Generating Capital in a Tough Business Environment
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In the current climate of global financial crisis, many companies are finding it very difficult to generate capital to help weather the storm. Due to tight credit conditions, some businesses simply cannot obtain loans. As a result, struggling companies are addressing problems in their internal processes to improve efficiency and cut costs where possible.
External funding was already getting quite tough to obtain several months ago, as a result of the 2007 summer credit crunch and the subsequently more stringent conditions surrounding lending terms. The fall of Lehman Brothers this September, and the domino effect this caused in financial institutions and markets worldwide, have resulted in further tightening those conditions, as lenders with available cash and borrowers who are able to repay their debts are becoming ever rarer.
Even non-traditional lenders, such as hedge funds, which started emerging as attractive sources of funding a few years ago, are now running into trouble. According to a strategist at Man Investments, up to a fifth of managers in the $1.6 trillion hedge fund industry are at risk of failing in the next two years, even when market conditions finally recover. This year is only the third year ever, apart from 1988 and 1994, in which hedge funds have generated losses. Governments’ efforts to inject capital into distressed financial institutions and markets have helped to temporarily relieve pressure, but in the long term, these moves may prove insufficient to save some of the more severely impacted entities.
Yet, even in the shrinking commercial financing market, there are still some lenders willing to lend, although there are often niche providers. Angel investors and venture capital firms, for example, are providing equity capital. It is assumed that this type of financing, usually raised by a business in return for a share in ownership, will play an even more important role over the next few years.
Similarly, asset-based lenders (ABL) are also still continuing to supply money. This type of finance, which enables companies to borrow funds against outstanding invoices, premises, equipment, machinery or even a brand, is becoming increasingly popular. In late November, the Commercial Finance Association (CFA) released its ‘Quarterly asset-based lending index, Q3 2008’, revealing a 17.1 percent increase in these new types of credit commitments in the third quarter alone, coming on top of 16.2 percent growth for CFA members in the second quarter. These figures highlight how ABLs are currently filling the void in lending left by the credit crunch. “Asset based financing is still available from a number of US regional and money centre banks,” says Lawrence F. Flick II, a partner at Blank Rome LLP. “The pricing and structure is much more favourable to lenders in this market, where financing is available. Lenders that are making new loans can be very selective.”
Yet some of these lenders are also concerned about the problems in the credit markets. A recent survey showed that more than half of CFA members fear that their access to capital might be diminished in the coming months. “Asset-based lenders tend to be doing deals with lower loan to value ratios and steering clear of certain segments,” explains Ron Glass, a principal at GlassRatner. “In addition, the need for guarantees and additional collateral has substantially increased. The days of covenant light loans are behind us.” Consequently, these financing options remain very expensive and companies in some sectors simply cannot afford them.
The situation is particularly serious in the real estate, construction, and retail segments. These industries have been severely affected by the economic downturn and subsequent erosion of consumer spending and the sharp decline in the housing market. For businesses operating in these areas, obtaining loans can prove a tremendous challenge, points out Paul Andrews, managing director at UHY Advisors FLVS, Inc. “There is little to no lending on real estate. If a company has real estate, sale-leaseback financing options are available but are very expensive. In addition, the sale-leaseback process has become very complex and lenders are being very selective. Occasionally, one can find opportunities to sell inventory and equipment now and buy back later to enhance working capital. Factoring of receivables is also occurring,” he notes.
For many businesses, the only solution left in the commercial lending market may eventually be to restructure their debt with current lenders. This is particularly relevant in the case of distressed businesses struggling to stay out of bankruptcy and find financing for multiple debt tranches, or obtain debtor-in-possession financing as part of a Chapter 11 process. But in this tough environment, companies are also highly advised to re-evaluate their internal processes as an efficient way of generating capital.
Evaluating internal processes
Whether they are distressed or not, to survive the crisis companies are being encouraged to take a detailed look at their business and the various solutions available, as early as possible. Ignoring this critical process can lead to disastrous consequences, with companies possibly unable to recover from difficulty. Unfortunately, for some it may be too late. “Companies that have not yet reacted may be unable to move quickly enough now,” says Mr Flick. “Several people at distressed private equity funds have told me that they are seeing companies that could have been saved, and might have presented an attractive turnaround investment opportunity, but they are getting to them with no time to do anything to save them.”
The key for all businesses is to act immediately, and a good starting point is to seek external advice, insists Mr Andrews. “If a company is stressed, they should immediately address the situation. The best approach would be to retain competent professionals – attorney and/or financial advisors – and approach their creditor constituents. The last thing a company should do is to defer those discussions to the point where all parties involved have limited available options.”
A team of professionals will generally start by helping create a plan, including projections for months or even years to come. These financial forecasts are essential to the restructuring of internal processes. Advance planning is also vital for creating financial arrangements well in advance of when the money is required, as negotiating funding when the business is already in trouble is often tough to impossible.
But not only should a plan be well structured, it also needs to be updated regularly so that realistic forecasts can be achieved. This is essential to build trust with creditors and appear credible when negotiating with them, explains Mr Glass. “Equity sponsors, lenders and shareholders in troubled companies need reliable forecasts. The fastest way to get off-side with a lender is for the borrower to provide unreliable or incomplete forecasts. Therefore, the ability to manage expectations and work through a troubled situation is tied to trust and if a borrower can provide reliable financial information, it goes a long way to building the trust factor.” Based on reliable financial forecasts, companies can start reprioritising all expenditure projects.
Consideration might need to be given to postponing the purchase of non-essential assets. For example, a company wanting to replace delivery vehicles or representatives’ cars after a certain number of years could delay that replacement by a few months, as even small steps like this can help protect cash flow. For larger companies, a solution could be to prioritise those projects likely to provide the fastest capital generation. The products that offer the highest gross profit, while being the most economical regarding the use of working capital, offer the best options for troubled companies. In the meantime, unprofitable or underperforming lines in the business should be eliminated or sold. In this way, instead of being a burden, redundant or idle assets will start generating liquidity.
Throughout the evaluation process, focus should also be maintained on sales effort, a key point that is too often overlooked by distressed businesses. Companies encountering harsh financial issues tend to prioritise ways of restructuring and cutting costs, rather than spending time maintaining a high level of sales activity. But in the longer term, the latter solution may prove to be as, if not more, efficient to recovering from liquidity troubles.
Improvements in working capital can also be achieved “by advancing the speed in which receivables can be collected, reducing inventory and raw material inventory level, advancing billing by reducing manufacturing or product completion cycles,” points out Mr Glass. Controlling and managing inventory levels can indeed enable a business to become more cash efficient. Optimisation can be gained in all three main areas of inventory: raw materials, work in progress and finished goods stock. The raw materials side can often be improved through negotiating better delivery schedules and reviewing order quantities to help reduce the stock value. Efficiencies in this area generally have a direct impact on the manufacturing process, resulting in a reduction of the necessary buffer stocks. On top of these, demand forecasts for finished goods should also be reviewed, in order to be able offer customers on time delivery, as well as reducing the stock required and avoiding obsolescence. Good communication with customers is central to addressing their needs and responding to them adequately. As a result, profitable relationships will end up being reinforced. Similarly, relationships with suppliers should be reviewed, as the financial crisis may help negotiate improved terms.
But some advisers believe that in the current difficult times, the best and possibly only solution to quickly unlocking a substantial amount of capital is by selling a stake in the business. “Management should look at possible strategic buyers for all or part of the company, to create cash while maximising value to shareholders and its creditors. Sometimes this is the best available alternative,” argues Mr Andrews. Companies can also evaluate the possibility of disposing of assets they hold in other companies. Troubled carmaker Ford recently announced its intention to sell about two-thirds of its stake in the Japanese automobile manufacturer Mazda Motor Corp, hoping to raise about $538m. Mazda said it will buy up to 6.87 percent of its own shares while several strategic business partners are set to mop up the rest.
Going forward, companies that have not already done so will be forced to revaluate their debt and refinance where possible. “Many companies will need to completely restructure and right size their capital structure and balance sheet,” suggests Mr Flick. “They are aggressively shrinking their leverage and in some cases asking senior and mezzanine lenders to convert debt to equity. On the other hand, stronger companies with cash on their balance sheet are looking for opportunities to purchase weaker competitors,” he adds.
With credit markets tight, struggling companies are increasingly forced to look at alternative ways of generating capital, instead of desperately trying to obtain new loans. Renegotiating existing terms and, in particular, analysing the options available for releasing capital from within the business, are considered the most favourable solutions at present. Whether companies are on the verge of collapse, or are simply encountering some financial difficulties, planning ahead is essential to address short as well as long term issues.
This article first appeared in Financier Worldwide’s January 2009 issue. © 2009 by Financier Worldwide Limited. Permission to use this reprint has been granted by the publisher. For further information on Financier Worldwide and its publications, please contact James Lowe on +44 (0)845 345 0456 or by email: james.lowe@financierworldwide.com.