Let’s suppose for a moment that 2014 is a time of uncertainty for investors. Renewed competition from banks and public debt is matched by an ever increasing supply of credit from the non-bank sector and the valuation of some collateral is beginning to look aggressive. Investors have seen margins on new lending erode and there always seems to be someone else who is prepared to overpay.
So before considering returning money to LPs or chasing the competition in a race to the bottom, it may be worth considering types of private debt investment which have not received so much attention.
One such product area is receivables finance. This is the unglamorous world of factoring, forfaiting, asset-based lending, even trade finance. This is the type of finance that has to happen if businesses are to grow. It does not depend on M&A activity or rising real estate values, it depends on businesses selling goods and services and being prepared to take a discount in return for getting paid sooner. Annualised yields in high single digits are possible.
So why don’t all debt investors diversify into receivables finance? Well, receivables finance brings with it certain unfamiliar challenges.
Receivables are generally short-dated. You can’t just buy one receivable and wait for it to mature if you want to make money – financing is generally provided on a revolving basis against a shifting pool of assets. It is possible to buy individual receivables, but this requires active management and constrains scale: you need to start small and work hard, or find sellers with a lot of receivables to sell at once.
They are also generally unsecured. It is possible that receivables will be sold with retention of title of the sold goods or that they are covered by trade credit insurance, but there is no underlying real estate or equipment to foreclose on. If the debtor doesn’t pay, you are an unsecured creditor with a relatively small claim and no seat at the table in a restructuring.
Then there are some peculiar legal risks. For example, regulatory constraints prevent many investors from buying receivables from French sellers directly and there are circumstances in many jurisdictions where the sale of a receivable can be challenged by an insolvency official of the seller under certain circumstances. In that way the purchaser or financier of a receivable is exposed to the creditworthiness of both the seller and the debtor. What’s more, purchasing a receivable can expose the purchaser not just to credit risk, but also to performance risk, for example. If the goods in question turn out to be defective and there is a dispute, there may be no receivable at all.
There are solutions (partial or full) to all of these problems but ultimately this asset class requires expertise, structuring and considerable due diligence. On the positive side, receivables are self-liquidating and uncorrelated with other asset classes. Precisely because they are short-dated they allow a quick and hopefully complete exit. And while they are not secured, a trading business which doesn’t pay its suppliers may soon find itself out of business.
We are seeing an increasing number of non-bank financiers explore this area. Some, such as Falcon Group which provide supply chain and working capital finance on a large scale to businesses particularly in emerging markets, have achieved spectacular growth. Others, such as Aztec Exchange, act largely as intermediaries connecting private capital with corporate sellers.
We also expect to see more capital markets and fund products backed by trade receivables. This will open the market to more passive investors looking to take advantage of the yield opportunities without doing quite so much work, and allow the injection of leverage. Some of the hottest opportunities are in the areas where the banking sector is most dislocated, such as Italy, or in emerging markets where banks simply cannot keep pace with the growth of trade.
Receivables finance is unlikely to challenge leveraged finance or real estate finance as a destination for private capital any time soon. However, for investors looking for diversification and relatively high yields which are not correlated to exuberant markets, it presents some exciting possibilities.
Nick Stainthorpe is a partner at Reed Smith and is based in London. He specialises in complex finance transactions with a particular focus on derivatives and structured finance.