RK&O Outlook: Resiliency - What To Do When Your Supply Chain Breaks

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April 1, 2020

In times of correlated financial stress, no manufacturer needs a disruption in the flow of critical components through its supply chain. Apart from the supply chain disruption, the manufacturer’s liquidity may be constrained due to limited financial resources, reduced inventory or receivables for borrowing base calculations, fully drawn lines of credit and, in the worst case, one or more defaulting lenders. The manufacturer’s revenue may have fallen due to decreased demand for the goods in the marketplace and performing customers may bargain for extended payment terms. Adding the failure of a critical supplier increases the manufacturer’s misery and requires urgent brainstorming.

The standard manufacturer playbook for supplier default starts with a search for alternative vendors. If other vendors are not readily available, perhaps because the needed component is bespoke and integral to the final product, manufacturers offer financial support to a troubled supplier. Loans, convertible notes, or convertible preferred equity are common financial structures and instruments deployed to rehabilitate stressed suppliers.

Under the standard model, the financing is designed to provide a key supplier enough liquidity to continue operating, and often includes an equity kicker for the manufacturer’s benefit. However, if the manufacturer is financially constrained, or if the supplier is in extreme difficulty, then financial support will be insufficient to carry the supplier through the crisis. In these types of cases, manufacturer-provided financing will not ensure supply chain resiliency over the long haul. 

Recently, one of our manufacturing clients had a novel solution - buying the specific plant, equipment and intellectual property used by the supplier to manufacture the critical component. Structurally, the transaction was a “carveout” transaction, in which the specific (mission-critical) plant, equipment, and related IP were all purchased, and the supplier’s manufacturing know-how was transferred to the manufacturer and made available to its employees. This allowed the manufacturer to take full and lasting control of a critical link in the supply chain.

In contrast, while a loan or other financing transaction might have solved supplier’s short-term liquidity issues, such a financing may have left the manufacturer vulnerable to a second round of supply chain disruption if the period of market stress persisted. Purchasing a bespoke and narrow range of plant, equipment and IP proved to be the sturdier solution.

We are in challenging times, and supply continuity is a continuing concern. Given the uncertainty as to the duration of the current financial crisis, it makes sense to fashion legal solutions that prioritize manufacturer-control and resilient (truncated) supply chain architecture. In some cases the novel approach will outperform solutions that will require constant further attention and support.