These days, the standard textbook model for supply chain finance says that it is a tool that enables lower-credit quality companies (SMEs, for example) to get access to finance at a cheaper rate than they could ordinarily. They can do so because they are suppliers to better grade buyers, and banks and other finance providers are prepared to advance them the cash, reasonably safe in the knowledge that the larger, more highly-rated buyers are good for the money. It is, in effect, an arbitrage opportunity where SMEs can get funding at a rate somewhere between their normal cost of capital and their customer’s somewhat lower cost of capital.
But recently, Alexander Pawellek, head of supply chain finance at Lufthansa, told SCF Briefing that the first supplier to be onboarded for the new SCF programme had a higher credit rating than the airline’s BBB- (Standard & Poor’s). This seemed to fly in the face of conventional wisdom about what supply chain finance is supposed to do.
“We had originally excluded every company that has a better rating than Lufthansa,” Pawellek recalls. “[We were] very conservative, focusing on that standard way of doing SCF: we were thinking that SCF would only work with companies that had a lower rating than ours so that the financing rates were attractive.”
But Pawellek says that he now appreciates how useful supply chain finance can be to better-rated businesses, even if it doesn’t offer cheaper borrowing. “If they [suppliers] use supply chain finance, they’ll be able to get that money much earlier. They’re taking a significant portion of the DSO away from their books.”
Supply chain finance before the financial crisis
The better-rated supplier is also offloading the lower-rated credit risk to the bank. David Quillian, general counsel with PrimeRevenue, says, “Before the financial crisis, supply chain finance was frequently used by the supplier organisations as a credit risk management tool. They sold off the obligations due to them by companies that may have had a worse credit profile than their own to reduce their credit exposure to those enterprises and to pass that credit exposure off to a financial institution.”
Times have changed however, since then, as Quillian says: “Financial institutions are not as willing to expose themselves to companies that do not have very strong credit ratings.” Even though banks may be more reluctant than they were to fund higher-rated trade creditors on the basis of the comfort of a lower-rated trade debtor, the appetite for such finance can still be found. “It can be used to clean up balance sheets, reducing receivables outstanding at the end of the period,” Quillian says. “So there are lots of different financial reasons why a company even with a very strong credit rating might be willing to take that small discount in order to get their cash earlier.”
CRD IV, the latest European Capital Requirements Directive, is in effect the legislative mechanism for implementing the Basel III regulations. “Under CRD IV, the banks need to go through various processes to show how they calculate their credit risks,” says Stephen Baseby, associate policy and technical director at the UK Association of Corporate Treasurers. These rules not only demand that banks take a more rigorous approach to the assessment of credit risks but that they set aside more capital against riskier assets. “So, logically banks would [now] prefer to have the credit of the better rated entity.”
The great irony is that, as the banks have de-risked themselves by preferring to offer supplier finance facilities such as reverse factoring to the suppliers of better-quality corporates, they are in fact getting cash into the pockets of smaller businesses that would otherwise find bank finance either too expensive or even unavailable at any price. Regulations which dissuade banks from lending to SMEs appear to be encouraging lenders to offer supply chain finance instead, because of the effective protection given by the better-rated trade debtor. Before the start of the crisis, banks preferred the extra returns they could make by offering supply chain finance to the suppliers of less-secure buyers.
The fact remains, however, that some of the best-quality suppliers to mid-quality buyers are still perfectly happy to take advantage of the offer of supply chain finance. Baseby offers another explanation as to why this is so, over and above offloading credit risk and window-dressing: diversity of funding.
Those better-rated businesses, Baseby says, are asking themselves, “Do I go out to the banks for revolving credit facilities to cover my working capital? Or do I just take advantage of this supply chain finance programme, which I can dip into and dip out of as I wish?”
“Always borrow when you don’t need to”
Clearly there is a trade-off: “For most high-quality corporates at the moment, that kind of revolving credit from the banking world is quite cheap and readily available. Those that aren’t using [revolvers] tend to be over-funding themselves with things like bond issues and running cash positions.” In other words, businesses are reverting to the old mantra that you should always borrow when you don’t need it. Aligned with that is the desire to have a diversified funding base. “I wouldn’t be surprised to find someone doing it [tapping supply chain finance]. I would be surprised if we found that high-quality companies are choosing by default to fund themselves this way, because structurally they have cheaper ways of doing it.”
Putting this in the broader picture, Baseby points to examples such as Vodafone, which in August issued 33-year bonds worth £800m at an average yield of just 3.4%, said to be the lowest rate for a BBB-rated issuer for such a long-dated maturity. It’s not as if Vodafone needs the money: it has free cash flow of £1bn and cash in the balance sheet worth £10bn. But as Baseby sees it, the opportunity was so cheap it made sense for the company to just do it and say, “We’ll worry why we’re doing it over the next 30 years.”
That’s why supply chain finance remains an interesting potential source of funds even for those quality corporates that don’t need the finance. “Because there’s so much uncertainty, particularly over the regulation of banks, treasurers are doing many things they traditionally wouldn’t do, simply to increase their range of options,” Baseby says. “They may just keep that [supply chain finance] option going, just so they know it’s there.”