By Neil Johnson is CEO of Duke Royalty
The global pandemic has dealt yet another blow to business in general, and Small and Medium Enterprises (SMEs) in particular.
Even at the beginning of the year, the level of indebtedness across this community was untenable. To make matters worse, recent research has highlighted that a quarter of a million companies are at risk of collapsing under £35bn ($44bn) of unsustainable debt taken on during the COVID-19 pandemic. This is foreboding, to say the least.
However, the outlook need not all be doom and gloom. Alternative and more flexible forms of finance have been on the rise since the Global Financial Crisis sent shockwaves through the markets in 2008. Now, 12 years on, businesses have more options than ever before when it comes to finding an innovative capital solution which promotes, rather than encumbers, growth. Evaluating these will be essential for management teams as they look to stabilise their business in a post-pandemic world and create a stronger growth platform for 2021.
The biggest sector you have never heard of.
Royalty Finance is one such solution. It is probably one of the biggest sectors you have never heard of. Popularised in North America, this form of alternative financing is estimated to be worth around $50 billion in the region and has been recognised as a viable capital solution for companies operating across a range of sectors since the 1980s.
The solution sees well-established companies receive capital in return for a slice of their revenues. Models vary, but typically royalty financing works as a type of 'corporate mortgage', where a business exchanges a small percentage of its revenues over a long period of time in return for capital today. It is because of its ability to provide supportive capital which does not saddle the business with re-financing risk that its relative obscurity in the UK and Europe is quickly changing.
The advantages are clear: because it is passive, unlike other options, royalty financing is the only source of capital which enables business owners to realise their long-term business goals without compromising owner control, adding amortizing bank debt to the business or, in most cases, diluting equity shares.
Since the royalty company is taking a slice of revenue from the business, it also means that the interest of the two partners are aligned (arguably, unlike other traditional finance methods), with the repayment percentage adjusted annually to reflect any movement in an investee's revenues. This means that it represents a true partnership model.
As an additional benefit, the company's repayments cover the principal as well as the interest. Many companies use the money to replace existing short-term debt to allow them to grow. Royalty financing eliminates re-financing risk because it has a payback over decades, hence the analogy to a 'corporate mortgage'. As well as being used to refinance debt, other common applications include M&A, shareholder restructuring and organic expansion.
A transatlantic shift
The transatlantic jump for royalty financing originally came as a result of a shift in how SMEs perceived and dealt with their banks on the back of the Global Financial Crisis. Just two years ago, the UK's Federation of Small Business (FSB) reported that small credit business approvals had fallen to a 30-month low, with only 60% of small firms that applied for credit being successful, establishing a significant SME funding gap and frustrating growth.
Fast forward to today, and the coronavirus has shifted this sentiment of stagnation a full 180o to the other extreme. The UK government's decision to act as a guarantor for business loans to prop up the private sector during the pandemic, however well-meaning, has created a staggering debt mountain. Worryingly, the implications for the SME sector, which employs 60% of the UK's private sector workers, and its future growth prospects are even more eye-watering.
Banking industry executives fear that the loans will lead to widespread corporate failures in 2021 when companies must start paying interest on the debt, leading to a swathe of job losses. Even among businesses that can afford to service their loans, debt impedes a companies' ability to invest and grow, thereby creating a significant drag on any economic revival after the Covid-19 pandemic.
The UK government has already started work on how to tackle the corporate debt mountain. A likely solution will be to enable the debt to be swapped by the government for equity stakes in businesses, much like we saw during the global financial crisis. This will make many of our SMEs accountable to UK Government, presenting an array of new potential headaches for management.
This raises the question: is this the only way? After the initial drop in revenue experienced by companies almost across the board in April 2020, when the pandemic first struck UK shores, many have started experiencing a relative upturn in trading. For those businesses which have a proven, long term track record of profitability, but have taken a hit during unprecedented times, there lies the opportunity to evaluate their options, refinance this debt and once again make themselves the masters of their own destiny.
A new tomorrow
The accelerated adoption of pre-existing trends, whether it be flexible working or digitalisation, during the pandemic has been a hot topic over recent months. In my mind, this extends to the application of alternative finance as well. In times of short-term uncertainty, long term capital, which does not need to be continuously repaid or have an identified exit strategy in place, represents a no-brainer for management teams.
The businesses of today benefit from a financial landscape that is more diverse than ever before. Now that the dust has settled following the initial shockwaves sent through the business community at the start of the outbreak, management teams have the perfect opportunity to take their future into their own hands and ensure that their capital structure works for, not against, their business.
With its aforementioned advantages and amid a quickly changing finance environment among SMEs in particular, royalty financing is set to grow from strength the strength across the UK and Europe. You could call its sudden rise a surprise, but all the right conditions have been there for growth of the industry.