Supplier finance: a brief background
In a traditional commercial terms negotiation, Buyers and Suppliers have conflicting objectives: Buyers want to pay as late as possible while Suppliers want to collect their money at the earliest. Supply chain finance programmes ease this tension by separating the payment date from the collection date. Suppliers can get their money early (reducing their days sales outstanding) as a bank provides financing for the period from the payment date to the collection date. The cost of financing is usually borne by the Supplier. However, the superior credit rating of the Buyer ensures that the cost of funds is lower than is available to the Supplier under normal circumstances.
The underlying trade flows in supplier finance are continuous as the Supplier sells goods on an on-going basis to meet the Buyer’s manufacturing requirements. The tenor of invoices can differ depending on agreed terms with various Suppliers and acceptance dates. Consequently, there is a high reliance on operations to manage discounting of invoices and collection of funds at maturity on daily basis.
Since a supplier finance facility for discounting account payables is legally an uncommitted facility based on the Buyer’s irrevocable payment instructions, the Buyers and Suppliers want relationship banks to be involved to ensure continuity of their business and availability of bank finance irrespective of the market conditions.
Requirements of various supplier finance parties In a Supplier finance programme, the Buyer and Suppliers necessarily have different needs. The key requirement for the Buyer is continuity of its business and vendor/Supplier management in order to safeguard its manufacturing process. Buyers want to be able to continue showing underlying purchases as accounts payable rather than converting them to debt and have a preference for not signing any additional documentation. All collections and payments for the Buyer must be via one operating account with the Seller Bank which should also be the supplier finance platform provider.
Suppliers’ requirements are relatively straightforward. They want to get paid upfront for their invoices with no recourse basis from the Seller Bank and/or any Investor involved in the supplier finance programme. Most important is the availability of credit and discounting facilities on an ongoing basis to ensure a smooth manufacturing process and enable reliable forecasting of cash-flows.
Investors’ objectives in a supplier finance programme are principally to optimise returns on capital or equity. Additional requirements include full disclosure to the Buyer/obligor given that the paper is not rated and direct recourse to the Buyer/obligor. All Investors and the Seller Bank should be ranked pari passu with the Buyer in the event of default. As Investors’ participation is funded, it is imperative that there is no settlement risk on Seller Bank.
The Seller Bank needs to play an imperative role in meeting the Buyer’s, Suppliers’ and Investors’ requirements. In addition, it must also provide off-balance sheet solutions for all supplier finance assets sales, have the ability to sell-down at regular intervals, be able to manage its credit and liquidity exposure under each programme, and simultaneously service its clients’ needs on an on-going basis.
What solutions are possible? There are three basic structures to sell-down supplier finance assets in the secondary market: assignment; promissory notes; and trust.
Under an assignment structure, each invoice is specifically identified to be sold-down for 100% of its value to the Investor. After acceptance of the invoice by the Buyer, the Seller Bank discounts the invoice for the Supplier and then assigns the specific invoice in favour of Investors prior to their funding.
The advantages of an assignment structure are that Investors’ participation is fully disclosed to the Buyer – therefore there are relationship benefits – and Investors have a 100% share in a specific invoice. In addition, the assignment of invoices to Investors occurs before funding.
The disadvantages of an assignment structure are that each invoice must be acknowledged by Buyers to ensure legal assignment, making the process onerous for the Buyer. Moreover, the Buyer does not want to change its payment process and the Seller Bank needs to act as a collection agent on behalf of the Investors.
Under a promissory notes structure (Diagram 1), Buyers issue notes on acceptance of invoices. Promissory notes could be for each invoice and/or a collection of invoices with a specific maturity date. The Seller Bank discounts these promissory notes to pay Suppliers upfront and then sells them to Investors.
The principal benefits of the structure are that promissory notes are a tradable instrument, enabling liquidity in the secondary market for Investors. The drawback of using promissory notes is that each note needs to be physically presented to the Buyer to get payment at maturity, which is operationally cumbersome. Furthermore, additional documentation is required from the Buyer to issue promissory notes. A promissory notes structure also results in an accounting conundrum: how should the Buyer account for invoices and promissory notes on its balance sheet that pertains to same purchases of underlying goods?
While a trust structure involves a Seller Bank discounting accounts receivables to a Supplier and placing the receivables from the Buyer into a trust account, the trust then uses the specific Master Risk Participation Agreement (MRPA) customised for supplier finance programmes, to sell down 100% of the outstanding invoices to each Investor and the Seller Bank participate on a pro-rata basis into the trust.
A trust structure (Diagram 2) has a transparent sell-down process from a Buyer’s and Supplier’s perspective as it requires no additional documentation. It is operationally efficient for Investors as they sign participation agreements only. Moreover, if the provisions of transferability can be added to customised supplier finance MRPA, these assets can also be tradable, enhancing liquidity as well.
(See Diagram 2) Shortcomings of a trust structure are that it is a time consuming process with intensive initial work that needs to be concluded before execution. It also entails a one-off large external legal fee to create customised participation documentation and achieve true sale. A trust structure also entails an additional fee for a trust account and its management.
The way forward
Given the current constraints in the international banking system and the importance of supporting growth of the supplier finance business, the creation of a secondary market for supplier finance assets – with standardised terms and conditions to bring various partners together – is essential. Key to achieving this is standardising the underlying MRPA for supplier finance assets via independent bodies such as the Bankers Association for Finance and Trade (BAFT) or other similar organisations, which will make it easier for banks and Investors to negotiate documentation.
Additionally, transferability provisions need to be included as part of the supplier finance MRPA so that banks can trade supplier finance assets between themselves and create liquidity in the secondary market for this new asset class. Work must also be done to educate an alternative investor base of hedge funds, pension funds and insurance companies about the merits of supplier finance assets and their ability to invest in this short-term self-liquidating asset class, which in-turn will lead to expansion of the secondary market for supplier finance paper.
At the same time, banks must increasingly work together in “club” deals in order to facilitate increasingly large supplier programmes that are large for any one bank to manage on overall basis.
The changing requirements of the market is expected to lead to certain banks, such as Citi, focusing on providing electronic platform for supplier finance programmes to their clients with cutting edge operations to process multiple transactions on an on-going basis and help create economies of scale to clients. Other banks and alternate investors can minimise their operational costs by not replicating supplier finance platforms/technology while continuing to support their client relationships by focusing on funding supplier finance assets like in syndicated facilities.