25 January 2023
According to our latest survey with Make UK, manufacturers recognise the need for continued investment. At the time of the survey (late summer 2022) 59% of manufacturers confirmed that they plan on investing more over the next two years, but this was prior to the current slide into market turmoil. Nonetheless, manufacturers continue to borrow, partly to finance inflation-driven increases in working capital need, and partly because they recognise there is a continued need to invest. With 51% of manufacturers confirming they have held back investment in plant and machinery because of the events of the last two years, this also suggests there are likely to be a lot of manufacturers assessing their finance options relating to investments during 2023.
But will recessionary pressures delay investments further?
There is no doubt that the manufacturing industry is in recession; the industry has been contracting since August 2022. As outputs, new orders, employment, and stocks of purchases fall at accelerated rates, this does beg the question of whether the industry’s investment intentions are likely to come to pass. And this will of course impact the sector’s borrowing requirements. Our survey results unsurprisingly indicate that the top three scenarios that will demotivate the sector to invest are increasing costs, a recession, and an inflationary environment. It is fair to say 2023 is likely to be a turbulent period.
How do manufacturers prefer to finance their investments?
How manufacturers plan to finance their investments differs according to their shape and size. The results from our survey with Make UK showed that the preference amongst manufacturers is to use retained profits to finance capital investment where possible. This type of financing is often seen as the easiest and safest route. Easy because the funds are available to the group already without any application process, and safe because it doesn’t involve letting in outside stakeholders. This is especially true for smaller businesses where considerations of stability and continuity tend to outweigh any thoughts of Weighted Average Cost of Capital analysis, which would lead them to debt financing sooner than using up their own equity.
However, the picture changes the larger the capital expenditure need is. 70% of those surveyed said they’d use past profits to finance basic equipment but the percentage falls to 48% when considering purchases of longer-term assets, such as premises and vehicles. Conversely, the next most likely financing source – borrowing – increases from 16% of responses to 39% between basic and long-term capex. Debt is preferred over equity typically (only 10% of respondents mentioned equity), as although it involves giving security over the assets of the business, it doesn’t require companies to give away a valuable stake in the company. This is as we’d expect it to be – debt remains the best value financing proposition as long as it is available.
So what debt options are available?
Debt financing comes in a great many shapes and sizes, and from a number of different providers, but all of them boil down to two basic types of financing, against assets and against cash flows. Both of these can be used by manufacturers.
Asset financing is the most widespread at the lower end of the market, as it’s the most straightforward for lenders to get comfortable with. The asset of choice is not in fact a physical asset, but invoices, or receivables. As a note of caution, if borrowing against receivables to finance investment, it’s important to leave plenty of headroom, as a drop in turnover would reduce availability, leaving a financing gap.
More bespoke financing can also be available based on the assets themselves, equipment financing for plant, machinery and vehicles, and mortgage financing for factories and warehouses. Availability of finance on plant and machinery varies widely, but it’s wise to assume a preference from lenders for assets to be new or nearly new, and the more generic and moveable the better. Key to real estate financing is a recent valuation, though advance rates are much tighter than those in the residential world, around 50% is typical.
Cash flow facilities are available fairly easily to larger groups, and there is an increasing number of specialist providers who will provide such facilities for smaller concerns. Lending on this basis requires a more thorough assessment of the company than asset-based financing. The key ingredient for this type of borrowing is a good financial model, as lenders will need to be able to compare the historical performance of the company with its future prospects and understand clearly the assumptions behind the forecasts. How much a lender will provide is typically expressed in multiples of a company’s EBITDA (in much the same way as is done for valuations), a good rule of thumb is to assume a company can borrow up to around half of its valuation.
Can you have the best of both?
A recent development has been the rise of “ABL+” loans, which seek to bring together the advantages of asset-based and cash flow borrowing into one package. This can be the ideal solution for many borrowers, with as much as possible being borrowed against the assets at the lower price, and additional financing from a term loan for the remainder.
Where to borrow from…
The banks: Remaining at the core of the market, banks provide the widest range of loans to companies large and small, and their pricing is typically the lowest in the market. But they tend to be more prudent – in other words the pricing reflects the risk appetite. This tends to lead to a concentration on asset-based lending, and an overall reluctance to contemplate cash flow lending until a company has reached a considerable size. Even then, their preference will be to keep leverage multiples low.
Specialist asset financiers: Competing with banks to lend against invoices, equipment and real estate, specialist asset financiers are typically a little more expensive than bank lenders, but will usually give the borrower some advantage in return, such as contemplating a higher advance rate against any given asset class, or looking at a sector that banks find harder to do.
Private debt funds: Finally, there are private debt funds, who typically specialise in providing cash flow loans at racier multiples than what banks will do, and at a correspondingly higher price, but with likely easier repayment terms.
How does the market stand?
The debt markets are undoubtedly choppy at present, with base rates on the move, but also lenders facing the classic greed versus fear quandary, as they need to lend in order to make their returns but have credit teams anxious to avoid issues in the portfolio during the tough year they’re expecting. A reaction we’ve seen in past times has been lenders aggressively chasing deals they perceive as good, whilst finding it harder to do more marginal deals.
What should manufacturers do?
We’d always advise manufacturers looking to borrow to finance investment to review their options widely. The review should incorporate an assessment of which type (or combination) of borrowing is the most suitable for them, as well as which lenders would be best placed to provide that.
- Go smarter: Work hard with your advisers on the presentation of the credit, in particular the mitigation of the downside risks, to present yourself as being in the ’quality’ category
- Go wider: Approach a wide number of lenders across the different categories – predicting which lender will ‘click’ with you and be the most interested is becoming harder and harder, so it’s important to have access to the full field.
If you are interested in discussing your borrowing options in more detail, contact Greg Moreton.