FACTORING: CORPORATE FINANCE - To factor or not to factor

Whether or not to take advantage of factoring or confidential invoice discounting (CID) in putting together the financial engineering for management buyouts (MBOs) and buy-ins (MBIs) has become an increasingly popular question to consider for financial advisers and venture capitalists.

Traditionally, conventional wisdom dictated that the amount of debt that could be afforded by a company should be limited by the extent of its net assets. So, for every #1 of debt there should be #1 of equity to match it.

The spectacular growth in the UK of MBOs, and latterly MBIs, in the past few years (and their hybrid, BIMBOs) has seen a more flexible approach to financial engineering. It is now not uncommon to see up to 70% of the purchase price being sourced by senior debt with the balance being provided by venture capitalists and management.

For many developing businesses, a traditional bank overdraft may prove to be too inflexible for their needs following an MBO or MBI. More and more companies are turning to factoring and CID as an alternative and more flexible means of providing working capital. Both provide businesses with lending facilities based on their outstanding debtors.

The company can either leave all its credit control to the factor or, with CID, retain control of its sales accounting and cash collections while customers remain completely unaware that their supplier is using outside help. Typically, 80% of a business’ debtors can be used to generate working capital.

Factoring or CID

Companies utilising a factoring facility tend to be smaller with turnover of up to #2m. It can also be a very good source of finance for a start-up business. CID, on the other hand, is for the larger, well-established company where turnover generally exceeds #1.5m. It is this type of company which is more likely to be the subject of an MBO or MBI.

In the past, both factoring and, to a certain extent, CID have been stigmatised as ‘lender of last resort’. This image is changing. It is now a legitimate and real alternative to the traditional bank overdraft as businesses become more aware of the need to match the finance to their plans for growth.

Moreover, the Bank of England also acknowledges that these products have a role to play in the UK economy as an accepted form of lending.

To add even more flexibility, a number of companies which specialise in this area are now offering businesses a lending facility pioneered in the US, known as asset-based finance (ABF). This form of lending, secured against a complete range of assets such as debtors, stock and property, can provide a company with access to funds well in excess of 100% of its debtor base. It can also provide a source of finance which grows in line with the business – a useful facility for a company growing either organically or through acquisition.

The UK is slowly beginning to reflect the US trend where almost 40% of businesses are financed by overdrafts and 60% by ABF. Currently, ABF accounts for about $120bn of funding for small and medium-sized businesses in the US.

In comparison, the CID and factoring industry in the UK currently provides businesses with in the region of #3bn a year and is growing at a compound rate of 20% per year.

The opportunity for growth in this sector is considerable. On top of this, lessons have been learned from the last recession. This has led to a much more realistic approach to the type of financial engineering now employed in structuring and pricing transactions.

This has been particularly evident in the MBO/MBI arena where a mixture of CID and or the ABF approach has given financial advisers a genuine alternative to the more traditional facilities offered by senior debt providers.

The case of Sandwell Castings

One recent example illustrating the new developments in debt provision is a second generation management buyout that took control of a long-established Midlands aluminium foundry business in a recent £2.9m transaction.

Four existing shareholders, led by managing director Martin Allport, comprised the management team at Sandwell Castings, West Bromwich. They expected their MBO would give added impetus to the business which was the subject of an initial buyout in 1981.

Sandwell Castings, which before the 1981 MBO was part of Delta Metals, manufactures non-ferrous castings. It weathered some of the most difficult trading conditions the industry has seen. Today, its customer base includes passenger and commercial vehicle manufacturers as well as the diesel engine industry.

Commenting on the MBO, Allport said: ‘Our decision was made with the confidence of knowing we have a successful business. Our optimism developed from the backing we had from TSB Commercial Finance and the West Midlands Enterprise Board. The MBO will allow us to grow the business at home and abroad, and secure the future for the company and its 240 employees.’

Banks and venture capitalists

The use of asset-based finance and CID in MBOs and MBIs reflects the recent emphasis by banks and venture capitalists for cashflow lending and pricing of MBO/MBI transactions. Advisers can now call on these additional sources of finance to ease the potential pressures of ‘geared equity’ balance sheets on the development of the business following the completion of the buyout or buy-in.

Ultimately, it should be borne in mind that MBOs and MBIs are a means to an end. A successful exit will be more readily achieved by financial engineering which is appropriate to the future development of the business.

In this respect, CID and asset-based finance may represent a more flexible option than other types of senior debt, especially as they do not usually involve the restrictive covenants which are often associated with term bank finance in MBOs and MBIs.

Graham Spooner is national director of corporate finance at Kidsons Impey.