The potential "win-win-win" solution for the liquidity problems of many private small- and medium-sized companies.
Some months ago, I read a piece praising Procter & Gamble for having finally adopted the “new standard” of paying suppliers in 90 to 100 days rather than the “old” 45 days. This new standard comes from using “Reverse Factoring,” a financing approach that became popular in Spain in the ‘80s and ‘90s (oddly enough, the “Spanish” name for Reverse Factoring is “confirming,” a registered name by Banco Santander). The practice has spread since 2008 to many other countries, especially in Northern Europe.
How Reverse Factoring works
Consider a strong buyer (say with a credit rating of AA) that buys on account from its weak suppliers (say with a rating of BBB), and pays them in 40 days. Suppliers in need of liquidity sell some of the buyer’s receivables to a financial institution at a high cost of, say, 15%. The cost is high because 1) the bank protects itself against the risk of the buyer not paying the supplier and 2) the supplier is weak so it may not be able to repay the bank if the buyer doesn’t pay the supplier.
Now the buyer, in conjunction with its bank, proposes the following to the supplier: “Whenever you need liquidity, you can sell my receivables to the new bank, which will charge you a mere 6% rather than 15%. In return, I will pay you in 80 days rather than 40.” The bank is willing to charge only 6% because it has the commitment from the buyer that it will pay at due date (remember that the buyer is financially strong). The supplier is better off because, even if the supplier is paid later, the lower cost of the factoring contract more than makes up for it. The buyer is better off as well because the buyer pays 40 days later to the supplier, freeing up a nice pile of cash.
Therefore, Reverse Factoring (the transaction just described) seems to be a “win-win-win” solution. That may be the reason why some European governments, such as the U.K. last year, have seen Reverse Factoring as a potential solution for the liquidity problems of many private small- and medium-sized companies. Thus, they are encouraging firms and financial institutions to adopt reverse financing programs. Others, as the Dutch government, might follow suit.
Where the problem stems from
The scheme works beautifully as long as the buyer pays on time – which is expected, since it is a relatively financially strong player. However, what if the buyer cannot duly pay for her invoices? Banks may immediately opt out of the corresponding Reverse Factoring program, which may well drag weak suppliers into bankruptcy. This may affect an entire industry, and even a major portion of an economy. In fact, if these Reverse Factoring practices become pervasive, they may well become the seed of the next financial crisis.
You may be right to think that odds are not high that a strong player cannot pay its suppliers on time. But it does not mean that it is impossible. For instance, Moody’s, Standard & Poor’s, and Fitch Ratings all rated Lehman Brothers an “A” credit or better when the latter went bankrupt in September 2008. Similarly, 75% of the analysts covering Parmalat had a buy or neutral rating on the stock a quarter before it collapsed in 2003. OF course these two corporations went bankrupt because of a financial scandal, but it is a fact that financial scandals do occur.
How to prevent Reverse Factoring from growing exponentially
Although Reverse Factoring programs may be beneficial under some circumstances, its growing use may lead to serious situations. One way to prevent these programs from growing too much would be for “factors” – the financial institutions that provide liquidity – to impose a risk premium on buyers, as compensation if there is a negative outcome. Additionally, suppliers should be aware of the risks of joining Reverse Factoring programs before it is too late.
This article first appeared on Serrano’s personal blog and was republished with permission.