We know now that trade financing is still an underrepresented asset class in investor portfolios. In chapter one, I explained how trade finance is uncorrelated to the stock market and, as a result, receives little analyst and research coverage. With banks financing less and less of the global SME trade, the need for investments from and to emerging industries continues to grow as well. Trade financing has better and quicker returns than associated investments like stocks or bonds.
The trade-financing gap has been compounded by the big banks’ continuous rejection of trade-finance applications, the amendments to regulatory laws enacted after the GFC and the recent response to the Covid-19 pandemic. Between increasing restrictions, there are severe international trade sanctions imposed by the US and other countries ranging from Iran to China, with China imposing its own sanctions against the US and others.
Trade finance amounts to about nine percent of the global trade market, leaving billions on the table for investors interested in bridging the gap between SMEs looking for capital and suppliers looking to divest more inventory and gain assistance to sell their products.
Trade financing is a part of the broad category of private debt providing capital to a business upfront under the terms that the advance shall be paid back by an agreed-upon date. Trade financing can take many forms, depending on the needs of the SMEs requesting the financing; the type of market they are in; whether the business is importing or exporting goods; and the type of financial support requested.
The lack of easily digestible information available sometimes prevents many investors from engaging. Best not to do what one does not understand.
Trade requires a seller and a buyer. Others help the transactions by supplying the capital for the trade. When small or medium-sized enterprises are short of capital to finance the goods, private lenders are the modern and feasible option for most. Trade financing is highly collateralised, making the investments more secure than other financial assets. Trade finance has many similarities to a fixed-income type of product; it is a subset of private debt, not equity.
Forms of Trade Financing
The two most common forms of trade financing are supply-chain financing (SCF) and factoring. Factoring takes place when an investor or a firm like Artis buys an invoice from an exporter at a discount and receives the payment from that invoice by the importer on a pre-agreed future date. Factoring helps the exporter to collect payment sooner than the importer can provide it, hence optimising liquidity.
A good example is where a textile company needs to clear the current inventory at the end of the season, freeing up warehouse space for the next collection. The buyer isn’t scheduled to pay the invoice for another three or four months.
The seller requires their working capital back as soon as possible, selling the invoices, often with credit insurance, at a discount and can use the cash flow to finance the next season’s purchases. The importer still pays for the goods within the contractual timeframe.
You might think that factoring is a helpful tool for frontier, emerging or marginal markets – and it is, particularly for SMEs in most countries and all across Europe. Discount margins vary strongly between and within regions, for example between European countries. In addition, each trade can be credit insured, reducing the default risk to a minimum. In 2021, Artis had a trade pipeline in Switzerland exceeding 1.5 billion Swiss francs. In wealthy Switzerland, you might wonder? Absolutely.
Currently, we favour short-term trade receivables up to 120 days. Other, often larger investment firms have different strategies. Some offer financing for up to one year or beyond, which requires a different risk assessment and often additional collateral. The next longer financing term is almost the same as project financing. When a trade financier finances the export of sugar cane or next year’s sugar harvest, a project financier finances the sugar-processing plant. It is a different business and a different risk. We stick to trade.
The supply chain summarises the steps from raw material to a saleable product in any given industry. For a pillow manufacturer, the supply chain includes the procurement of textiles, stuffing, sewing, packing, stocking, shipping and, ultimately, selling to a customer. Each link in the supply chain has its own funding needs, including the textile company, the packager and the distributor. Supply-chain financing can take the form of an LC, financial guarantees, cash with order (CWO) or cash on delivery (COD).
As noted earlier, trade credit is a subset of trade financing. Trade credit defines the payment relationship between importer and exporter. When an importer and exporter or a buyer and a seller get into a contract together, the seller might expect to be paid within 30, 60, 90 or sometimes 120 days from the date the seller receives their goods.
In many (European) countries, the buyer has the choice to pay the bill in full within 10 days and deduct a two percent discount from the total amount − often referred to as “skonto” − or to pay the bill on the due date without skonto. A two percent discount for 10 days does not sound much but is substantial on an annualised basis.
Trade credit has become a popular tool among trade investors for its margin, safety and ability to preserve cash flow as the business grows. Exporters and suppliers can generate more business without demanding cash up front. Financiers receive a margin and often ask for collateral from the buyer to protect themselves. Even though there isn’t a bank involved in the lending process, the buyer still risks added fees and interest if not paid on time, just like any other financial agreement might require.
The best illustration for trade credit comes from a store that has grown into an international powerhouse across 20 different countries today: Walmart. Walmart did not start off as ‘American made’. When Sam Walton first sought to start Walmart, his goal was to deliver the best goods to the American people at the lowest cost possible. To do that, he had to buy the goods as cheaply as possible, which often meant favouring imports. American-made goods were proving to be too costly for Walton.
Early in his company’s enormous expansion, he decided to set up trade across the Pacific to make importing a pillar of the Walmart business model. Walmart at the time was still an SME. Looking to expand its company overseas was a big jump that required more capital than he had access to.
The good news was that Walton didn’t have to do it all on his own. Walmart was showing promise as an enterprise and was making waves but was still a relatively new business in the early 1980s. Instead of pooling together just enough Walmart money for his first international trade coming out of the Pacific, Walton was able to make use of trade credit with a trade financier and the desired exporter. Walmart negotiated to buy the low-cost imports that they required and paid for them later.
Exporters out of the Pacific were happy to begin working with Walmart, a company on the rise, but they operated strict trade credit in the beginning. Exporters provided the goods under the ‘net 60’ terms, meaning that Walmart had to pay the entire balance 60 days after receipt of goods. If the balance was paid within 10 days, there was a 20 percent discount available. If paid within 30 days, the discount decreased to 10 percent. When Walmart received the goods, it sold them to its customers with its margin and consistently paid the balance owed ahead of schedule, giving the company a better margin.
According to a confidant, Walton himself estimated that imports accounted for nearly six percent of Walmart’s total sales in 1984. But Frank Yuan, a former Taiwan-based apparel middleman who dealt with Walmart in the 1980s, puts the number, including indirect imports, at around 40 percent from the start. Either way, Walton’s vision was a harbinger of far more extensive global sourcing today.
The 2019 Small Business Credit Survey found that trade credit finance is the third most popular financing tool used by small businesses. Yet, the SMEs taking full advantage of this business-to-business lending option don’t tend to stay small or medium-sized for long. Trade finance has led to the enormous growth of economies across the globe as it has bridged the financial gap between importers and exporters. An exporter is no longer afraid of an importer’s defaulting on payments, and an importer is sure that all the goods ordered have been sent by the exporter as verified by the trade financier.
The pandemic had a monumental impact on the global economy and revealed several inefficiencies in the trade-financing industry. Weaker capital reserves and bargaining power have hurt the ability of SMEs in developing countries and emerging or frontier economies to get efficient trade-financing facilities and they are subjected to higher associated trade-financing costs. Banks prefer to work with more established, so-called large-cap companies.
With the lack of support for SMEs during this pandemic, the World Trade Organization (WTO) has raised concerns that underdeveloped nations and financial systems could be left out of the trade-finance markets. The most vulnerable sections of the trade- finance market should be getting more flexibility and funding through specific programmes designed to help emerging economies survive a pandemic. Business-to-business/P2P lending continues to provide greater flexibility to businesses struggling to obtain financing from the financial sector, despite a valid and collateralised trade.
The Political Risk of Trade
Sanctions generally have a devastating effect on trade, a result that is very much part of the calculation of the sanction issuer, be this a nation or an international body, for example the UN or the EU. Political risks to the trade industry often stem from simmering geo- political tensions (Middle East), military issues (Ukraine), human- rights issues and child labour to name a few. Political risk affects local and international trade and supply. Dramatic examples with dire results for the civil population are the long-standing sanctions against North Korea, Syria or Iran, where the lack of bank payment facilities suffocates basic trade, often including products for survival – food and medicines. The sanctions that countries impose on each other is a moral failure of societies.
Trade sanctions are not a modern invention. Napoleon Bonaparte found his own continental blockade system extremely helpful. The embargo which banned British ships from entering European ports was applied intermittently, ending on April 11, 1814. Napoleon could not enforce a boycott through all European countries and extensive trade continued throughout Spain and Russia, so he invaded both countries. Overall, the blockade caused little economic damage to Britain, although British exports to the continent (as a proportion of its total trade) dropped from 55 percent to 25 percent between 1802 and 1806.
The legal force of national and extraterritorial sanctions could prevent a company from receiving or issuing a letter of credit (LC), collecting on funds or fulfilling confirmed, even prepaid orders. Credit insurance should shield exporters and investors from this risk.
Public, private or hybrid credit insurance exists for most markets at competitive prices. Even today, some provide coverage for countries like Afghanistan and Iran. Public credit insurance is the insurer of last resort and a government tool to encourage national exporters to sell beyond their comfort zone. Political risks are a quasi-permanent concern when dealing internationally, especially but not only with frontier markets.
Even with detailed research and stringent protocols in place to structure and finance a transaction, residual risks to bear in mind remain, particularly along the supply chain, like an incorrect or damaged product arriving at a distributor.
We mitigate these risks using LCs, bank guarantees, trade-credit insurance and our proprietary risk- mitigation process.
Then there is always the ‘black swan’, the unforeseen such as the default of a customer on its loan. Artis has had none so far. Insurance and collateral are there to mitigate the remainder of the risks of default. When a customer defaults, the credit-insurance company is informed immediately and will take over the handling of the recovery process, a process that involves all parties. An alternative to factoring individual invoices and reducing industrial or political receivable exposure in bulk is to sell an entire package to a trade financier at a discount.
The Supply Chain Risk
Political risks, often translating into commercial risks or losses, remain a concern when dealing with frontier markets. While research, checklists and processes mitigate risks, there are micro risks to be conscious of, particularly in the supply chain.
A typical supply-chain issue is when the product is delivered incorrectly or arrives at a distributor damaged. While it can feel like the end of the world for all the parties involved, these risks are mitigated using LCs, trade credit, transport insurance and our own extensive risk-management process. In these situations, investment firms can also use insurance and collateral to mitigate the remaining default risks.
When companies have difficulties paying an invoice on time, a trading or trade-finance house can often provide more flexibility and act faster to restructure payment and avoid default. Banks often are less agile due to stricter lending terms, inflexible payment dates and multi-jurisdiction sanction catalogues to respect.
Going into default on traditional business loans can have dire consequences for the business, creating unnecessary losses for the company, trade partners and shareholders. Trade-finance firms can use additional collateral to shield themselves against unprotected losses.
Past Mistakes Breed Future Successes
We don’t often get involved in issues of clients defaulting on their payments, but I want to share one example. A few years ago, our firm, Arjan Capital, had to navigate our client out of a truly terrible lending situation. It was the non-payment of an open-account trade which means delivery of the goods comes first with payment later.
Sounds crazy, I know – to trust your client without collateral. A flock of black swans, one might think. The black-swan excuse does not hold as the risks were known, understood, recommended against and explicitly accepted by the exporter. So, what happened?
The client was a multibillion US$ FMCG company with significant export experience in frontier markets. We had an advisory role and were also involved in the handling of the transaction, including logistics and payment. Our financial obligation was fiduciary only. We paid to the seller what we collected from the buyer after deduction of our fee.
The sales manager wanted to access this potentially large market that was difficult to access at all costs, selling imported premium goods into the nation’s many pharmacies, with a market structure not unlike that in France. Similar products were being produced locally under international licences at half the cost. To be fair, the quality of locally manufactured product was often inferior to the imported original. The country was and still is in an economic ‘pickle’ and the consumer’s purchase decision was mainly driven by price not quality.
Multiple market analyses confirmed a promising outlook for this large and up-and-coming frontier market. The first deliveries went well. There were some delays due to unclear and changing customs import rules and complex payment situations due to currency controls.
Our client’s buyer was either unwilling or unable to produce an LC, either because they were trying to save the one percent LC cost or simply did not have the funds available, hoping (remember Sam Walton) to pay the supplier after he sold and collected on the product.
We kept telling our export client to ship only either against prepayment or at least with some collateral – for instance, LC or credit insurance. Even a personal cheque would have helped. Product or money-recovery procedures were unclear, and the rule of law is largely untested by international firms.
The exporter’s sales desk and his superiors decided to provide the buyer with unsecured trade credit of about €250,000, the value of an average shipment. To receive the next shipment, the previous one had to be fully paid for.
The black swan in this situation was that to preserve foreign currency, and to fight inflation and unemployment, the importer’s government decided overnight to ban the import of thousands of finished goods, leaving countless container loads stranded at the border or perishing in warehouses. Products could only be imported either in parts, also called SKD (semi-knocked down) or as raw material but not as finished goods, apart from whatever the country did not produce internally.
For reasons of quality control, our client decided against delivering anything other than finished and packaged goods. Raw material in bulk and packaging locally was not an option either. This decision was communicated while the shipment was sent out but not yet paid for, and the importer knew that this was the end of the commercial relationship.
The goods had about two years of shelf life left. With the shelf life ticking away, goods were losing value every day. Shipping back to Europe was unreasonably costly, so the importer sensed the opportunity to force a farewell discount from the buyer. On the one hand, we had a reputable European multinational seller, on the other side a competent but financially weak and small importer.
The buyer felt that the legal system in his frontier market would protect him as a local company and discourage the foreign seller, hence he took a rather high-handed approach.
We cautioned the buyer that the multinational seller would pursue him in court in his home country in case of non-payment. After negotiating for weeks and weeks, the seller agreed to a very generous 40 percent discount, to get paid and to get out. The discount amount offered was in the low six figures.
We mutually agreed on a payment date and a daily penalty with a cap of 60 days in case of further non-payments. The buyer paid 85 percent on time and then stopped again. We reminded him that the multinational would legally pursue the remaining 15 percent, and he was at risk of an arbitration case where his 40 percent discount could be invalidated. It was to no avail. After 60 days of further non-payment and the required formal notices to the buyer, the seller filed in arbitration for the full amount, including penalties. For the seller, our legal expense was an investment with a potentially high upside; for the buyer, a large downside only. We could not understand the buyer’s reasoning, risking 40 percent discount plus penalty payments and legal costs instead of paying the remaining 15 percent.
Awareness
One of humankind’s most remarkable features is our capacity for awareness. Now that we were aware of the existence of these trade inefficiencies, we began to triage them. We invested in proprietary systems and processes to monitor and address the relevant challenges of sectors and industries.
Only when processes are transparent and easily understood will trade financing be more widely used by private investors and considered a valuable investment class. With that in mind, we have created a six-step framework to process a trade, reducing the risk for all parties involved, including investors and trade partners. The framework further addresses legal compliance, fraud risks and domestic or cross-border sanctions, and guides investors towards increased returns.
