By Hamlin Lovell, NordicInvestor

Greensill Capital’s collapse in March 2021 highlights some risk factors in supply chain finance and accountancy firm, KPMG, published a report in May 2020 claiming there is a pandemic of fraud in the area. NordicInvestor interviewed Tom Arnold, Director and Head of Sales of Record Currency Management to discuss how risk factors can be managed and mitigated.

Greensill Capital and other corporate collapses involving some form of supply chain finance included NMC Healthcare, Abengoa S.A., DIA (Distribuidora Internacional de Alimentacion) and Carillion plc. Several of these cases involve alleged or proven fraud.

Categorising the strategy

Trade finance and supply chain finance are broad strategy groups that can be categorized differently according to how investors perceive them. “Some say it is quasi-cash, others view it as alternative fixed income or even private credit. Since it is not public markets it does not fit into traditional fixed income, but the short duration does make it relatively liquid,” says Arnold.

An important investor group for trade finance is insurance companies, partly because the strategy can obtain favourable weightings under Solvency II. For example, for the Siegfried strategy, “the credit ratings on obligors flow through to the fund. The investment grade weightings, combined with average duration of 90 days, can result in a Solvency II capital requirement as low as 1.1% based on the standard model. Of course, this does not take account of liquidity or fraud risk,” says Arnold.

Reverse Factoring versus Traditional Factoring?

The aforementioned corporate collapses all involved “reverse factoring” or payables finance, in contrast to traditional factoring, which finances suppliers.  Reverse factoring is widely used by some of the world’s most creditworthy companies who have a higher credit rating than banks and essentially want to disintermediate banks and other financing companies. But it can also be used by firms seeking to buy time and borrow outside their balance sheet. “Reverse factoring can be self-selecting for companies with weaker balance sheets who are interested in cheaper credit and want to keep financing off balance sheet,” says Arnold. A September 2019 report on reverse factoring from credit ratings agency, Moodys, found that “fewer than 5% of the non-financial companies that we rate globally disclose such a programme in their public accounts”. Companies might report a healthy cash balance, and positive free cashflows, but then suddenly be on the hook for payments that wipe out most or all of their working capital.

Concentration risk

It is not impossible to build a diversified book of payables finance with high quality counterparties, but traditional factoring may make it easier to select and diversify counterparty risks. “Reverse factoring tends to involve buying an entire book of receivables from a manufacturer, which can lead to a high degree of concentration,” says Arnold. When questioned by UK members of parliament, Lex Greensill admitted that, “We did have a concentration on certain customers that was too high”. It emerged that five clients accounted for about 90% of Greensill’s exposures.

A more selective approach can result in better risk control and diversification. For example,

“We prefer an approach of choosing invoices one at a time, and cherry picking which suppliers’ invoices we want to buy, based on the end customer. This involves diligence on individual transactions, and we can change obligor if circumstances change,” Arnold points out. An average duration of 100 days also makes it easier to pivot the portfolio if risk profiles deteriorate.

Fraud

“The key risk in trade finance and supply chain finance is generally accepted to be fraud. Typical frauds include counterparties being undisclosed affiliates; using a recently ended relationship to obtain finance, or using the same invoice as collateral for multiple loans,” says Arnold.

Technology and due diligence

Technology can be used to guard against some forms of fraud. For example, “An SCF fund we work with, Siegfried, works with origination partner, VTeam, which was specifically set up to counter fraud. VTeam was established as anti-fraud software in 1998, and sold to commercial banks. VTeam has technology including algorithms and factoring patents. It also benefits from a network effect, since it is widely used by banks and has visibility over their transactions,” says Arnold.

Technology does not remove the need for traditional hands-on due diligence however: “VTeam also do on-site due diligence, meeting management to understand their business model, before on-boarding, and this continued throughout Covid,” he adds.

VTeam is the first level of filtering. Siegfried also select the transactions they want for their investment portfolio. For instance, “before initiating a new supplier, we establish a functional relationship. We would not fund the first deal or transaction. We need to see a track record of deliveries, flows and payments,” says Arnold. Siegfried also carries out verification. This entails the painstaking matching up all documents, such as bills of lading, cargo receipts, invoice numbers, boxes and containers.

“Record performs a third level of checks, reconciling and verifying information such as bank balances with cash that is not in receivables. This is more reactive than preventative”.

“None of this is a perfect risk mitigant but all of these measures ensure we have oversight of the value-chain and drastically reduces fraud risk,” says Arnold.

Bank, platform or self-origination?

Origination can sometimes result in perverse incentives. Many TF and SCF deals are originated by banks, which can raise concerns highlighted by investment consultants such as Cambridge Associates and bFinance. If the bank does not retain any risk, there may be an “adverse selection” issue if it has an incentive to offload weaker credit risks. Some funds originate their own dealflow while others use platforms. For example, Siegfried has a longstanding relationship with VTeam, which banks also use for their own origination.

Credit Ratings and trade credit insurance

Credit ratings have not predicted every corporate collapse, but have sometimes been a useful warning signal: Moodys withdrew Abengoa’s ratings in March 2017, nearly four years before the firm ultimately filed for insolvency after two sets of restructurings and a pre-insolvency process. Carillion was unrated. DIA (Distribuidora Internacional de Alimentacion) saw a series of credit downgrades from Baa3 to Caa1 throughout 2018. Greensill was exposed to relatively weak credits such as Norwegian Air and Gupta.

Siegfried restricts credit risk to investment grade companies, rated at least BBB+.

Trade credit insurance can be a risk mitigant, particularly for lowly rated or unrated companies, but it can also be ephemeral. “Historically Siegfried also bought trade credit insurance to deal with unrated firms such as IKEA, which have a strong balance sheet but no credit rating. That has now been abandoned because trade credit insurance cannot be obtained on the same terms,” says Arnold. For instance, Euler Hermes reportedly reduced or canceled coverage in 2020, and withdrew coverage (which had actually paid out in relation to NMC Healthcare) from Greensill Capital. If financing deals last longer than trade credit insurance, there is clearly a maturity mismatch problem.

Bankruptcy stress test

Investment grade companies do very occasionally go bankrupt and the VTeam platform provides something akin to quasi credit insurance. “VTeam provides a repayment guarantee, buying back receivables that are not repaid. Providing VTeam itself was solvent, this could cover principal and interest,” says Arnold.

If VTeam itself failed, “There would be full recourse to suppliers. Short term receivables would tend to rank ahead of some other credit, but come after taxes and salaries, in the waterfall,” says Arnold. Siegfried has no experience of this since it has not been exposed to any defaults, including in 2020.

Covid payment delays

Relationships with originators can also be important for late payments, such as those around Covid, which settled down by October or November 2020. For example, “these had no impact on returns for most of the vehicles. We roll maturing receivables with VTeam, and then it takes on the risk of late payment. The vehicles that do not roll invoices with VTeam actually saw their returns boosted, because they started charging punitive penalty interest after a grace period of 30 days,” explains Arnold.

The rolling arrangement with VTeam is also one way to minimize “cash drag”. It ensures 99% of the fund is put to work at any time.

Yields, currency and leverage

The currency hedges do not entail margin or cash drag either. Currency hedged share classes in CHF, EUR, GBP are available with JPY launching in June (the origin of the relationship was Siegfried asking Record to structure these). DKK, NOK and SEK hedged share classes could easily be created.

Net returns for investors have been in line with the 6.5% target in USD. The yields that Siegfried’s borrowers pay are nominally fixed rather than the common practice of applying a spread over a floating rate interest rate benchmark. Borrowers are paying 8-10%, which is less than the 10-15% they might be charged by Asian banks.

Other structuring options for investment vehicles include choices between accumulating or distributing share classes, and leveraged share classes.

“A double leveraged share class financed at a spread of around 200 could increase target returns to 10-12%, and investors could blend this with the unleveraged share class for a smaller amount of leverage. One client has even requested a 3 times leveraged vehicle,” says Arnold.

Watch this space: ESG improving

Fraud is arguably an ESG risk factor that comes under the umbrella of governance, which might be poor even in companies with high ratings on E and S criteria. Abengoa was active in renewables and clean technology, which show how companies with high ESG scores are not immune to risks around their financing arrangements and accounting disclosures.

So far the main focus has been mitigating fraud and credit risk but ESG risks will receive growing attention. “ESG is at an early but developing stage for this strategy. We currently only look at the buyers, who are generally large multinationals. We are not working with environmentally poor obligors, and are expanding the process to include more data. Risk metrics are also expanding to include environmental risks such as floods and fires,” says Arnold.

“On the supplier side dealing with many small Asian companies, the ESG data is not good enough but this is changing very quickly. We are expanding engagement with them. They have an incentive to provide more data because they get a better deal than they would get from the banks”.