Private capital - stepping in to support SMEs during the recovery
16 July 2020
Ambitious SMEs will need to find working capital to replace government support when it comes to an end, says Claire Madden
When you’ve been thrown a potentially knockout curve ball in the shape of Covid-19 and its impact on the economy, how do you stay in the game, let alone achieve the scale-up success you’ve been dreaming of?
Emergency moves such as the furlough scheme and government-backed loans have helped many small and medium-sized businesses (SMEs) ensure they have enough cash to remain in play and save jobs in the short term. Longer term, more permanent solutions will need to be found to support them through the recovery and enable them to fulfil their ambitions.
Businesses could benefit from opening their minds to the different options available to them, among them private investment.Bank lending may not be the answerFor businesses in need of capital, banks are often the obvious choice, and traditional lenders are to be applauded for stepping up to the plate and providing ready access to loan schemes right now.
However, there are good reasons why bank lending may not be the answer for all businesses as we look ahead. For one thing, there’s the issue of availability. Banks have been taking a cautious approach to SME lending ever since the financial crisis over a decade ago and they may do so again, once their current commitments to the Coronavirus Business Interruption Loan Scheme and the Bounce Back Loan Scheme are over.
Their ability to lend more or restructure existing debt on favourable terms cannot be taken for granted. The vast levels of capital deployed under CBILS and CLBILS will continue to weigh on traditional lenders’ ability to fund SMEs for an extended period of time, if for no other reason than the level of bandwidth it will take from their teams to work those loans out over the coming two to three years and the inevitable process and bureaucracy which will follow in cases where loans go bad, even with a government guarantee in place.
The good news is that private capital in the form of high-net worth (HNW) investors is waiting to step in to fill the gap. Research we recently conducted among our private investor clients found that more than half have already increased their cash reserves since the start of the Covid-19 crisis so that they have liquidity to back high-quality SMEs whose growth, though interrupted, still has potential. Nearly three in five said they are interested in private equity investments over the next 12 months and one in three wereinterested in opportunities including quasi-private equity style mezzanine finance solutions, aware that such assets are a vital component of well-structured investment portfolios.
What about mezzanine finance?
Depending on the company’s requirements, these private investment options may be more suitable than bank lending. High-growth SMEs are often constrained by standard amortising loan structures that don’t fit their business profile, when what they really need is flexibility. Moreover, since uncertainty and economic upheaval are likely to continue for some time, it’s also a tough call to sign up to loans with such strict covenants attached, such as high profitability-to-debt ratios.
Mezzanine finance may be worth consideration in such cases. Sitting as a hybrid between private equity and bank debt, mezzanine options can deliver the kind of innovative structures that no bank’s standard terms could ever accommodate. For example, loans which require a single final bullet payment, enabling cash generated to be deployed within the business while it gets back on its feet or to build scale when it does, or “cov-lite” opportunities, which are subject to less restrictive covenants.
That flexibility could prove more vital in a post-Covid world than ever, as businesses need to be as agile as possible as uncertainty persists and the “new normal” has yet to take shape. Providers may seek to negotiate some sort of equity “kicker” but many for SMEs, it’s well worth it to secure funding that is tailor-made to suit their needs.
Alternatively, there is the option of pure private equity itself, providing the nature of business’ shareholder structure permits it and it works with the company’s future plans. Choosing a private equity sponsor who focusses specifically on the SME market is important here.
Institutional investors often have bigger fish to fry, but private capital from HNW investors who tend to be successful businesspeople or entrepreneurs themselves could be the solution. It is often the case that such sources will have the inclination and the means to offer valuable expert guidance as well as financial support, if required. After all, private investors – whether direct or acting through professionally-managed investment collectives – want to help businesses maximise their potential – that is how they make their returns, so such investments should be mutually beneficial partnerships rather than purely financial transactions.
Private capital is in a prime position to do things its own way. Unlike banks and institutional investors who are confined to rigid rules, it has the freedom to structure each transaction on its own merits, and to commit follow-on rounds of investment if the need arises and it sees fit. It is also ideally placed to spot opportunity in a part of the market that is often overlooked by the bigger players, who tend to focus larger companies.
Even previously successful businesses are already very stretched thanks to a toxic combination of income being slashed and costs such as rent piling up. The reality as they emerge from this crisis is that that pressure on working capital will continue even as trade picks up, as staff come back to work, supplies need to be restocked and deferred tax bills fall due.
But accessing the capex for growth is another challenge altogether. Today’s short-term fixes are not designed for long-term use, and more sustainable solutions will need to be found.
As well as considering the immediate concerns around getting through this crisis, it will pay to start thinking ahead about what sort of financial support SMEs might need in the not-too-distant future when government support ends and/or the recovery gets underway. Growth businesses are nothing if not brave and forward-thinking. Now’s the time to demonstrate those qualities.
What to expect from private investors
Taking on private investment is a big decision, so what should scale-up SMEs expect?
Entrepreneurial – they will see the business opportunities that exist
Commercial – they will understand the challenges businesses face
Flexible – they do not take a one-size-fits-all approach: they can do things in the best way they see fit, taking into account businesses’ specific and changing needs
Constructive – they can offer the benefit of their experience on strategy and advice when things don’t go to plan
Focussed – this is their own money they’re investing, so while a fund may pay more attention to certain assets in a portfolio, especially investments in larger companies, private investors will be highly supportive of every asset they have a stake in
Easy to deal with – these are seasoned decision-makers who know how to make things happen and who will give quick answers and honest opinions
Claire Madden, Managing Partner