Macroeconomic volatility is creating headwinds for merger and acquisition (M&A) transactions. Inflationary pressures have driven up interest rates, triggering a global repricing of assets while simultaneously making borrowing more expensive. This volatile climate has already caused economic debris to fall, with the failure or takeover of several banks on both sides of the Atlantic as collateral damage. Future liquidity events are probable, with unpredictable ripple effects.
Geopolitical Pressures: A Spotlight
Geopolitical uncertainty remains a constant, but the causes and impacts vary around the world. In Europe, for example, the conflict in Ukraine has driven commodity and energy prices up, directly increasing operational costs for multiple industries and amplifying costs across entire supply chains, impacting trade relationships. Globally, eyes are on China, with the potential changing world order adding complexity to decision making. Investment models need to consider the economic and political volatility of the ‘3 D’s’ - Deglobalization, Decoupling and De-dollarization.
Amid geopolitical tensions, supply–demand instability and shifting markets, deal volumes are steadying after recent declines. Making sustainable long-term investment decisions in a volatile environment will challenge dealmakers in 2023. In navigating these challenges, dealmakers are reassessing their financing strategies to access and safeguard capital.
Financing Strategies are Shifting
As a result of these factors, financing transactions are shifting in the M&A market. With debt markets less accessible for certain investors, and only at a higher cost, banks are reluctant to finance big ticket deals given that they are still about to clear credits from their books that have been stuck in syndication. High-quality corporate entities are picking up some of the weakness, taking advantage of their flexibility and relationships with banks to perhaps finance deals at more favorable average earnings multiples. Additionally, more nontraditional sources of financing are being used. Private credit funds are eager to deploy capital and are acting as financiers themselves as they have been able to negotiate better pricing and debt servicing covenants.
High interest rates are not necessarily an issue for private equity firms, provided those rates are stable. What has affected the current M&A market, is the sudden fluctuations that occur while deals are being negotiated, affecting valuations over a short period of time. These shifts mean that debt financing is not as generous for borrowers as it was a year ago, but, for high-quality transactions, financing is still available. Safeguarding capital amid economic volatility will be critical in building sustainable growth. Trade credit insurance can unlock value in deals in three key ways.
Driving down the cost of borrowing and increasing financing. Trade credit insurance has historically been used by businesses looking to hedge risk on what is usually their biggest asset, their accounts receivable. But as we look toward continued economic volatility, companies are using trade credit insurance to reduce the cost of financing.
When securing debt to finance deals becomes more challenging and expensive, it constrains the amount of capital buyers can collect to reach vendors’ expectations on valuations. That causes companies to turn to trade credit insurance to bridge the financing gap by credit enhancing their accounts receivable, lowering their overall cost to finance deals - putting trade credit insurance to work. Not long ago, dealmakers had sufficient funds to forego this route, as the cost to finance through banks was significantly lower. Now, firms are using trade credit insurance to insure their pool of receivables, transferring their risk to a AA/A+ rated insurance company. A bank that offers receivables finance that is backed by this form of unfunded credit protection for a portfolio company’s account receivables pool can not only lower their cost to finance due to the preferred risk weighted assets treatment, but also help bridge the gap to vendor price tags.
Lenders use trade credit insurance as well, insuring receivables finance portfolios (often on a silent basis) and facilitating off-balance sheet structures. Structured credit insurance is also used by lenders to insure loans, such as those for acquisition finance, increase facility sizes and improve capital. Insurance capital will continue to help bridge funding gaps and increase credit accessibility.
Reducing post-deal volatility. There are a few significant ways that trade credit insurance can reduce post-deal volatility. Trading issues commonly identified within the scope of the Financial Due Diligence include difficulties in collecting debts or identifying high historical levels of bad debts. It is imperative to include warranties in the Share Purchase Agreement to give certainty to the purchaser that no assets are paid for which do not carry any economic value. The identification of issues in the target’s customer base will support the strategic risk mitigation decisions required by the purchaser post-completion. Trade credit insurance therefore helps to bridge the negotiation gap between seller and buyer and adding clarity to the economic value of a business’s receivables.
Secondly, when carving-out an entity, new sources of financing will be required. In those cases, buyers will often have to provide new credit lines. Trade credit insurance can help firms enhance collateral and secure additional financing from banks.
In addition, in the wake of a transaction, buyers can use the access to trade credit insurers’ data platforms to model expected credit losses, implementing the model required according to IFRS 9. Once identified, this may be used as a price negotiation tool for the purchaser.
Finally, political risk insurance (PRI) is a useful tool for buyers. As a risk mitigation tool, PRI helps to provide a more solid environment for investments into developing countries, and to unlock better access to finance. Some examples of events covered by PRI include war, terrorism, government expropriation that can directly affect an investment's operation and violate its ability to perform critical functions.