BG: Supply Chain Financing – The Good, The Bad & The Ugly
Last week, the financial world has been captivated by the crisis engulfing Greensill. It is reported that the London based supply chain fintech could be facing insolvency after Credit Suisse froze $10 billion worth of investment funds earmarked for its supply chain business. The drama unfolding at Greensill puts a timely spotlight on the business of supply chain financing (“SCF”) and more broadly invoice financing where the monetary value of invoices is unlocked through the use of third-party funders. Credit insurers, a key clog to the financing machinery have been conveniently blamed for withdrawing insurance cover triggering investor alarm and stopping the liquidity flow but this misses the bigger problem as to how the humble supply chain financing product found itself structured and wrapped as a financial product for investors. Understanding the product is the vital difference between riding the liquidity wave or collapsing under a financial tsunami and the key question to be asked whether as a financier or an investor is, whose benefit is it really for?
The good – cash in hand earlier
Supply chain financing or reverse factoring is a variant of invoice financing which works on a basic concept of the time value of money that $0.80 cash in hand today from an invoice is worth more to a business than $1 in 30 days. Invoice financing whether in the form of payables or receivables serve to plug a gap in the time it takes for invoices to be paid – giving suppliers of goods much needed access to cash earlier. Receivable financing allows a supplier to monetize its invoice due in the future by selling it to a financier for immediate payment at discount. Payables or supply chain financing achieves the same outcome but instead of the supplier selling to the funder, the buyer with its stronger balance sheet aggregates its invoice liability to a funder who pays off each supplier earlier. The supplier, typically a SME without sufficient banking lines gets to reduce its cash conversion cycle giving it crucial working capital. The buyer with its bigger balance sheet, is able to “support” its supplier through the insertion of a third-party financier who makes early payment. The financier makes early payment for a fee and takes a relatively comfortable credit risk on the buyer which tends to be a large corporate. Everyone wins, or at least so it seems.
The bad – lack of transparency in financial accounting
Supply chain financing was conceived for the benefit of the SME supplier where early payments could make the difference in its survival as a business. But in applauding the benefit received by small businesses all across the world, the advantage received by the large corporate buyer tends to be overlooked. A corporate buyer’s SCF programme may run into the tens or hundreds of millions which their numerous suppliers have to agree to as part of its business. In these programmes, suppliers may find their typical payment terms of say 30 days extended to 90 days as part of the institutional SCF programme. Noone bats an eyelid – the SME supplier has no bargaining power over its corporate MNC buyer to individually negotiate its payment terms. In any case, any concern the supplier may have over extended payment periods is easily allayed by the financier agreeing to pay its invoice immediately, which means the supplier suffers no prejudice. But it is the large corporate buyer that finds itself able to hold on to that dollar longer than 30 days and it is not just the time value of money that the buyer benefits from – what is questionably a third party loan to finance its liability is is recorded as a trade payable. When debt is recorded as a trade payable, there are serious ramifications for all that rely on the financial statements of the corporate buyer – this includes their auditors, banks, insurers and investors of the SCF programme. Leverage and gearing ratios are important not just to a SCF financier and its investors but also the principal lenders of the corporate buyer who are primarily concerned with overleveraging. With no regulations mandating SCF programmes to be accounted as debt in financial statements, a corporate buyer may sidestep the necessary disclosure of borrowing, skewing the presentation of the financial health of the company. Insufficient disclosure, poor transparency on leverage and a lack of regulation can quickly turn a liquidity wave into a financial tsunami for a corporate buyer – the high-profile collapses of companies like Britain’s Carillion, Spain’s Abengoa and the United Arab Emirates’ NMC Health are cautionary tales particularly in SCF when all eggs are placed in one buyer’s basket of payables.
The ugly – packaging SCF as an investment
SCF is not a new form of financing. It has been used by banks focussed on investment grade companies. A confluence of factors in recent years have accelerated a move of SCF programs from the traditional banking sector to non-banking avenues like fintech companies. Increasing regulatory challenges on deployment of capital, know your customer protocols, coupled with the manpower needed to monitor SCF programs, meant that nimbler companies like fintechs could disrupt the marketplace, leveraging on algorithms to onboard, assess risk and deploy funding in days what was traditionally done in weeks by teams of backoffice staff. With the move to newer lenders, the net of buyers was cast wider to companies that were non-investment grade as SCF providers chased after top line capital deployment numbers to attract further investment.
While institutional investors retreated from SCF programmes of their own, banks and pension funds have kept their interest in SCF programs, deploying large sums of money as investors into third party SCF programmes. As a result, the unassuming invoice now finds itself the subject of financial reinvention as SCF programs attract institutional funding that is repackaged for their own investors in an evolution that has too many uncomfortable similarities to the mortgage products that triggered the 2008 financial crisis. The entire machinery moves to generate liquidity in a pursuit of financial scalability and at the heart of this steroidal transformation from simple cashflow solution to sophisticated financial product lies the use of credit insurance which seeks to cover the risk of non-payment of the SCF buyer. Reliance on insurance coverage is often misunderstood in the financial world – credit insurers underwriting the risks of non-payment have increasingly found their product misused as a financial tool to get liquidity. That credit insurers have become the inadvertent lynchpin in billion-dollar financing schemes, demonstrates the inherent risk in such a business model. There are also other aspects of credit insurers that are misapplied in SCF – for one, many SCF providers view the insurer’s underwriting assessment of the credit risk of the buyer to be a substitute rather than a complement to its own due diligence. Taking blind comfort that insurance acts as a guarantee, SCF providers may gloss over the transactional due diligence, disclosure requirements, inadequacies in basic shipping documents, the risks of fraud or disputes – all of which a credit insurance policy will not generally respond to.
The sobering truth is the growth of SCF needs to be tempered for its primary use and approached with greater caution as a financial product. The approach to SCF should also return to the question of whose benefit is the SCF programme for – a question which is not static and should be asked by funders at every stage of the programme rather than by lawyers like myself at the time of pursuing claims of non-payment in litigation or insolvencies.
Part of the answer can be found when analysing who is likely to suffer the most if a SCF program is cancelled.