How Credit Insurance Can Enhance Private Equity Transactions

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Today’s deal environment is very competitive and every private equity professional is looking for an edge.  You may not realize this, but some insurance products can be a valuable tool in order to differentiate a bid, or, ultimately, facilitate a transaction.  Credit Insurance is one of those strategic tools that can be utilized to loosen restrictive lending requirements that continue to limit deal activity and leverage ratios. 

Credit Insurance (also known as "Trade Credit") protects a company's accounts receivable against a bad debt due to insolvency or protracted default. Simply put, credit insurance makes certain that valid (non-disputed) accounts receivable will be paid, either by the debtor or by the insurance company.  From a risk mitigation standpoint, when you acquire another company, you inherit a customer list or a trade sector that you might not be familiar with. Vetting that customer list through a credit insurance underwriter provides you with excellent feedback on the creditworthiness of those customers, not to mention the valuable protection that you secure at a vital time during the acquisition and beyond.

A company's accounts receivable is typically one of its top 3 assets. While the others (property; equipment; inventory; executives; cash) are almost always insured, accounts receivable often go uninsured, even though they may be the most vulnerable to loss and the most likely to be affected by business cycles. Insuring its accounts receivable can provide a company with significant balance sheet protection.

Chris Ball is Vice President of Reliance Insurance Agencies, Ltd.  He can be reached at 604-251-8322 or cball@reliance.bc.ca 

Mark Johnson is Account Executive at Reliance.  He can be reached at 604-251-8360 or mjohnson@reliance.bc.ca 

Reliance represents Equity Risk Partners Global in Vancouer

 

Perhaps the most direct benefit that credit insurance can bring to a private equity transaction is in connection with the financing of the transaction - either the acquisition itself, or to enhance the working capital financing post-acquisition by increasing the level of accounts receivable that are eligible to be financed. 

If a company's accounts receivable are being used as collateral for a loan, credit insurance can facilitate the bank's ability to lend, and the borrower's ability to borrow. Typically, a portion of a borrower's A/R might be excluded from the borrowing base for various reasons (either there is too much concentration with certain customers, foreign receivables, etc). By insuring those receivables, a company can make those ineligible receivables eligible, thereby maximizing the value of its borrowing relationship. Additionally, banks will often reduce interest rates or waive some security requirements in connection with the borrower's purchase of credit insurance. In the current tight lending environment, using credit insurance can be an important component to getting bank financing.

Example:  A plastics blow-molding company with $6MM accounts receivable ($5MM domestic, $1MM export) wants more working capital to fund the lease of new machines that will lead to sales growth. It secures a credit insurance policy on their 15 foreign clients that represent $1MM AR at any given time. After naming their lending bank beneficiary of the policy, they can borrow up to 85% against the insured AR. This provided them with $850,000 additional working capital to fund growth.

By protecting itself against bad debt, especially catastrophic bad debt from a large and unforeseen loss, credit insurance enables a company to maintain its cash flow and profits with a smoothing affect on losses; adding predictability to the business cycle.  Additionally, credit insurance can allow a company to reduce its bad debt reserves, freeing up working capital and taking advantage of the tax deductibility of the insurance premium. 

If you are acquiring a company that exports using letters of credit (LC), credit insurance can allow you to increase revenue by using the ability to offer open terms as a tool to get more business and increase the return on your investment. 

Example: A specialty chemical wholesaler exports $20MM worth of product to Europe and Asia using the protection of LCs that average 1.5% of sales ($300,000 annually); dependent upon country and debtor. By insuring those transactions at an average rate of .5% ($100,000), they were able to reduce expenses by 66%. Furthermore, by offering open terms, they were able to increase overall business with each customer.

If a company's credit practices are constraining sales, credit insurance can help. This is especially true for exporters who require LCs as payment terms from their foreign customers. While these payment terms address the issue of credit risk, they may result in sales being lost to competitors who are willing to offer open terms. By using credit insurance instead of LCs, an exporter can help grow its sales while eliminating the administrative burden of LCs. The same benefit applies to companies looking to expand into new markets, or acquirers who do not have a familiarity with the customer base of the company that they have acquired. 

Example: If a company that has 20% gross margins and a Days Sales Outstanding of 45 days is able to increase its credit limit on a customer from $200,000 to $300,000 because of credit insurance, it will gain $160,000 in increased annual gross profit from that customer. 

Policy Underwriting and Pricing

Policies are typically priced using a sales based model. The insured estimates sales for the upcoming 12 months to the accounts being insured, and the insurance company sets the rate based on their underwriting analysis of the insured and the insured's customers. This rate is then multiplied against projected sales to determine premium. Premium rates depend on a number of factors such as; volume of sales being covered, industry sector, historical bad debt experience, level of credit limits needed, and policy structure. Rates are a fraction of 1% of covered sales, and can range from 0.1% to 0.4% for domestic coverage, and the same or higher for export coverage depending on the type of countries being covered.

Determining the creditworthiness of your customers can happen in a matter of days and with limited information.  Going through this process does not impact the customer’s D&B report because credit insurers utilize their own records.  After the initial review is completed an indication of coverage can be provided.  More information will be required for full underwriting, which can take one or two weeks.  If accurate customer information was provided at the beginning, the final terms are typically very close to the initial indication. 

Jerry Paulson, New Business Agent with Euler Hermes in Chicago, has seen firsthand how private equity professionals have utilized Credit insurance.  “Trade credit insurance provides multiple layers of value to the Private Equity community. It’s not just about protection of that valuable asset; accounts receivables, anymore. The active and progressive firms that I work with are using credit insurance as a competitive advantage during buy-side and sell-side transactions while leveraging the strength of its ongoing protection within their current portfolio.” 

Chris Ball is Vice President of Reliance Insurance Agencies, Ltd.  He can be reached at 604-251-8322 or cball@reliance.bc.ca. Mark Johnson is Account Executive at Reliance.  He can be reached at 604-251-8360 or mjohnson@reliance.bc.ca.  Reliance represents Equity Risk Partners Global in Vancouver.

Equity Risk Partners Global is the first and only international insurance brokerage alliance focused exclusively on the needs of the private equity marketplace. Comprised of independent brokers in countries with a significant amount of private equity activity, this worldwide consortium is dedicated to improving the efficiency, structure and return of private equity transactions through a unified and consistent approach to due diligence and client service.  For more information, visit www.equityriskglobal.com.