Supplier finance: a brief background

In a traditional commercial terms negotiation, Buyers andSuppliers have conflicting objectives: Buyers want to pay as lateas possible while Suppliers want to collect their money at theearliest. Supply chain finance programmes ease this tension byseparating the payment date from the collection date. Suppliers canget their money early (reducing their days sales outstanding) as abank provides financing for the period from the payment date to thecollection date. The cost of financing is usually borne by theSupplier. However, the superior credit rating of the Buyer ensuresthat the cost of funds is lower than is available to the Supplierunder normal circumstances.

The underlying trade flows in supplier finance are continuous asthe Supplier sells goods on an on-going basis to meet the Buyer'smanufacturing requirements. The tenor of invoices can differdepending on agreed terms with various Suppliers and acceptancedates. Consequently, there is a high reliance on operations tomanage discounting of invoices and collection of funds at maturityon daily basis.

Since a supplier finance facility for discounting accountpayables is legally an uncommitted facility based on the Buyer'sirrevocable payment instructions, the Buyers and Suppliers wantrelationship banks to be involved to ensure continuity of theirbusiness and availability of bank finance irrespective of themarket conditions.

Requirements of various supplier financeparties In a Supplier finance programme, the Buyer andSuppliers necessarily have different needs. The key requirement forthe Buyer is continuity of its business and vendor/Suppliermanagement in order to safeguard its manufacturing process. Buyerswant to be able to continue showing underlying purchases asaccounts payable rather than converting them to debt and have apreference for not signing any additional documentation. Allcollections and payments for the Buyer must be via one operatingaccount with the Seller Bank which should also be the supplierfinance platform provider.

Suppliers' requirements are relatively straightforward. Theywant to get paid upfront for their invoices with no recourse basisfrom the Seller Bank and/or any Investor involved in the supplierfinance programme. Most important is the availability of credit anddiscounting facilities on an ongoing basis to ensure a smoothmanufacturing process and enable reliable forecasting ofcash-flows.

Investors' objectives in a supplier finance programme areprincipally to optimise returns on capital or equity. Additionalrequirements include full disclosure to the Buyer/obligor giventhat the paper is not rated and direct recourse to theBuyer/obligor. All Investors and the Seller Bank should be rankedpari passu with the Buyer in the event of default. As Investors'participation is funded, it is imperative that there is nosettlement risk on Seller Bank.

The Seller Bank needs to play an imperative role in meeting theBuyer's, Suppliers' and Investors' requirements. In addition, itmust also provide off-balance sheet solutions for all supplierfinance assets sales, have the ability to sell-down at regularintervals, be able to manage its credit and liquidity exposureunder each programme, and simultaneously service its clients' needson an on-going basis.

What solutions are possible? There are threebasic structures to sell-down supplier finance assets in thesecondary market: assignment; promissory notes; and trust.

Under an assignment structure, each invoice is specificallyidentified to be sold-down for 100% of its value to the Investor.After acceptance of the invoice by the Buyer, the Seller Bankdiscounts the invoice for the Supplier and then assigns thespecific 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 arerelationship benefits – and Investors have a 100% share in aspecific invoice. In addition, the assignment of invoices toInvestors occurs before funding.

The disadvantages of an assignment structure are that eachinvoice must be acknowledged by Buyers to ensure legal assignment,making the process onerous for the Buyer. Moreover, the Buyer doesnot want to change its payment process and the Seller Bank needs toact as a collection agent on behalf of the Investors.

Under a promissory notes structure (Diagram 1), Buyers issuenotes on acceptance of invoices. Promissory notes could be for eachinvoice and/or a collection of invoices with a specific maturitydate. The Seller Bank discounts these promissory notes to paySuppliers upfront and then sells them to Investors.

The principal benefits of the structure are that promissorynotes are a tradable instrument, enabling liquidity in thesecondary market for Investors. The drawback of using promissorynotes is that each note needs to be physically presented to theBuyer to get payment at maturity, which is operationallycumbersome. Furthermore, additional documentation is required fromthe Buyer to issue promissory notes. A promissory notes structurealso results in an accounting conundrum: how should the Buyeraccount for invoices and promissory notes on its balance sheet thatpertains to same purchases of underlying goods?

While a trust structure involves a Seller Bank discountingaccounts receivables to a Supplier and placing the receivables fromthe Buyer into a trust account, the trust then uses the specificMaster Risk Participation Agreement (MRPA) customised for supplierfinance programmes, to sell down 100% of the outstanding invoicesto each Investor and the Seller Bank participate on a pro-ratabasis into the trust.

A trust structure (Diagram 2) has a transparent sell-downprocess from a Buyer's and Supplier's perspective as it requires noadditional documentation. It is operationally efficient forInvestors as they sign participation agreements only. Moreover, ifthe provisions of transferability can be added to customisedsupplier finance MRPA, these assets can also be tradable, enhancingliquidity as well.

(See Diagram 2) Shortcomings of a trust structure arethat it is a time consuming process with intensive initial workthat needs to be concluded before execution. It also entails aone-off large external legal fee to create customised participationdocumentation and achieve true sale. A trust structure also entailsan additional fee for a trust account and itsmanagement.

The way forward

Given the current constraints in the international bankingsystem and the importance of supporting growth of the supplierfinance business, the creation of a secondary market for supplierfinance assets – with standardised terms and conditions to bringvarious partners together – is essential. Key to achieving this isstandardising the underlying MRPA for supplier finance assets viaindependent bodies such as the Bankers Association for Finance andTrade (BAFT) or other similar organisations, which will make iteasier for banks and Investors to negotiate documentation.

Additionally, transferability provisions need to be included aspart of the supplier finance MRPA so that banks can trade supplierfinance assets between themselves and create liquidity in thesecondary market for this new asset class. Work must also be doneto educate an alternative investor base of hedge funds, pensionfunds and insurance companies about the merits of supplier financeassets and their ability to invest in this short-termself-liquidating asset class, which in-turn will lead to expansionof 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 supplierprogrammes that are large for any one bank to manage on overallbasis.

The changing requirements of the market is expected to lead tocertain banks, such as Citi, focusing on providing electronicplatform for supplier finance programmes to their clients withcutting edge operations to process multiple transactions on anon-going basis and help create economies of scale to clients. Otherbanks and alternate investors can minimise their operational costsby not replicating supplier finance platforms/technology whilecontinuing to support their client relationships by focusing onfunding supplier finance assets like in syndicated facilities.