The second article in our three-part capital structure series discusses that there is no magic formula for the right blend of debt and equity in a business – the answer to that depends on the nature of the business, its operations, growth strategy and where it is in the business life cycle. Below, we look at how access to capital has shaped over the last 18 months and what this means for businesses.
Coronavirus Government support schemes
The level of Government support in terms of loans and furloughing during the last 18 months has been unprecedented and without it a lot of businesses would have failed. It has been necessary and it has been good for businesses. Where we’ve tended to seen it operate most is in the smaller entities – looking at the level of borrowing between Bounce Back Loans, CBILS and CLBILS, it’s significantly skewed toward those accessing the bounce back scheme. Our key concern with this is how do those that probably had more limited resources to start with (and now probably have more debt on the balance sheet) manage going forward in terms of their capital and funding? Everything they can do to fund those loans off their own balance sheet will improve their financial position.
With regard to going forward, the Recovery Loan Scheme (RLS) will give many a further comfort blanket and hopefully enable businesses to really push forward and take us through to the next period when people will likely need to tighten their belts. If businesses can access RLS funding to support their recovery into growth, then great. However, what we should point out here is that it should never be used as a sticking plaster for operational issues. All these forms of Government support are debt, they are not grant money, it will have to be repaid in the same way as most commercial debt. Yes, there has been a soft view and easy access to this money, but it does need to be repaid and therefore making sure you’re in the best place possible to generate profit in the future and meet debt obligations is vital.
The banks have been incredibly supportive alongside the government during the pandemic. Where previously we’ve seen some quite stressed relationships, a lot of clients feel like they’ve had good support from their banks. At the same time, with banks being very supportive to existing customers, there has been more caution around taking on new customers. In particular, if an established business is coming to a new lender for a funding line their first question is why your existing lenders aren’t providing the capital; there must be an underlying reason for it and they’re quite sceptical. We would always advise to go to your existing lenders first before going to a new lender, even in the case of accessing some of the Government support schemes, as they may be able to offer you more competitive terms. However, if you are in the situation of approaching new lenders, then the more prepared you can be to both 1) field their scepticism, and 2) provide evidence for why the funding is needed, what it will be used for and the business’ valuation creation strategy, the better.
There is a lot of discussion already about interest rates and inflation rates over the coming months, and there’s no doubt we will start to see inflation coming in. What this will mean for businesses, particularly those experiencing lower growth and lower profitability is that margins will be getting squeezed which will have a further impact on profitability. While we see a need to start funding more businesses through debt and funding working capital for growth, the other side of the coin is that we’ll see a reduction in margins and profitability to meet that. It may also mean that existing facilities just aren’t providing businesses with what they need to allow growth. In these circumstances, one of the things we always consider as advisors is whether there are different lending structures or options that could maximise a lender’s ability to provide funding e.g. cash flow lending vs. asset based lending (ABL). Businesses that have high revenues but low profitability tend to require a lot of working capital and are therefore are usually better suited to an ABL fund line, rather than cash flow. Having these conversations and seeing whether there are better options available via your lender may unlock much needed capital support.
There is definitely a lot of caution and expectation among banks that they’re going to see increased chances of default, and while there is quite a lot of support and changes around legislations to stop businesses going into insolvent positions, we’ll still likely see a lot of rigour going into bank’s approaches to lending and further cautiousness (particularly if some of those businesses that have accessed government support do default). Therefore, our advice is to ensure you are really clear and prepared from the outset with the information you lender will need in order to enable them to put funding in place, and that you’re prepared if you have to go through any kind of pre-lend review or due diligence via their accountants. Ultimately, you need to be able to prove and evidence to lenders why you need the money you’re asking for and that you’ll be able to fund it – so having a clear strategy, having a clear set of forecast financials that demonstrate that and demonstrate how you’ll repay is vital.
There is a lot of cash in the form of equity at the moment looking for a home. As ever, for those equity investors with dry powder they’ll be looking to understand the quality of the business, the growth opportunity and prospects, the quality of the management team (to the extent of how well they operate and what their point of difference is relative to others in the market), and how sustainable the business and its profitability is. What is important for anyone looking at private equity is to understand what’s the investment proposition going into it (what does the business look like with and without equity), and therefore how much would the value of the organisation improve and how much of that value are they willing to give up. While some of this will be subjective on the basis of what management are willing to give up, it should also be based on data both of comparable deals in the space (to get an idea of cheque size, valuation and stake given) and the business’ longer term funding plan and expected use of other instruments such as EMI schemes and share options as these will all incur further dilution that investors (and existing shareholders) should be fully aware of going into this round. Secondly, it is also important to consider what you need from an investor both now and in the future, and in terms of cash and relationship, as that can have an important bearing on who you go to for investment. For further information, access our article on business planning here.
Increasing competition for Private Equity
We’re seeing large corporates with improving balance sheets and cash positions, but lower growth rates – these circumstances are creating a perfect environment for these corporates to turn to acquisitions for growth and we are certainly starting to see businesses come back into this market.
We are also seeing a lot of overseas money, in particularly US investment, coming into the UK both from private equity and US private equity backed businesses coming to the UK for opportunities to acquire and invest in their own growth into the UK.
It will be interesting to see how UK private equity will respond to this increased competition for opportunities. However, for those businesses looking for investment this increased competition hopefully results in increased and, perhaps, unexpected options on their own growth moving forward.
There’s a hope in the community at the moment that with all the support that’s been provided to businesses from debt that the route back to growth for businesses and the economy is through equity. During the events of the last 18 months, we have seen private equity firms put more behind their existing portfolio, both in terms of management time and funding, which has resulted in some capacity restraints to look for new opportunities. However, anecdotally, we are certainly seeing them now come back on the ‘looking for opportunities’ trail, so there may be increased opportunities for businesses requiring equity as the world returns to normal.
This article was written by Phil Sharpe, a partner in the SCF team. If you believe you’d benefit from reviewing your capital structure but are unsure of where to start, or have done a review and want to know how to move forward, then please contact Price Bailey’s Strategic Corporate Finance team using the form below.
We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide, and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.