Structure Variations in Export Financing

Background:

?Export factoring is a process by which suppliers can realise their export receivables earlier based on the credit quality of their buyers. This form of financing typically offers several benefits over traditional collateral based financing structures. The limits are normally set up much faster and the quantum of limits can be large enough to support the business growth opportunities available to the exporter. This is a big enabler for the exporter as the business opportunities available are often in excess of the ability to raise finance through the traditional route. Another key benefit is that the structure is off-balance sheet for the exporter and provides protection against the risk of payment default by the buyer.

?Despite the above advantages, export factoring on non-recourse basis is a complex transaction requiring co-operation between multiple parties (buyer, supplier and lender) to operate properly. Unlike a traditional documentary credit, where underlying rules and risk framework are well understood and defined in a water–tight manner, the open account transaction financing structure is more loosely defined. It is similar to crossing a land with shifting sands where the nature of the risk to be overcome may change suddenly.

?Therefore, product design in export financing cannot be mono-lithic or based on a single framework that is implemented on a one size fits all basis. This is likely to result in many good transactions involving strong counter-parties being missed out due to non-compliance with the rigorous documents required in a perfect structure. The purpose of this article is to present to the lender a policy framework for judiciously permitting product variations based on a thorough assessment of the risks of the underlying trade transaction.

?The twin variables: NOA Acknowledgement and Invoice Acceptance

?While export factoring confers several benefits on the exporter, there are certain disadvantage as well. Procedurally, unlike a simple credit limit on the exporter, a non-recourse export facility requires the co-operation of the buyer to execute successfully. This co-operation requires the acceptance of a Notice of Assignment (NOA) which is a notice to the buyer that the receivables have been assigned to the lender and that all future payments on current and future invoices (in case of whole turnover factoring) relating to the specific supplier have to be made directly to the lender.

?In addition to the NOA, there is also a step known as Invoice “Acceptance” which is typically the point in the transaction where the risk and ownership transfers from the supplier to the buyer – at least from the view of the financial lender. This step has the potential to create inherent contradictions as the concept of a formal “acceptance” step may typically not exist in many supply chain processes and thus often needs to be artificially introduced. It is normally the incoterms agreed in the contract between buyer and supplier that would determine the point of risk transfer. While suppliers expect to be funded on a post shipment basis, there are several common incoterms where supplier responsibility extends beyond mere shipment of goods. This essentially means that ‘performance’ in the strictest sense would occur at some future point after shipment so that buyers would provide acceptance (if they agree to do so in the first place) at a later point in the transaction when supplier interest in availing financing may be limited.

The Heisenberg principle:

?The requirement of buyer co-operation on these two aspects of the transaction – NOA acknowledgement and invoice acceptance – often makes these transactions harder to execute. In fact, the better the buyer quality and lower the credit risk, the lower are the chances of compliance with these two transactional aspects – it is practically impossible for the highest rated listed buyers. This may be referred to as the ‘Heisenberg Principle’ of export factoring – the product of the credit quality times the ideal transaction structure cannot be lower than a minimum threshold which basically suggests that we cannot have excellent credit quality and ideal transaction structures going together in this form of financing.

?The above has special implications for designing an export finance product that works with the least friction – these aspects are covered in the next section.

Structure variations:

?Export factoring procedures are determined by the relative strength of the buyer and the supplier. Simply put, it is about the payment ability of the buyer and the performance ability of the supplier. Unlike a loan, there is not an unconditional documented recourse to a specific party and while primary risk is on the buyer, the risk may devolve on the supplier due to non-performance.

Therefore, in the real world, there is a risk spectrum along which various structures may be required to specifically address these risks in an acceptable manner.

?The following two variations may be considered on case to case basis depending on the financial strength of the supplier and buyer and the trading track record between the parties:

?1).?Undisclosed Factoring with Collection Agency Agreement:

?Here, the supplier acts as collection agent on behalf of the buyer and continues to receive funds from the buyer as per normal business practice to be held in trust on behalf of the FI. It is contractually agreed that any Funds so received from the buyer are to be remitted within strict timelines to the FI on whose behalf Supplier is acting as a Collection Agent.

?This is the default arrangement in case of undisclosed factoring where the factoring transaction is done without disclosure to the buyer. However, same must be disclosed in case of overdue and any imperfections in assignability at the time of disclosure (due to non-acceptance of NOA for example) immediately triggers a repurchase event.

?As may be expected, this type of structure is typically acceptable only in case of both the buyer and supplier being strong credits of good standing.

?2).?Post shipment, Pre-acceptance financing:

?Based on the financial strength of the buyer /seller and the trading history between them, invoices may be paid on the basis of a one-time NOA and without acceptance from buyer on transaction to transaction basis. This is required because - as discussed earlier - the point at which risk and responsibility is transferred to buyers may be beyond the shipment date which requires that funding is done prior to Acceptance or alternatively, buyer may not be willing to provide any acceptance at all.

?Pre-acceptance financing structures may typically require higher margins for possible payment dilution and any disputed transaction triggers an immediate recourse event.

Mitigants to Applying Variations:

?The two key elements of a factoring transaction that have to be acceptable to the lender is the credit risk of the buyer and the performance risk of the supplier. Both these risks must be acceptable to the lender for a Receivable Purchase transaction to be even contemplated.

a).?Credit risk of buyer:

?The credit risk of the buyer will be determined by the lending policies of the lender and their internal credit processes relating to whether they directly underwrite the buyer based on available financial data or rely on credit insurance – either way, this will be assumed as being acceptable to the lender and will not be discussed in detail here.

b).?Performance risk of Supplier:

?The performance risk of supplier is harder to ascertain and lenders may not have a firm policy around this process. However, in considering the acceptability of structure variations, firms must take into account supplier performance risk and create a well thought out policy in this regard.

?This policy must include, inter alia, the following:

?a). Number of years of Supplier experience in the line of business.

b). Supplier standing & reputation in the industry.

c).?Volumes exported earlier in similar business line.

d).??Technical Complexity of the product and scope for rejections.

e). Quality certifications held by the Supplier.

f).?Quality checks done in-line by buyer and on supplier premises to minimise rejection losses.

g).?Analysis of sales ledger data showing earlier transaction history of delayed payments as well as payment dilutions with the same or similar buyers.

?Hence, once the buyer credit risk and the supplier performance risk are found acceptable, the key is to have a matrix to determine which variation is suited to a specific transaction. The factor which determines this should be the credit risk of the Supplier – undisclosed transactions for excellent credit quality suppliers, pre-acceptance transactions for acceptable credit quality suppliers and no structure exception for low credit quality suppliers. The exact threshold for classification of suppliers into low, medium and high risk is left to the lender's specific risk policy and tolerance levels.

Conclusion:

?The above provides one policy framework for adopting a more flexible approach to non- recourse export financing. The model can be adopted directly or with some variations and can be further refined over time based on transaction experience and improved understanding of trade dynamics. However, the key message is the recognition that judiciously implemented variations in export factoring can lead to better business opportunities without compromising transaction risk and controls.