What to consider when investing in a trade receivables portfolio?
Bruno Botelho
Director at Originate Capital | Working Capital Financing | Receivables Finance | Factoring | Invoice Discounting
Receivables financing is one of the oldest forms of lending. What has traditionally been a bank or factor business is now, due to accessible securitization, a common way for banks, platforms, and treasuries of Fortune 500 companies to offload debt, finance companies and reduce borrowing costs.
According to Jim Leonard, former managing director of Finacity, “it has been almost 30 years now since the first securitizations of trade accounts receivable were structured and placed with investors in the U.S.”. But despite the three decades, banks have not been able/willing to boost this investment class until they were somehow forced to. After the 2008 financial crisis, regulators pressed banks to reduce their loan books and increase compliance and KYC/AML checks. During the same time, international trade flows grew and became more complex, but the banking industry and the tighter regulation didn't cater to SMEs’ needs. The traditional borrowing-based approach was still the answer that fast-growing businesses were receiving. This gave space to light-asset lending platforms to flourish. The non-bank Greensill recently received another US$655 million from Softbank which shows how the originate-to-distribute model still has a lot of room to grow. This is especially true in countries where there is a huge demand for trade finance solutions such as China, India, Brazil, and regions like APAC and MENA.
I would argue that this growth of receivables as an asset class is not just a result of the lower set-up costs of securitization or more recent technology brought by fintechs. Rather, the unprecedented cash accumulation and BCE’s negative interest rates, and the trade war sustaining the growth in demand from institutional investors looking for annualized yields that can range from 3-5% in Europe and 8-12% in Asia.
How to evaluate the credit-related risks of a trade receivables portfolio?
While sitting on the balance sheet of a supplier an invoice is an asset capable of being secured using credit insurance. Although a portfolio approach, i.e ‘wrap’ the portfolio and obtain insurance from AIG, Heuler or others, is typically the best to go.
A credit insurer will typically take the senior tranche leaving 20% un-secured. For that reason, when structuring a supply chain finance program, we invite the Obligor to take the junior tranche and add an extra layer of comfort to the investor(s).
Nevertheless, the measure of the judgment of an investor goes beyond default events. Looking at the historical performance of the portfolio might bring some questions to existing eligibility criteria, allocation per obligor and dilution ratio. I will not add too much complexity or focus on a specific type of portfolio but rather identify some of the most common risks:
(The risks that appear below are not listed in order of importance)
Commingling of cash
Commingling is defined by the Cambridge dictionary as "To mix an amount of money belonging to one person, business, or account with that of another when the money should have been kept separate".
Trade receivable portfolios exhibit higher rates of payment and turnover than other asset types, so commingling risk takes on special importance. In order to avoid money being held in the event of bankruptcy obligors should be instructed to 1) make payment to a lockbox account, 2) all lockboxes should be transferred to a Special Purpose Vehicle (SPV), 3) the lockboxes should be swept daily to an account that is established at a reputable bank, and 4) the servicer should see its access limited to either the lockbox or sweep accounts.
Arrival
The arrival of the container(s) is typically when the client will calculate the dilution on an invoice, i.e. a reduction to a receivable balance that is not attributable to default or write-off. Dilution risk does not derive only from product return or damages but from advertisement allowances, volume rebates, or good customer programs. As dilution can have different time horizons and can change according to industry and management philosophy, it is important to understand how a portfolio of receivables can be impacted by it.
Carrying costs
The carrying costs of running an SPV should include a reserve yield sized to assume volatility and length of day’s sales outstanding (DSO), losses and frequency of investor interest payments. In these costs a reserve will be made for ‘anticipated payment defaults’ and ‘dilution events’, which can occur when customers’ payments might be reduced for unanticipated commercial reasons. I will not expand on this as most investors will not run their own SPV, but it important to note that an investor may be called to pay a higher servicing fee over time.
Obligor Default Risk
The obligor is by far the main risk that a portfolio of security-backed assets is subject to. We should look at Obligor's risk of delinquency and in the worst-case-scenario, risk of default. Historic delinquency and write-off performance generally are the best indicator of portfolio credit quality. Most companies carry delinquent trade receivables far longer than a bank would before writing them off. This can be viewed as a positive because recovery processes are usually taken till all options are considered. On the other hand, there are different incentives in play and this can lead to data manipulation. An analyst with a trained eye will breakdown delinquency rates by product, seller, payment terms, month, etc.
Seller
Structured finance allows the risk of default to be isolated to the asset and not linked to the bankruptcy of the seller (or the SPV). Nevertheless, the seller plays an important role in the performance of the portfolio. First, the collection of receivables usually stays with the seller. Second, the dilution rate can increase if the seller is going through a difficult financial period or its interests are not fully aligned. Third, if the seller is at the risk of default the obligors could feel less motivated to honor their payments.
Modeling risk is somehow an ungrateful process as so many unforeseen situations can arise. Luckily modern technologies such as digitalization and database interoperability bring us new possibilities, namely originate portfolios of receivables in countries outside of the OCDE. As secondary market liquidity improves, price discovery will allow a larger and more diverse base of investors. From risk-averse life insurance companies and pension funds to opportunist hedge funds and family offices, investors are looking at this asset class as a way to mitigate the risks associated with the downward turn of the economic cycle.
How do you see this asset class performing in 2020? Feel free to leave your comments or questions below.
Good piece Bruno. Trade as an asset class is in reality a private placement market. As a group, we investors tend to apply an uncritical eye to asset classes, and accept them as they come to us. In terms of narrative, Trade Finance as an Asset Class punch way above their weight in narrative land - in the area of a Cannabis ETF. Questions we rarely ask in more than a perfunctory manner: ? Do they refer to any sensible organization of securities with similar underlying traits? ? Are they subject to features at the arbitrary power of an organization deciding where they belong? ? What are investors actually buying? What rights do they have? There are no League Tables to help put any of this in perspective. No one knows how big this market really is, everyone has their different sausage factory.