Working Capital Finance: moving into the mainstream for private equity

Private equity firms are increasingly using working capital finance as a way to create value in their portfolio companies. We explain how these solutions work and why a high-interest rate environment makes them particularly attractive.

In 2010 I was running GE Capital’s leveraged finance commercial team in London with around $6bn of loans on the balance sheet.  As the market stabilised post crisis, we started to see demand from financial sponsors looking for working capital solutions to support the acquisition of companies in need of operational restructuring and portfolio companies in need of additional liquidity.

Over the past 10 years a lot has changed. A massive expansion in the growth of private equity and debt markets combined with historically low interest rates and an abundance of liquidity reduced demand for the traditional use cases associated with restructuring and special situations. Despite this, demand for working capital solutions has steadily increased, as financial sponsors begin to see the product not just as a substitute for traditional borrowings, but as a tool to drive value across their portfolio companies.

There are four ways in which working capital solutions create value:

1. Release and redeploy capital.  Selling the receivables you have on balance sheet creates a one off injection of cash which is sustained through a committed obligation to repurchase future receivables as they are created.  This also helps finance growth.
2. Reduce Financing Costs.  Costs associated with off-balance sheet financing typically generate savings of 50 – 150 bp relative to comparable debt products.  We have seen some examples where this can be considerably higher.
3. Increase your valuation multiple. Off-balance sheet structures reduce leverage either by refinancing existing indebtedness or substituting debt to finance growth.
4. Improve Cash Conversion Cycle. Either by selling receivables to reduce days-sales-outstanding (DSO) or providing liquidity to suppliers to enable increased days-payables-outstanding (DPO) (longer terms) working capital finance used to shorten the cash conversion cycle.

It is not new to point out that improving operational cash flow is an important element of the private investor toolkit when building an investment case. What is not always fully appreciated is the way in which operational improvement can be accelerated with the use of working capital finance.

Longer payment terms can lead to increased sales and profit growth yet increases the risk that needs to be assumed by treasury and consumes cash. This can be solved by selling those receivables to a specialist who will underwrite the risk leaving the treasury team to focus on ensuring efficient collection processes. On the other side of the balance sheet longer payment terms results in an improvement to operating cash flow which can be assisted by a payables financing arrangement enabled by the buyer where the supplier can accelerate payment and improve their own working capital position.

Rising interest rates and the return of inflation will serve to sharpen the focus of private equity practitioners on liquidity and operational performance. Some of the world’s largest corporate multinationals use these products for exactly these purposes and the bank trade teams that service them are investing heavily in expectation of continued growth.

Factors that have restrained market adoption have included a lack of automation to drive process efficiency, an opaque market for funding partners and structuring considerations that can vary considerably by jurisdiction and industry segment. At Demica we can help solve these problems and are increasingly working with sponsors and their portfolio companies to identify opportunities for value creation.