The invisible driver

Private equity groups could drive supply chain finance adoption, argues Justin Pugsley. It’s just that they may not realise it yet.

Private equity groups could become keen promoters of supply chain finance (SCF). It’s just that they simply don’t know it yet. But once they do cotton on, the impact on supply chain finance adoption could be significant. Especially, given the dramatic rise in the number of corporates owned by private equity groups.

Indeed, supply chain finance (SCF) could prove invaluable for a private equity group looking to optimise the cash flow of an acquisition. But there are some potential challenges over issues such as credit quality, which can occasionally arise. Nonetheless, private equity groups are always looking for an edge in their deals. With asset values on the rise and with financial engineering becoming commoditised, It seems only a matter of time before they become firm converts to SCF.

Some estimates suggest that around 20% of corporate Britain is private equity-owned and given current market conditions that’s likely to increase. This wave of private ownership is also sweeping North America and continental Europe. They’re even been setting up shop in Asia. Most of the big private equity groups are represented in Tokyo and many are active in India.

Yet, few private equity groups have much knowledge of SCF, despite the potential benefits. GTR contacted several leading private equity groups. All declined to be interviewed. The main reason given is that they didn’t feel they knew enough to comment on the topic. Others had never even heard of the term.

According to Lex Greensill, vice-president, fixed income, with Morgan Stanley, this could all change in six to 12 months time. “Intellectually the concept makes a lot of sense for them,” says Greensill. “Besides, SCF will one day be mainstream anyway.”

Private equity groups are experts in areas such as financial engineering and spotting hidden value in a company. In that sense it is surprising that more of them don’t implement supply chain finance programmes in the companies they acquire. This is because the savings in financing costs and the liberation of working capital can be considerable. The size of those savings is dependent on a number of factors. Not least there’s the credit quality of the company in question, the industry it’s in and the structure of its supply chain. In other words, each case is different.

Bob Kramer, vice-president working capital solutions, with IT supply chain finance specialist, PrimeRevenue, reckons for each US$1bn in turnover a highly credit rated company can pull out US$25mn-75mn in capital.

For capital-intensive businesses such as retailers or manufacturers, the impact can be considerable. A figurative company with US$10bn sales and US$2.5bn tied-up in working capital can claw back 25% of that capital. “That makes a big difference to the bottom line,” says Andrew Betts, global head supply chain business, transaction banking, ABN AMRO.

Possibly the main reason SCF doesn’t yet figure on the radar screens of private equity groups is down to who they talk to at their advising banks. Advice will usually come from the corporate or mergers and acquisitions teams. Supply chain finance is generally handled by the trade finance division of the bank, an area few private equity deal makers venture into.

Yet, ABN AMRO, for one, is seeking to spread the word through its financial sponsors group. This group devises financing solutions for clients such as private equity groups. “Supply chain finance solutions are usually presented at the second stage, although they can sometimes form part of the preliminary talks,” says Wieland Janssens, global head, financial sponsors group, global clients, ABN AMRO. “The long-term aim of SCF is to free up as much working capital as possible.”

He explains that any working capital retrieved can be used to amortise debt at a faster rate. This can give the financing of a buy-out a more solid footing and may even enable a private equity group to out-bid the competition.

Handling a downgrade

However, the normal modus operandi of a private equity group is to conduct highly leveraged buy-outs with the target company taking the debt. This maximises the upside on their equity tranche and in markets such as the UK, this is also tax efficient.

But that high gearing can create challenges down the supply chain. This is particularly so if the company sees a downgrade in its credit rating as a result of high gearing. If the rating goes from an investment grade of say BBB, down to CCC, a junk rating, problems can emerge with suppliers. Some may not feel able to carry on offering 60-day payment terms to a company with a low credit rating,

Pierre Veyres, managing director and head of global trade services, BNP Paribas, says credit quality can become an issue with leveraged buy-outs (LBOs). However, he explains that supply chain deals are generally structured to improve the working capital management, the metrics and ultimately support the credit rating of the company.

Nonetheless, due to the weight of debt, down grades do sometimes happen.

There have been several cases in the US, where suppliers have demanded to get paid within 15 days in such circumstances, according Kramer. It’s what Greensill calls term compression, a relatively common occurrence when a highly leveraged buy-out takes place.

The main option for a supplier is to usually purchase credit insurance. This can significantly increase their costs though.

It is in light of this phenomenon that Morgan Stanley has developed its SCF offering. Through various risk mitigation strategies Morgan Stanley can reduce the cost for suppliers when compared with alternatives.

Greensill explains: “It’s all about providing flexibility for the suppliers.” In other words, Morgan Stanley will sit in the middle of the supply chain and effectively buy the receivables. Naturally, the loan is at a rate of interest which reflects the credit rating of the buyer.

Nonetheless, the supplier can effectively get paid when they want. It is also likely to work out cheaper for the supplier than borrowing from their own bank. This is particularly so if they happen to be based in an emerging market country where lending rates are typically quite steep.

Also, due to the way Morgan Stanley hedges its risk with use of credit default derivatives for instance, it can continue providing liquidity to the leveraged company should it run into some problems. All this adds up to considerable comfort to the suppliers. Indeed, if the bought-out company previously had no supply chain finance programme, implementing one can still produce savings for the supply chain.

The corporate in question may even be able to still push out its credit terms at the same time. This gives an invaluable boost to the bottom line by releasing previously tied up working capital.

This is despite a deterioration in the credit quality. However, if an SCF programme is already in place, higher financing costs are likely to result. But at least the programme can be kept in place.

Basically, a financial institution, due to its access to capital markets and its critical mass, is in a better position to manage and mitigate risk than a corporate. According to Greensill, the idea is to lend that edge to a corporate’s supply chain.

Once private equity discovers the benefits of SCF, they’re very likely to be keen on their companies applying it. Indeed, only about 28% of companies are thought to have an SCF programme, according to researchers, Aberdeen Group. This implies that there is still plenty of room to improve cashflow optimisation.

If the managements of these firms don’t pick-up on this, it is highly likely that in time, private equity groups will. Indeed, it is quite conceivable, given their growing ownership of companies, that they could become key drivers in the use of this financing technique.