Ahead of a looming threat of recession, as well as during an actual recession, capital becomes more risk-averse because there is real or perceived increased potential that capital provided may not return as economic uncertainty increases.
While pricing may increase to compensate for some of the risk, the typical response is to husband capital, particularly in the regulated bank industry, which has regulatory targets and ratios to maintain.
In this installment of the “How to Prepare for a Recession” blog series, consider the importance of keeping stakeholders in the loop.
CONSIDER THE CAPITAL PROVIDER
The finance business is all about risking capital to lend to or invest in a business as well as determining the optimal level of risk to make a deal. For that reason, it is important to consider the capital provider and what information they consider important.
Whether through debt or equity, funding is provided in anticipation of both a return of that capital as well as a return on that capital in the form of interest or equity ownership that is later liquidated. Bank loans, for example, carry an interest rate in return of those funds. Equity investments from private equity, on the other hand, expect a higher return than banks, typically through ownership of a portion of the business.
REDUCE SURPRISES BY ADJUSTING EXPECTATIONS
While capital providers generally dislike surprises, they especially dislike surprises when they are already nervous about an economic downturn. Many lenders will take a proactive look at their balance sheets to reduce risk exposure and may call loans in advance of what they foresee as economic headwinds. In recent weeks, we have seen the bank-syndicated markets become more challenging as institutions have fundamental disagreements with each other on important terms and conditions. Because of this, larger transactions are becoming more difficult to close.
As addressed in the last installment of this blog series, business owners may need additional working capital to fund operations when receivable collection slows down, vendors demand payment and payroll must be met. Counteracting those working capital requirements may mean fewer inventory purchases, so all factors must be considered.
KEEP AN OPEN CONVERSATION
With these conditions in mind, GHJ’s Growth Planning and Strategic Advisory team recommends having open and regular dialogues with banks and investors. Regular updates will bring comfort to capital providers that business leadership is aware of their performance and straightforward about its prospects. They will be far more willing to work with the company if trouble arises than if they are surprised with an unexpected need down the line.
Some key topics of conversation:
- Apprise them of current events in the business and, if appropriate, acknowledge the potential need for liquidity to meet day-to-day needs.
- Provide the granular forecast created from the earlier blog post in this series and deliver regular updates on the performance to this plan.
- Make them aware of what downside scenarios look like and whether liquidity may be needed. While they may not be able to provide these requirements, they can refer capital providers who can help.
GHJ’s team can help with forecast creation/development and prepare clients for potentially difficult conversations with their capital providers.
In the next installment of this series, learn the importance of reviewing profit and loss ratios. To learn more about managing capital or preparing for a recession, contact GHJ’s Growth Planning and Strategic Advisory team.