Leave no stone unturned:
PE firms must dig below the surface in liquidity hunt

Private equity firms are scrabbling to prevent liquidity shortfalls amid the COVID-19 fallout. But as they help their portfolio companies unlock cash through bank finance, there is a series of less visible options they should turn their attention to.

The ‘cash is king’ mantra has never been more relevant for private equity (PE) firms as they grapple with the economic impact of COVID-19. Maintaining liquidity and capital has been top priority during the lockdowns and will remain so as long as the path of the pandemic remains uncertain.

PE firms are scrutinising their portfolios to unlock much needed liquidity. Yet many are overlooking key tools – perhaps less intuitive than bank financing, but still valuable – as they work to free up cash. Such options include the use of insurance instruments to access and structure capital, leveraging intellectual property (IP), and rationalising existing insurance arrangements. All three options involve less cost than bank credit, and can help provide a sound financial platform for renewed growth.

Exploring alternative credit options

Aon estimates that only 20% of large corporates are actually making use of credit insurance as an alternative means of accessing funds. “The other 80% are overlooking tools that can not only provide immediate relief and working capital support, but also help them pursue sustainable growth as they come out of this period of uncertainty,” says Jake Tobin, EMEA head of financial sponsors at Aon. He adds that, even before the crisis, banking regulation was restricting means of accessing traditional forms of financing. “Insurance, with its intrinsically lower cost of capital compared to banks, should be viewed as a complement or alternative to bank credit arrangements, and it frequently offers more flexible terms,” says Mr Tobin.

Credit insurance can help shorten cash conversion cycles by giving companies the increased ability to extend payment periods with suppliers, reduce penalties and accelerate trade receivables from customers. In addition, there are opportunities to unlock liquidity by using insurance instruments to meet contractual demands for security. Replacing letters of credit, bank guarantees or cash collateral used to underpin company transactions or operations, with off balance sheet insurance instruments can positively impact liquidity.

Insurers and banks can, however, play complementary roles. Ergon Capital, for example, has insured 100% of its companies’ receivables, according to Riccardo Collini, a partner at the firm. It is concerned, however, about the longer term creditworthiness of some of its companies’ suppliers. If the latter’s ratings fall, he says, they may not be extended credit in a year’s time. Therefore, his firm is considering the use of reverse factoring, by which suppliers will benefit from the portfolio company’s credit rating and gain easier access to liquidity. This may be viewed as another means of reducing a company’s supply chain risk.

Harnessing the value of IP

IP is becoming more integral to valuing businesses as intangible assets increasingly drive returns. “It also has incredible staying power through distressed markets and periods of uncertainty,” says Mr Tobin.

PE firms with IP-intensive companies in their portfolios can harness the value of their intangible assets in a variety of ways to improve liquidity. These include:

• Patent pruning. Abandoning patents that are no longer core to the business can free up a tremendous amount of cash, especially for a midsize or large company. The extra liquidity comes from eliminating the cost of maintaining the patents and, if sold off to third parties, from generating additional revenue.
• IP as collateral. The use of IP can create new financing opportunities. PE firms can work with their portfolio companies to identify value in the IP stack, and use this information to support financing conversations with banks and other funders. Supported by insurance capital, it is a means of raising debt without diluting equity.
• Licensing. Choosing to license IP is another option to generate revenue. Companies can use IP analytics to identify potential licensees and valuations of their IP to secure better licensing terms.

The use of each of these tools should be based on a clear understanding of the quality and value of all the IP existing within a PE firm’s portfolio.

Rationalising insurance

A reliable short-term method of unlocking cash is to rationalise existing insurance arrangements across the portfolio. PE firms can, for example, eliminate unneeded insurance, reduce or transfer coverages, limit benefits, and claim refunds for the unused cover. Should new insurance arrangements make sense, firms can look to reduce overall costs by aggregating coverages across the portfolio companies. Identifying potential insurance claims to recover losses arising from the pandemic can generate additional liquidity. And receivable discounting could be used to accelerate payments on other open claims.

Looking to the longer term, PE firms should help their businesses transfer risk away from balance sheets. Step one is to ensure that each company has a comprehensive and up-to-date business continuity plan and a resilient, secure technology infrastructure to support it. The pandemic has also rammed home the need, especially for manufacturers, to reduce supply chain risk. PE firms can achieve this by gaining a clear picture of who their suppliers are, where they’re located and what their financial condition is. Weaknesses will likely be found somewhere, and different types of disruption (shipment delays and supplier insolvency, for example) can be insured against to move such risks away from the balance sheet.

Learning from the past

PE firms’ liquidity management in this economic crisis has benefitted from lessons learned in the last major one, in 2007-2009. Equistone, for example, according to Paul Harper, a partner at the firm, has put itself in front of all discussions with insurers, banks and other stakeholders to support individual portfolio companies rather than leaving them to go it alone. One of the priorities of DeA Capital during the crisis, says its managing director Andrea Bertoncello, has been to avoid taking on additional leverage in the search for liquidity. According to Ergon Capital’s Mr Collini, meanwhile, the imperative for all PE firms—a lesson learned in the previous crisis—should be to increase liquidity without putting the whole supply chain and customer base at risk and compromising the portfolio’s ability to grow later.

Using the liquidity management methods we have outlined in this article—none of which entail leverage or compromising the crown jewels—can make the objective articulated by Mr Collini eminently achievable.