04-04-2023 | Marc Verkuil | treasuryXL | LinkedIn | Marc heeft gewerkt en gewoond in diverse Europese landen, de VS en Dubai. Met zijn uitgebreide leiderschapservaring in diverse grote en middelgrote ondernemingen, heeft hij meer dan 35 jaar gewerkt aan het ontwerpen en implementeren van wereldwijde treasury- en belastingstrategieën.
| 8-1-2019 | by Marc Verkuil |
In the first part of this article, which focuses on the potential disadvantages, risks, and pitfalls of SCF and RF Programs in particular from the perspective of the Seller, the benefits of an RF Program were mentioned, while the almost unavoidable impact on a Seller’s WACC and the potential negative outcome for the Seller from an EVA, ROE and EPS perspective have also been discussed. In this final part of the article, focus will be on the possible commercial impact on account of SCF for a Seller, as well as on the regulators’, investors’ and credit rating agencies’ points of view. The article will present conclusions and some recommendations in the realization that since no company is the same, the thought-process going into the decision for entering or not entering into SCF will not be the same either; certain positive or negative arguments described herein may be more relevant for one company, while others may be more impactful to another. It is safe to conclude, however, that there is substantially more to SCF than what is typically presented and marketed, and it is hard to argue that SCF is the ‘holy grail’ to working capital finance for each and every party involved.
What may be overlooked by Sellers when they are concluding upon a “cheap SCF solution that increases their ROIC and reduces their working capital balances”, is that such solutions are different from the usual forms of debt funding in the sense that even though the Buyers can not be a party to the transaction, these solutions implicitly involve all three parties in the combined commercial/financial transaction. This results in the Sellers having little control on the terms, conditions, and continuation of such funding solution, while there is an important commercial element that is not apparent in more common debt funding. The potential consequences of a lower credit-worthiness of the Buyer or less credit capacity or appetite of the Factor to the Buyer have already been mentioned in this respect. Moreover, and as argued before, an RF Program is usually offered subsequent to the Buyer, being the financially and commercially ‘stronger’ party, requesting an extension of its payment terms from the Seller. Even though the Seller may not be in a position to decline such a request anyhow, the Seller should carefully consider a number of commercial questions and, if deemed relevant, negotiate these as best as possible upfront with the Buyer: “does the RF Program provide real(istic) opportunities to increase sales and EBIT or ensure a more committed and longer term relationship between Seller and Buyer, i.e., do the commercial benefits outweigh the negative (financial and/or ratio) impact, if any?”, “can the Seller charge the additional funding cost, including the cost of extending its payment terms, of an RF Program structurally through to the Buyer?”, “could such a program create a precedent, and if so, what could be the impact (think of other customers requesting/requiring the same extensions and programs)? E.g., what are the long-term consequences of extending payment terms under an SCF program and what happens if or when the program is terminated; will the Terms & Conditions ‘automatically’ return to the old payment terms?” A sound argument in favor of an RF Program may be the fact that credit insurance (on the Buyer or in the market as a whole) may either no longer be available or be higher priced than what the Factor is offering. Hence, a number of questions and arguments a Treasurer usually does not need considered, let alone answered in a straightforward, bi-lateral working capital facility with a lender.
There is clearly a trend, driven both by regulators and investors, towards (public) companies being required or demanded to reporting or disclosing more financially relevant information, and as such, not only to leave less room for the non-disclosure of off-balance sheet transactions that may be relevant for the public, but even to add certain transactions that have historically been treated off-balance sheet, back into the financial statements for certain reporting parties; think of IFRS16 as a recent example in this respect. Currently, if receivables (invoices) are sold in an RF Program on a non-recourse basis there are no required reporting or disclosures in any financial statement filings under US GAAP or IFRS. For the MD&A section of a public company’s quarterly and annual filings (at least under the US SEC rules), however, disclosures are more judgmental and subject to materiality thresholds. Such potential disclosures cover a wide range of corporate events, of which the most relevant (from an SEC and FASB perspective, but probably similar for IFRS purposes) are: (a) “trends, demands, commitments, events or uncertainties that will result in, or that are reasonably likely to result in, liquidity increasing or decreasing in any material way”, and (b) “any known material trends, favourable or unfavourable, in capital resources, including any expected material changes in the mix and relative cost of capital resources, considering changes between debt, equity and any off-balance sheet financing arrangements”. An exact materiality threshold above which a company would be required to disclose its off-balance sheet (SCF) programs has not exactly been defined (yet) from an SEC or FASB perspective.
The reference above to the impact of certain (SCF) transactions on a company’s liquidity position is worth explaining further, as this is a position the major credit rating agencies also tend to take: due to the uncommitted nature of basically all SCF solutions and certain other (significant) financial transactions that are not reported in the financial statements of a company, the rating agencies, if or when made or becoming aware of these types of deals, will add these back into the financial statements for ratings purposes. The most important reason for their argument is that the moment these programs are terminated, the company’s liquidity position will be impacted and the company will most likely need to replace the off-balance sheet funding with an alternative source of funding, which the agencies unconditionally assume to be on-balance sheet unless the company can and would want to proof differently, which is a difficult task. Although there are no exact materiality thresholds with the rating agencies either (to the author’s knowledge), it is clear they effectively decide to adjust for those known SCF solutions that they deem relevant and material (in total) in both the balance sheet and income statements.
SCF solutions, including RF Programs, may be a valuable additional and alternative source of funding, even for financially and commercially ‘weaker’ Sellers participating in such programs. However, these parties in particular should be well aware of both the broader financial impact, i.e., beyond the “cheap discount rate and positive ROIC impact” as often advertised by the Factor, as well as of the immediate and strategic longer term commercial and financial consequences of such programs, i.e., these solutions should only be entered into for “all the right reasons” and at the “right” cost (of marginal debt funding as the upper limit). Finally, from a Treasurer’s point of view, typically targeted with at least considering, if not outright optimizing the investors’ interests and having a ‘bottom line’ (WACC, ROE, EPS, EVA) perspective on things, it is recommended to ensure that even if certain of these solutions do not tick all above boxes positively, they do not impact or threaten to impact the company materially, both instantly and in the future, which could include putting a firm limit, e.g., an x% of total debt threshold, for these types of programs in place. Finally, it would probably not hurt for Treasurers, particularly those employed by Sellers again, to pro-actively advise their executive management teams and wider (financial and commercial) organizations of those arguments in this article that they deem to be relevant for their businesses.
Treasury Professional
| 7-1-2019 | by Marc Verkuil |
Supply Chain Finance (hereinafter referred to as ‘SCF’) involves financing solutions helping businesses, usually through the involvement of a third party lender, to free up working capital trapped in supply chains. These solutions target financing of specific working capital items, such as payables, inventories or receivables, as the underlying products move from origin to destination in the physical supply chain. Examples of SCF solutions include factoring, inventory repurchase, dynamic discounting, and reverse factoring programs. The latter solution (hereinafter, the ‘RF Program’), which has been offered by an increasing number of banks lately, involves a Seller being given the opportunity to sell its receivables (invoices) on a specific Buyer (typically) without recourse to a financial institution or investor (hereinafter, the ‘Factor’) at a discount in return for the immediate receipt of the (discounted) cash or liquidity from these receivables. In funding the Seller, the Factor is exposed to the Buyer as it assumes the credit risk on the latter, i.e., the (in)ability of the Buyer to pay its outstanding debt to the Seller (or Factor directly) at maturity.
SCF is often marketed as a ‘win-win’ for all parties involved. In recent years dozens of articles in Treasury and related magazines and possibly a similar number of sessions at conferences and seminars, some of which were even completely dedicated to this subject, have heralded SCF, and RF Programs in particular, as the ‘holy grail’ in working capital (finance) management. Although most of the observations in this article are valid for other SCF solutions, focus will be on RF Programs, which are based on the premise that a Seller will benefit from the better credit-standing (or rating) of a Buyer, as a Factor is willing to provide funding to the former on the basis of the credit (risk) of the latter, i.e., at a discount rate similar to the one the Buyer rather than the Seller would be able to obtain from lenders for funding its working capital. Interestingly enough, however, principally without exception all of these articles and sessions have been written and presented by representatives of two of the same participants in these solutions: the Buyers and the Factors, and although they all provide various, mostly valid arguments for the benefits of these solutions to the Sellers, they also tend to provide little or no input on the disadvantages, risks, and pitfalls of these solutions to the latter. Therefore, this article focuses on the perspective of the Seller, the financially and often commercially ‘weaker’ participant in the SCF transaction. Please note that the reference to the ‘weaker’ participant does not limit this to small SMEs, but in day-to-day reality applies to the vast majority, if not all Sellers (with an intent to) participating in SCF as the premise of the solution would otherwise not be valid anyhow. The author of this article used to work for an investment grade rated, powerful, global commodities trading company with revenues in excess of USD 45 billion, which was in fact frequently requested, or even practically forced to participate in RF Programs as the ‘weaker’ Seller.
One other aspect of basically any RF Program is important to take into account; even though an RF program cannot be directly or formally linked to the (payment) terms & conditions agreed between Seller and Buyer, as the program may in that case be deemed by auditors to correspond to and thus to be reclassified as debt in the financials of either participant which would defeat at least part of the purpose of these solutions, the most common benefit sought by the Buyer, often even expressed prior to the Seller being made aware of the opportunity to enter into an RF Program, is the request to the Seller for an extension of its payment terms to and in favor of the Buyer. The Buyer clearly does not wish to cannibalize the debt capacity with its lenders (read: the Factor) in return for nothing; in fact, the Buyer is usually the initiator of the sequence of events leading up to an RF Program in its efforts to improve working capital management first and foremost for its own and rightful benefit (and even if a Buyer would claim it (indirectly) offers an SCF opportunity in order to support a ‘struggling’ Seller, this would still be done primarily in the best (short term) interest of the Buyer, which in that case will no doubt already be looking for longer term buying alternatives). It should be evident that an extension of the payment term has an embedded cost for the Seller, which it should (at least try to) pass on to the Buyer through an increase of its product pricing. A term extension from, e.g., 45 to 90 days, will otherwise require the discount rate of the SCF solution to be half of the Seller’s existing cost of (incremental or marginal) debt funding in order for both funding options to break even.
The most obvious benefits of RF Programs to Sellers are well documented: lower cost of funding, immediate availability of liquidity, lower working capital and (usually) debt levels, financial opportunities to grow and invest, and more limited credit exposure to the Buyer(s). The risks, disadvantages, and pitfalls to the Seller are on the other hand much less frequently mentioned.
One of the most important objectives of a Treasurer, certainly one of a public company, is minimizing its company’s weighted average cost of capital or ‘WACC’, i.e., achieving the optimal level and cost of debt and equity funding. By entering into an RF Program, and most other SCF solutions for that matter, the Buyer and Seller are effectively scaling down the value of their working capital and balance sheets respectively; the Buyer by virtue of obtaining extended terms from the Seller and thus of increasing its days of payables outstanding leading to lower net working capital and (debt) funding balances, and the Seller by virtue of converting part of its receivables balance into immediate liquidity and thus of reducing its days of sales outstanding typically followed by the repayment of outstanding on-balance sheet debt. As the proceeds of an RF Program will practically never be used to return funds instantly to the Seller’s shareholder(s), the Seller’s WACC will practically always increase as it has reduced the normally more cost efficient (i.e., less expensive after tax) debt balance on its balance sheet without proportionally reducing its more expensive equity position, e.g., through share repurchases. An increase in a company’s WACC is hardly ever a desired outcome for a Treasurer in considering a financing transaction, and even if this by itself does not necessarily preclude Sellers from entering into these types of (off-balance sheet) transactions for other good reasons, especially the size and relative proportion of this type of debt funding should merit careful consideration from a Treasurer in its analysis of the company’s total (future) debt to equity mix. A company with a not a-typical debt to equity ratio of 30/70, a cost of equity of 8,5% and a cost of debt of 3,5% has a WACC of 7,0%; if, as a result of an SCF solution and the subsequent repayment of some of its on-balance sheet debt (and all rates staying equal), such company would end up with a debt to equity ratio of 20/80, its WACC would increase to 7,5%, even if its total cost of debt funding, i.e., including the cost of an SCF program that is less expensive than the existing cost of debt, would end up being lower in this example!
One of the most important reasons for companies to use the proceeds of RF Programs to pay down debt is the fact that a vast majority of these programs is uncommitted, implying that each participant in the relevant supply chain, Seller, Buyer or Factor, may unilaterally and ‘without cause’ decide to discontinue or amend the RF Program at any given moment. E.g., a Factor may decide to increase the discount offered to the Seller if the former assesses that the Buyer’s credit-worthiness has deteriorated (or if the Buyer has been downgraded) or it may decide to discontinue or limit the RF Program if the Factor no longer has (sufficient) credit available on the Buyer, while the Buyer and/or Factor may decide to discontinue the Program if the Buyer needs its credit capacity for other transactions, such as a significant acquisition financing need. The Seller should consider two pitfalls as a result of the uncommitted nature of these SCF solutions: (1) the cost or discount rate of these programs should be compared to existing cost of debt funding of the Seller, and (2) prior to entering into an RF Program, the Seller should carefully assess its commercial proposition both at inception and at the moment these programs are discontinued.
With reference to the first pitfall, marketeers of SCF solutions regularly argue that their programs are “cheaper than the WACC of the Seller”, “will increase the return on invested capital (hereinafter, ‘ROIC’) of the Seller”, or will “decrease the total cost of debt funding”. With respect to the comparison to the Seller’s WACC, this argument has already been refuted earlier: it does not make sense to compare the cost of debt funding (in an SCF solution) to that of debt and equity funding (in a WACC) of a company, while SCF solutions will most likely increase the WACC in any case. The ROIC improvement argument is mostly true, but far from a complete one. Even if an SCF solution is significantly more expensive than a company’s cost of debt funding, an increase of its ROIC may be achieved due to the fact that despite the return, i.e., net income in the numerator decreasing, the invested capital, i.e., (receivable) assets in the denominator will decrease even more leading to an improved ROIC or return on net assets. However, in that case this company’s net income and thus its return on equity will decrease, while it will also lower the company’s earnings per share as a result of such transaction. Bottom line, such a transaction will reduce a company’s shareholder value (or EVA), another outcome a Treasurer would typically want to avoid. A numerical example of this is included at the bottom of the second part of this article which will be posted tomorrow. It suffices to say that unless a company only wishes to be managed and valued on its ROIC performance, which would be surprising to say the least, any SCF solution that is more expensive than a company’s existing cost of debt funding will harm most of its financial ratios and definitely its shareholders. This brings up the last argument mentioned above of a decrease of the total cost of debt funding; comparing working capital financing provided by SCF solutions to long term and often committed debt funding is an ‘apples to oranges’ comparison as the latter forms of funding are intended and used for different purposes or reasons, such as funding of permanent or other long term assets, or as a safeguard against volatile markets or sudden spikes in working capital needs. Furthermore, as argued before, the proceeds of SCF solutions are typically used to pay down short-term and usually uncommitted (working capital) debt making the comparison to the cost of (incremental or marginal) debt funding the only appropriate one in most cases.
In the next and final part of this article, focus will be on the possible commercial impact of SCF for a Seller and on the regulators’, investors’ and credit rating agencies’ points of view, while some conclusions and recommendations will be presented as well. To be continued…
Treasury Professional
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