The return of higher interest rates in mid-2022 caught financial investors and banks off guard. This applies above all to those areas where financing conditions were particularly aggressive during the low-interest phase following the financial crisis.

In Germany, this was predominantly the case in leveraged finance and commercial property financing. As low cost debt capital was available, owners of companies or commercial property were able to leverage their equity investments by loading up their assets with high levels of borrowing. Of course, companies still had to pay interest on this debt – but it made a huge difference to the equation whether the variable Euribor was factored in as a second price component at 0% or 4%, in addition to the fixed risk margin.

The sharp rise in the variable price component has therefore brought many highly indebted companies owned by private equity companies to the edge of their debt servicing capacity – or even beyond. The same applies to commercial property projects with high loan-to-value ratios. For credit funds and banks that have financed these companies and projects with large loans, it is a problem if their borrower can no longer fulfil the agreed debt service. Strictly speaking, this would be a payment default, which banks and credit funds alike want to avoid at all costs.

To buy time, the financial sector is therefore turning to an old trick. The current interest payments of these stressed borrowers are capitalised as a precautionary measure, and pushed to the end of the loan term. At first glance, there is nothing wrong with that, as it gives all parties time – and gives the indebted company some financial breathing space. However, it does not solve the underlying problem. It fights the symptoms, but not the disease. And the root of all evil is that these companies still have to bear too high a debt burden in relation to their economic performance.

Two things will therefore have to happen in the near future to make the calculation work: Firstly, variable market interest rates must fall again significantly by the time they mature. Secondly, the operating profits of the companies on which the debt ratio is calculated, and from which companies ultimately repay their debt, must increase significantly. Only then will these companies have a realistic chance of refinancing themselves conventionally on the market. In other words, if interest rates do not fall again quickly enough, things will become tight and may result in financial restructurings.

In view of the gloomy economic outlook in Germany, placing a bet on a profits growth miracle is a much tougher proposition than betting on interest rates falling further. At least in terms of sales, it is probably going to be difficult to achieve the ambitious growth targets that were set before the crisis. In order to keep the EBITDA of stressed portfolio companies stable or even improve it, private equity will have to cut costs considerably. For the management and employees of the portfolio companies, this naturally means even greater pressure on returns than is already exerted by private equity shareholders.

If this effort succeeds, the trick with capitalised interest will have retroactively proven to be a useful restructuring instrument, and the managers of private equity or debt funds will be able to pull their heads out of the noose. However, it is very likely that this will also result in one or two zombie companies that will not make it, and whose exodus will merely be delayed as a result. It can therefore be assumed that in future there will be one or two credit funds that will have to write off their investment or, in a last desperate attempt, take the keys to the company, in order to try their luck as a new owner in the tough restructuring process.