As companies who face falling demand for their products restructure to survive the recession, access to credit is imperative to allow controlled downsizing and to minimize redundancies. Will Stirling examines which borrowing options are available to manufacturers and asks if the Government’s loan guarantee schemes have made credit as accessible as some companies hope.
The UK manufacturing sector is in the grip of what is arguably the worst business environment for 30 years. In the last quarter of 2008, the CBI’s quarterly industrial tends survey – a measure of the business optimism of 527 manufacturing companies – recorded a balance of -43, its lowest since July 1991 (56% of companies reporting a fall in new orders versus 14% reporting a rise). Demand for goods both at home and abroad has fallen sharply in the last three months, as consumers tighten their spending. Growth domestic product fell by 1.5% in the last quarter of 2008, the sharpest fall in 28 years.
The recession is here. For many companies, across all sectors of the economy, the situation looks bleak, as in the months ahead demand is likely to fall further and unemployment is set to increase. The common denominator across the private sector – and manufacturing in particular – is access to credit. Companies have had to restructure, sometimes quickly, to reflect new demand levels. “There is now huge overcapacity in many industries, they cannot be allowed to fail suddenly,” says Julian Wilson, director at Matt Black Systems, a defense industry manufacturer. “We must enter into a period of dramatic, but controlled, contraction. Not too fast, or supply chains and the economy will disintegrate.” Slowing this process down will cost time and money, he adds. Money, however, is exactly what the banks appear to be short of.
When banks closed the door
Towards the end of 2008 when the financial crisis was at full tilt, the FSA, the banking regulator, imposed new bank capital adequacy rules. This meant banks needed a greater proportion of cash on balance sheet. Before, banks had commonly provided an overdraft to companies with the facility to extend the overdraft to a higher limit. Most companies drew down less than the total facility available. When the new capital ratio was applied, many banks reduced their overdraft facilities, forcing companies to draw down the entire facility, or take a smaller overdraft if they wanted to keep a portion of the facility in reserve. The net effect was to reduce the amount companies could borrow. This coincided with a contraction in demand for most manufacturers as the recession deepened.
The Government has poured millions of pounds into the financial system to get banks lending again. And in January it announced a package of funds and loan guarantees for qualifying companies, targeting small and medium-sized businesses (SMEs), totaling over £21bn. The assistance package is divided into three parts:
1) A Working Capital Scheme – provides banks with guarantees covering 50% of the risk on existing and new working capital portfolios worth up to £20bn = effectively £20bn worth of corporate lending. It is meant to free up bank capital that the banks must use for lending as a condition of the scheme.
2) An Enterprise Finance Guarantee – providing £1.3bn of new lending by banks for viable SMEs with working capital or investment needs. Open to businesses with an annual turnover of up to £25m, seeking loans of £1,000 to £1m, repayable over 10 years.
3) A Capital for Enterprise Fund – a £75m equity fund, £50m of state funding and £25 from big banks. Provides longer term capital to indebted companies which have exhausted their conventional borrowing capacity but that are economically viable long term.
More than a bandage
The Conservative party criticised the proposals as being “too little, too late… a small bandage on a massive wound.” Indeed part of the scheme, the first £1bn tranche of the £10bn of guarantees for short term loans, will not come into effect until March 1. Lord Mandelson, business secretary, defended it by saying the government was right not to rush into it, that it was technically complex and that it involved careful negotiations with the banks. The scheme has had a mixed response from the manufacturing community. While most people The Manufacturer spoke to agreed any action to get money moving again was welcome, some were skeptical about the size, timing and terms of the schemes. “The first part of the plan to underwrite the loans will not help recession-hit firms who are in trouble, as the banks will still not lend to these companies even if the government promise to cover 50%,” says George Kessler, deputy chairman of Kesslers, a maker of pointof-purchase equipment. “It is still too much of a risk. It will free up some lending but it will be of limited help,” he says, highlighting that the Government’s common clause for all three schemes is ‘economic viability’. While it is sensible and right not to spend taxpayers’ money on rescuing companies with little future, it is those companies with turnaround potential but high levels of debt that are most urgently in need of funding.
For such firms, particularly SMEs, the Capital for Enterprise Fund could be the best remedy. The fund provides capital for highly indebted yet viable companies, for a 10 year period, “using equity finance to restructure their balance sheets and continue their growth.”
George Kessler comments: “It really depends how it is used. If it is used as a way of getting around state aid in the same way that’s used in France and Germany, then it will be one of the first cases when the government has been imaginative”. Under state aid rules, you can’t legally give companies money to write-off debt. “So if it is a true grant that eludes this problem it will be an extremely helpful initiative which will see the UK catching up with our European counterparts. If on the other hand it is used as a venture capital fund – whereby we only put the money in if we can get it out again and at a decent interest rate – it will make no difference.”
The fund, however, is not state aid and must be repaid, although the repayment period is 10 years.
Living on borrowed time
The issue that the most eligible businesses should have access to funding appears to have been addressed by the separation of the main scheme into three parts, despite the absence of a portion that could be defined as state aid. But some manufacturing practitioners expressed concern that the bigger corporations with multiple suppliers would not directly benefit – the principle fund,the Working Capital Scheme, is eligible only for companies with turnover up to £500m. “This is a significant move forward to restore liquidity and addressing the immediate cash flow problems being felt by manufacturers,” says Adam Buckley, head of contracts and programmes at The Manufacturing Institute. “… [but] we also need to understand what, if anything, will be put in place to support large businesses as the impact here will be felt across the supply chain and the loss of large manufacturers could potentially remove the objectives and benefits of the business loan guarantee.”
Director general of the CBI Richard Lambert supported this view in a comment to the press following the scheme’s launch. “Although today’s package will undoubtedly help many hard pressed firms, it is silent when it comes to larger companies,” he said. “Those businesses at the heart of many vital supply chains face the daunting prospect of refinancing over £100bn of credit facilities in 2009. The sense of living on borrowed time is palpable.”
Government addressed this issue for the automotive sector later in January, announcing a £2.3bn package of government loans and access to European Investment Bank loans specifically for the car industry, which has a strong emphasis on developing greener vehicles. Economists including the EEF’s Steve Radley were quick to acknowledge the value of the scheme as a kick-start to bank lending, but emphasized the risk to the wider supply chain, saying government needed to put in place support for credit insurance and measures to protect skilled jobs.
Letters of credit and credit insurance have dried up in the financial crisis making it much harder for UK companies to participate in global supply chains.
The weak pound has not improved exports as much as one might think, because in many cases exporters have kept the foreign currency prices charged unchanged, so in sterling terms the price they receive has gone up as much as the currency has fallen, providing much bigger margins but less benefit for foreign buyers.
“UK plc has not responded to a weaker pound by chasing exports but has benefited enormously by seeing its profit margins improve,” says David Owen, chief economist, developed markets at Dresdner Kleinwort Investment Bank, London. “If it wasn’t for a weaker pound the recession would be a lot worse.”
Trade bodies respond
Since the guarantee schemes were announced, it is not surprising that attention has turned to real, branch level lending — is action matching the rhetoric? Two of the schemes have yet to be put in operation, but observers are expecting to see a change in bank lending soon, in the knowledge government guarantees are pending. EEF reports mixed reactions from its members, ranging from positive to fairly appalling. Banks are trying to be supportive, it says, with some exceptions. In one example, a member of the organisation’s North East branch which had been with its bank for 99 years had its overdraft pulled overnight with no notice. The EEF believes that banks have to improve their communication to business across the board from the top down to branch level. It also says that government still needs to do more to help banks improve their balance sheets which will then enable them to step up their lending to business.
The view that this measure is a good first step, though one that needs better communication on the high street, is backed by the Federation of Small Businesses. Latest research on members of the FSB shows that one in three small businesses have had trouble accessing finance. “The introduction of the
Enterprise Finance Guarantee in January, which very closely mirrors a scheme that the FSB proposed in October 2008, should free up credit for loans and overdrafts to be lent to small businesses,” says John Wright, National Chairman of the FSB. “This is a welcome development but the onus is now on bank branch managers to actively promote these funds to viable small businesses to ensure that this sector can fulfil its role as the engine room of the economy and drive the UK out of recession.” Referring to the fact that the banking system is in the process of receiving a taxpayer-funded liquidity bailout to the tune of £500m, he adds: “There are no excuses left for bank branch managers not to offer credit to those small businesses that need it.”
Open for business
Meanwhile some banks are bullish about their preparedness to help business and there are anecdotal stories of freer borrowing, as much as there are of discontinued overdrafts. “Barclays has been a key driver and supporter of the Enterprise Finance Guarantee, and we have played a key role in shaping it along with Government and other stakeholders,” says Ray O’Donoghue, a managing director for Barclays Corporate, Midlands. “Since the EFG was announced, Barclays has already processed and evaluated millions of pounds worth of applications, and we are proud to confirm we have already approved loans for customers.
In the process, these loans are helping to provide the financial assistance for viable businesses to weather the downturn.” With historically low interest rates and the government bailout injection, more businesses will be keen to put this and similar claims by other banks to the test.
Plan B, and C
An alternative source of non-bank funding is the regional development agencies, which provide a variety of funds for companies that have not been able to secure bank funding. The Northwest Regional Development Funding offers small business loans, a grant scheme for up to £100,000 and a new £140m venture capital fund launching in April, “a combination of loan, equity and mezzanine funding to support business growth for companies who have been unable to secure commercial finance and have a viable business plan”, for amounts from £50,000 to £250,000. While rate details are only available on application, it is acknowledged (by NWRD) that the rates are higher than bank loans, to offset greater risks of default. For some types of smaller corporate finance, generally for smaller amounts than a loan and where specific projects (e.g expansion, or diversification of business) are intended, government and EU grant schemes are accessible.
“It is no longer necessary for a company to restrict its location to one of the Assisted Areas to access grant support,” says Alistair Davies, a director in the regional development division of Deloitte in Cardiff. “Funding is now widely available to small and medium sized companies, regardless of location.” A company with below 250 employees may be eligible for a grant of up to 10% of the approved project’s costs, while companies with up to 50 employees might qualify for 20%. Criteria for the grants are tight, and “they will be tied into the investment plans of a company and won’t be available purely to serve the working capital needs of a business,” adds Davies.
Follow the market
Government and banks need to work hard to get finance to the companies that need it as the economy makes a painful transition. But while many rightly call attention to credit insurance and big company funding to protect dependant supply chains, some point out the simple truth that demand should dictate where funding should go. “There is little point giving money to motor manufacturers so they can send the workers back to build more cars that are going to stand on fields because people don’t want them,” said Professor Kevin Morley of Warwick Business School, a former MD of Rover, to the BBC in January. Long term, sustainable car manufacturing is essential to the UK economy, but Prof Morley has a point. The size of the global order book for a product will affect to some extent which companies see meaningful funding in the next 18 months.