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The Size Factor

When a bank or a specialist company “buys” the sales book of a small-to-medium-sized business, and advances monies on the invoices issued, it’s called factoring. When the money markets buy $500m of trade debtors from a blue chip corporation and advance the company money on trade invoices issued, that’s called securitisation. Is there a difference?

The answer is yes. Factoring is carried out by down-to-earth types who know their industry sectors like the back of their hand and can smell a bad debt from 1,000 paces. Securitisation is the preserve of the investment banks. We’re talking about the same people who lost billions lending money to Brazil and who don’t care about debt defaulting on a scale with less than seven zeros.

These are radically different worlds and while the two sides may, on paper, be doing much the same thing for their clients, in reality there’s a massive gulf between them. However, it seems that the gulf may be about to narrow as the factors seek to move up the chain.

On the one hand the factors and invoice discounters are up-scaling their activities and putting together propositions for larger and larger companies.

On the other, US investment banks with a history of trade debt securitisation in the US, are doing discrete deals in Europe, and keeping an eye on the UK market.

The amusing fact in all of this is that neither the US banks nor the UK ones want to introduce US-style trade debt securitisation into general UK practice. There’s an obvious reason for this reluctance. Factoring, invoice discounting and asset financing, is one of the most lucrative, if not the most lucrative of all the revenue streams in banking at the moment.

It currently provides annual returns in excess of 17 per cent for the sector. Securitising this market may generate much more business, but it will do so at the expense of margins that, at present, are very good indeed. In other words, what the banks gain in scale by moving to securitisation, they lose in profit. Therefore, the incentive isn’t there for them to change. It would in fact be far more lucrative for them to try to win blue chip business at something close to factoring rates.

As Jonathan Nicholson, head of business finance for Great Britain at Clydesdale Bank explains, the US didn’t move to securitisation of trade debtors by choice. Factoring in the US began as a service targeted at SMEs. However, since US business folk believe that cash is king, and because they have no inhibitions about generating cash through selling anything that’s going, factors found themselves with an easy market. With demand so brisk, supply soon quadrupled and then quadrupled again and again, with an increasing number of players taking up the factoring game.

What happened was that some of the larger factoring players took a leaf out of the mortgage and credit card debt securitisation that started in the US in the mid-1980s. Revenue streams based on consumer debt tend to be predictable and are only disturbed by huge swings in interest rates or by a rush of new card providers into the market. Some US factors decided to combine the books of dozens, possibly of hundreds of SMEs. They took these combined book of books to the money market as a securitised debt with a very reasonable rating. This enabled the factors who went down this route to offer a cheaper service to their clients while still making good profits.

The down side of all this is that in order to create an asset class that’s attractive to the money market, you need a book that amounts to substantially more than $100m. This creates both logistical and administrative problems if the book is made up of the trade receivables from dozens of SMEs. However, ex-investment banker Tim Nicholle, now managing director of the software house Demica, is marketing software aimed at enabling UK and European SME-orientated factors, to make the leap into the securitisation market.

Demica’s software makes it much easier for a factor to combine individual SME sales day ledgers electronically, into a single, secure book. He claims that using this software any bank or organisation currently offering invoice discounting to its clients, will be able to implement a platform that can make dozens of separate SME accounts look like a single book worth hundreds of millions of dollars.

“My background is securitisation, or the obtaining of collateralised finance from the capital markets. Clearly, the larger the collateral, the finer the margins are on the money, so scale is very important,” Nicholle explains.

But he also makes a further point. Although invoice discounting is good business for banks, it’s very expensive. The Banking Regulator considers lending to SMEs as a high risk, so this business has the highest tariff, at 100 per cent. This means that the bank has to deal with a 100 per cent capital weighting on its factoring and invoice discounting business.

They in turn, pass this cost on to the SME, who then has to pay a steep cost for the privilege of using a factoring service. For a large company the cost would come down to the bank’s wholesale cost of funds, plus 100 or 150 basis points (1/100th of one per cent). On the other hand, an SME would be charged at least 2.5 per cent over base rate plus a slew of additional charges that push the margin up to a very respectable figure.

“Because of the cost to the banks, although invoice discounting is a fantastically profitable business for them, it would be even better if they could put deals together in a more efficient way. This is where our software comes in. It enables them to do “tracked invoice financing”, where the corporate does the collections, and the software provides control.

It sends a snapshot of the client’s sales day book to the bank each day and contains intelligence that shows when invoices have been turned into money. The importance of this kind of system is first, it enables the banks to slim down their people-heavy invoice discounting departments, and second, it enables them to combine accounts,” he explains.

However, Bank of America senior vice president Graham Moffitt isn’t convinced that there’s much appetite in the UK for SME securitisation. Factors specialising in SMEs, such as Close Brothers, have a very good niche market and no real incentive to move up, he says. In fact Bank of America’s whole invoice discounting business is predicated on the idea of the stability of the two separate worlds of investment banks and SME style factors. As Moffitt explains, its invoice discounting business has a sweet spot for deals around the #25m to #30m range, which is much higher than most factors feel comfortable with. Deals larger than this but below the #100m range would be “clubbed” 50-50 with another organisation such as Citibank. Above this level Bank of America’s invoice discounting arm passes the deal on to its global investment banking arm for the full securitisation treatment.

“There’s nothing really new about investment banks doing securitisation of trade receivables for big corporates. We’ve been doing it for the past 10 years in the US, and it’s starting to take off in Europe as well,” he says. Bank of America recently helped Polaroid to finance its emergence from Chapter 11, for example, by providing it with a $100m securitisation deal on its global trade receivables via the Bank’s investment banking arm.

“The way it works for large corporates is that they can go to any one of a number of investment banks, including ourselves, and they will work with you to securitise the income stream from your trade receivables.

The structure surrounding the bond would be given to Moody’s or S&P to rate, and the rating it attracted would determine which investors you can sell it to,” he explains. If Moody’s didn’t fancy the quality of the debtors involved, the bond would have a lower rating and would attract a higher rate of interest. A high rating would mean that the bond was low risk and the attached interest rate would be lower.

In the US, where the bond market is mature, the market is liquid and it’s easy for an investor to buy in to a securitised trade receivables bond and to sell out of it when they want. In the UK and Europe, liquidity is still an issue, but progress is being made.

At the same time, as Tony Cox, vice chairman of the FDA notes, his members are also acquiring more of an appetite for larger corporate business.

“We are now seeing lines of credit being advanced up to #100m by our larger members,” he says.

However, Leslie Bland, managing director of Close Brothers, is adamant that his company isn’t in the big end of the market and has no ambitions in that direction. But he too, is seeing

Clear signs that big companies are starting to wake up to invoice discounting as an additional channel to create capital. At the higher end of the market, above £20m, where companies like GMAC operate, invoice discounting gets rolled in as part of asset financing.

“A company like GMAC will take all a company’s assets into account, including its buildings, plant and its sales day book. Funding the client in this way, as a bundled asset finance deal, will enable it to generate more cash for its client than the client could get from a bank. It may cost the client a little more than straight bank debt would cost, but if they can get a few million more to invest in their own business, and so generate better returns, it becomes a price worth paying,” he explains.

At bottom, while the lending may be being done against a basket of securities, the sales day book is the key instrument and it’s the strength of that day book that will determine whether or not the factoring organisation goes ahead with the deal or not.

Kevin Lambert, a manger in specialised financing at HSBC believes that it should be very simple for a company to understand the charging structure for invoice discounting. There are two basic components: a discounting charge and a service administration component. The discounting charge will be at a similar rate to a bank overdraft, which is the most directly competitive form of finance that an invoice discounting house faces. The service charge for a client with a very high quality sales daybook can be as low as 0.1 per cent of the client’s turnover. For a fully-serviced account, where the bank undertakes ledger maintenance and debt collection, it can be as high as one per cent of turnover.

Another service that bigger companies are finding worthwhile is the fact that HSBC and other invoice discounting “shops” are happy to buy the debt on a non-recourse basis. This means that the client company not only gets immediate access to a big chunk of every invoice that it generates (up to 85 per cent for the better quality clients), but it also manages to distance itself from any counter party risk. It doesn’t matter if their client goes into insolvency, there’s no clawback on the money that it has been advanced by the bank on the debt. The fee for this service ranges between 0.3 and 0.6 per cent, depending on overall risk levels.

With counter party risk taken out of things, and with instant cash available, there are only two possible reasons for a company not opting for invoice discounting. The first is that it’s already cash rich, and the second is cost. Factoring is a profitable game and it will only be made cheaper if securitisation takes off.

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