Ratings agencies and regulators have long feared that supply chain finance (SCF) might not survive an economic downturn, not least if liquidity-starved banks start pulling funding lines. However, since the outbreak and rapid spread of Covid-19, demand for SCF has soared and funding appears to have remained resilient. John Basquill examines whether the sector is shedding its risky reputation.
In late 2019, the US’ federal securities regulator set out a series of concerns over the use of reverse factoring by large corporates. The Securities and Exchange Commission (SEC) said the practice – where a provider pays supplier invoices early while granting the buyer extended payment terms – suffers from a worrying lack of transparency.
According to the SEC, as companies are not required to disclose their use of such programmes, investors are often “left wondering how sustainable reverse factoring is as a source of capital”. It added that, at the time, it was unclear whether SCF would survive a “snap-back” in working capital triggered by an economic downturn.
Those warnings were not new to providers of reverse factoring. Earlier that year, the so-called big four accounting firms had written to independent standards-setting bodies requesting they add SCF to their agenda for the following months. The idea was that they could consider formalising rules on how such programmes should be disclosed in companies’ financial statements.
The SEC cited a claim in the letter that clearer disclosure standards would give investors and auditors “a better basis for making informed decisions with respect to the entity’s financial position, liquidity, and cash flows”, and added: “We agree.”
However, since then, the situation has changed. In the first half of 2020, the spread of Covid-19 caused supply chains around the world to grind to a halt, as national containment measures prompted a crash in consumer demand and a dramatic slowdown in shipping and air freight. Working capital was immediately stretched.
At that time, providers of SCF reported a sudden and substantial hike in demand. San Francisco-headquartered Taulia said early payment volumes across its platform increased by more than 200% month-on-month in March, while Atlanta-based PrimeRevenue said the proportion of invoices traded for early payment rose from 77% in January to 93% two months later. Both companies suggested a need for liquidity was behind the surge.
Since then, the trend appears to have continued, including among the larger providers. London-headquartered Greensill said in June that volumes increased by 73% year-on-year during the first quarter of the year, while HSBC’s regional head of global trade for Asia Pacific said in September that SCF volumes were up 50% year-on-year in August.
Credit risk and transparency
For the industry, it should be seen as positive news for SCF’s reputation that soaring demand has generally been met and financing lines have remained resilient – yet authorities have stuck to their cautious approach.
The SEC issued a notice in June urging companies to provide “robust and transparent disclosures about how they are dealing with short and long-term liquidity and funding risks in the current economic environment”, including by considering their reliance on supplier finance programmes.
The SEC notice also asked companies to assess whether SCF arrangements have had a “material impact” on their balance sheets or cashflows, as well as whether payment terms have been changed as a result of the pandemic.
Ratings agencies also remain wary. According to Moody’s analysts, speaking in late April this year, the pandemic-induced spike in demand for SCF was a sign that its earlier concerns could be “coming to life”.
“The short-term nature of these facilities makes the risk that banks pull facilities a primary risk for entities involved in these programmes,” said vice-president and senior accounting analyst David Gonzalez at the time.
“We [also] expect companies to fully utilise these facilities as they look for liquidity,” he told GTR. “This exacerbates a risk by maxing out facilities that are short-term and that do not have certainty for renewal.” When contacted in September, a Moody’s spokesperson said the company’s position had not changed.
But that mood is not necessarily shared by the SCF industry itself. After those remarks, industry insiders reported that examples of banks pulling funding lines were few and far between and that financing was still being obtained relatively easily.
“You could say the supply chain finance industry is having a fairly good pandemic, in that there hasn’t been a mass withdrawal of liquidity,” says Sean Edwards, chairman of the International Trade and Forfaiting Association (ITFA).
“Banks and the big buyers – with government help – have been trying to keep supply chains alive, and that has worked very well. You have to take the good with the bad,” he tells GTR.
Bob Glotfelty, vice-president of growth at Taulia, says that in the long run being “battle-tested” is a good thing for the industry. “We are currently facing a huge economic crisis and the strength of SCF can truly be seen. When we look back in five years’ time, I think we’ll be saying those concerns didn’t really pan out,” he tells GTR. “Hopefully the uncertainty will be put to rest because SCF has proven to be incredibly resilient.”
The issue, then, is what comes next, with ratings agencies continuing to push for reforms around disclosure of SCF programmes.
“The main concern remains the lack of transparency,” says Frédéric Gits, managing director for corporates at Fitch Ratings. “Clearly, in the current context, investors are looking carefully at companies and whether reverse factoring transactions are entered into and not always disclosed.
“That gives the impression that operating cashflows are better than they actually are, and means it may be more difficult for investors to analyse the company. On that front nothing has changed: even if lines have not been pulled, it’s obvious that investors must have good information and there must be transparency.”
Transparency itself is generally not a concern for providers of SCF. As ITFA’s Edwards explains, the fear is that an overhaul of transparency rules could see such programmes accounted for in the same way as traditional bank lending.
“The banking industry does not have an issue with disclosure,” he says. “One of the ratings agencies’ arguments is that the vast majority of these facilities are uncommitted and so can suddenly be withdrawn, but that is actually true of lots of committed lending, like syndicated loan facilities. Those facilities would not be unconditional; they would have terms that could be breached, for instance in times of stress.
“For ratings agencies, that is fine as long as they know about it – but with supply chain finance, the fear is around reclassification, essentially that trade debt would be automatically reclassified as bank debt. That is a much more serious issue; the two should be distinguished from each other.”
Those concerns are not without cause. Fitch’s Gits emphasises: “Our point is not just that supply chain finance is more risky than normal credit lines, but that asking for an extension of terms of payment from a bank as a supply chain finance transaction is exactly comparable to borrowing the money directly from the bank.”
As of press time, standards-setting bodies had yet to issue any guidance and were unable to comment on whether buyers are likely to face similar disclosure requirements to other forms of lending.
GTR understands from sources close to discussions that a prescriptive approach to listing SCF programmes in financial statements is currently considered unlikely, with talks generally centring on either disclosure in notes as a risk to liquidity or no significant change to current guidance.
The pressure on suppliers’ working capital caused by the Covid-19 pandemic has been a significant concern to the business community.
An August paper published by the Harvard Business Review described the lack of stability faced by SMEs as a “less visible crisis deep within supply chains [that] could add to the woes of the global economy”.
“SMEs tend to be the first to feel the effects of financial crises. But their current plight is exacerbated by punitive payment terms that large companies began introducing in the aftermath of the 2008 financial meltdown,” says the paper, authored by academics Federico Caniato, Antonella Moretto and James Rice.
“These practices, in combination with the pandemic crisis, have starved countless SME suppliers of working capital and threaten to trigger a tidal wave of failures.”
Caniato, Moretto and Rice tout reverse factoring as a way of maximising payment terms without causing a squeeze on liquidity further down the supply chain, but add a caveat: buyers must now look to “exploit better data”.
“With massive amounts and new sources of data now available, large firms should be using this resource to better assess suppliers’ health and viability and then help them,” the paper says.
In one example, it cites the use of operational data from suppliers, which was collected by Gucci – the buyer – and shared with the bank providing financing. That meant the banks could accurately assess supplier creditworthiness and, as a result, reduce risk.
The paper’s call for richer data analytics feeds into a trend visible across the wider trade finance industry since the pandemic struck: the need to improve companies’ use of technology.
Daria Johnen, HSBC’s global product head for supply chain finance, tells GTR that a positive outcome of the Covid-19 crisis has been an acceleration in the move towards digitising trade solutions.
“Digitisation will make trade simpler, safer and faster, resulting in better risk management and higher resilience of supply chains,” she says.
“This trend will definitely impact trade finance. It is probably too early to say exactly how the ‘new world’ will look, but we can expect trade finance to continue moving away from paper, bringing higher availability, lower cost, better service.”
For providers of SCF, one of the standout use cases for digital technology is to collect and analyse supplier data for due diligence and onboarding purposes.
“Data is extremely important,” says HSBC’s Johnen. “By better knowing our customers, conducting customer due diligence and undertaking enhanced risk assessments, we are able to identify financeable opportunities within supply chains in ways that would have been inconceivable even 12 to 24 months ago.”
Thomas Dunn, chairman of SCF platform Orbian, agrees that maximising supplier access is “crucial”. “However you want to use data, analytics, scoping and so on, that is all secondary to ensuring that every supplier can access the programme being offered,” he tells GTR.
“Too often data analytics are not about enhancing the experience for all suppliers but a way of cherry-picking the suppliers that people, for one reason or another, prefer to have on the programme.
“That preference might be either that they are big suppliers that will most speedily move the dial on working capital metrics, or they are suppliers that will pay the most for access to early liquidity.”
In some cases, authorities have expressed concerns over how data analytics is used within the SCF sector. Notably, Australia’s small business watchdog has threatened providers with regulatory intervention after accusing some of exploiting data analytics tools.
In an April report, the Australian Small Business and Family Enterprise Ombudsman said it had seen evidence of suppliers being pressured into signing up to programmes that were not in their interest, in some cases aided by the use of artificial intelligence (AI) to “gouge” the greatest possible financial returns.
However, those fears have generally been downplayed by SCF providers, with companies arguing that in the vast majority of cases, AI is used to optimise adoption and maximise access to working capital rather than to exploit suppliers.
Whether Covid-19 will accelerate the use of technology in the provision of supply chain finance remains to be seen, and as ITFA’s Edwards points out, there has “not really been enough time since lockdown to see significant changes in the use of technology in payables programmes”.
“Over the next few months we’ll probably see more changes, for example using technology to make supplier onboarding take place more easily,” he says. “I think technology will enable smoother programmes, programmes that will be ‘platform-ised’, and that’s exciting as historically payables finance has been largely the preserve of the bigger banks and the big programmes.”