Jump into the pool
The arrival of pooled securitisations in supply chain financing solutions illustrates a continuing maturity and development of the supply chain business. A financing strategy is emerging in supply chain finance backed by the trade payables of a diverse set of buyers. Avarina Miller, Senior Vice-President at Demica, the supply chain consultancy, explains more.
Enormous attention has been paid to making the supply chain more efficient over the last 20 years, to the extent that little more refinement is possible. As a result, focus has now shifted to financing matters, where potential still exists for further streamlining.
Commercial bankers, along with their securitisation colleagues, are developing innovative asset-backed financing solutions that are helping to release cashflow in the supply chain, while also extending payment terms.
In these solutions (usually backed by trade receivables), large buyer organisations are ‘lending’ their credit rating to smaller supply-side firms in order to raise finance at reasonable rates.
The bankers’ view
Supply chain finance is generally viewed as the province of a commercial bank’s lending arm. In industries where efficiencies in the physical supply chain have been refined to the utmost level, attention has now moved to the financial supply chain.
Relationship banks offer a working capital management facility for their large corporate clients (product or service buyers, “buyers’), while at the same time providing prompt payment facilities for their suppliers.
Much in the same way as a factoring arrangement, the buyer benefits from extended payment terms, whilst its suppliers receive early payment. The result is abundant activity around financing solutions that allow buyers to ease payment terms while also ensuring that their suppliers’s cashflow is improved, thus reducing or avoiding instability in the supply chain.
Most recently, however, a partnership has begun to emerge between the commercial lending arm of a bank and its securitisation colleagues. Commercial banking certainly has, and will continue to manage the overall relationship with clients for whom it organises a whole range of credit facilities, treasury management, custodian services, and other services; including supply chain financing solutions as one element of this range.
On the other hand, securitisation colleagues are beginning to find themselves enlisted to structure, manage and execute these supply chain finance solutions, as they are in effect ‘reverse securitisations’.
With Basel II just over the horizon (which may change elements of the process), there is steadily increasing interest from US and international banks in finding additional methods of intermediating between borrowers and the capital markets. At present (although rules may change over time) current accounting regulations allow securitised assets to remain off balance sheet for banks running a conduit.
While the underlying risks having been in part passed to the capital markets (bar liquidity facilities and backstop guarantees), the bank’s usage of regulatory capital is reduced when compared to traditional balance sheet lending.
Supply chain finance is one area where a few pioneers have introduced just such an intermediation, in the form of pooled payables securitisation, issued to the markets as commercial paper through one of the bank’s existing, or specifically established, conduits.
A number of buyer organisations can be gathered together by the bank, then a pool of invoice debt can be created which is sufficient for a payables securitisation programme. This has been the case so far with a number of US and Nordic banks. The aggregated debt allows the bank to securitise a diversified pool of buyer obligations.
In these circumstances, banks have found it advantageous to reduce their capital exposure by securitising the debt effectively out to the capital markets. The price for the buyer community (corporate buyers of goods and services) may remain the same or less, but the bank has found that it can set aside less capital in the process. The element of economy pass-through that the bank decides to make in this structure is at its own discretion.
A financing strategy is therefore emerging in supply chain finance backed by the trade payables of a diverse set of buyers. Here, the credit quality of the large corporate buyer is virtually identical to the quality of the outstanding debt being issued into the markets (before any credit enhancements), and will affect the credit quality and price of the paper so issued.
This should provide the smaller suppliers with positive financing arbitrage, allowing them to effectively divorce their borrowing rate from their own credit rating (if they have one) and obtain cheaper financing based on the buyer’s cost of funds.
What is the advantage for the buyer community
- Well, by clubbing together under the aegis of a multi-buyer payables securitisation, they collectively benefit from the efficiencies of reduced bank regulatory capital, which may translate into even more efficient pricing. Certainly, banks will find this strategy more appealing when compared to traditional balance sheet lending.
Securitisation in the supply chain has been much discussed, but – until recently – little executed. Up to a few years ago, the idea of a pooled (multi-company) securitisation of trade payables was not considered economic or practical.
However, systems are now well established to effectively automate the collection of data from the buyer companies, track the payables and produce the relevant settlement reports. Furthermore, all this is possible across a multi-company, multi-currency, multi-jurisdiction and multiple time zones (Citigroup’s report: Optimising the Supply Chain, May 2006.
The corporate’s view
So much for the banker’s perspective on the issue of supply chain finance. What about the corporate angle
- During a period of industrial slowdown, every management team knows that cashflow can make or break a business.
For the purposes of illustrating the corporate side of the emerging supply chain finance situation, we have concentrated on the manufacturing sector, mainly because releasing cash flow in these relatively low margin businesses makes far more impact on commercial viability than in the service sector.
So for the US and UK manufacturing sectors, cash management has soared up the agenda in recent times. Both geographies are unquestionably experiencing pressures, although they differ.
Figures published earlier this year by the Institute for Supply Management showed that the US manufacturing sector “contracted for the first time in over three years” in November.
In the UK, the second quarter of 2007 saw sustained – if modest – growth in manufacturing, but that has been accompanied by far greater pressure from investors for better returns form manufacturing companies.
Although economically less important than it once was, the manufacturing sector is still recognised as a sensitive barometer of wider economic health. Consequently, at both a micro and macro level, it is critical that manufacturing companies manage their cash carefully to weather the current pressures.
Their outlook is positive. Prudent business management is something that the sector has proved itself to be rather good at. Over the last decade, almost every area of a manufacturer’s most critical business process – the supply chain – has been subject to strict efficiency measures.
It could be argued that the transition to ‘just-in-time’s manufacturing, coupled with years of relentless cost cutting and other efficiency savings, have almost squeezed the supply chain to the limit.
Corporate buyers have forced down prices to the point where suppliers’s margins are pared to the bone; and logistical (physical) processes have been streamlined to reach maximum efficiency. In reality, there is very little room for further price reduction and efficiency improvement.
In fact, as the sector tightens its belt and cashflow becomes more of a concern, the supply chain has become a battleground. In many cases, we see unproductive tugs-of-war taking place between buyers and suppliers over payment terms.
On the one side, buyers are seeking extended payment terms and lower prices; on the other, suppliers are demanding timely payment. If payment terms are extended, the buyer improves its cashflow, but the supplier’s cashflow suffers and they become vulnerable.
Of course, if the supplier is essential to the buyer, then the buyer is also threatening its own business. On the other hand, it the terms are shortened, it is the buyer who loses out. In effect, everybody loses.
Don’t upset the supply chain
So how can the manufacturing sector achieve further efficiency without jeopardising the very stability of essential supply chains
- The answer lies, as we discussed earlier, in the financing of the supply chain, and this is clearly an area that is rapidly coming under the spotlight as a great opportunity to further improve processes.
The US market is already reasonably advanced with the new breed of supply chain financing techniques, but there remains much scope for further take-up and awareness amongst manufacturers.
Europe, too, has begun to realise the great demand for new funding tools. A research report that Demica published earlier in 2007 investigated this demand more closely, and found that a large majority – over 70% – of large European companies are actively trying to extend the payment terms offered by their suppliers, in a bid to alleviate the working capital pressures they find themselves under.
Furthermore, the corporates and banks that were interviewed pinpointed manufacturing as one of the top five industry sectors that can benefit the most from supply chain financing, with buyer-supplier relationships in this sector seen to be under the greatest strain.
Supply chain financing programmes release the tension between the conflicting demands of buyers and suppliers, by enabling buyers to get extended terms (for example, moving from 30 to 90 days) from their suppliers, and suppliers to receive payment as early as days following invoice approval.
This process is facilitated by the financier (bank), who provides funding to the suppliers. But when assessing the credit risk, the financier looks at the buyer, who is the entity obliged to pay the invoices.
Such programmes are underpinned by a sophisticated reporting technology platform that allows invoices to be viewed, picked and approved for funding by buyer, lender and supplier in real-time, streamlining the execution of the transaction.
US and European banks have responded very positively to the new corporate demand for supply chain finance and many are already offering supply chain financing programmes.
At the very time when manufacturers urgently need to improve their cashflow and consolidate critical supplier relationships, they have the opportunity of harnessing these new tools to transform tugs-of-war with suppliers into a situation where buyers and suppliers begin to pull together in the same direction.
For the manufacturing sector, this can make a significant contribution to softening the blow of a sector dip.