Leveraging debt options to fund business growth

For many businesses, debt plays a vital role in their capital mix, helping to fund growth and asset acquisitions. However, debt can be expensive and isn't always the optimal choice. Whether for daily operations or broader expansion plans, a company's funding strategy often depends on its stage in the business life cycle. Early-stage or start-up companies typically have limited funding options, with equity or equity-like instruments being the primary sources of capital.

As companies mature, alternative funding sources become accessible, with senior debt being a key option provided by both traditional lenders (like AIB, Bank of Ireland, or Permanent TSB) and alternative/private lenders (such as Dunport Capital, Capital Flow, or Beechbrook Capital). Over the past decade, the evolving interest rate environment has prompted businesses to reassess their capital structures and re-evaluate their internal position on debt.

From 2015 to 2022, negative interest rates made debt an attractive, low-cost option for financing M&A and expansion. In contrast, cash-rich companies used this period to repay borrowings, avoiding the cost of paying interest on both loans and deposits.

Recently, however, rising interest rates have significantly increased the cost of debt, in some cases more than doubling the cost of capital. As a result, debt has shifted from an inexpensive funding source to a relatively costly one, leading companies to adopt a more conservative approach to borrowing.

Lenders typically evaluate a company’s debt capacity using metrics like leverage (debt divided by EBITDA) and debt service coverage (Free Cash Flow divided by Total Debt Service). Maximum leverage is influenced by factors such as sector, business scale, track record, and financial flexibility. Debt service is slightly different in that it is focused on a borrower’s ability to meet their debt obligations (principal repayments plus interest), with lenders usually requiring coverage greater than 1.2 times Free Cash Flow. During the negative interest rate environment from 2015 to 2022, leverage was the primary constraint on borrowing capacity. However, as lenders’ costs (often tied to EURIBOR) have risen, this has shifted that dynamic considerably, with a borrower’s ability to take on debt now being primarily restricted by debt service – effectively their ability to service and repay this new debt.

Different sectors may employ various metrics to determine appropriate debt levels. For example, in development or property finance, lenders might focus on loan-to-cost or loan-to-value ratios, while in acquisition financing, the debt/equity split may be more relevant.

Alternative/private lenders often have a different risk appetite compared to traditional lenders. They may evaluate prospective borrowers and even entire sectors differently, often offering greater flexibility on amortisation, distributions, and streamlined credit processes—albeit typically at higher interest rates. In Ireland’s relatively small market, where several key lenders have exited recently, alternative lenders are playing a pivotal role in supporting borrowers and SMEs who have fallen into the increasingly prominent lender gap.

Another less common alternative funding option in Ireland is Convertible Loan Notes, which offer a debt and equity financing hybrid. These notes provide interest-bearing loans that convert into shares under specific conditions, such as a future sale or equity raise. Convertible Loan Notes are often used when a company needs to raise capital quickly, such as ahead of an equity funding round or for time-sensitive needs like acquisitions. This approach generally involves lower interest rates than senior debt, ultimately reducing the cost of capital.

Paul Rickard is a Director in the Forvis Mazars Corporate Finance team with over 12 years’ experience working in the Corporate Finance and Corporate Banking sectors.

This article was published in The Irish Times September 2024 special report on Corporate Finance.