Investors in crowded sectors may look on the opportunities created by the supply chain as medieval adventurers once looked on the fabled kingdom of Prester John. Huge volumes of illiquid credit are created in sale transactions every day as goods and services are sold. This credit locks up working capital for sellers and limits their appetite to supply their customers. The effective yield on this form of financing is tied up in price negotiations.
This market is already supplied with credit by third parties through trade receivables securitisation, factoring and other variations on the theme of using trade debts as collateral on a recourse or non-recourse basis. In some cases this financing (for the right, usually larger corporate borrowers in the right sectors and locations) can be extremely cost effective. There are also many ways of transferring credit risk on sale transactions which may be paid for by the buyer or the seller. But a high proportion of trade transactions are not financed or protected in this way and the availability of credit in many sectors can be volatile or non-existent and pricing is inefficient. This all adds up to create opportunities for new capital.
If this is the opportunity, what are the challenges?
Challenge #1: Duration
Receivables tend to be short dated whereas many investors want to put capital to work for longer periods.
The obvious solution to this problem is to find a sufficient ongoing supply of receivables so that collections are quickly reinvested in new receivables. This can be structured in the form of a programme with one or more sellers selling receivables into an SPV structure. While this is the basis for trade receivables securitisation it is also used for more simple financing structures. The programme must be sized so that sufficient receivables are purchased to create the yield needed for the investors to achieve their expected return. The seller may be expected to pay a commitment fee to the extent the programme isn’t fully drawn or fund some kind of equity contribution which earns a return when the programme is used but funds payments to the senior investor when it is not. Alternatively, the programme may be entirely uncommitted in which case the seller choses whether or not to sell and the financier whether or not to purchase the receivables but both are incentivised to maintain the relationship as long as it works economically and have a framework under which they can transact quickly.
The solutions leave investors with the need to administer some relatively complex processes as receivables are collected and new ones are purchased. In particular, in the context of a programme the investor must ensure that the quality and collectability of receivables are maintained. These challenges are unavoidable and as trade receivables tend to be relatively granular require material ongoing work. However, it may be possible to delegate these roles to a servicer.
In the next instalment of this blog, we will consider challenges which arise in relation to credit risk on receivables.