Private companies have both inherent strengths and weaknesses when seeking credit approval for their debt financing. In 2021, these credit issues will be impacted by sector and security considerations more than ever before, raising four dilemmas for CFOs, explains Shaun O'Callaghan.
Mid-market private companies, not owned by private equity investors, have always faced both advantages and headwinds in the market for debt financing. Positive factors can include:
Long-term relationships with bank lenders
Reputation of the family or entrepreneur for business acumen
Lower levels of borrowings to real assets
Personal wealth and assets of the owners
A fervent commitment to the endurance of the business
Credit concerns for debt providers to private companies can include:
The lack of a private equity sponsor’s financial firepower
The absence of the governance and discipline of listed and private equity-owned companies
The lack of a foreseeable exit, as for a private equity-owned business
The lack of access to equity markets, as for a listed company
Sometimes less-granular financial information and reporting
Navigating these credit plusses and minuses for a private company has become much more challenging as a result of the impact of COVID-19. In particular, certain sectors will continue to find it extremely difficult to raise additional debt financing in the absence of further government support.
Changes in the security priority for certain government claims in an insolvency, together with banks’ concerns over returns and cost of capital, will change the landscape of funding options for companies. Below, I have set out four dilemmas related to credit quality that CFOs might have to resolve as they look into 2021.
1 Asking early versus forecasting robustness
The findings from our bi-annual global survey of mid-market businesses – those with revenues of £15 million to £1 billion – put financial modelling and forecasting as, by far, the leading concern of CFOs (as mentioned by 74% of respondents).
This is reflected in the concerns that lenders and funds are raising with us when reviewing business plans. The more uncertainty in the financial forecasts, the more conservative any credit approach is likely to be.
Therefore, if a CFO has a refinancing requirement during 2021, is it better to defer discussions with lenders to gather more data about the market, or is it preferable to start the conversations early? 25% of mid-market leaders anticipate needing access to new funding in 2021.
One approach to resolving this dilemma is to use additional forecasting tools and methods to provide more insight and comfort to lenders. For example, reverse P&L and cash flow forecasting work from the bottom-up rather than from the top-down. It shows the minimum levels of revenue and margins required to sustain a cost base.
The question for the management team then becomes 'is that level of revenue credible'?
2 New funders versus existing funders
The general market approach to debt financing in 2020 has been that, if you need more flexibility in your debt structure, some forbearance or even new money, it has been easier and quicker to approach existing shareholders and lenders, rather than new third-party funders.
The number of applications has meant that some funders have struggled with the volume and the varying quality of the loan applications they are receiving. If you do need new funding, the quality of your funding request, particularly the written materials you submit, will have a significant impact on the likelihood of acceptance and the speed at which your application goes through.
We have been helping CFOs divide their requests into three buckets:
1 'Soft' forbearance requests, such as covenant resets
2 'Hard' forbearance requests - extending to the deferral of scheduled amortisation payments
3 Cash interest roll-up and new money requirements.
CBIL and CLBIL schemes have provided many companies in 2020 with a longer runway to navigate the dislocation in markets caused by COVID-19. However, we see that for some companies (and some sectors), existing lenders are now at the limit of their debt appetites.
This could be one of the most fundamental shifts in the market in 2021, as CFOs seek to increase facilities, but - even when there is strong credit story - there is no further lending capacity from their incumbent lenders. We are advising CFOs to be ready for an unexpected 'no' from their current lenders to any new money requests and to run concurrent processes with existing and new lenders.
3 Banks versus debt funds
The UK credit market has evolved significantly over the last twelve years. While banks remain the dominant lenders to the UK mid-market, there has been a rise in alternative sources of credit, including debt funds.
Banks and debt funds occupy different, although overlapping, spaces in the debt market, with differing credit policies and strategies. If an incumbent lender does not have the capacity to increase or amend facilities, there may still be other options for the CFO to consider with a debt fund.
For private equity backed mid-market companies, debt funds have a strong appetite to provide facilities that are outside of the typical scope of the banks, including higher levels of leverage, greater flexibility on amortisation profiles, more headroom on financial covenants and higher individual ticket sizes.
These benefits come at an all-in cost that is higher than more regular (ie, conservative) lending from the banks. For private companies, the credit flexibility provided by a debt fund has often been less generous than for private equity backed businesses.
The tension between higher pricing and credit flexibility is often more of a sticking point for private companies compared to sponsor owned companies. One of the principal advantages of a debt fund for a private company is their ability to structure lending throughout the capital structure. An owner who does not want to give up control via an outright sale can work with a debt fund to raise investment finance (and potentially a partial cash out) with senior, mezzanine and minority equity slices.
4 ABL versus RCFs for working capital
There is a wide array of structured lending products available to the mid-market CFO for the funding of working capital and other specific assets. Often, these are the least expensive forms of funding available to a company as the lender has security over a specific asset, or set of assets, rather than relying on the general cash flows of the company.
Many companies are well-versed in invoice-discounting products and add in other assets beyond trade receivables to create an asset-based lending (ABL) structure. Creating this enlarged borrowing base beyond trade receivables can often generate higher leverage than compared to the traditional multiple-of-EBITDA approach used for cash flow-based lending.
The alternative to an ABL structure to fund working capital is to use a revolving credit facility (RCF) or overdraft, which have advantages and disadvantages compared to ABL funding. RCFs and overdrafts are not formally set against a borrowing base, and so the company may be less constrained from this perspective.
Equally, this may result in inefficient use of assets, where such assets are not being used to borrow against and hence generate the most liquidity. The definition of what compromises an asset for borrowing base purposes is flexible dependent on the individual circumstances of a business.
One increasingly popular approach for mid-market companies is to unlock liquidity from their intellectual property or royalty income. A company may have a brand that is licensed to others or has a strong goodwill value with reliable cash flow income that ABL funders can include as an asset in the borrowing base.
A point for all CFOs to consider is whether facilities as committed or uncommitted. In general, RCFs are committed, whereas overdrafts are uncommitted.
A committed facility can give more certainty over the availability of funding but will incur a non-utilisation fee for any committed facilities which are not used. Overdrafts are uncommitted, but give the lender the ability to stop funding at any point - an overdraft is an on-demand facility at the discretion of the lender. For ABL facilities, there are both committed and uncommitted facilities available, albeit there always needs to be a sufficient borrowing base to support any given level of funding.
Playing your best hand
Lockdown has dealt CFOs very different hands across the economy. The challenge is to play the best game with the cards you have been dealt.
Reasoned financial forecasts, unswerving discipline around preserving cash and careful consideration of where to source new funds – these can all help you survive and prosper through uncertainty and come out ahead in 2021 and beyond.
For help in navigating your firm back to self-sufficiency, get in touch with Shaun O'Callaghan.