Movables Finance: Concepts, Key Elements, and Structuring Jinchang Lai Principal Operations Officer, and Lead for Financial Infrastructure, Finance & Markets, World Bank Group Rabat, September 25, 2014
Contents ü Opening Remarks ü Movables Financing: Concepts and Approaches ü Accounts Receivable (AR) Financing ü Inventory Financing ü How to Go about It in a Credit Institution? ü What are New in This Space?
Opening Remarks Strategic Rationale How do firms compete in a modern economy? ü ü ü ü Price Quality of product Financing Services Competition is no longer just about price and quality Financing has become a key competitive factor How does your credit institution/credit industry fit in? Example: What may this retailer need?
Opening Remarks Strategic Rationale Competition is intensifying in the credit market: ü Opening of the sector ü Increasing use of technology (e.g., internet-based financial services) ü Clients have much more options and are becoming more discerning What can be your credit institution s strategic response? ü Go down/up to the market that you did not do before, with new ideologies ü Reach the clients that you did not serve before, using new methodologies Example: What may this dealer need? Do they have real estate as the basis for borrowing?
Movables Financing: Concepts and Approaches Insights of a Practitioner - Business is more valuable than land and building. Flow of funds (transaction data) is more reliable than financial statements. - In movables lending, loans are not repaid from profits; loans are repaid by the cash generated from operating cycles Also, with the availability of financing, an operating cycle can become progressively larger. - Chinese banker, Yang Dayong, from New Finance, October 2013
Movables Financing: Concepts and Approaches
Movables Financing: Concepts and Approaches Basic Credit Principles Among others, business loan structuring usually needs to ensure that: ü A loan finances an asset of the borrowing business ü A loan can be repaid by the cash flows generated from the normal course of business, including a proper matching of timing ü Security-taking, if any, is consistent with the asset structure of the borrowing business In emerging markets, what is the typical asset structure of a SME? Are their financial statements generally reliable? Are businesses inclined to engage in arbitrage behaviors?
Movables Financing: Concepts and Approaches Movables financing: Any debt financing based on movable assets (credit secured by movable assets--i.e. movables ) May include credit arrangements using movables information and monitoring/incentive mechanisms, without an explicit security agreement Key ingredients: ü What assets to finance? Where is the financing gap? ü A borrowing base, including future and changing assets ü An advance rate ü A monitoring and re-calibrating (matching) arrangement Security taking is not just about reducing LGD; it is a way of overcoming the information and incentive problems inherent in debt transactions
Movables Financing: Concepts and Approaches Economics of Secured Credit How lenders control the borrowers? ü Various loan and security agreements, and covenants ü Security interests ü Disbursement methods ü Monitoring based on the above Why take security? ü Information ü Incentive ü Controlling Loss Given Default (LGD) ü Reputational and moral effect
Movables Financing: Concepts and Approaches Case I Talk with a construction materials wholesaler in US: Q: Do you borrow? How do you borrow? A: Yes. We are a typical small business. My customers normally pay us in one month. I need working capital. It is not difficult to borrow from my local bank. I give them my receivables and inventory as security. Q: How does the bank monitor you? A: My manager sends them a monthly report on receivables; and the Loan Officer comes to see our inventory once a month. My current account is also with the lending bank.
Movables Financing: Concepts and Approaches Potential Dimensions of Structuring a Movables Credit Legal form of transaction Underwriting basis Control of collateral, and monitoring and recalibration frequency Advance rate Role of third-party services providers (e.g., CMCs, credit enhancers) Lenders involve in AR & inventory collection/management? Filing of security interests? Transfer of title: With or without recourse? What is the level of MIS support? E-Platform? Notification to account debtor (customer)? Support from supply chain/cluster actors (suppliers, buyers, etc.) Bulk or detail? and so on
Movables Financing: Concepts and Approaches Degree of Control Quality of Borrower High Low Low FS Loan Degree of Control Bulk High ABL
AR Financing The most important movable asset to use Closer to cash justifying for higher advance rates Examples of AR: ü AR of a supplier to a supermarket ü AR of an agri inputs dealer from the farmers ü AR of a wholesaler ü AR of an equipment manufacturer/vendor ü AR of a hospital from social security scheme/insurance companies Quality of AR: dilution, concentration, turnover Not all ARs may be eligible : ü Typical ineligible ARs: accounts beyond X days, cross-default, cross-aging, contra account, over concentration, accounts due from certain customers, etc.
AR Financing Basic Structure Borrower (client) Goods & Services Accounts Receivable Account Debtor (customer) Lender
AR Financing Four types of AR financing in a normal market: ü Financial Statement (FS) Lending (Bank Finance) ü Asset-Based Lending (ABL, Commercial Finance) ü Factoring and Off-Balance-Sheet Finance ü Debt Instruments based on AR; and Securitization Two basic legal forms: ü Assignment of AR (similar to pledge of account in some countries) ü Transfer (sale) of AR (with or without recourse)
AR Financing FS Lending For clients with better credit standing Advance rates typically between 50-95% Often controlled through a borrowing base certificate Often in the form of a revolving credit, but not always; financing amount can grow with sales/current assets Short-term credit: renewed regularly, but may need 30-90 days clean period per year Medium and long-term credit: not unusual, tied to a sustained growth of business (growth in current assets)
AR Financing FS Lending Apart from the typical DD requirements on business loans, need to ensure that: ü ARs are from the normal course of business ü Account debtor is not related to the borrower (i.e., not from the related businesses) ü Borrower has reasonable commercial credit management capacity ü ARs have no burdens (no prior interests) ü Some validations may need to be performed Basic regular information requirements: ü Sales ledger and collection details ü ARs Aging ü Bad debt list with details ü Customer list with contact details ü Payables details and aging ü Signed Borrowing Base Certificate
AR Financing Calibration Calculation of Lending Amount Sales 120 Minus: Cash Sales 20 Accounts Receivable 100 Minus: Ineligibles 10 Eligible ARs (Borrowing Base) 90 Advance Rate 80% Availability 72 Credit Limit 75 Lending Amount = Min (Availability, Credit Limit) 72
AR Financing Calibration Periodic Calculation of Draw-Down Amount Outstanding ARs, beginning of period 5000 New ARs from the period 1000 Minus: Ineligibles 200 Outstanding ARs, end of period 5800 Advance Rate 80% Availability, end of period 4640 Already Drawn 3900 Available for Drawing 740
AR Financing Asset-Based Lending An intensively monitored form of lending for lower quality clients Very frequent matching of borrowing base, availability and outstanding credit amount to maintain the Advance Rate Controls over collaterals: desk analysis; selected validations; and field audit Controls over borrower cash flows via Lock Box, Designated Account or Blocked Account Higher cost, higher pricing
AR Financing Asset-Based Lending This type of lending has significant social benefits Potential clients: ü Higher risk clients that cannot be taken on by FS Lenders, e.g. lower-than-top-tier SMEs ü Others: new businesses without much history, high-tech firms, highly-leveraged firms, even financially distressed entities Need ability to realize movable asset collaterals efficiently in case of default Requires a different mentality and philosophy than those under traditional business lending Often, conducted by a lending team different from the traditional business lending team
AR Financing Asset-Based Lending Main contents of field audit: ü Invoices vs. supporting documents ü Sample check on customers and their trading history ü Client s bank account details vs. collection/cash ledgers ü Validation of copies of credit memos ü Examining payables and contra accounts ü Regulatory compliance (e.g., tax, special industry requirements) ü Follow up with the previous field audit findings The concept may also be applied to large invoice discounts through three-party agreements Example: How is the different Degree of Control exercised in practice?
AR Financing Difference between Bulk and Detail Example of a Leading Player Bulk Product Detail Product Pool of ARs Individual ARs Posted No Customer Credit Guarantee Customer Credit Guarantee Recourse Client Submits Aging Daily Matching with Advance Rate Cash Dominion Non-Notification, or Notification (the latter is called "factoring with recourse") Non-Recourse or Recourse Agings Generated by Lender Daily Matching with Advance Rate Cash Dominion Notification Source: Author compilation, based on Rosenthal & Rosenthal materials.
Inventory Financing Examples of inventory: ü Raw materials of a manufacturing SME ü Goods for re-sale of a trading company ü Commodities in store of an exporter ü Merchandise on shelf in a shop ü Livestock, crops, and final produce of a farm ü Equipment in stock of a dealer Often done together with accounts receivable financing based on an operating cycle Different degrees of controls for different levels of client risks under various products Lower advance rates
Inventory Financing Quality of inventory: Preservability, inventory mix, liquidity, turn-over & aging, warehousing/compliance aspects Similar process of eligibility advance rate availability lending amount -- drawn-down amount calculations and matching Valuation risk: Fluctuations of commodity price; need to hedge, if possible For new lenders, maybe easier to start with Floor Planning
Inventory Financing Often involve field warehouse, particularly for SMEs Use of 3 rd party collateral management companies (CMCs): ü Lenders need to have acceptance criteria on (and an eligible list of) CMCs ü CMCs better have liability insurance ü Reporting, valuation and inspection requirements ü Who is responsible for the quality of stored goods? Two main types of contracts: CMA and SMA What standards are your CMCs following? ü Do they do serious DDs on borrowers and warehouses? ü How many active contracts do they have? ü Are they really holding the only key to the warehouse in the case of CMA? ü What is the risk of writing multiple warehouse receipts by a CMC and their collusion with the borrowers?
Inventory Financing Basic Structure (I)
Inventory Financing Basic Structure (II)
How to Go about It? Enabling Environment Basic foundations: ü A secured transactions law ü A modern registry ü Lenders willingness and capability Further development: ü Rules and guidelines from the banking regulator ü A collateral management industry ü Availability of credit enhancement services ü Value chain finance e-platforms There are always some transactions that can be done with or without one or more elements
How to Go about It? Movables Financing Innovation in an Economy
How to Go about It? Movables Financing Innovation in a Credit Institution
How to Go about It? How It Looks Like in a Relatively Matured Lending Institution? Movables lending is practiced in practically all client segments (small business, mid-market, corporate banking) Under the lending function, several business units (Departments, or sub-lending lines) are engaged in the business Successfully established a product system, not just one product Have several brands... often in overt or embedded advertisements
How to Go about It? How It Looks Like in a Relatively Matured Lending Institution? Have a series of operational guidelines and/or product manuals Based on value chains (supply chains) or clusters; may have one or more e-platforms Strive to provide non-credit services leveraging value chains/clusters Remember: What clients need are practical solutions! NB: Movables lending is a conceptual word --- actual business goes under numerous product and brand names.
How to Go about It? Players in Value Chain Finance
How to Go about It? What it Means for Your SME Borrowers?
How to Go about It? Case II
How to Go about It? Comments of a Borrower - Like me, I do not have land and buildings to be used as collateral. A CGB banker studied my flows, inventories, inventory ledger, and sales ledger. Then, the bank gave me a loan. This is unthinkable before. - Now, they give me a loan in three days. Since I do not have adequate financial statements. No bank could lend to me before. I even went to informal lenders; but they asked for 45% interest rate. - A small shoes exporter in Dong Guan and client of CGB, from Economy & Nation Weekly, November 11, 2013
How to Go about It? Flyer of a Community Bank
How to Go about it? Examples of Two Players A mid-sized national bank: ü Under three business lines: Small Business, Transactional Banking, Corporate Banking ü Under one business line alone, 42 products form a movables product system (by April 2013) A very small credit guarantee company (finance company, as of early 2013): ü Recently launched a new SME product suite An Shang Loans ü It contains five credit products: Real estate equity loan; supply chain finance (AR & inventory); intellectual property loan; loans based on trade flows (AR & inventory); and unsecured loan for entrepreneurs (natural persons)
How to Go about It? Example of a Supply Chain Finance Suite Rolled out by a joint-stock bank around 2009-10 Brand name: Win-Win Chain It contains seven products (as of 2013): ü Future inventory financing: Lender controls borrower access to inventory; for procurement purpose ü Inventory rights pledge loan: Based on WHR, Bill of Lading, etc. ü Inventory pledge loan: Secured by a changing pool of inventory ü Accounts receivable financing: Based on a pledge of AR or factoring of AR ü Cross-border payments financing: processing and financing in one package ü Global confirmation financing: Combines with credit enhancement
How to Go about It? Example of a Supply Chain Finance Suite -- Advertisement
How to Go about It? Example of a Supply Chain Financier -- Advertisement
How to Go about It? Online Supply Chain Finance Product -- Advertisement
What are New in This Space? Developing and formalizing a collateral management industry The rise of e-platforms: ü Digitization of ARs and WRs ü The Visibility and transparency of value chains have increased greatly with technology ü Entry of the payment services providers The extraordinary rise of e-commerce players: ü What are the Information and Incentive advantages that an e- commerce player have in comparison to the traditional commercial banks? ü What Controls and even Possessions that an e-commerce player have over a borrower or a collateral?
What are New in This Space? Case III Group A is a major e-commerce player with two large online shopping platforms. Not long ago, it started a finance subsidiary to provide loans mainly to the MSME suppliers/sellers on its platforms. The loans are said to be all unsecured. By August 2014, about half a million MSMEs have been supported. The payment process for online shopping: buyer places an order à shop accepts order and delivers the goods à the purchase amount moves from the buyer s online wallet to an escrow account controlled by Group A à money moves from the escrow account to the seller s online wallet after buyer clicks to indicate satisfactory receipt of goods or automatically 7 days from the date of purchase. Group A also has power to expel or block a shop on its platform. Questions: What is the nature of the credit provided by Group A? Is it a secured loan? Is this movables lending?
Thank You! The views and judgments of this presentation are those of the author. The conclusions and judgments contained herein should not be attributed to and do not necessarily reflect the views of IFC, or its management and Board of Directors, or the countries they represent. The author, by means of this document, is not rendering any professional advice or service, and shall not be responsible for any loss sustained by any person who relies on this presentation as a substitute for professional advice or service.
Annex: Terminologies (I) In local language Secured Transactions, secured financing, secured credit, secured loan! Security Interest, security right Security, collateral, guarantee Personal property (movable asset, or movables), real property (immovable asset, or immovables) Possessory, non-possessory Movables financing Asset-based finance, assetbased lending (ABL), commercial finance
Annex: Terminologies (II) In local language Collateral management company (CMC)! Collateral Management Agreement (CMA); Stock Monitoring Agreement (SMA) Value chain, supply chain, cluster Accounts receivable (AR) financing platform, supply chain finance platform, movables finance platform, e-platform Account Debtor (customer, buyer); Borrower (client, supplier, obligor) Bulk/Detail Security interests registry (collateral registry)
Annex: Terminologies (III) In local language Invoice! Trade Debtors/Debtors; Trade Creditors/Creditors Credit Memos/Credit Notes Non-deposit-taking lenders (NDTLs) Aging, Availability, Cash Dominion Notification, Recourse Field Audit Field Warehouse, Public Warehouse Floor Planning