Published: July 01, 2013
As trading business undergoes a shift from letters of credit (LC) to open account transactions, financial supply chain management solutions have become increasingly relevant. The credit squeeze triggered by the financial crisis has made large corporates more alert to issues surrounding liquidity and risk in their supply chains. To ensure supply chain stability, forward looking companies are seeking value-added financing facilities that benefit the various stakeholders located along the corporate supply chain. This new attitude has contributed to the increased uptake of supply chain finance (SCF), as attested by global banking institutions in previous research reports commissioned and released by Demica in recent years.
The heightened awareness of supply chain risk is also drawing amplified attention to downstream distributor finance (DF) – an area that has so far attracted less interest than SCF and yet a crucial topic that should not be neglected. In many emerging markets, small and medium enterprise (SME) distributors are struggling to obtain affordable credit. This is further compounded by sellers’ pressure to increase sales. As major corporates are expanding further afield in high growth regions, DF holds the key to opening up new markets and unlocking sales potential. It complements SCF to provide efficient financing for SMEs both up- and downstream in a major corporate’s supply chain, supporting the full process to market with short-term working capital funding.
In order to examine the current usage of DF in the market, especially in developing economies, Demica, along with the support of the management consultancy Capacent, has interviewed a number of global corporates to investigate the scale and fashion with which DF is being offered to their distributors. Together they have also interviewed a sample of international banking corporations to understand their approach to DF. This qualitative research report aims to deepen understanding of this emerging credit facility as well as to provide a primary assessment on market potential.
Distributor finance (DF) can be defined as:
“Financing solutions that support the working capital needs of a corporate seller’s distributors and potentially the distributors’ resellers, to ease the flow of product through the channel.”
DF solutions may include:
There are also other variations of DF models. For example, distributors purchase goods from seller with extended payment terms. This model is funded by seller and therefore has an impact on its balance sheet. Distributors might also employ asset-based lending to obtain lines of credit backed by fixed assets or inventory (excluding floor planning). In addition, the relationship between seller and distributors might allow the seller to give an extended payment term under LC. The advising bank might be backed by an export credit agency. As for distributors with reasonable strong balance sheets, general working capital lines are often the most common alternative to DF. These are typically medium-term revolving credits.
For sellers, DF programmes help them expand into new and under-served regions/segments and deepen distributor relationships in emerging markets, in addition to supporting SME clients’ growth. DF also enables sellers to offer qualified distributors improved terms, with unchanged or reduced credit risk and positive or no liquidity impact. In fact, in many emerging cases, offering DF allows sellers to demand competitive commitments from their distributors, such as product or category exclusivity.
For distributors, DF programmes help improve their working capital through increased days payable outstanding (DPO) or reduced inventory and better management of balance sheet. As an alternative financing technique, DF gives distributors an additional source of and a lower cost of funding and reduces capital requirement for expansion. Furthermore, distributors can grow business volumes with lower capital.[[[PAGE]]]
Under-capitalised SME distributors in emerging markets are often the bottleneck in corporate value chains. These trading companies tend to have a small asset base and weak balance sheets and therefore restrained ability to find attractive financing. This is especially true in many emerging markets where cost of funding is high in general, local banks have limited capacity to lend and global banks have finite appetite to fund local SMEs. The limited or expensive funding for these distribution networks often becomes a major obstacle for growth in those emerging markets, inhibiting both local development and the sales growth of major corporates selling through these channels. Allowing local distributors to draw on the banking relationships and credit rating of a global corporate seller in the value chain might hold the key to unlocking financing and opening up the financial bottleneck.
On a broader level – of interest to governments as well as corporates – the provision of DF to local distributors can contribute to overall growth and economic development in these emerging markets. First of all, it allows job creation and preservation. Secondly, it helps distributors build long-term relationships with major sellers and global banks and encourages them to increase focus on these emerging markets. In addition, the introduction and expansion of viable DF programmes also opens up further development potential for the local financial markets.
Certainly, not all distributor networks are relevant for DF solutions and even fewer are currently served by commercial banks. DF solutions are primarily applicable in value chains with:
Owing to these considerations, the relevance of DF, as well as the specific requirements and suitable structures, varies strongly among sectors. However, even when preconditions exist and potential is good, some banks might still be hesitant to offer DF owing to a lack of skills and structures fitting the needs of the value chain; an unwillingness to take the needed exposure on (SME) distributors; and insufficient support from sellers.
Currently, most DF programmes are funded on-balance-sheet by a bank or a captive finance company, although various risk mitigation approaches may be used to limit the credit risk. Banks financing DF programmes on-balance-sheet may draw on various structures to limit the risk exposure and regulatory capital requirements, and/ or syndicate larger programmes with other banks. Captive finance companies (a subsidiary owned by a manufacturer whose function is to provide financing to customers buying the parent company’s products) normally fund themselves through the parent company’s treasury and credit risk usually remains on-balance-sheet. Captives partly serve as a sales facilitator and may offer subsidised rates to selected distributors and customers.
In addition, financial institutions and some corporates might also use the asset-backed commercial paper market as a source of funding for trade receivables deals, which provide short-term asset-liability match (e.g., securitisation).
There are a number of common approaches which can be deployed to manage credit, business and country risk in DF programmes. These risk reduction mechanisms include seller support, assets as security and structural risk mitigation. The seller, for example, can help mitigate risk by providing detailed information on distributor history, performance, inventory levels etc. It can also introduce first loss default guarantees (FLDG), potentially shared with the banking partner. Furthermore, the seller can provide contractual support with stop-shipment clauses and re-purchase agreements, or by retaining title/repossessing goods in case of distributor default.
With structural risk mitigation, credit or country risk insurance or risk-share/tranching is arranged. Specific limits, triggers and eligibility criteria will also be identified within the programme framework. A diversified portfolio approach, possibly with distributor in agent role if customer base is more diversified (or financially stronger) than distributors, might be adopted as well.
The choice of risk mitigation approach in each DF programme is contingent on numerous factors including programme objectives, seller credit, collateral quality, jurisdiction and currencies, legal framework and impact on accounting treatment, as well as sensitivity to pricing.
The conversations we had with international enterprises indicate that there is a growing interest in DF products in the corporate space. For industries with capital intensive goods (e.g., heavy agricultural equipment), expanding the business requires substantial capital investment for financing deals and their sales. Companies’ primary objectives for implementing DF solutions are to:
1) grow sales in emerging markets without applying more of their own working capital;
2) give the offered product a competitive advantage;
3) reduce SME distributor risk;
4) make favourable financing available to the distributor base.
All interviewed companies are looking to expand in emerging markets, albeit with varying focus and prioritisation. There are already quite a few DF programmes running in emerging markets in the fast moving consumer goods and telecom, media and telecommunications sectors. Eastern Europe, Asia and Latin America are the current priorities.[[[PAGE]]]
Looking to broaden its footprint in BRIC countries (Brazil, Russia, India and China), a leading global machinery manufacturer stressed that credit is a key growth driver in emerging markets. To enable its equipment sales in high growth markets, the manufacturer supports the working capital needs of its dealers through wholesale finance (mainly floor planning) or otherwise mainly through letters of credit. It also provides retail finance with payment terms up to 200 days. This financing facility is generally supported by its own captive finance company through receivable purchase and is funded on the parent company’s balance sheet (sometimes covered by trade credit insurance). Such credit facilities are generally offered to all dealers in a country, though there might be some exceptions (e.g., weak standing of distributors). Utilisation of retail finance also varies in countries, depending on common market practice and availability of other financing options.
A global dental equipment manufacturer, who has over 70 distributors in EMEA, provides its distributors with financing terms of 30 - 60 days for off-the-shelf items and 120 - 180 days for larger equipment. It also uses a direct export model (with distributors acting more as an agent) to some extent, but usually sales are conducted via distributors. The company pointed out that in some cases it has limited financial information on distributors in emerging markets, which narrows credit assessment possibilities. This respondent also noted that in some markets there is a concentration of end-customers in the public sector and that in these cases payments to distributors are almost always late. The effect on cash flow has to be built into the financing model and terms. Another growing orthopaedic device manufacturer described the financing challenges faced in its extended distribution chain. Distributors generally have to get expensive capital funding from their local banks. At the same time, they are suffering from stretched credit terms with end-customers (since public sector and private hospitals have relatively long payment terms ranging from 6 to 12 months).
One global tablet mobile device manufacturer interviewed has a distributor network mainly consisting of SME entities. In some emerging markets, this group constitutes a large portion of the sales, in some cases even up to 80%. These distributors generally have limited access to financing. Even though their financing need is short-term (normally no more than 90 days), the volumes can be high, particularly in emerging markets where large sales volumes are handled by a single distributor. As business margins are thin, it is vital for distributors to have access to reasonably priced financing.
This manufacturer has set up several DF programmes in emerging markets in co-operation with large global institutions as well as some local banks, depending on the country conditions. These programmes offer revolving type, short-term credit lines for 30 - 60 days. Such facilities are extended by the international or local financing bank and normally require a personal guarantee by the owner of the distribution company or a pledge of physical assets as collateral. In terms of eligibility for the programmes, in addition to the company’s own selection criteria (e.g., history with distributors, share of business etc), the banks may also impose certain criteria on the distributors. The volumes of financing vary across different countries, but mostly over US$5m.
Based on its own experience, the corporation believes that global banks are more open than their local equivalents to implementing DF programmes, partly owing to their greater appetite for risk. Local banks, in comparison, are more conservative and less familiar or capable with such programmes. Furthermore, sometimes their lack of access to wholesale market funding makes it difficult for them to compete. Access to dollar financing is normally more competitive when provided by global banks. While portfolio management is mostly done by the financing bank, the company also performs its own credit analysis and portfolio monitoring and provides support to the bank when necessary.
Another research participant – an international food products company – has already been running both SCF and DF programmes in emerging markets to improve payment terms for their suppliers/distributors. Its distributor base mainly consists of small enterprises. The company provides financial guarantees to local banks so they can take on additional exposure to the distributors, enabling them longer credit terms. As distributors and suppliers are normally local firms instead of global companies, SCF/DF programmes are not set up on a corporate level but in each individual market as opportunities arise.
In general banks interviewed in this study have a relatively high interest in offering DF solutions, but their activity level and approach varies. They agreed that corporates have a strong desire to provide efficient financing instruments to distributors, especially since there is a growing awareness that distributors in many emerging markets and industries are often the weakest link in the supply chain and hence a bottleneck for growth. In addition, after some recovery from the financial crisis, there has been an increase in open account trade, further adding to the demand for DF.
Banks generally tailor each DF programme to the sector, customer and supply chain in question and DF normally sits within a bank’s SCF service area. While some banks emphasise DF as a major flagship product, or are increasing their focus on this area, others do not sell DF to customers on a stand-alone basis, but as a complementary product to key clients. Indeed, some banks have yet to offer DF to their customers. Distributor due diligence is normally performed with varying reliance on banks’ own local footprint as well as seller’s assessment. Many of the banks interviewed rely largely on sellers for due diligence of distributors, but some prefer to conduct in-depth financial analysis on distributors themselves, especially if they can leverage on their local footprint. Even though seller risk sharing is often a prerequisite for many banks, it is not necessarily a requirement for others as they may put a higher emphasis on supply chain linkage instead.
The scope of product offering, focus and definition clearly differs among banks. One global bank defines DF as the financing of (selected) distributors through extended terms with the primary objective of supporting sales growth. Products involved are usually high volume, low ticket and high gross margin, meaning an increase in sales can easily offset the cost of the programme. Floor planning or structures where distributors pay when the item is sold are not included in the bank’s DF programmes as these setups require emerging market country monitoring and auditing which does not fit its footprint. DF solutions offered to the clients are all specialised because of the difficulty of managing distributor risk with a standardised offering.
The bank’s DF programmes (usually regional, occasionally global), are receivables based. The DF solutions have a portfolio pricing, generally with arbitrage. The product financed should be a leading brand product and the distributor should be a growing business, indicating a strong relationship with the seller and economic stability of the distributor. The bank also highlighted that it is important to have a close relationship with the sellers so that they do not go outside the programme, allow distributors to exceed limits, or take on additional product.[[[PAGE]]]
According to this institution, their risk mitigation and sharing is as much based on sellers’ business and supply chain linkage, as distributor evaluation and payment performance monitoring. Risk control is exercised through a number of different means: credit insurance (covering up to 90% of endorsed limit, which may be over 60% of total outstanding); first loss default guarantee on sellers’ part to cover insurance gap (perhaps up to 15%); stop shipment clause when invoice is overdue; sellers may take on temporary recourse to cover spikes in volumes due to seasonality; sellers may also take recourse if needed, when insurance does not cover and extra limit needed (even if result is on-balance).
The bank emphasised that a good platform for monitoring exposure is crucial (whether in-house or a third-party solution). Other measures such as checking payment performance on a regular basis, reviewing the distributor portfolio annually as well as analysing a sample of distributor base’s financial data are equally vital. In its opinion, high-tech, media and telecommunications are the dominant sectors while agriculture, pharmacy as well as chemicals also have promising potential. From the regional point of view, Eastern Europe, the Middle East, Russia, South America and the Far East should provide scope for DF development.
According to another international banking institution, there is increasing demand for DF products, especially from the consumer goods and IT sectors. At the moment, the bank tends to offer DF as a complementary product to enhance existing customer relationships. Its DF model is an account receivable purchase programme. There is no minimum distributor turnover for participation as it is based on internal credit rating only. Each distributor has a credit line assigned to them. Sellers usually only support with information for the bank’s in-depth financial analysis on distributors and their on-boarding, but are unwilling to share risk as off-balance sheet treatment is crucial for them. In some cases, sellers take up to 10% first loss on a portfolio basis (not on individual distributors). This is value-added when the distributor portfolio is diverse. To monitor outstanding volumes of programmes, the bank uses a technology platform which also services several other trade finance products.
One banking behemoth adopts a seller-centric approach in DF, where sellers (large global corporates) select distributors. Advance rates are normally between a minimum of 80% and can be up to 100%. As clients bring a whole portfolios of distributors, the bank cherry-picks unless the seller takes major share of risk. Sellers will typically not take over 10% of the first loss in order to keep the arrangement off-balance-sheet. Servicer risk usually lies with sellers, even though the bank may take on a proportion in some cases. The bank has observed growing demand for DF in the market space, especially from the technology sector.
Having engaged in a few DF transactions in Eastern Europe, one finance specialist interviewed is looking to increase DF volumes in other geographies. In its DF model, the receiver of the funding may be seller or distributor, depending on the setup of the programme. The financier’s DF offerings include distributor-centric receivables based programmes, asset-based lending, floor planning and private label financing. Sellers usually bear the cost of the programmes while distributors might make instalment payments or pay when equipment is sold, depending on the type of goods and programme setup. Pricing is generally the same for all distributors if sellers are paying interest.
Managing the volume of transactions and credit risk requires an efficient technical platform. Banks may develop their own in-house platform, or integrate with a third party platform provider. It is important that external solution providers have versatile abilities to fulfil the numerous administrative and technical requirements.
From the processing and integration perspective, solution providers need to be able to integrate information flow between participants effectively, supported by a user-friendly interface. Equally crucial is the capability to process complex invoice-based financing techniques. Furthermore, providers need to be flexible enough to deal with the requirements of the transaction’s term sheet and the non-financial requirements of the programme. The management of dilutions such as discounts, credit notes and rebates and the support of accounting and regulatory requirements are also professional skills needed by providers.
Another important aspect is monitoring and reporting. It is vital that solution providers have the ability to report on exposure to funders, preferably on a daily basis and down to the item level. Tight monitoring and reporting is seen as a key factor in risk management and mitigation, spotting any problems as soon as they appear and triggering remedial action. As well as supporting credit analysis of distributors, solution providers need to demonstrate proficiency in analysing payment behaviour and programme performance.
The organisational capabilities of DF solution providers also help to ensure the success of a DF programme. It is imperative that they can work seamlessly and efficiently with banks, sellers, distributors and credit insurers alike. In addition, platform providers’ expertise and knowledge in assisting /supporting roll-out to distributors in relevant emerging markets will certainly prove to be an invaluable asset for the programme.
One of the main challenges of developing and implementing DF programmes is risk minimisation. Any distributor finance programme requires some form of risk mitigation and sharing between parties to ensure efficient pricing and an effective alignment of interests. As SME distributors’ balance sheets often imply high credit risk and require enhanced efforts to monitor and analyse, support from sellers and/or consideration of supply chain linkage is required.
Since different products and markets demand different structures and solutions, there is not a ‘magic bullet’. Approaches can vary among banks, sectors and regions and are also dependent on seller’s priorities and support. It is therefore important to understand distribution structure and competition for each potential programme and market in order to fine-tune the solution to the needs and risk profile.
Setting up a DF programme calls for the consideration of the principal legal, regulatory and tax and accounting elements, therefore a complex tailored approach is required. From the legal perspective, perfection of the true sale (of receivables) and/or security, including requirements on notification and/or acknowledgement, needs to be carefully structured. Country sovereign risk, insolvency laws and commingling risk as well as off-set risk (credits) all need to be taken into account in determining legal framework predictability and stability.[[[PAGE]]]
From the regulatory standpoint, developments of DF will inevitably be shaped by the global and national regulatory framework such as Basel III and foreign exchange controls. Prudence is required on information transfer owing to varying requirements and constraints enforced by domestic regulators. From the tax and accounting point of view, issues related to VAT, stamp duties and other taxes triggered by local law need to be clarified.
From this small qualitative study, it seems clear that corporate and banking opinion almost unanimously sees DF programmes rising in popularity. This may well be driven by sellers seeking to expand in emerging markets as the economic climate in their home territories remains lacklustre. International banks appear keen to support the emerging DF needs of their clients, whether offering the service on a stand-alone basis or as an additional product for existing clients. Most frequently, DF arrangements are based around the use of receivables as asset or collateral, and all respondents emphasised the importance of monitoring and reporting on receivables performance, right down to the item level, in order to manage and mitigate risk in a DF programme. It has also been suggested that governments may also become interested in the rise of DF programmes, as they are perceived to enable economic growth in countries where access to working capital is much less developed compared to economies in more mature continents.
Research was conducted amongst a sample of five international corporations with broad distributor networks in emerging markets and five large banking institutions with a global footprint. Corporate respondents were asked about their demand and usage of DF, programme model and distribution challenges in emerging markets. Global bank respondents were interviewed on their approach to DF, product offerings, risk management, sector demand as well as challenges in setting up DF models.
How Thought Leadership Can Reduce the Cost of Sales by Patrik Havander, Havander & Partners A focused attention on the costs incurred by the global sales and marketing processes is becoming increasingly important for corporate banks and their transaction banking departments. While the client/bank relationship remains vital, research has shown that in fact relationship selling […]
