Spotlight on automotive industry: Introduction to the series and financing

By outsourcing production of major parts of car components, carmakers have also outsourced a substantial amount of their financing needs and associated risks to their suppliers. Still, despite rather slim margins, the prospect of a fairly stable cash flow over a number of years has made the automotive supplier business viable in the past. However, this viability is becoming questionable. This is visible in the number of struggling or even insolvent suppliers, the German group Eisenmann being a very recent example.

The automotive industry faces several challenges as a whole, but these challenges hit the suppliers the hardest.

Numerous factors such as digitalisation, electrification, autonomous driving and environmental regulations have put an expiration date on cars as we know them. This forces manufacturers and their suppliers, especially those who produce car parts for existing internal combustion engine (ICE) models, to invest heavily in R&D to keep up with actual and expected developments– despite the uncertainty about where the industry is heading and what the car of the future will actually be.

Another challenge for the industry is the declining popularity of cars as a means of transportation and a growing number of carsharing concepts.

Despite all of the above, in order to stay in the industry you need to produce. And production usually requires substantial up-front investments. However, obtaining the necessary financing is becoming increasingly difficult as banks shy away from financing an industry with an uncertain future. Weakening sales may also cause trouble under existing financings. This hits suppliers especially hard as manufacturers rarely give a hard guarantee of minimum sales, making this low-margin business less and less viable.

When it comes to securing cash flow, it is best to be prepared and to have a good overview of the terms of existing facilities and of the possibilities to secure new financings, if needed.

Manage existing facilities

In terms of economic troubles, companies often focus purely on the operational side of business. While this reaction is understandable, a good understanding of the financing agreements is key when dealing with lenders.

In times of financial instability borrowers should in particular check the following provisions in their facility agreements:

Financial and other covenants: When is the next report to the bank due? Which indicators have to be reported and will the current financial issues already show up on these indicators? Are there any covenants on the agreement with the automaker / OEM (such as minimum monthly revenue requirement)? Are there covenants on incurring new financial debt (and if so, is leasing covered by the definition of financial debt)?

Is there an option to remedy a breach of a covenant, e.g. by injecting equity? What is the consequence if a covenant is breached once or several times?

Information Obligations: Is there an obligation - in the contract or under applicable law - to inform the bank in the case of a deterioration of the financial situation or the economic outlook?

Utilisation: When relying on a revolving credit line, what are the conditions for utilising this credit line or, conversely, what are the drawbacks? Consider building up a liquidity buffer in case financial difficulties are expected, so that you can prepare for such a situation.

Events of Defaults: Check the events of default section to make sure that any other financing you might consider, such as managing your working capital by delaying payment to suppliers (thereby pushing the issue further down the supply chain) or factoring structures, will not trigger an event of default, e.g. under a cross-default provision under the facility agreement.

After having reviewed the financing arrangements, suppliers should carefully evaluate their options. For stronger businesses that foresee only temporary troubles it might make sense to take a very pro-active approach to engaging with the bank. More generally, communication is key: Albeit that meaningful discussions appear to be difficult at times, given lender sentiment towards an entire industry, explaining to business partners (including financiers) what, if any, adverse impact is expected by the factors that presently drive the industry is important. -- Clearly, there is a difference in outlook depending on whether you produce spark plugs or airbags but, then again, financiers who might be overexposed to an industry will need to be educated on how to differentiate within the broader industry between affected and non-affected businesses.

Secure new financing

In need of new financing? Here is a short list of potential sources for financing as an alternative to banks:

Leasing / Sale and Lease back: Feasible only for financing investments as it requires an actual asset to lend against, thus no substitution for revolving credit lines. Available only against assets that provide the leasing provider with adequate security for the entire amount.

Factoring: Factoring is already widely used in the automotive industry. Some OEMs even actively offer factoring together with preferred banks to their suppliers in order to prolong their payment periods (reverse factoring). Evaluate whether this is feasible for your business.

Supplier Credit: Using payment terms offered by suppliers is a way to manage working capital needs. Make sure that cross-default provisions in the facility agreements are not triggered by paying suppliers late.

Grants/Subsidies: In many CEE countries, the automotive industry plays a major role in economic growth and employs a significant number of people. The governments are thus inclined to support the industry and to react fairly quickly to any issues the industry faces. Check whether there is any support available for your production – this can be in the form of (effectively) lower social security contributions, flexible working type modules available for this industry or investment support.

Carmakers: Given their dependency on a stable supply of car components, producers may have to support their key suppliers. Whether this will be through increased reverse factoring, agreeing to a legally binding minimum off-take per year, providing some other form of credit enhancement or directly financing the suppliers remains to be seen.

Managing Running Costs

Given the unstable business environment, suppliers are looking to reduce their running costs. How to cut costs by using annual vacation closures of plants, flexible working hours and reduction of the overall workforce will be the subject of one of our next legal insights in this series.

Insolvency

In some countries, insolvency proceedings may offer a way to deleverage an overindebted company while continuing business operations. For more on this topic, read the next legal insight in this series – "Insolvency – new beginning or dead end?"

Interested in topics relevant to companies active in the automotive sector? Stay tuned.

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