Managing Liquidity Risk with Outstanding Suppliers

by Hilary Weatherstone, Director, Lloyds TSB Corporate Markets

Although the liquidity crisis has been rumbling on in the banking sector for almost 18 months, the collapse of Lehmans in September has pushed the crisis into the real economy. This event marked a profound transformation of the financial sector, and every government, bank, corporation and individual is now seeing the impact. What is also apparent is the phenomenal speed with which the downturn has taken place: since the summer, when it was largely “business as usual” for companies outside the banking sector, companies of all types are now experiencing a significant fall in revenues. With economic change accelerating, and such a rapid and substantial alteration in companies’ liquidity profile, the focus for all firms must be to create working capital and preserve liquidity. However, this focus extends beyond the company’s own finances to its supply-chain. Many firms are dependent on their outsourcing suppliers for business-critical services/infrastructure. This is often paid-for upfront by the supplier and repaid incrementally by the company, creating substantial risk to that company should the supplier collapse. As a result, a firm that experiences a critical supplier failure would need to soak up any overhang cost or replacement cost of the service – draining liquidity from the balance sheet.

Approaches to the Crisis

The demand for liquidity far outweighs its supply in the current market, driven primarily by a significant deterioration in the confidence of market participants. In fact, sources of liquidity, which companies previously took for granted, are disappearing or the pricing has increased dramatically (margins have moved by a factor of up to 10 times in some cases) making them prohibitive. With declining revenues and fragile financing, companies are approaching the crisis in different ways. Mature, seasoned companies, which have weathered downturns before, have placed professionals with substantial financial expertise at the helm of their business. These companies recognise the importance of sourcing adequate liquidity to cover difficult times, despite the high costs of doing so. While these firms may experience lean times ahead, they will ultimately survive.

However, not all companies have the experience or expertise in-house to appreciate the importance of shoring up the company’s finances or to recognise how to go about doing so. This is particularly the case for lower rated companies, or those which have grown quickly during the benign economic period of the past ten years. In these cases, many senior executives will not be equipped to keep up with the pace of change in the deteriorating economy. Even though the cost of borrowing may be high today, securing financing when a company’s liquidity has dried up and performance is poor is likely to be impossible. In many cases, executives of these companies may believe that they are acting prudently by maintaining the debt burden at pre-crisis levels, but in reality, a “wait and see” approach is likely to prove fatal. [[[PAGE]]]

Mitigating Supplier Risk

Managing costs in the supply chain is also another important way of optimising working capital. One of the ways of doing so is to outsource various non-core business functions, including telecoms and technology. This approach has a range of advantages: costs are frequently lower and services are conducted under the terms of a service level agreement. Despite depressed economic conditions, the indications are that companies will continue to invest in technology as a means of reducing costs and enhancing their competitive position. However, some of the companies providing these technology services may fail. Inevitably, smaller companies without sufficient access to liquidity, which characterises many providers of outsourced technology services, are most susceptible. There is undoubtedly overcapacity in the outsourcing market, illustrated by a string of recent acquisitions in the industry, including HP’s acquisition of EDS, and further consolidation is likely in the future.

The demand for liquidity far outweighs its supply in the current market, driven primarily by a significant deterioration in the confidence of market participants.

Activities, which could easily be taken back in-house or transferred to another provider without interruption to the business or loss of reputation, are unlikely to be a priority. However, there are likely to be a variety of essential services in which the company needs absolute confidence. Even an immaculately well-run and well-financed company may find its business severely hampered or its reputation damaged in the case of supplier failure. For example, a supermarket whose supplier of retail systems or loyalty card processing fails would incur substantial losses and customer dissatisfaction even though the fault was not theirs. Consequently, every company needs to consider its risk to outsourcing suppliers, particularly providers of business-critical supplies and services.

There are various ways of mitigating these risks. Some firms will take the approach that, using the old adage, “no-one got fired for buying IBM” and work with larger vendors with greater financial stability and access to liquidity. The market indications in recent months have suggested that there are certain flagship firms in each sector, which governments would not allow to fail. This could result in companies reducing their total number of outsourcing suppliers, including moving away from the “multi-sourcing” model which has become prevalent, in which companies select vendors to provide different elements of a service according to their business strengths.

This approach will not suit all firms however, and there are ways of continuing to work with smaller or specialist providers which are best equipped to provide the services required, whilst still ensuring service reliability and overall cost reduction. A typical IT outsourcing contract could extend for 5 or 10 years, so companies need to ensure that their suppliers have appropriate liquidity to enable them to deliver services over this period. In the case of tier 2 suppliers, this could include leveraging the company’s own ability to obtain finance on behalf of its suppliers.

Specialist Financing

Long term contracts need long term financing solutions and treasurers who may not have been involved in negotiating supplier contracts in the past are now taking a greater interest. While it may not be appropriate for companies to have the cost of purchasing assets on which outsourced services are based on their own balance sheet, there is an increasing appetite for financing structures that accommodate their own, and their services providers’ liquidity requirements. For example, non-recourse financing, based on specific assets, has potential benefits for both parties. Key to a successful solution is a close relationship between a supplier and customer, in which both clearly understand the needs and pressures on the other party. Furthermore, every financing solution will be different according to the supplier, the customer, the nature of the service and the assets involved. Working with the right bank, which can deliver flexible solutions, taking into account all the various elements, is vital. Lloyds TSB, for example, has a growing specialist technology financing team providing bespoke financing solutions to companies and their suppliers.

Whatever financing option is put in place, companies need to ensure that they are entitled to take over the assets used to provide the service (such as business critical hardware and related software in the case of technology contracts) to bring it back in-house or transfer to an alternative supplier, in the event of supplier failure for whatever reason. Some of the issues to consider, and include in the supplier agreement, include:

• Who controls how expenditure within the service contract is incurred?

• Who pays for the assets required to deliver the service and who has legal title to them?

• What is the trigger for the company to take control of the asset and/or transfer the service in-house or to an alternative supplier?

• What is the mechanism for doing so?

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Successful Financing of Outsourcing Suppliers

The next few months at least are likely to prove challenging times for all companies, which creates a ripple effect through to their suppliers and customers. With every company in the supply chain affected by the liquidity squeeze, stronger-rated companies with better access to financing can manage their own business risk more effectively by extending support to their suppliers, particularly those of business-critical services, and potentially benefit from better pricing and preferential service as a result. As well as establishing a direct and open relationship between supplier and customer, working with the right banking partner is key to an effective financing solution which benefits both parties. An open and honest relationship with the bank is crucial to building confidence and ensuring that the company is in the best position to secure appropriate financing, with a realistic approach to the challenges which exist.

About Lloyds TSB Corporate Markets

Lloyds TSB Corporate Markets is a division within the Lloyds TSB Group providing a dedicated service to businesses with annual turnover in excess of £15m. Corporate Markets offers a unique approach to relationship banking which gives customers access to a service tailored to their distinctive needs.

Lloyds TSB Corporate Markets employs a wide range of industry experts in a number of areas, including capital markets, treasury services, debt and equity finance, international business services, leasing and financial institutions. This includes innovative flexible finance solutions, both simple and highly complex, for a variety of business requirements.