At the time of this writing, we find ourselves immersed in the hardest moments of the pandemic generated by the COVID-19. The Government has just decreed the closure of industrial activity until April 9 and the state of alarm implemented at least until April 11. This is an unprecedented scenario in Spain's recent history and has the potential to have a very severe economic impact.
It is also a global crisis that today has 40% of the world's population in quarantine. Borders, airports, limitations on rail and road transport, temporary closure of shops and companies in all sectors have been closed.
It is a demand shock in the economy, which has led to a very significant downward adjustment in asset prices. The Spanish stock market fell by 22% in March. The price of oil is at the lowest levels in the last 18 years with the WTI reference at 20 USD per barrel and the Brent at 23 USD per barrel. The VIX volatility index is now at 66.52 when in January it was at 18.84. All economic indicators point to a scenario of global economic recession. In Spain, an annualized GDP reduction of 13% is expected.
Given this scenario, I will now reflect on the strategies and alternatives possible in corporate finance for companies in Spain.
1.- Initial situation
Capital markets are very efficient and adjust asset valuations to future scenarios very quickly. The market capitalization of listed companies has been significantly reduced. There is more volatility, greater risk and uncertainty in the execution of companies' future business plans. Reduced future company growth (lower sales) generally leads to a reduction in gross operating profit (EBITDA) and free cash flow. It also increases the risk premium and its impact on the cost of capital and the cost of debt. With these indicators, company valuations are reduced.
However, if the business model was solid before the crisis, it is advisable to make pragmatic and objective adjustments to guarantee the future liquidity of the companies and to be able to continue being operative and profitable during the recession. In my opinion we are facing a scenario of economic recovery in U, where it will be critical to overcome 2020 and adjust to a 2021 in recession.
Financial management measures
In the scenario we are facing, we must rethink the future business plans of the companies, being more conservative and with the ultimate goal of maximizing the liquidity of the business. We must be very attentive to the management of working capital. In order to carry out their activity, companies need a set of working assets (raw materials, products in process, finished products, collection rights, cash). Companies need permanent levels of working capital. As they have the character of permanent resources, their optimal financing must also be long-term, mainly through two channels: - financing of suppliers and other creditors arising from operating costs. - financing by means of permanent resources: equity and long-term debt. In essence, when the average payment period is shorter (payment days) than the average collection period (collection days), there is a positive cash cycle and external financing is needed, since it is not sufficient to finance the operation's creditors. To manage this cash cycle companies can manage the following levers: - payment channels and periods ( cash discounts) - stock management of both raw materials and finished products. Investments in working capital represent a choice of risk-return. In times of crisis it is advisable to increase investment in working capital (conservative policy): By increasing stock levels and credit to customers. Liquidity is increased at the expense of profitability.
Other conservative measures in the management of capital investment in fixed assets and in the shareholder remuneration policy. We are already seeing how companies are reducing their CAPEX investments, are also reconsidering their M&A strategies, and are also managing their shareholder remuneration policy (reduction and or cancellation of the dividend) and the cancellation of share buy-back programs.
These conservative management measures are aimed at optimisizing and maximizing free cash flow liquidity. In times of crisis such as the present one, the much revered Cash is King principle applies more than ever.
Financing Instruments
Companies in times of crisis have to adjust their optimal capital structure, the combination of debt + equity. This optimal value will depend very much on the life cycle of the companies, it is not the same as a (Start -up) , as a growing company, or a company in a period of maturity. As the risk in the life cycle of the companies is reduced, the different possibilities and alternative sources of financing of the companies increase.
In times of crisis, public capital markets suffer greatly from risk aversion and are closed as a source of funding for many companies. IPOs and issues of promissory notes and corporate bonds of high-risk companies (high yield) are greatly affected, with the market almost closed. Bank financing and alternative financing are very important in this scenario.
1.- First of all, it is advisable to resort to all possible sources of financing instrumented by the government for SMEs and the self-employed in its anti-crisis measures. Government guarantees for bank financing of SMEs. ICO loans, and the temporary aid financing offered by Spanish banks.
2.- There is a wide variety of alternative financing on the Spanish market. According to ASCRI there are some 4.5 billion euros available in Spain for private equity operations. We also understand this to include Venture Capital in all financing round status from seed capital to later financing rounds. The funds have a need to invest that capital and I know that they continue to analyze operations.
3.- Debt funds. Debt funds have proliferated in Spain in recent years. They are very specialised funds that have been established to finance very specific sectors in Spain. Real estate funds, logistics funds, hotel funds, and renewable energy funds, to mention but a few. There is also an ecosystem of short-term financing funds that allow for the discounting of invoices and advance financing.
They can be a complement to the factoring of banks.
In conclusion, my reflection is that we will get out of this crisis, and when we return to our routine in the post COVID-19 reality, business management in times of recession will require conservative management criteria and financial flexibility. The diversification of financing sources and the adjustment of business plans to the new scenario will allow companies to remain operational and profitable.
Carlos López Jall
Partner- Senior Advisor at Beka Finance