Investors in Receivables Finance transactions primarily expect to be repaid out of collections for receivables that they have purchased, usually without recourse to the seller. Therefore, investors concentrate their efforts to ensure that the risk on debtors, aka the portfolio risk, is as limited as possible, by using credit insurance or reserve mechanisms. However, they are still at risk if they do not pay attention to seller risk.
So why does seller risk matter?
What is seller risk?
In most large size Receivables Finance transactions, the receivables originator (the seller) continues to service receivables after their sale. It is, in effect, best placed to do so, as it has the commercial relationship with the debtors and knowledge of products and services, access to underlying documentation (sales contracts, purchase orders and delivery notes, and so on), as well as staff and systems capability to perform collection, reconciliation and recovery activities without disruption to the commercial relationship, therefore maximising the efficiency of the collection process. Funders will therefore grant a servicing mandate to sellers.
However, this servicing responsibility places obligations and associated risks on the originator, namely:
- Operational risk: the servicer must have the resources and systems in place to perform its work.
- Dilution risk: to facilitate the collection of receivables the servicer may grant credit notes, especially in case of disputes on the goods and services, late delivery, and so on. These risks come in addition to certain contractual arrangements, such as volume rebates that may have been granted by the originator to secure a sale to its client.
- Commingling risk: debtors often continue paying the seller, most of the time on dedicated secured accounts that are swept to the purchaser on a regular basis. However, this is not a perfect protection of the collection, as some means of payments may require action by the servicer. All debtors may not pay on these accounts and, in the case of insolvency, the effectiveness of the security of accounts may be challenged by the administrator.
- Other risks: as trade receivables are not interest-bearing, costs and expenses of the transaction are often paid by the seller; FX risk, in the case of any mismatch between the receivable’s currency and the financing currency, is often covered by an indemnity from the seller.
- Fraud risk: this risk is often underestimated.
These risks can increase very rapidly if the originator’s credit quality deteriorates: poor performance in provisioning of goods and services, staff reduction in collection teams, faulty IT systems, and so on. Investors may have undisputable legal title on receivables owned by quality debtors, but they may not be paid.
How can seller risk be mitigated?
Risks are usually mitigated by using legal and structural mechanisms, such as:
- Regular audits of the portfolio.
- Dynamic reserves that take into account any credit notes issued.
- Triggers that ensure that a transaction stops if asset performance deteriorates.
- Early amortisation clauses based on seller and servicer credit risk monitoring.
However, best protection is provided by true operational mitigants:
- Availability of detailed information and reports on receivables
- Back up servicing: the backup servicer notifies debtors in a very short timeframe and starts the asset collection process. This is an essential tool for securing a transaction, only to be used in exceptional circumstances, that can provide comfort to investors and therefore enable corporates to have access to Receivables Finance in the best conditions.
Demica and Coface Collections, part of the Coface group, have set up a partnership to provide backup servicing in addition to the complete suite of reporting tools for corporates and investors.
To learn more about how we can help mitigate seller risks in Receivables Finance, get in touch:
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Jiameng Yu joined Demica in August 2021. Prior to Demica, Jiameng accumulated over 15 years of experience in Tax, Corporate Finance and Corporate Treasury at Deloitte, Tate & Lyle and Vodafone. Jiameng is leading the effort in turning Demica’s product vision into reality.