Today, resorting to Private Debt is very attractive for fast-growing small and medium-sized companies. This form of financing is now well established in the United Kingdom due to its attractive risk/return profile, and it is also expanding in Europe precisely as an alternative source for SMEs.
Flexibility of corporate financial structure
If we analyze the international best practices about the management of the financial structure of non-financial companies we see that numerous researches, conducted in industrialized countries – i.e. Graham, J. and Harvey, C., (2001), Bancel, F. and Mittoo U.R., (2004) and Dallocchio M., Tzivelis D., Vinzia M. (2017) – show that the choices regarding debt are marked by ensuring flexibility in the corporate financial structure, while guaranteeing the best possible Credit Rating (CR). This hinges on the fact that decisions regarding the corporate financial structure are clearly subordinate-and could not be otherwise-to choices regarding the core business and in particular investment policy. Therefore, CFOs (Chief Financial Officers) prefer a sub-optimal financial structure from a cost perspective, but one that is more flexible and therefore less risky.
Basically, in order to optimize the risk-return combination, from the point of view of the net financial position (NFP), companies tend to diversify the sources of debt, although this may entail, at least in the short term, a higher cost of financing (of funding). This aspect in the Italian context appears particularly significant since companies are inclined to raise money mainly by resorting to the banking system.
The problem of reduced diversification of financial sources
This reduced source diversification activity, more often than not, does not manifest itself in the larger entities with investment grade ratings (i.e., BBB- to rise), but in the many viable smaller entities with non-investment grade ratings: in which case the banking system remains the main route and unfortunately often the only one. In relation to the latter entities and in general for SMEs, this phenomenon has then been further emphasized due to the “Liquidity Decree” (ex lege 40/2020 and the Support bis Decree ex lege 73/2021), which allows companies to raise new bank debt, taking advantage of public guarantees. E.g., Mediocredito Centrale offers a guarantee of up to 80 percent of bank exposures of up to a maximum of 10 years to finance new investments and working capital, but also to consolidate existing debt, transforming short-term debt into medium- to long-term debt, while maintaining the lower cost of funding typical of a short-term exposure.
This measure, aimed at coping with the pandemic, meant that banks continued to provide credit to entities for which, for the purposes of the government guarantee, they still have to check creditworthiness. This is not surprising, given that the ability to generate cash flow, and thus to be able to repay debt, is the condition underlying the granting of credit by any financial intermediary. However, Government support for bank debt does not seem to be able to be a structural tool, and therefore serious reflection is required on the desirability of diversifying sources of funding especially for medium-sized entities, even if they have non-investment grade ratings.
The solution: rely to Private Debt
One avenue that could be considered, in order to diversify financing sources, is that of Private Debt, i.e., resorting to private placements with direct lending and private equity funds, usually owned by institutional investors and/or family offices.
In this way, it is possible to start the process of diversifying sources primarily to give rise to corporate growth or restructuring operations, thanks to structured access to new forms of ordinary or extraordinary finance. In other words, while large companies with investment grade ratings are normally organized to place debt issues on a continuous basis in the market; for smaller entities these could be more occasional operations and therefore the use of these specialized funds on non-investment grade and higher leverage borrowers could be a solution to effectively diversify financial sources.
The importance of cash planning (cash flow)
Therefore, in view of fading public support in the future, the importance of being able to plan for corporate cash generation, consistently assigning goals to management and measuring their achievement over time, in order to produce a positive cash flow that ensures repayment capacity and in general compliance with the financial covenants included in the financing should be reiterated once again. Without effective cash flow planning and control, not only does diversification of financial sources become problematic, but continued access to any form of debt, whether bank or private direct lending, becomes complicated.
The expert’s advice
In conclusion, public guarantees to collateralize bank debt cannot be eternal and it pays to move in time. Therefore, in order to continue to tap the debt market, while diversifying financial sources appropriately, it is necessary to have cash generation under control in the company. In fact, without an effective cash flow planning and control process, one runs the risk of not being able to ensure a solid and flexible financial structure to support the core business.
