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By Hilary Rosenberg
FEBRUARY 3, 2000

Just How Bad Is This Rate Hike for Small Biz?

Expanding companies won't let a quarter-point stop them — but it could hurt


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Cheer up, entrepreneurs. Another quarter-point rate hike isn't the end of the world — even though Alan Greenspan clearly thinks the U.S. economy needs its wings clipped. The Fed weighed in with its fourth consecutive rate increase on Feb. 2 and hinted that it's ready to strike again to quell inflation. The federal funds target rate, the U.S. benchmark rate, is now up to 5.75% — a hike of one full point since last June.

Still, the Fed's move shouldn't stop small-business expansion cold. Except in a few rate-sensitive sectors, such as agriculture and residential real estate, demand should remain strong. As some owners of fast-growing businesses point out, the previous increases have been percolating through the economy since last June but haven't deterred them from investing and borrowing.

That's what consulting firm PricewaterhouseCoopers' most recent survey of mostly small, fast-growing companies shows. In the fourth quarter, 24% of the manufacturers and distributors in the survey took out new loans, up from 18% in the previous quarter. Among service companies, 24% were new borrowers, unchanged from the third quarter.

NECESSARY INVESTMENTS. The companies can't just scrap plans to expand capacity and upgrade their technology because of higher credit costs, explains Peter Collins, director of the survey. After all, the economy is still going strong and isn't expected to grind to a halt. "Even with interest rates going up, they're going to need to make these investments. They are not going to put these plans on hold for a quarter-point," he points out.

Take Command Medical Products. The Ormond Beach (Fla.) maker of medical devices foresees 100% revenue growth this year. The company is in the process of doubling its staff, to 300. To do that and fill orders, it must borrow. "I'm already committed, so we're going to have to absorb [the rate hike]," says CEO David Slick Sr. That doesn't mean he's happy: "It's going to hit us right between the eyes," says Slick.

The most immediate impact for companies such as Command Medical will be slimmer profit margins. "Small manufacturers and distributors can't pass on price increases," says William L. Walton, chairman of Allied Capital Corp. in Washington, D.C. Small business absorbed last year's increases. "But it's getting to the point where it's going to hurt," Walton adds, particularly if yields on 10-year Treasuries, a common benchmark for small-biz loans, rise sharply.

Companies that don't plan any new borrowing or carry little adjustable-rate debt probably won't feel an impact until it hurts their customers — which could be a ways down the road. Lowell Gordon, controller of Electronic Environments Corp., a Canton (Mass.) electrical construction and service business with mostly commercial clients, believes that only "a full-scale economic slowdown" would hurt his business. The company's revenues have doubled in the past year, its debt is at fixed rates, and it doesn't intend to take on more. "A lot of our clients are large companies, and a point would not make much of a difference to them," he explains.

Not everyone feels quite so invulnerable. Hydro Environmental Technology, an Acton (Mass.) environmental consulting firm with about $3 million in annual revenues, rarely taps its line of credit and has no borrowing plans. Still, one aspect of its business — environmental audits of properties for banks — could be affected by the latest rate increase. "When interest rates go up, there are fewer real-estate transactions and less due diligence," says Hydro President Hayden Solomon.

REDUCED CURRENCY. Interest rate hikes won't immediately affect the hottest growth companies, the dot.coms, because they don't borrow. Instead, they sell equity to raise money. But they could also end up feeling the pinch, warns Allied's Walton. "If rates continue to go up, they have to affect stock-market valuations," he predicts, cutting the prices entrepreneurs can get for their companies. Even without a market conflagration, Walton thinks investors will eventually balk at high equity valuations. That will force entrepreneurs to accept more expensive financing with an interest component, such as preferred stock and convertible debt. "Dot.coms have capital-intensive business models," Walton says. Once their stock becomes less valuable as a currency, "they're going to be back with us lenders."

Higher rates aren't universally seen as a bad thing. Sure, financing costs for expanding the computer system will rise at FMA Alliance Ltd., a debt-collection and billing agency in Houston. On the other hand, the rate increase means more business for FMA. "If it makes it more difficult for a consumer to pay off debt, it's likely to be charged off, and end up in my agency for collection," says Jeffrey Spiegelhauer, FMA's president. It's the entrepreneurial spirit to make lemonade out of lemons. The question is: How many more quarter-point hikes will occur before that spirit is dampened?


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