Old meets new: Combining forfaiting and letters of credit for supplier finance with a smaller buyer

By Luis Quilico, Director, Global Transaction Banking, Americas, UniCredit  

In the wake of today’s economic downturn, supply chain finance has been rising in demand as buyers look to support their supply chains and suppliers seek liquidity to tide them over in the short term. This is an altogether effective approach when there is a risk arbitrage between a highly-rated buyer and lower-rated supplier, but what if things are the other way around?

This was the conundrum facing one of UniCredit’s oil & gas clients in the US. Luis Quilico, Director, Global Transaction Banking, Americas at UniCredit, explores how a combination of factoring and letters of credit solved the puzzle

The optimisation of working capital is a perennial issue for corporates and the current climate has brought the topic into sharper focus than ever before. The economic downturn precipitated by the COVID-19 pandemic has wrought economic turmoil worldwide, with the US economy, for instance, contracting 9.5% quarter-on-quarter in Q2 2020[1] – the largest quarterly fall since Q4 2008. This dramatic shift to the status quo has prompted companies to move quickly and decisively to shore up liquidity and working capital over the past few months – both for their own businesses and for their supply chains.

As a result, demand for supply chain finance (SCF) has been steadily rising. In Italy, for instance, retail store Esselunga – with the help of UniCredit – extended financial support to its suppliers by expanding its pre-existing reverse factoring facility to EUR 530 million.

In addition, UniCredit Factoring recently made a total of EUR 750 million in loans available to Conad’s suppliers, facilitating access to capital ahead of the payment terms of their trade receivables.

Such financing techniques are effective in propping up supply chains – provided the anchor buyer holds a higher credit rating than the supplier. The solution required becomes more complex, however, when the circumstances are flipped, and the supplier has a higher rating than the buyer. This was the challenge faced by one of UniCredit’s US clients in the oil & gas industry.

The challenge

The company, an emerging-market buyer in the oil and gas industry, was looking to extend its payment terms with a larger supplier in the US in order to enhance its cash flow position. The US supplier, however, was not comfortable extending payment terms, due to the perceived increase in risk. In particular, it was concerned that it wouldn’t be able to recoup its capital in the case of non-payment. On top of this, extending payment terms would also incur costs for the supplier – creating a liquidity gap that would need to be bridged via financing.

Under other circumstances, a supply chain finance programme would help mitigate these issues for the supplier. However, since the buyer in this case was not better-rated than its supplier, there was no risk arbitrage to be gained from such a set-up, and as such, no improvement to the financing terms for the supplier. The cost of financing the gap would most likely be higher.

The solution

To solve this problem, the buyer turned to an innovative solution, whereby UniCredit issued a Letter of Credit (LC)  guaranteeing payment of the buyer, through which the US supplier could request a cash advance against presented documents. This offered quick, secure liquidity at an advantageous financing rate that couldn’t be achieved through SCF under the circumstances.

The structure immediately helped mitigate some of the risks for the supplier, since LCs (bank guarantees of payment) are much more robust than invoices (supplier requests for payment) when it comes to making claims. LCs are tried and tested instruments that come with a set of uniform rules that counterparties must abide by to transfer documents and titles and settle transactions. Conversely, it can be challenging to create a robust legal structure around invoices and their assignment in cross-border transactions.

This approach also makes it possible to carefully balance the economics between the buyer and seller. The buyer pays the premium for its own risk by issuing the LC, while the supplier pays for the liquidity through forfaiting. This ensures that the financing costs for the supplier are better aligned with those of its existing revolving credit facility (RCF).

Even with the cost of the liquidity priced at the same as the seller’s RCF, the discounted LC represents the more attractive option, since it does not cause them to draw on their own liabilities. What’s more, the discounted LC is executed on a non-recourse basis and potentially off-balance-sheet solution – meaning no further financial debt need be incurred.

A blueprint for future transactions?

Going forward, this approach may be used as a blueprint for many other similar transactions where suppliers need liquidity or risk management support, but find the relative credit profiles are not conducive to economic benefits. It is also worth noting that the structure is best suited to larger, discrete deals, as opposed to smaller, scattered ones. Processing USD 50 million, for instance, across thousands of invoices, would create a significant admin burden tied to high-volume, low-value transactions, whereas a single large transaction or a handful of sizeable ones can be handled quickly and efficiently.

If these conditions are met, combining LCs and forfaiting can offer several benefits to buyer-supplier relationships, including better protection against buyer bankruptcy (where claims against an invoice may be harder to recoup in a foreign jurisdiction) through a more robust framework; potentially favourable accounting treatment, with the transaction remaining as a trade payable, rather than becoming bank debt on the balance sheet; and a more even distribution of costs between buyer and seller.

As the need for liquidity and efficiency continues to bite, this innovative solution, bringing together old and new financing techniques, presents an interesting alternative means of mitigating supply-chain risks and improving liquidity.

[1] Daniel Vernazza, Chart of the Week, 31 July 2020