United States: Trends In Trade Receivables Finance

Introduction

With partners having over 30 years' experience in financing trade receivables and trade payables, Mayer Brown has a unique insider's view of the global trade finance industry. Emerging from a tumultuous 12 months in the midst of a global viral pandemic, we look back in wonder at the resilience and innovation this industry demonstrated through exceedingly challenging times. That resilience and innovation continue unabated, and we see certain defining trends emerging for the near term. Given the longevity of trade finance, its critical importance to businesses around the world and a quickly changing and developing global economic, political, regulatory, accounting and overall business environment, it is no surprise to see ongoing innovation in structural technology and disintermediation, the entry of new players in the market, coalescence of thought on accounting implications and broadened use of the product by companies in varying states of the business and credit cycle.

While we could write volumes and fail to capture the nuances of all the types of trade finance tools in the market today and the evolution of such tools over the last 30 years, for the purposes of this article, we will limit the discussion to four particular trends that we have witnessed in the trade finance space in 2020 that seem likely to continue in 2021 and beyond:

1. The convergence of "securitisation" structures and more traditional trade finance technology.
2. The entry of private equity and credit funds and insurance companies as investors.
3. Broader acceptance of US GAAP off-balance sheet structures that do not result in negative consequences under ASC 230.
4. Increasing comfort by lenders and investors in structures that will not only survive but thrive pending and during insolvency proceedings.

The Convergence of "Securitisation" Structures and More Traditional Trade Finance Technology

The fact that trade finance has endured for many decades is a testament to the value of business-to-business trade receivables in supporting high credit quality and liquid investments. Traditionally, trade finance can include: (a) investments, typically in the form of factoring or other purchases of individual receivables (or other financial assets created from or otherwise supporting those receivables), whether to provide financing to buyers or suppliers (or other intermediaries) in the supply chain (which we will generically refer to as "obligor-specific transactions"); (b) asset-based lending ("ABL"), typically constituting loans, provided to a supplier of goods or services and secured by a revolving portfolio of short-term receivables and inventory; and (c) securitisation of trade receivables (which we will refer to as "structured finance"), which may be financed by banks or more widely in capital markets, but always utilising a bankruptcy remote structure. It should be noted that obligor-specific transactions may provide financing to multiple obligors under the same agreement but with underwriting of each included obligor.

Although obligor-specific transactions can be done in many forms and on a one-off or revolving basis, disclosed or undisclosed, and committed or uncommitted, the common thread in these transactions is that the investor need only assess the credit (and short-term credit at that, given that these assets typically mature in 90 days or less) of one corporate entity – the buyer of the goods or services at issue. Of course, structural elements could add additional risks, such as potential credit risk with respect to a supplier/seller if the transaction is not respected as a legal true sale or if all dilution risk has not been eliminated, potential credit risk with respect to an intermediary that takes title to the receivables for financing purposes or potential credit risk with respect to an insurer if a credit insurance policy has been obtained to insure payment of the purchased receivables. Given the short-term nature of the transaction and the limitation of potential credit risks, pricing for these transactions will typically consist of par minus some discount that reflects the expected time to payment as well as the investor's credit assessment of the obligor.

ABL transactions are typically secured loans and, as such, typically financed by banks and typically on a committed basis as part of a company's overall working capital management or even as part of an acquisition financing. These transactions require more sophisticated underwriting as they must assess the credit quality of a portfolio of receivables as well as that of the supplier/ borrower and its ability to continue to generate a consistent portfolio of receivables to support the financing. These facilities are typically longer term (normally over a year) and will therefore often include triggers relating to the supplier/borrower's credit and the pool performance that will stop the committed financing early. While pricing of these facilities will typically be based on pricing the supplier/borrower's secured credit assessment, the amount of funding available at any point in time will depend on the performance of the portfolio of receivables and will take into account the expected life of the portfolio in a run-off scenario, as well as historical defaults and dilutions and obligor, and perhaps other, concentration limits. The combination of all these factors will result in a borrowing base to support the financing but the financing will be full recourse to the supplier/borrower, even if it turns out that, in retrospect, the borrowing base calculation overstated the value of the portfolio of receivables supporting the financing

Structured finance, like ABL transactions, requires investors to underwrite a revolving portfolio of receivables based on historical performance data but, unlike ABL transactions, is not full recourse to the supplier. Like ABS transactions, structured finance typically includes a dynamic borrowing base that takes into account ongoing pool performance. However, these transactions are designed to isolate the receivables portfolio from any insolvency risk of the supplier by transferring the receivables portfolio to a bankruptcy remote special purpose entity (an "SPE"). Consequently, structured finance transactions can result in pricing that is better than that which a supplier may be able to achieve in a full recourse transaction that relies on its credit, even if secured. However, even with such isolation, the transaction will expose investors to some credit risk relating to the supplier, which may include dilution recourse, indemnification for representations and warranties regarding the nature of the portfolio, servicing of the portfolio as well as the continued generation of new receivables to replenish collected receivables in the event that collections are not immediately segregated. Consequently, structured finance transactions in trade receivables will normally include some triggers relating to supplier credit issues that can have the effect of terminating the revolving nature of the portfolio, starting cash trapping or imposing other limitations on the ordinary servicing procedures of the supplier. It is worth noting that in structured finance, although recourse to the supplier for obligor credit performance is typically quite limited in the sale transaction to the SPE, there is no such limit on the recourse of investors to the SPE. That is because the transaction between the SPE and the investors need not be a legal true sale in order to provide investors with the isolation in bankruptcy that they require. The SPE is designed never to become the subject of an insolvency proceeding and the SPE's assets and liabilities cannot be substantively consolidated with the supplier in the event of a supplier insolvency proceeding. The advance rate (or borrowing base) in these transactions will likely be the same or lower than in ABL but with better pricing and, like in ABL transactions, the supplier has no possibility of delivering any "upside" to its investors because the discounting self-adjusts for historical performance both prospectively and retroactively. The investors cannot receive more than their investment and cost of carry for the duration of their investment.

The types of convergence that we are seeing include: (a) obligor-specific transactions that include higher levels of recourse to the supplier that add stress to the legal or accounting sale characterisation of the transaction and may correspond to insurance coverage acquired by the investor; (b) "securitisation-lite" structures designed to solve for the higher levels of recourse by inserting an SPE between the supplier and the investors, but without the more complicated advance rate/borrowing base calculations included in ABL and structured finance transactions; (c) the emergence of "aggregation" entities sponsored by investment managers or payment platforms, which seek to pool trade assets acquired from multiple unrelated suppliers; (d) the inclusion of credit insurance, traditionally endemic to obligor-specific transactions, in structured finance transactions; and (e) investors financing particular obligor "excess concentrations" using obligor-specific transaction technology but from a portfolio otherwise included in a structured finance transaction already, as well as investors financing residual or subordinate interests in structured finance transactions.

The first two types of convergence generally go hand in hand; that is, the desire to increase recourse levels, even for obligor-specific transactions, drives the securitisation-lite structures that have emerged in the market. Suppliers can enjoy a higher purchase price/advance rate if they provide some level of guarantee of payment by their obligors, whether through an increase in discount if the obligor pays late, or an absolute guarantee of a certain percentage of losses. Because higher recourse levels can be detrimental to obtaining a strong legal true sale opinion, which in turn is generally required for off-balance sheet treatment under US GAAP, and can result in non-US GAAP reporters failing to achieve sale treatment under International Financial Reporting Standards ("IFRS"), adding an SPE to the structure can often result in the supplier and investors both "having their cake and eating it too". We will discuss current off-balance sheet technology under US GAAP in more detail later.

The third type of convergence is a natural result of the emergence of non-bank investors who want alternative avenues to invest in trade assets outside of the traditional inter-bank participation market.

There is also an increasing trend in the marketplace for buyers of goods to want to engage in arrangements where they can arrange for their inventory to be financed on an off-balance sheet basis. This usually involves the imposition of a third-party entity agreeing to purchase the inventory either from the buyer or directly from the buyer's suppliers and holding the inventory on its own books. Often, the third-party entity will finance its ownership of the inventory through one or more banks. These arrangements involve complex accounting and regulatory questions and are often highly bespoke in nature.

We have observed an increase in the inclusion of credit insurance policies in trade finance transactions for several years. Of course, a credit insurance policy can be used as an enhancement to the credit risk of obligors in any of the trade finance structures in the market. However, it has more recently found its way into structured finance transactions. For many banks that are not subject to US regulatory capital rules, credit insurance can dramatically reduce the required capital to support these transactions (although, unless cash collateralised, there is little utility in such insurance in the US, outside the securitisation framework). Although clearly beneficial to investors in these transactions, regardless of the capital benefit, the motivation for such inclusion often comes from the supplier. With an insurance policy covering the portfolio, the supplier can obtain a higher advance rate against its portfolio but also may be able to obtain off-balance sheet treatment for a transaction that is otherwise investment grade risk to its primary investors. That is because the risk assumed by the insurer may be considered to satisfy the IFRS requirements to have a significant risk transfer. Investors in transactions with such insurance policies should consider whether counsel should be charged with reviewing the policies in detail, as structured finance transactions can result in complexity in determining what entity holds the receivable and has an insurable interest under local insurance law. Often, there may need to be multiple insureds in order to ensure that the interests of the investors and the SPE (as to its residual interest) are covered. Also, the policy will normally need to be adapted to fit the transaction to ensure that although the supplier may no longer own the receivables, it is still the entity servicing them and responsible for insurance reporting.

As we will discuss below, the level of interest from non-bank investors in the trade finance space has increased rapidly over the past several years. Given that many of the non-bank entrants in this market are private equity, credit funds and other alternative lenders that are not constrained by banking regulations and that typically seek higher yields, it is not surprising that these investors are finding ways to acquire residual or subordinate tranches in existing and new structured finance transactions. Of course, in new transactions, the structure can be designed to accommodate subordinate investors through subordinated notes or other similar mechanics. In existing transactions this can be trickier but these new investors and banks are finding ways to make it work, including by transferring subordinated participation interests, acquiring financial guarantees or credit default swaps, or by issuing credit linked notes that support a subordinated tranche of the bank's investment. We also see investors applying obligor-specific technology to existing structured finance transactions, by acquiring receivables owing by particular obligors that are in excess of the amount of funding available against such obligors in the structured finance transactions. These "excess concentrations" can be financed by the supplier with other investors but typically require the consent of the existing bank investors.

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Originally published by ICLG.com

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