«ASSET-BASED FINANCE WHITE PAPER #1 CONTENTS Acronyms Introduction Executive Summary A. Asset-Based Finance A1. Background A2. Instruments and Applications A2a. Accounts Receivables Finance A2b. ...»
Future receivables are a potentially important source of factoring and should be included in any definition of factoring. A stable commercial relationship usually means future cash flow from product delivery will be reliable, so an SME may wish to factor the receivables and the factor may wish to purchase them. This is a common practice that increases the flexibility of factoring as a financing instrument.
Factoring is one type of receivables financing. There are other types that should not be
included in the definition of factoring:
1. Forfeiting is the purchase or discounting of documentary receivables (e.g., promissory notes) without recourse, involving financial rather than commercial transactions with different collection characteristics
2. Refinancing is the assignment of receivables against some form of bank or other credit granted to the assignor
3. Securitization can involve issuance of securities backed by commercial receivables of various types purchased by the issuing securitization company from the commercial entity that originated the receivables
4. Project finance, or loans to project contractors secured by future revenues generated by the project 4 ASSET-BASED FINANCE: WHITE PAPER # 1 If the SME and its factor are in the same country, it is called domestic factoring. The domestic factor is solely responsible for the collection and quality of service.
International factoring is when the SME is in one country and its factor is in the country where the SME’s customer is located. A single factor can conduct the activity (known as direct factoring) in international factoring. However, there are advantages to the so-called two-factor system, in which a factor in the SME’s country (the export factor) and a factor in the SME’s customer country (the import factor), responsible for collections and the quality of service) cooperate. An SME exporting to several countries signs one factoring agreement with the export factor in its own language, and the SME customers deal with a local import factor in their own language. This is useful to facilitate the SME’s sales to foreign markets.
With reverse factoring, a factor purchases A/Rs from only select, high-quality customers. This allows the factor to determine the credit risk of only high-quality customers, assume the risk of default by and factor in emerging markets on a ―without recourse‖ basis, allowing SMEs to sell A/Rs in greater amounts at lower costs.
Non-consumable assets range from equipment (e.g., heavy road machinery or a dentist’s chair) and real estate (e.g., a manufacturing plant or improvements to it) to vehicles (e.g., aircraft and cars).
For SMEs, leasing has several advantages over a loan:
The lease is a contract describing the asset. It sets forth the duration of the lease, the payment schedule and amounts, insurance requirements, and purchasing options at end of term. Payments by the SME lessee can be tailored to its cash flow: seasonal payments ASSET-BASED FINANCE: WHITE PAPER # 1 5 adapted to higher payments in peak season; varying monthly payments based on predictable income variations; and deferred lease payments that allow time for equipment installation, staff training, and a period until the equipment can generate income.
In longer-term leases (i.e., more than 1 year), the lessee often selects the supplier from which the lessor purchases the asset to be leased. The supplier is then responsible to the lessee for warranty, and an after-sales service package may be added.
Excluding a simple rental, which is a type of short-term operating lease for a fully maintained asset that is returned at the end of the contract (e.g., a car rental for a day
trip), there are several types of leases available to SMEs:
A2f. Asset-Backed Securities An asset-backed security, or securitization, is an asset-based finance product available on the capital market. It is, therefore, non-bank finance. Consider an SME that leases cars and has accumulated a substantial leasing business. It has reached the point where it needs to replenish funds tied up in contracts so it can enter into more leasing contracts to
meet consumer demand and generate more business and profit. It has several choices:
borrow additional money from a bank, raise funds on the capital market by issuing shares or even bonds, or obtain financing from its own asset (i.e., its portfolio of outstanding leasing contracts that generate payments now and in the future, and the cars leased in that portfolio).
As originator of the leasing contracts, the SME sells that portfolio for cash to a securitization company, or special purpose vehicle (SPV), which pays the SME a discounted price for the value of the portfolio. The SME (i.e., the originator) uses the funds to continue underwriting more leasing business.
6 ASSET-BASED FINANCE: WHITE PAPER # 1 To obtain repayment, the SPV sells on the capital market through a private or a public placement, a bond (a debt investment security) guaranteed or backed by the income stream of the lease portfolio.
Investors (bondholders) are repaid their principal amount plus interest over the period of the bond from the incoming cash flow from leasing payments. They also have the security of the cars as collateral for any payment default by lessees. Because the bond is guaranteed by an asset, its rate of interest should be less than what the originator SME would pay on an unsecured bond or a bank loan.
Portfolio valuation and bond rating must apply under securities laws, but a crucial element is to ensure the asset belongs entirely and exclusively to the bondholders. For this reason, the sale of the asset by the originator to the SPV must be a true sale, because the SPV acts as the trustee for bondholders. There must also be bankruptcy remoteness for the SPV, precluding the originator from claiming any right over the cash flow and cars that belong to the bondholders.
Securitization can be structured on a true sale of the underlying asset to the SVP so the asset will be off balance sheet and the originator has no liability to bondholders. It can also be structured without a true sale: The originator retains the portfolio on its balance sheet and assumes liability to bondholders for any default in payment of the principal and interest of the asset-backed bond.
A2g. Islamic Finance Islamic finance is included in this white paper because it is asset-based. It offers a solution when/where conventional finance may not be tolerated; it also provides an alternate product or supports an alternate finance provider.
Islamic finance is a financial system consistent with principles of Islamic law (Shariah), which prohibits usury, the collection and payment of interest (riba), business activities contrary to Islamic values (e.g., selling alcohol or pork, or operating a casino), and requires finance structured on an underlying asset or the profit it generates.
Here are three Islamic financing products matching conventional asset-based financing
products (USAID, 2008a):
Ijara is a manfaah (usufruct) contract whereby a lessor (owner) leases an asset or equipment to its client at an agreed rental fee and pre-determined lease period upon the `aqad (contract). The ownership of the leased equipment remains in the hands of the lessor. It is equivalent to leasing.
Ijarah thumma bai` is a contract that begins with an ijara contract for the purpose of leasing the lessor’s asset to a lessee. At the end of the lease period, the lessee will purchase the asset from the lessor at an agreed price by executing a purchase (bai`) contract. It is equivalent to sale and leaseback.
A sukuk backed by any Shariah-compliant asset-based products is equivalent to an asset-backed bond or securitization.
A financial institution’s ability to extend asset-based financing — and an SME’s ability to obtain it — depends on factors that determine or can further its accessibility and viability.
B1. Legal, Regulatory, and Judicial Environments
The bedrock of asset-based finance is a combination of:
the general law governing commercial contracts and assignment of book debts or receivables laws and regulations directly affecting a specific product (e.g., factoring or leasing) or more general laws (e.g., bankruptcy law) that implicitly affect products the regulatory body, if any, that supervises non-bank financial services the tax code and accounting rules, as applied to asset-based transactions, providers, and users the knowledge of courts of law or arbitrators in such transactions It is possible to design or adjust these to develop an asset-based finance industry — but only after these environments are thoroughly understood.
Key legal issues include whether these environments properly address factoring as a sale and purchase; efficient debt collection; bankruptcy procedures for leases; and the ability to freely assign receivables and transfer assets to an SPV. A law that recognizes factoring or leasing law as ―financial services‖ and clarifies the nature of the transaction will legitimize the industry, as will electronic security laws that allow electronic sales and transfers of goods in support of viable technology infrastructure for warehouse receipts (Klapper, 2005, pp. 9-11; Giovannucci, Varangis, and Larson, n.d.).
Adequate regulation is a balancing act for finance providers that do not take deposits (Fletcher, Sultanov, and Umarov, 2005, pp. 14, 25) because it can limit competition or hinder industry development with burdensome and costly regulations (Bakker, Klapper, and Udell, 2004, p. 9). Non-bank lessors and factors use their own funds or borrow on commercial markets, and have the expertise to judge and assume credit risks without outside intervention (Fletcher, Sultanov, and Umarov, p. 26). A best practice in developed economies is to leave leasing and factoring unregulated, except perhaps for consumer protection or stipulating moderate minimum capital requirement for deposittaking financiers (USAID EFS on factoring and leasing). Securities laws and the regulator must look after the interest of the investing public in asset-backed securities, with adequate disclosure and bondholder protection mechanisms. Furthermore, raising judges’ and arbitrators’ awareness to the fundamentals of asset-based finance, collateral, repossession, and foreclosure are advisable programmatic activities (Fletcher, Sultanov, and Umarov, p.22).
8 ASSET-BASED FINANCE: WHITE PAPER # 1B2. Secured Lending and Collateral Registry
Factoring and leasing do not depend on secured lending laws, a collateral registry, or the judicial foreclosure of collateral because they are the property of factors and lessors who can freely dispose of them to recover value. But A/R, POF, and WHR finance entirely depends on them. Nevertheless, a collateral registry for moveable property, essentially targeted at secured lending (e.g., A/R and POF), will facilitate access to all asset-based finance products and prevent fraud because it determines ownership of the asset underlying the financing (Fletcher, Sultanov, and Umarov, 2005, p. 22). In addition, for the benefit of third parties, civil law regimes generally require publication of a transfer of book debts (A/R finance, factoring) through an entry in a registry. A collateral registry is an important element of finance infrastructure in the World Bank Doing Business project methodology, which grants 10 points for the strength of secured lending with collateral registry.1
B3. Credit Information Bureau
Asset-based finance is greatly assisted by dependable credit information about local businesses from sources such as credit information bureaus and business registries.
Promoting the development of credit information bureaus and accurate business registries, therefore, is vital to developing a stable asset-based finance system. In fact, it is the other essential component of ―access to credit‖ in the Doing Business project, which grants six points for depth of credit information.
B4. USAID Development Credit Authority Guarantee program
To reconcile conservative bank lending practices with the need to support access to finance, USAID missions use the Development Credit Authority (DCA) guarantee program to stimulate lending through partial credit guarantees in support of sustainable broad-based development. The facility can be considered when designing programs contemplated by the Foreign Assistance Act. DCA covers up to 50 percent of the default risk sustained by financial institutions.2
B5. Industry Associations
It is difficult to envision the development of an industry without an association representing its unified interest. A leasing, factoring, or a combined asset-based finance trade association would serve the finance industry to develop business standards, ethics, and operational guidelines; gather and disseminate information; train professionals;
promote industry; participate in formulating government policy and reforms; and even organize sharing member clients’ data with a credit information bureau.
Where sectors are not developed or underdeveloped, finance providers could join an international association such as the U.S. Equipment Leasing Association.
see http://www.doingbusiness.org/MethodologySurveys see http://www.usaid.gov/our_work/economic_growth_and_trade/development_credit
International standards foster good business and attract international players.
It is important to understand what fiscal regime applies to asset-based finance, particularly factoring and leasing, and what accounting practices are applied by the fiscal authorities, regulators, and the accounting and auditing profession.