Reverse Factoring – risk management considerations
As we enter more uncertain economic times, there has been much debate within our industry as to how the Reverse Factoring product (also known as confirming, supply chain finance or payables finance) impacts corporate liquidity in times of crisis. Reference has been made to the well-known examples of Abengoa, Carillion and DIA as examples of where these programmes have accelerated liquidity issues for corporates and, in turn, contributed to their demise.
There are many comparable examples of new products within the financial services industry which have driven significant benefit to corporates and investors over time, such as interest rate and exchange rate products in the 1980s, which provided treasurers with new ways to manage liquidity and risk. As with open account trade products, these required careful disclosure to all stakeholders to ensure all were aware of the risks involved. In some European countries, receivables finance represents more than 10% of GDP and a recent report suggests that outstanding’s are now USD$21bn for large banks representing 18% of trade finance deals. This product is popular as it allows hundreds of thousands of SMEs to access cheap liquidity when it is most needed with limited costs and complexity.
We do not believe it is productive to point out examples where poor management, weak disclosure and overleveraged balance sheets have caused companies to collapse, while highlighting Reverse Factoring arrangements that were in place at the time. It is more important to consider the benefits that the product offers and the rules that responsible market practitioners need to follow in order to keep all stakeholders aware of the risks they are taking.
We have therefore set out our views on some of the questions levelled at our industry.
Is traditional factoring a more “risk-friendly” product than Reverse Factoring?
Reverse factoring is a solution that is buyer-centric because it is originated by the buyer instead of by suppliers, who may alternatively use factoring to access liquidity by discounting their invoices. It has been argued that factoring is a more risk-friendly product because the credit exposure is against a diversified portfolio of buyers, instead of one single risk.
This ignores the reality of risk management within the industry. In practice, factoring firms will typically accrue huge claims to individual debtors in industries where the practice of factoring is widespread, such as retail or automotive. Often highly dependent on credit insurance, the underwriter of the risk outsources its analysis on the debtors to the credit insurer, with no direct access to the debtor. This contrasts with Reverse Factoring, where funders often have a broader banking relationship with the corporate which can be leveraged to manage risk.
Both products have an important place when it comes to financing open account trade. They have distinct risk characteristics which need to be measured and monitored by credit professionals who take into account the needs of the customer. Reverse factoring provides systematic access to capital at reduced cost and complexity through robust tripartite relationships between the buyer, supplier, and funder. Factoring arrangements will enable bilateral deals to be struck quickly with funders and corporates with protections against dilutions built into the deal structure.
Is this a way to force suppliers to channel new spend through programmes or accept an extension of payment terms in exchange of participation?
Critical to the continued treatment of reverse financing programmes as trade credit obligations on the part of the buyer is Rule 1: any commercial negotiation with a supplier to extend payment terms must be completely separated and detached from the implementation of any Reverse Factoring programme. Suppliers must have the option to accept or decline an offer of entry to a programme to get early payments.
A corporate will always have the right to negotiate with its suppliers the commercial terms of their relationship, and the right to ask for a term extension – independent of whether or not the corporate has implemented a Reverse Factoring solution.
A further protection for suppliers comes from Rule 2: with respect to a terms extension, the ask for the extension must be moderated and in line with market and industry standards for payment terms.
When we conduct our supplier analyses (the analyses of Corporates’ spend data), we always recommend staying within industry and market (mainly country) standards. If, after having implemented a Reverse Factoring solution, a corporate increases payment terms to its suppliers significantly beyond industry and those market standards, the link between the working capital benefits and an unfair treatment of supplier payments can also be sufficient to risk reclassification of the receivable on the balance sheet.
A corporate, whether it is a buyer or a supplier, will typically have the internal objective of improving its own working capital. Professionals like banks, advisors or platform providers should, therefore, identify the point at which the corporate, as a buyer, improves its working capital position. The supplier also benefits by accessing early payments at an attractive cost, whether they be cheaper or not very different to the cost they would have to pay to do factoring of those invoices or to get a working capital loan. When subject to these very clear rules, the result is that suppliers will access new forms of liquidity – and unlike with factoring, they will have access to a 100% advance rate, without using their banking lines, and typically at lower costs.
A final Rule 3, which should be adhered to by market participants in order to avoid reclassification, is that the buyer must be blind to and separated from any Reverse Factoring solution offered to suppliers from a financial perspective. The buyer can invite suppliers to participate voluntarily and can explain the potential benefits suppliers may obtain – but the buyer must not participate in any financial discussions the funder may have with the suppliers to offer early payments.
Taken together, these three rules afford significant protection to suppliers from the risk of commercial exploitation from buyers, as the key element is that suppliers must be treated fairly, and that they must not be in an overall worse position after the implementation of a Reverse Factoring solution than before. As with any product, we can never be sure that rules are followed and not overlooked from a governance perspective. However, we do know that market participants, notably banks and corporates, typically adhere to them – especially given that this is an audit point.
At times of stress, will Reverse Factoring make a bad situation worse?
It is a truism that at times of financial stress, credit limits and insurance policies become vulnerable when their providers believe there is a risk of financial impairment. This applies to Reverse Factoring in the same way that it does to a revolving credit facility and other forms of short-term liquidity. Whilst it is true that a funder pulling lines from a corporate may well trigger a renegotiation of trade terms in favour of the supplier, this is equally true when insurance limits are withdrawn in a stressed credit position. The advantage to a supplier is that risk is transferred to a professional that is able to evaluate counterparty risk fully, and that has the capital to absorb the loss in the event of a corporate failure. This is in stark contrast to participants in the supply chain who have less sophisticated credit tools available to them with which to evaluate risk and for whom financial loss will compound the issues created by customer loss, following a corporate failure.
Should Reverse Factoring only be reserved for highly rated customers?
For lower rated customers, supply chain finance programmes provide considerable benefits for suppliers by offering an alternative source of liquidity, as well as transferring collection risk to the funder. The cost of the programme will clearly differ relative to that of an investment grade offering, which means that the value to the supplier must justify the price on offer.
We are seeing an increase in demand for Reverse Factoring amongst lower rated corporates. Our duty of care is to ensure that we structure these programmes with investors who truly understand the risks associated with the programme. Mitigants including credit insurance can be explored. Where credit support is provided by the corporate (such as pledging cash against Reverse Factoring lines), reclassification from trade to financial assets is sometimes required.
Can more be done to improve disclosure of Reverse Factoring programmes?
Our view is that much can be done to improve disclosure of Reverse Factoring programmes so that investors and stakeholders, that rely on credit or equity valuation, are informed as to the risks and benefits that they generate.
This could be achieved by disclosing the SCF facility as a note on Accounts Payable – not as a liquidity risk, but to show full transparency on the potential utilisation of that line by a funder to make early payments to suppliers, through a factoring operation backed by an irrevocable payment undertaking (IPU). In any case, this note should not reflect the outstanding amounts of the facility, in line with the second rule which says buyers should be blind and separated from the financing activity.
What other best practices should be followed to keep the industry safe?
Aside from our three rules, some other examples of best practice include the following:
- Any renegotiation of the commercial terms between a buyer and its suppliers should only affect future transactions and invoices, and not novate existing ones.
- A Reverse Factoring programme with a committed facility, if incurred, should be reclassified as a loan.
- Sufficient cash should be maintained on hand to protect the corporate against the scenario where lines are pulled. This practice can be applied to all forms of uncommitted short-term credit and is associated with prudent risk management.
In summary, we believe it is prudent to derive lessons learned from corporate failures where Reverse Factoring was one source of liquidity, and to take measure as the industry evolves, just like with any other financial product, to keep companies and their investors informed of the risks. In an environment where the acceleration of cash to SMEs is required to fuel growth in an increasingly uncertain environment, we expect the use of Reverse Factoring to increase and keep playing an important role in the economy going forward.
For more information about Demica’s payables solutions click here.
Written by Head of Supply Chain Finance, Enrique Jimenez.