowdown on the horizon with the total amount available to borrow reducing. Equally, the higher cost of financing could force more sellers into the market as struggling businesses burn through cash reserves. Both are likely to result in a decrease in valuations in private markets, mirroring the decline already seen in publicly traded securities in the sector.

Our analysis of Q3 deals showed that 70% of all transactions in the sector were private equity-backed, up from 64% in the previous quarter. While lower valuations could lead to opportunities for them to accelerate buy-and-build strategies, they will likely be met with resistance from shareholders of potential targets whose valuation expectations remain unchanged.