Working Capital Management for Private Equity Portfolio Companies and Acquisition Targets
25 Apr 2017
2016 was another exceptional year for the fast-growing private equity investment business, with the annual record of investment totalling USD681bn, surpassing the previous benchmark set in 2015 by 9% . It seems such growth will continue in 2017 given the macro-economic environment however, this may be impacted by some wild cards, mainly geopolitical, that could negatively affect such expected growth.
Source: PWC – 2017 Private equity report in Europe
During an acquisition process, it is crucial for private equity firms to assess the potential level of cash available in an acquisition target. To maintain company growth, treasury departments are under pressure to provide efficient solutions to achieve working capital objectives.
What is working capital management?
Working capital management is a treasury strategy which involves taking all required actions to maintain an optimum balance of working capital - receivables, inventory, and payables - in order to ensure that the company has the necessary liquidity to pay short-term liabilities while avoiding unnecessary investment in working capital that would result in an opportunity cost and lower profitability.
Working capital optimisation is very relevant for Private Equity firms as it is a key enabler for value creation. It is an optimum way to release cash out of non-profitable assets to repay debt, expand through investment, or conduct acquisitions without incurring further indebtedness.
There are many companies with the right products, services and commercial strategy but not efficiently managed from a financial perspective. Such companies are the main target of PE funds. Working capital management / optimisation is generally one of the first tasks to be performed in order to release cash, amortise debt and improve financial ratios.
Some companies have failed to optimise working capital as they believe such optimisation comes at the cost to their P&L with limited consideration for the benefits of such solutions. At the same time, management often believe that working capital is only a financial issue, in reality it is also an operational issue, driven by multiple interconnected processes. This is why technology should not be separated from financing when talking about working capital (e-invoicing, supply chain finance platforms, etc).
In this article we will focus on financial and technological solutions to improve company’s working capital. Of course, enhancement of commercial and industrial processes (sales, production, inventories, and collections) are also very relevant factors.
There are several ways to optimise a company’s working capital position:
- Account receivables: sale of a portfolio of receivables without recourse, monetising illiquid assets, while accelerating the cash conversion cycle and improving the DSOs (Days Sales Outstanding). Receivable Finance and Trade Receivable securitisations are financial products that support such objectives. Generally, these solutions do not consume the company’s banking lines, and are especially useful for non-investment grade clients that will be able to raise funds at a rate lower that its existing cost of capital.
- Account payables: Extension of payment terms to a corporate’s suppliers. This can be achieved in two different ways:
- Using the company’s power of negotiation; imposing longer payment terms. The issue with this kind of solution is that this strains the commercial relationship with the suppliers and risks losing any strategic partnerships.
- Establishing a Supply Chain Finance programme where the company extends the payment terms with their suppliers and offers the possibility early payment at a competitive price (where the funder will be bearing buyer’s payment risk). This solution is important for SME suppliers who have difficulty accessing traditional forms of finance. At the same time, the company’s supplier relationship will strengthen. Supply Chain Finance programmes may also enable companies to improve their P&L through rebates and discount capture structures.Such programmes work as a payment risk mitigation tool for suppliers, as the funder will bear such risk once the early payment has been requested.
Many wonder why working capital management is so important when the market has plenty of liquidity at attractive prices. The response is that companies with the right working capital structure are better prepared for an economic downturn where liquidity is scarce and expensive.
Demica has been successful in helping PE owned companies to optimise their working capital. Our most successful sectors have been industrial, logistics (receivables) and retailers (payables) but any sector is suitable for such a solution. For example, we recently closed a circa EUR175m multi-country, Trade Receivable Securitisation with a non-investment grade global logistics company, improving their cost of financing by over 100bps through a bespoke and operationally efficient structure.
Working capital is not well known area but it is one of the most relevant to companies from a financial and operational standpoint. As of 2015, 81% of Fortune 500 companies are focused on working capital management and state it as a high priority in their strategic objectives.
Working capital matters!
Author: Angel Blanco