It would be a mistake for private equity firms - under pressure from the credit crunch - to take a long holiday, writes Martin Arnold

It looks like being a frustrating summer for private equity's masters of the universe. Their ability to pull off mega-deals has been severely restricted as the recent credit crunch has cut off their access to cheap money.

The temptation for many will be to take a long holiday somewhere exclusive, quiet and sunny while they wait for the credit market to sort itself out. But this would be a mistake, warns Alvarez & Marsal, a specialist turnaround advisory firm.

Antonio Alvarez III, son of A&M's co-founder and head of its European operations, says private equity firms need to do more, not less, to ensure the companies they own are not susceptible to the risks that a tighter credit market will bring.

To help the buy-out titans stay focused over the summer months, A&M has provided a checklist of tasks to protect their portfolio companies from the fallout of a harsher financial climate. This may all seem a little fanciful to some private equity bigshots. Several say privately that the credit crunch is good news for them and that they have little to worry about other than where to go on holiday this year.

Granted, they say, the banks will have to take some losses. But credit markets must open after the summer and then deals can start again, with the added bonus of lower prices.

Mr Alvarez says these optimists are deluding themselves.

"Before, you could always turn to financing from the market to get breathing room if there was a problem. Now there is no room for error. What used to be withstandable shocks are now no longer withstandable," he says.

As a top partner at one of Europe's biggest buy-out funds puts it: "Banks are going to have some very tough discussions with their auditors at year end. This is going to make life harder for everyone."

In a credit crunch, banks react by turning the screw on their borrowers. This means private equity companies may find their credit facility is cut. Any breach of covenants will result in a tightening of terms.

Trade suppliers - squeezed by the banks themselves - are likely to put pressure on companies to tighten credit terms. Customers may make demands for lower prices or to pay more slowly, squeezing profit margins and working capital.

Ross Marshall, chief executive of Dunedin, a UK private equity fund focused on small to mid-cap deals, says that in a downturn the focus must shift from profit to cash.

"You must concentrate on cash, which is how you keep the bank happy," he says.

"It is not private equity firms that shut companies down - it is the banks. So keeping them informed and on your side is essential," says Mr Marshall.

Rule one is to take the hard decisions now before it is too late. Stop hesitating over whether to sell the company's under-performing subsidiary to raise extra cash for debt-reduction: do it now, says Mr Alvarez.

Companies that hesitate over difficult decisions such as selling or closing a subsidiary could be forced by banks into doing it later in a fire sale, earning much less for the same assets.

Blitzing cash management is the second golden rule for A&M.

If a company is poor at forecasting its cash needs, it will have pools of "buffer cash" to tide it over through any cash-shortages in the various countries where it operates, says Mr Alvarez.

He argues that when companies hoard cash, as used to occur at Alstom, the French engineering group, it is pure waste.

"This is the worst deployment of assets. The greater precision a company has on cash forecasting the more cash it can free up."

Private equity managers should ensure the companies they are running receive the best terms from suppliers. "Make sure invoices go out when they should - you would think this happens naturally but it does not necessarily," says Mr Alvarez.

Equally, companies should not pay early, as this is wasting working capital. "You would be amazed how many pay bills early because it is easier," he says.

As they are likely to have less room for manoeuvre, buy-out bosses must force themselves to look in the darkest closets of their portfolio companies for the nasty surprises they would rather ignore, such as currency risk and pension obligations.

They should also check for costly balance sheet items, such as special purpose vehicles, uncollectable receivables, and contingent liabilities, which could all mean that if push comes to shove they have less cash than they thought.

Third, buy-out bosses need contingency plans. It may never happen, but Mr Alvarez says they still need to know what to sell in the event of a cash-crisis, which capital expenditure can be delayed and how many products are non-core.

Some cash should be put in reserve for redundancy plans, especially in countries such as France and Germany, where they are particularly costly.

Mr Alvarez says he has seen companies decide on a rescue job-cutting plan only to discover they do not have the cash to pay for it.

Finally, private equity bosses should pay extra attention to the capital structure of their portfolio companies. The maturity of debt should be extended to avoid repayments eating into cash needed for restructuring or investment. Covenants should be loosened where possible.

Most private equity bosses agree that the party seems to be over for the most extravagant benefits of the now defunct credit boom, such as covenant-lite debt and payment-in-kind loans. But the number of deals financed with these loosened terms should help private equity-owned firms survive a downturn more easily.

Buy-out chiefs may complain they do much of this already.

But the long era of easy credit may have bred complacency and these areas need more attention in a downturn.

"Like in any cycle, the good ones will continue to do well, keeping a close eye on cash and taking the hard decisions quickly," says Mr Alvarez.

But he warns: "I can tell you with conviction that credit has for the most part stopped in the last week and that is going to have a big impact. We are going to be busier. There will definitely be some defaults by private equity-owned companies."

Will the buy-out titans take his advice? Many partners at private equity firms are relatively young - often in their 30s or early 40s and work at firms that are yet to experience an economic downturn.

If they fail to prepare for the next financial slump, they could face a grim few months on their return from holiday.