Trade Finance is one of the oldest forms of institutionalized lending. For investors it remains a relatively new asset class with a few hurdles. Jörg Hörster of TrustBills describes the characteristics and risks of this private debt segment and shows how regulation processes and technical developments have facilitated access.
Private Debt is a dynamically growing segment whose record increases make the headlines time and again. The reason why what generally tend to be risk-averse life insurance companies and pension institutions opt for Private Debt alongside Asset Managers is evident: investments in this area currently constitute one of the few solution approaches for attaining median guarantee/invoice interest in the range of 3-4% p.a. in the fixed income segment.
But the large investment volumes streaming into this segment have a negative impact on risk premiums. Investors have long since had to accept greater risks for their target returns even in the case of Senior Loans, Infrastructure Debt and Real Estate Debt. The consequence is market maturity and market expansion. Opportunistic investment approaches are increasingly more strategically oriented. Moreover, in addition to the traditional Private Debt instruments other forms of corporate finance for investors are gaining significance. The strong demand is favored by technical development. Particularly in the area of Trade Finance investment opportunities are being unlocked for the first time through phenomena such as AI, Block Chain or Big Data. This also applies to trade receivables. As a Trade Finance investment, they have relatively low default rates, correlations and volatilities. Despite these positive portfolio characteristics, trade receivables are underrepresented with Asset Managers and institutional investors. The reason for this lies with their poor accessibility to date. However, through standardization and automatization, trade receivables are rapidly gaining significance.
The first part of the following article introduces trade receivables as an investment class and elucidates the previously existing markets. The second part deals with risk assessment of receivables, whilst the third part elucidates legal aspects of receivables investment on an individual title basis and potential funds vehicle.
What are trade receivables?
Trade receivables are receivables from supply transactions or services between companies/corporations arising from invoicing by the party providing the good or service. Under Civil Law, trade receivables may be the subject of transfer through sale pursuant to § 433 BGB (Civil Code) and assignment pursuant to § 398 BGB.
The transfer of trade receivables can generally also occur through mere (short-term) monetary investment by the buyer of the receivables. The latter exchanges liquidity within his portfolio for receivables against the third party to the future payment of money. If the buyer assumes the receivable together with the concurrent default risk (delcredere) it is a “true sale transaction” (non-recourse). Normally, the buyer attains a mark-up/return through discount on the nominal amount of the receivables.
Which markets have existed to date?
Today, the intention of the transfer of trade receivables has been the financing of receivable terms, especially by the seller. Diverse forms of financing have developed in this context on the international capital market. If there is a revolving transfer of receivables by a company against one or several debtors to a financer before the payment date, this is a case of factoring. However, if only individual receivables are transferred this is a case of non-recourse financing or simply individual factoring purchases. Until now, such sales solutions were in the hands of banks or special companies. To date, institutional investors had to resort to ACBP (Asset-Backed-Commercial-Papers-) programs or other securitization mechanisms in order to attain exposure in the trade receivables. In the case of securitization numerous trade receivables are bought up by an intermediary, e.g. in the form of a bank or special purpose company, (Special Purpose Vehicle, SPV) and the purchase re-financed through the issue of a security (e.g. a commercial paper or bearer bond) which is hedged by trade receivables streamlined according to their due date. The capital costs of such securitization structures are composed of claimed equity returns, regulatory requirements and necessary guarantee promises. Through these relatively expensive structures the potential returns for investors have been comparatively low. Securitization was the only possibility of managing the volumes in order to be able to manage a large amount of small share, heterogenous trade receivables at all, due to the manageable nominal amounts of trade receivables. Digitalization now enables new ways of volume management. With the rise and interplay of new technologies in the areas of real-time auctions, AI methods, fraud prevention and automatic payment procedures, automatization is replacing securitization. Traders can filter receivables uploaded to platforms on auction platforms and acquire them algorithmically through participation in an auction, as if they were securities. The platforms generate assignment contracts automatically for every single receivable acquired which serve as proof of securing to the bearer and additionally deposit these digitally with selected storage bodies. Payment for the acquisition of the receivables and for payment at maturity, where applicable payment reminders in the case of delayed payment, inventory and risk reporting and even the generation of accounting entry formulas are taken care of automatically from these platforms. In this way, large portfolios of small share, heterogenous trade receivables can be managed with fewer Human Resources and lower costs than in the area of Asset-Backed Securities.
Why are trade receivables suitable as an investment object?
New risk premiums
As the securitization requirement no longer applies, investors can participate directly in a new type of risk premium. To date, the measure of judgement of a debtor was his credit rating, which is a benchmark for a debtor’s solvency. In contrast, in the case of trade receivables, payment willingness, i.e. payment history is the focus. Payment history is not so much characterized by credit rating but by the relationship between the supplier and debtor and the position of the parties involved within the client relationship. And this does not necessarily always co-relate with creditworthiness.
If we look at the current structure of the factoring market, the comparison with a flea market comes to mind. There is no real pricing process, the processes are slow and inconvenient and the buyers lack an overview of the total offer. Statements regarding returns can only be derived via profit analyses related to the median receivables’ portfolio from the balance sheets of the factoring companies. With the rise of a true sale marketplace for trade receivables there is a certain transparency for prices and returns. The range of the capital returns between 30 bps p. a. (receivable from a receivables seller with a “very good” credit rating against a debtor with a “very good” credit rating) and 20 % p. a. (receivable by a receivables seller with a “poor “credit rating against a debtor with a “poor” credit rating) is quite significant. For example, the transaction history of this still new marketplace shows that the annualized capital returns from receivables from German medium-scale businesses against large debtors in the IG sector to date are concentrated between the range of 2% and 8%.
Owing to the discrepancy between insolvency (rating) and payment willingness (payment history) the anticipated correlations to the credit spread and other investment classes are comparatively low. This correlation effect is consolidated through the granularity of a trade receivables portfolio, i.e. the use of the diversification potential through compilation of the individual receivables on the basis of individual investment criteria.
The prerequisite for a risk-adequate market assessment would be that the payment history within the supplier-debtor relationship is known and measurable. Payment history statistics and thus new, measurable risk metrics such as payment delays and dilution of supplier-debtor relationships should be provided. On the basis of return expectations and weighting of the risk metrics investors can efficiently submit risk-adequate bids for a number of receivables at such a marketplace. Without these payment history statistics, assessments can only be derived from estimated default probabilities.
The median duration of trade receivables is between 30 and 90 days. The interest change risk through a possible interest hike is therefore very low. Alongside the resulting low volatility, the short duration also has the benefit for insurance companies of low equity requirements under Solvency II in comparison with (long-term running) corporate bonds with comparable earning potential even where the receivables are trade receivables from unrated companies.
Absolute Return characteristic
A well-diversified portfolio of trade receivables further possesses absolute return characteristics in pure form, as there is only a loss potential in the case of dilution or default, which may however be diversified through a spread across a large number of diverse trade receivables. Delayed settlement of a receivable only entails a decreased return but still leads to an (absolute) positive return.
In contrast to investments in alternative investment categories in the Private Debt sector for which premature withdrawal is only possible with great difficulty due to the long capital-binding period, a portfolio of trade receivables liquidates autonomously upon requirement without any outside effort. There are no transaction costs. The challenge lies instead with the re-investment of the money resulting on a daily basis from the settled trade receivables.
Taxonomy of the risks in trade receivables
In jurisprudence, the term moral hazard designates the legal validity of a receivable. The moral hazard concerns the risk of a creditor that there is no valid receivable against a third party or that it loses its validity. Normally, a factoring agreement includes moral hazard guarantees by the seller of the receivables which obligates him to the defect-free assignment of the receivable and whose structure is fixed in the contract.
Insolvency risk of the debtor
The insolvency risk of the debtor is the risk that the debtor is no longer able to settle the individual receivable in the case of insolvency. This credit risk is empirically measured through default probabilities from rating models.
Insolvency risk of the receivables seller
Factoring companies circumvent the risk exposure of insolvency risks of receivables sellers by pledging or assigning the receivables accounts. In contrast, platforms frequently obligate the receivables seller to pass on the payment to the receivables buyer when the payment is due (i.e. forward payment). Whenever payment is made via the receivables seller, there is the risk in the case of insolvency of the receivables seller that the money is not received by the receivables buyer. In this case the default probability of receivables sellers is to be taken into account in the risk calculation.
In contrast to securities or loans, payment delays are the rule in the trade of goods and services. Payment delays are interest risks, as the capital being used cannot be deployed elsewhere.
In factoring the term dilution refers to all transactions which diminish the amount of a receivable, e.g. because the service rendered was defective. On the basis of the moral hazard guarantee the buyer of a diluted receivable may have the reduced value compensated by the receivables’ seller.
Risk measurement of investments in trade receivables
The risk degree as an anticipated loss in relation to the nominal amount of a receivable can be modeled by a decision diagram (see FIGURE 1). If the debtor is insolvent there is a total default of the receivable with a probability of . However, if this is not accurate, within the scope of a forward payment and in the case of an insolvency of the supplier/the receivables seller with a probability of he may “get stuck” with the payment. Then there would also be a total loss for the investor. Even if this is not the case, there still is the risk of a dilution of the receivable to the amount of the expectation value DIL (known from payment history statistics). The latter is generally compensated by the receivables seller within the scope of dispute management and a moral hazard guarantee of 100 %. However, the prerequisite for compensation is that the supplier/receivables seller does not become insolvent within the period of Dispute Managements (DM) with the probability . This results in the formula for the anticipated loss:
1 | Anticipated Loss of a Receivables Investment in the case of Forward Payment
= Dilution = Reduction
= Default probability Debtor in relation to the anticipated receivables duration
= Default probability Supplier in relation to the anticipated receivables duration
= Supplier insolvent before guarantee satisfaction (1 year)
Assessment of items in trade receivables
Investors calculate the fair value trade receivables taking into account the anticipated loss with the following parameters:
= gross invoice amount of the receivable
= days until payment deadline for the receivable
= anticipated payment delay in days
= DtD + LPD
= anticipated reduction of value which according to the principle of caution is not compensated
= Insolvency probability of the debtor (in relation to 1 year)
= Insolvency probability of the receivables seller (in relation to 1 year)
= risk-free target return p. a.
Let us look at a receivable as a zero-coupon bond for which the nominal value is prospective at the time of the payment deadline. Taking into account the anticipated dilution and anticipated payment delay, the risk-adjusted price P will be the cash value of the anticipated nominal value which can be attained in the case of an anticipated (extended) duration and with which the investor intends to attain risk-free annual returns to the amount of the ROI.
with i as the risk-adjusted annual return
The risk premiums r of the trade receivables with the anticipated duration are calculated as follows in the cases of forward payment:
The cash value of the receivables can be calculated for each day between the purchase of the receivable and the anticipated payment date with the following formula:
At the anticipated payment date equals zero and thus:
i as the sum from the risk-free interest rate and the creditworthiness risk premium remains constant over time. However, this assumption can be accepted, as only short time spans are observed. If payment is made after (before) there is an unanticipated loss (gain). The same applies where the actual dilution is greater (lesser) than the anticipated dilution DIL.
Acquirability of trade receivables
Under Investment Law trade receivables are not securities because no right is chartered in them. However, in analogous application of the AIFM guideline and the KAGB (Capital Investment Code) they may be classified as loan receivables. In any case, trade receivables are an admissible investment object pursuant to the AIFM guideline and KAGB through investment vehicles such as alternative investment funds (AIF). Trade receivables can directly be acquired by institutional investors (recorded companies as defined by the AnIV) to the extent that they are regarded as subordinate receivables as defined by § 2 Sect. 1 No. 9 AnlV or also pursuant to § 2 Sect. 1 No. 17 AnlV through investment in an investment fund. A suitable investment vehicle here is i. a. the Reserved Alternative Investment Fund (RAIF) according to Luxembourgish law. Acquisition through close, domestic special AIF is not limited. For acquisition by open, domestic special AIFs with fixed investment terms pursuant to § 284 KAGB, acquirability depends on the classification of the trade receivables. Trade receivables can also be evaluated according to recognized evaluation methods (see above).
Trade receivables as debt securities are true private debt. Due to lack of accessibility trade receivables have to date only been traded in securitized form. Through new digital marketplaces automatization is replacing the relatively expensive securitization for the management of large volumes of small share, heterogeneous receivables, making investments in trade receivables more economical. The benefits of trade receivables as an asset class include low volatility with their positive contribution to the risk-return ratio, low degree of correlation with the previous asset classes, short capital-binding duration as well as the inherent absolute return character. The risks of trade receivables can be categorized and modeled. The extent of these risks can be measured with known model input factors such as default probabilities and payment history statistics. Likewise, the receivables can be evaluated before and after acquisition in analogy to the pricing of a zero-coupon bond. Trade receivables are also acquirable for institutional investors through investment vehicles such as Alternative Investment Funds (AIF). Expanding global trade principally running on an open invoice basis as well as the increasing substitution of bank activities (e.g. in the credit business) by institutional investors pushes trade receivables as an investment class more and more in the foreground.