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10 March 2021

Guest opinion: Supply chain finance – reputation in tatters? Deserved or just deflection?

Middle East & Africa, Americas, Asia-Pacific, Europe
Deputy Chair at World Trade Board
Supply chain finance and particularly payables finance is back in the spotlight after the news flow on Greensill. Is this the death knell for the product or is it a case of mistaken identity?

Like any victim of a crime, supply chain finance (SCF) practitioners are angry. The crime is that their darling product, payables finance or reverse factoring in the suite of SCF solutions, is being identified as a key suspect, when they believe payables finance is in fact the victim and the real suspects are just deflecting blame. 

The recent press on Greensill and their well-documented problems, along with the hangover from the Carillion and Abengoa bankruptcies, has led to many reputable publications laying the blame at the feet of payables finance (along with the other ‘red flags’ of a company in trouble that seem to be only apparent after the fact). 

The Parliamentary Report commissioned post-Carillion’s bankruptcy summarized:

Carillion’s rise and spectacular fall was a story of recklessness, hubris and greed. Its business model was a relentless dash for cash, driven by acquisitions, rising debt, expansion into new markets and exploitation of suppliers. It presented accounts that misrepresented the reality of the business, and increased its dividend every year, come what may. Long term obligations, such as adequately funding its pension schemes, were treated with contempt. Even as the company very publicly began to unravel, the board was concerned with increasing and protecting generous executive bonuses. Carillion was unsustainable. The mystery is not that it collapsed, but that it lasted so long.

In terms of financing, the report highlights that Carillion forced suppliers to accept 120 days payment terms and offered early discount.  When Carillion went bust, the SMEs who had discounted their receivables had been paid and the supply chain finance providers ended up holding the credit loss.  

It will no doubt be interesting to read the inevitable Parliamentary Report on Greensill if the worst happens and there is a significant impact on the economy and jobs (though, for the sake of the many companies Greensill is financing, the author sincerely hopes a solution is found).  

As to whether people realize that payables finance is not to blame for these bankruptcies and is actually a key part of the solution to enable equitable finance for many smaller companies is yet to be seen. I believe that the truth will come out, and payables finance in the suite of SCF solutions will take its place in positively reducing the finance gap to smaller companies. 

A recent history of SCF

SCF has been used as a catch-all term to describe ‘reverse factoring’ or ‘payables finance’ which is financing of an invoice once the buyer has ‘accepted’ to pay – in other words, the goods or service were delivered to the quality expected, and the buyer is reiterating its commitment to pay on the due date of the invoice.  It has been productised relatively recently in the world of trade finance (~30 years) and we have been seeing evolution and refinement of SCF solutions over the past 5 years. 

In 2016, the industry, through the Global Supply Chain Finance Forum (GSCFF), released Standard Definitions for Techniques of Supply Chain Finance, which defines everything from Reverse Factoring through to Forfaiting and Inventory Finance.  Standards enable the industry to increase transparency and help to remove the uncertainty, ambiguity and lack of clarity when terminology is used in both technical industry discussions and in broader conversations.

The Industry has continued to progress and learn from incidents like the Abengoa and Carillion bankruptcies and we have seen the Bankers Association for Finance and Trade (BAFT) publish a document outlining the principles of payables finance. In addition, a number of accounting firms wrote to FASB and to IFRS, and Rating Agencies sounded the alarm to highlight the risks of SCF. Specifically, they warned that payables finance and its accounting treatment could mislead investors and hide debt. 

In principle, the Rating Agencies’ concerns are valid.  Any company using any technique to hide debt is worrying and speaks to the principles of the company hiding the debt. The GSCFF released a paper highlighting that the misuse of supply chain finance was worrying but not widespread.

The reality is that the warning signs for Carillion were there and highlighted in the summary of the Parliamentary Report. The warning signs for Greensill were there as well – the Financial Times’ Investigative Reports date back over a year (as they did for Wirecard).  Interestingly, the FT’s continuing breaking coverage of the Greensill saga outlines that Apollo/Athene is allegedly in talks to take on Greensill’s most creditworthy clients (the read across from GTR is that these clients are investment-grade multinationals with Payables Finance programmes) and recently acquired Finacity (an invoice securitisation administrator), but not GFG exposures.

If you’ve never heard Margaret Heffernan explain the dangers of wilful blindness, then I would highly recommend spending 15 minutes watching her excellent TED Talk to get a sense of how, despite all the warning signs, it’s human nature to not see what you don’t want to see.

Misunderstanding SCF

It is unfortunate, though perhaps not unexpected, that as the media breaks stories of companies’ downfalls that the detail and role played by SCF is oversimplified and a little one-sided. A story from a top-tier media outlet, as an example, explains SCF as follows to its readers:-

On the face of it, steps 1-4 are simplistically correct.  Step 5 (more an opinion than a step) is misleading at best.  There are many other examples of misunderstanding or misrepresenting SCF, and it is incumbent on the industry to educate stakeholders on the products to ensure the reporting from tier-one media is more balanced.

To appreciate Payables Finance, it helps to think about it from a supplier’s vantage point. As a supplier, imagine you have sold goods to a big buyer and let’s say you have 90-day payment terms. First, you need to finance your raw material purchases and production costs, maximize your credit terms to your suppliers, minimize your inventory and accelerate your cash flow from your buyers, before you cover the remainder with your capital or borrowings.  Generally, payables finance offers the lowest cost financing option (unless you have a cheap loan secured on your assets) and the following cost of finance equation holds: -payables finance < factoring < invoice financing < overdraft < cost of capital

It holds because the supplier risk, seniority of debt and self-liquidating nature of the asset improves from right to left. For example, in payables finance the financier is taking buyer credit risk, but in factoring there is a mix of supplier performance risk and buyer credit risk. The risk is priced accordingly. 

The big hoo-ha that led the Big 4 to write to the accounting bodies was the accounting treatment of payables finance – should it be classified as a trade payable or bank debt?  Rating Agencies & investors worry about bank debt being disguised as trade payables. Obviously, you don’t want to be the auditor who signed off on the accounts of a company that goes bust or the Rating Agency that downgraded the rating too late.  

So, should payables finance be treated as bank debt rather than a trade payable?

This is “Step 5” in the media example above and it is not always a straightforward question to answer. Most payables finance programmes, while agreed and automated with the help of the buyer, are actually the purchase of receivables (or cash flow rights) from the seller.  The discount is paid by the seller.  Sellers don’t have to join the programme – they can finance their business the way they want to.  Usually, the credit period is negotiated separately and sometimes SCF is offered as an additional funding solution to suppliers if they so choose.

Many financiers may wish that their Payables Finance programmes were highly utilised – they have investment grade obligors and generally high returns – the reality is the opposite is true with low utilisation in many programmes. There are of course some programmes that are other forms of structured finance dressed up as Payables Finance and this is the problem that needs addressing.

Accounting bodies have responded to the concerns being raised.  Both the US-based Financial Accounting Standards Board (FASB) and UK-based International Accounting Standards Board (IASB) have taken up the gauntlet. They also met jointly in November 2020 to discuss the issues raised.  

In October 2020, the FASB decided to undertake a project with the purpose to “develop disclosure requirements that enhance transparency about the use of supplier finance programs involving trade payables.” The IASB’s International Financial Reporting Standards (IFRS) Interpretations Committee, having discussed and debated the issue in its meetings since April 2020, in December 2020 concluded not to undertake a standard setting project on Payables Finance explaining:-...that the principles and requirements in IFRS Standards provide an adequate basis for an entity to determine the presentation of liabilities that are part of Reverse Factoring arrangements, the presentation of the related cash flows, and the information to disclose in the notes about, for example, liquidity risks that arise in such arrangements.

The outcome mirrors comments made in the second of two speeches on the subject by Robert J. Comerford of the U.S. Securities and Exchange (SEC) in 2004 where he first encourages preparers and auditors of a company’s accounts to take a close look at the roles, responsibilities and relationships of each party in a structured payable transaction, before taking a step back and looking at the totality of the arrangement.  Is it an intermediation in the trade payable that exists? Or is it something else? 

The quote from Comerford’s speech that continues to resonate with me is: "Pondering this myself, I find that I am naturally drawn to the following conclusions. If a transaction walks, talks and smells like a short term borrowing, it probably is. If a transaction makes smart business/economic sense on its own, without giving consideration to its accounting treatment, do it."

We shall see what FASB decides on their project, but if I were to hazard a guess this quote from Comerford is likely to be the guiding principle.  The key financial institutions that offer SCF have been following this guidance and BAFT’s principles document is an articulation of what those institutions have been doing for a long time.

Most providers of Payables Finance have in place product suitability processes like a deal review that tests a number of parameters prior to offering the product.  These include: -

  • Payment terms being aligned to commercial terms and within Industry Norms

  • Joining a programme is at the choice of the supplier with invoices being paid on due date regardless of whether they are discounted or not

  • The buyer is not a party to the receivable purchase agreement, and no economic value is being transferred to the buyer

  • The buyer is not paying for the financing costs

So, if the SCF programme is financing a one-year payment term on perishable goods to all suppliers where the buyer is paying the interest, then it walks, talks and smells like a loan, whereas if it is financing a 30-day term that is in line with credit terms in the industry and the programme is taken up by 10% of suppliers who pay the discount costs, then it walks, talks and smells like a trade payable.

So, what’s next?

Much of the discussion in the media with respect to supply chain finance on Greensill is around the quality of receivables it has purchased, whether they are current or future receivables or whether they are receivables at all. There are questions as to whether the insurance that is in place for these receivables is enforceable.  

The thing about insurance policies that provide buyer risk cover for receivables is that if the asset is misrepresented then the cover may lapse.  The data shows that trade credit insurance pays even in bad times and non-payment is rare and usually due to the non-fulfilment by the insured entity (the Insured) of an obligation or term under the policy within the Insured’s control.

There has been very little in the media about Greensill’s payables finance programmes other than they are seen as the quality asset that are going to be potentially sold to Apollo/Athene and I am fairly confident that any leading bank would stand in line to take on the lead roles of some of the enviable Payables Finance programmes Greensill has secured over the years.

Over time, the facts will become clearer. Although you could argue that the industry could have perhaps acted sooner and faster, I believe that Payables Finance will not be the villain of this story. 

There will be lessons to be learned, however.  For example: -

  • Banks and SCF providers will need to review their suitability procedures.

  • Technology solutions that increase transparency and end-to-end visibility will become more attractive.

  • Auditors and Rating Agencies will need to ask deeper questions on classification of trade payables and review any programme in the totality of any trade finance arrangements until clearer disclosure guidelines are shared.

  • Regulators will need to start considering whether non-bank providers are becoming more material and require regulation to protect the system.

As a solution payables finance is still in the early stages of its development, and we will see it evolve as technologies such as Blockchain, Artificial Intelligence, IOT and others mature, all of which will allow for greater transparency and improved credit decisioning, not just at the point an invoice is accepted, but much earlier in the working capital cycle. This is going to be only good news for smaller companies that today struggle to access equitable finance.

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