Never have fragmented reactions, as seen to recent global crises, be that Covid-19, climate change or geopolitical power shifts, illustrated better the acute need to have sustainable strategies in place.
We have seen a proliferation in solutions for working capital, typically addressing businesses’ immediate or limited financing needs. These solutions comprise securitisation, factoring, invoice discounting, supply chain and inventory finance, among others. In view of the global drive for sustainable finance, there is a strong case for examining these solutions holistically and strategically, as they apply to a business’ working capital framework.
Before diving into the details of specific working capital solutions, several recent phenomena need to be considered, when forming a strategy:
Oversell of Supply Chain Finance (SCF)
This solution has achieved significant notoriety in recent years, supported by new providers with technical platforms for streamlining the onboarding of suppliers. However, SCF, when offered in an unrestrained manner, can have dire consequences. It was most remarkably illustrated by the downfall of Greensill Capital, with the perceived key causes being the weak and unproven credit quality of their clients (‘the buyers’), the intertwined ownership structure between the buyers and suppliers, and the invalidity of the payables funded. Funding was understood to have taken place against purchase orders or even worse, future flow, rather than against invoices for which there had been a delivered product or service.
Decentralised Finance (DeFi) and Cryptocurrency Exchanges – government interventions
The growth in digitalisation of trade through Distributed Ledger Technology (DLT) is bringing transparency, funding source diversification, increasing liquidity, sustainability, and cost-efficiency to securitised finance. However, this is raising government and regulator concerns with respect to circumventing capital controls, money laundering and the purchase of illegal goods and services. Governments are also taking steps to protect investors, increasingly exposed to cryptocurrency volatility and theft through exchange systems hacking. Notwithstanding, this technology is delivering new concepts:
- Blockchain networks have permitted companies to share openly information on their trades, on a single data network across counterparties, allowing equivalent visibility and verification
- Decentralised Finance (DeFi), linked to Blockchain, has seen exponential growth in recent months, providing securitisations better access to new and diverse sources of finance
- The use of Smart Contracts has permitted digital representation of contract terms, increasing speed, accuracy and reducing costs
- Tokenisation has provided a secure currency for trading real-world assets issued through Blockchain
The Prominence of Environment, Social and Governance (ESG)
Investors are increasingly seeking ESG compliance in mobilising their funds. This has meant that companies able to demonstrate their ESG credentials are accessing greater liquidity on more favourable terms. More and more, this is leading companies to acquire official ESG ratings for their business in advance of restructuring or obtaining new finance.
The drivers for a sustainable working capital strategy
As funding solutions are explored, there are several considerations to address when formulating a sustainable working capital strategy. My experience with clients over the years has led to the following key observation:
- Need to protect against future economic downturns: Funding is often sought when a business is financially strained. This may be due to internal business or external economic factors. While counterintuitive, there is merit in securing funding when a company is in a position of strength and funding is least needed.
- Limit dependency on existing funding sources: The concept of relationship banking has prospered over the years, providing a sense of comfort that bank relationships will be there to support businesses when most in need. This reassurance has often run hollow causing disappointment and undue businesses distress. The proliferation of non-bank alternative lenders allows for diversification and the spread of this risk. Furthermore, DeFi has unlocked an additional dimension for funding source variation.
- Capacity to support business growth and geographic expansion: As businesses develop into non-traditional and emerging markets, access to working capital, in support of these markets, can often prove more challenging. There is merit in a company anticipating this demand and securing the relevant additional funding when obtaining funding for its core business.
- Ability to maximise liquidity, when needed: Stringent eligibility criteria against receivables or payables can result in significant reductions in the ultimate level of funding. These exclusions, which may apply to certain geographies, payment terms, currencies, concentrations, etc., require careful evaluation to limit their adverse impact.
- Mastering Delinquency and Dilution: Delinquency is typically measured when invoice payment is more than 60 days past its due date, after which the invoice is considered ineligible for funding. Poor previous invoice payment and collection performance may also have a detrimental effect on the funding advance rate against eligible receivables. A similar dynamic applies to dilution, when the ultimate collection on an invoice differs from the original invoice amount, due to disputes, commercial discounts, or shortfalls in the delivered product or service. Again, high levels of historic dilution are likely to have a negative impact on the funding advance rate. Purposeful steps may be taken early in the process to track effectively and minimise invoice delinquency and dilution.
- Ensuring funding cost stability and control: Overall, recent interventions by the leading Central Banks, easing business access to funding, has reduced the concern placed on funding availability and pricing. Notwithstanding, securing funding at pre-agreed pricing, over a set timeframe, can mitigate funding availability and pricing risk. Financial instruments may also be used to secure fixed interest rates and hedge borrowing currencies.
Conventional working capital solutions
There is a range of working capital solutions to consider when formulating a strategy. These are typically offered by global banking groups, but increasingly by alternative finance providers. The solutions are best categorised and evaluated individually as they may apply to a business:
Securitisation is a mechanism for companies to raise capital against their portfolios of receivables. Typically, the receivables are sold to a Special Purpose Vehicle (SPV) on a non-recourse basis. Using the receivables as collateral, the SPV is structured to issue Investment Grade notes to raise funds for the company.
Securitisation brings a range of benefits, including:
- Competitive pricing
- A medium-term funding commitment, often easily extended
- Methodology which maximises the advance rate
- A structure with minimal restrictive and financial covenants
- A solution in which other assets are unencumbered
- Potential for risk mitigation and off-balance sheet treatment
Factoring and invoice discounting
Factoring (with or without recourse) and invoice discounting are considered simpler means of funding receivables and best considered when:
- The receivables pool is relatively small or composed of a small number of buyers
- A company is seeking to fund invoices on an individual and select basis
- There is approved credit insurance limit cover on the receivables
- Invoicing is from jurisdictions in which invoice factoring legislation is well established
- The time to funding is more important than the transaction pricing
- Off-balance sheet treatment may be of interest
Supplier and payables finance
Supplier and payables finance is a means of using the credit strength of a buyer to obtain extended payment terms, while securing cheaper finance for its suppliers. Often, particularly for international trade, this is achieved through the funding of Letters of Credit (LCs) issued by the buyer’s bank for the benefit of the supplier. LCs are typically issued on a supplier-by-supplier or trade-by-trade basis.
As an alternative, supply chain finance (SCF) has recently been gaining prominence, permitting a more streamlined, all-inclusive, and cost-efficient supplier financing option. While SCF relies on the credit strength of the buyer, there has been increasing use of single buyer credit insurance cover when the credit strength of the buyer alone is insufficient in providing comfort to the funding source. Also, SCF moves the due diligence and risk assessment processes away from an LC issuing bank, placing the responsibility on the SCF onboarding platform and funding source, respectively.
Secured inventory finance
In seeking finance against inventory, crucial determinants are the attributes of the product concerned. Principally the product should be non-perishable, have a secondary tradeable market and can be warehoused and accessed securely. Typically, such financing works well for certain commodities, especially if traded on a listed exchange. When taking a view on warehousing, its location in terms of jurisdictional enforceability is of major importance.
Also, unlike receivables, the asset value of inventory is not static. While an invoice has a fixed amount owed against it, the value of inventory, commodity or otherwise, fluctuates based on market conditions. This often results in the funding source offering a significantly lower advance rate against the current inventory value.
An asset-based loan (ABL) is most appropriate when a company wishes to monetise a range of asset classes, including receivables, inventory, equipment, and other property in a single funding facility. ABLs are structured as secured loans with a charge on the company’s selected assets. Typically, an advance rate is established for each of the asset classes, against which the loan may be drawn.
The main benefits of ABLs are speed and simplicity, although these benefits may be counterbalanced by higher pricing and a lower overall advance rate. Also, an ABL does not allow for off-balance sheet treatment.
This form of financing is most developed and widespread in the USA and UK, although it is becoming increasingly available in a selection of EU countries, notably Germany.
Hybrid and creative alternatives
While the above working capital solutions are widespread, a range of hybrids and creative alternatives, applicable to specific business sectors, have evolved more recently and are being offered by non-bank lenders:
Product as a service finance
Product as a Service Finance transforms what would be a capital expenditure into the purchase of a service. In this solution, a third-party conduit purchases the product from the supplier and offers usage rights to the customer. One of the key benefits is the accounting treatment for both the supplier and customer. For the supplier, sale recognition is immediate. For the customer, the accounting treatment of the purchase is as an expense rather than a purchased asset. In this solution, repayment is secured through credit insurance rather than the residual value of the product, as is the case with operating leases.
Inventory finance with a Standby Letter of Credit
Inventory finance is often sought by companies with a strong credit rating and easy access to cheap alternative forms of finance, with their motivation being the off-balance sheet accounting treatment. In these cases, the funding sources gain comfort from repayment guarantees offered by the company, attaching less importance to the attributes of the inventory itself.
A similar solution is now being made available to weaker companies, using a Standby Letter of Credit (SBLC). The SBLC, issued by a relationship bank, is structured to pay out if the inventory finance contract conditions are not fulfilled by the company, providing the funding source with the necessary level of comfort.
Marine Bunker Fuel Finance
This structure, which is dependent on unique maritime law, provides shipping companies with a cost-effective means of funding their purchase of bunker fuel. While the rights exist to collect money owed against the unconsumed fuel, maritime law also allows for the seizure of the implicated ships and for having the company’s other assets monetised, including the ships themselves, to pay off the debt.
Intermodal Trade Finance
This concept, being piloted with a selection of leading container shipping groups, provides their customers with financing, collateralised by the good being shipped. The funding period may begin as soon as the goods are in the possession of the carrier and ends no later than the time of final delivery. During this time, the goods may be docked at a terminal or in transit, be it by rail, road, or sea.
Funding is provided by the funding source in collaboration with the carrier, with the knowledge that goods can be seized if the loan is not repaid prior to the final delivery of the goods.
The loan amount is based on several factors including:
- the perceived value of goods being shipped;
- the ability to monetise these goods, should the need arise; and
- the credit strength of the borrower.
The landscape for working capital is changing rapidly, both in terms of the needs and solutions being offered. Awareness of these changes and the ability to set strategies benefiting from them will prove a differentiator in a company’s ability to react quickly and resourcefully.