Inventory is, for many companies, the largest component of working capital and can be very slow to turn over. It’s an expensive burden – and yet inventory finance has traditionally proved difficult if not impossible for companies to access. Banks are not enamoured with the product because the risks involved weigh heavily on their balance sheets, directly impacting their capital requirements.
Banks also shy away because of the risk and the difficulty of actually having to get hold of the inventory should they need to do so. There are several reasons for that. The inventory may be in someone’s warehouse or it may be at sea. Title to the inventory may be in dispute if the purchaser hasn’t yet paid the supplier – and banks won’t want to get caught up in that. And of course the resell value of inventory in a distress sale situation is a fraction of what it would realise in the ordinary course of business.
Logistics service providers (LSPs) are in the sweet spot here and are much better able than the banks to provide or facilitate inventory finance. The LSPs physically sit on the inventory – it’s either onboard their ships, planes or vehicles or being looked after in an LSP’s own warehouse. Just as importantly, however, the LSPs have all the necessary information about that inventory – where it is, where it’s going, when it will get there. This information supply chain puts LSPs in an ideal position to be able to create a bridge between the physical supply chain and the financial supply chain.
To make this work, LSPs need to have great data management systems – underpinned by great data, of course. And good credit risk management and credit insurance arrangements can help reduce the exposure to vendor or buyer default. Given this, however, LSPs can play a crucial role in the funding of inventories.
There are a number of different inventory finance models, as we have seen from the work that Supply Chain Finance Community universities have recently been conducting with a number of LSPs (for the moment, disregard how the LSP sources its funding):
One way is for the LSP to buy the inventory from the vendor then upon delivering it to where it’s needed, resell it back to the vendor effectively at the same price, with an appropriate adjustment for the financing costs. This structure – which we have seen being successfully used by SwissPost – basically means that the vendor is outsourcing the holding of inventory to the LSP.
- Note that title in the inventory transfers to the LSP.
- The structure is a good working capital play and takes advantage of the situation where the LSP has a lower cost of finance than the vendor does.
- The LSP does not have credit risk exposure to the vendor’s customer.
- The LSP does have credit risk exposure to the vendor – and this is the main risk borne by the LSP.
- The LSP is protected from the risk of the value of the goods falling provided the vendor’s credit risk is acceptable and the vendor is able to buy back the inventory at the agreed date if there is a problem (such as the goods becoming obsolete or otherwise unsellable).
LSP becomes part of the supply chain
Another operating model is for the LSP to buy the inventory from the vendor and then sell it to the vendor’s customer at pre-agreed pricing – again, taking into account the financing costs. In the illustration below, logistics service provider HAVI ships product for the McDonald’s restaurant group, buying directly from McDonald’s suppliers and then selling to the McDonald’s franchisees.
- As before, title transfers to the LSP.
- The model helps the working capital position of both the supplier and the ultimate customer.
- In this case the LSP has credit risk exposure to the buyer rather than the vendor, so good receivables management is required on the part of the LSP.
LSP joint venture with bank
So far we have discussed inventory finance with the unwritten assumption that the LSP itself is providing the finance. That may be the case, but in fact as this funding model becomes increasingly more popular, LSPs would need to have increasingly robust balance sheets to take the strain. More likely is that funding would be provided in partnership with a bank, financiers such as pension funds or hedge funds, or the capital markets. The LSP’s role in a sense then reverts to its traditional core service function, but leveraging the supply chain data to facilitate the provision of finance.
This in turn opens up the opportunity for other inventory finance models, such as that used by LSP Simon Hegele, which operates a joint venture with a German bank. In their model, Simon Hegele does not take title to the inventory – it is held as collateral in return for the funding provided to the supplier or buyer. This structure enables the provision of finance but does not remove inventory from the supply chain parties’ balance sheets.
While banks generally don’t like to directly take on the risk of exposure to inventories as such – and hence might be expected to work in partnership with an LSP which creates a risk buffer – there are exceptions. BNP Paribas, for example, has a specialist subsidiary, Dublin-based Utexam, which will buy inventory from the supplier, hold it, then sell it at the agreed price and date to the buyer. The actual handling of stock is done by an LSP such as DHL – but the relationship is between the supply chain parties and the bank’s specialist subsidiary, and not directly with an LSP as in the models above.
Inventory finance is particularly rewarding the longer the lead time is between goods leaving the vendor’s factory and being used by the customer. But it’s not just the time spent en route via an LSP’s ships or lorries that’s a determining factor here, it’s the LSP’s service as a warehouse manager that means inventory finance can be particularly attractive.
For example, take the case of an Italian manufacturer we have been working with that exported to the Netherlands. The exporter needed to have a lot of inventory close to its Dutch customers but had neither the large scale warehouse nor the large scale balance sheet to be able to cope with that. Rather than boosting the balance sheet with more equity to fund that, the company used an LSP who provided the warehousing facilities and the finance. Increasingly often, when warehouse management contracts are being negotiated, a finance offering is being included as part of the LSP’s package.
LSPs will, of course, always try to protect themselves from exposure to the value of the inventory. But they are better able than banks to deal with distress situations where inventory does, in fact, have to be offloaded to someone other than the original customer. Provided the inventory is not particularly customer-centric, an LSP’s knowledge of local markets and other customers could enable it to tap into alternative buyers willing to pay more than liquidation prices.
Our work with five LSPs – HAVI, SwissPost, DHL, Simon Hegele and Utexam – shows that there is a matrix of possibilities for supply chain finance. Arrangements can be put in place to fund the supplier or the buyer, with the funding itself coming from the LSP, an LSP joint venture with a bank, or even an LSP wholly-owned by a bank. Different working capital, financing and risk management benefits arise from each, but underpinning them all is the information flow that arises from the LSP’s physical handling of inventory. It is evident that this is a very promising family of methodologies for injecting much-needed finance into supply chains.