Banks used to be the primary lender for SMEs looking to sell into new markets. Since the early 2000s, more trade-fund specialists have emerged. These firms are often focusing on specific sectors or geographies. One fund might specialise in Uzbek trade only; many focused or still focus on Africa, financing trade or harvest. Another does Cuba only, and a Florida-based trade fund finances bicycles to Florida residents. Horses for courses, so to speak. An interesting case we are pursuing is financing the export of Uzbek textiles to German buyers. Our factoring clients are the German importers. High margin, one percent per month combined with a German risk is quite rare.
While the above-mentioned might be easy investments for a local Ukrainian or local Florida-based investor, they are complex, if not unsuitable, for investors – Artis included. All resides in the fund manager’s expertise, which led us to adopt a focused approach as discussed in chapter three.
As there are various ways to participate in financing trade, so there are various parts of a trade that can be financed. All parts of a trade combined constitute the value chain.
A Girl’s Best Friend: Diamonds
The value chain is defined as a series of processes that a specific firm or industry undertakes to transform raw material to a product of value and sell to the final customer.
In 1985, economist and Harvard business academic Professor Michael Porter coined the concept of the value chain. In trade finance, the value chain is essential for investors to understand and make informed investment decisions at each level of the value chain. With each production or manufacturing stage that the product passes through, its economic value should increase.
The overall process of moving a product through the value chain to eventually be purchased by a consumer is referred to as the value system or industry value chain. From raw-material sourcing to transportation, the industry value chain also includes third-party contractors and suppliers providing necessary support as a product shipment travels through the stages of the chain.
Artis has experience in facilitating trade-finance arrangements at different levels of the value chain. We focus on certain parts of the value chain and exclude others. Today, Artis does not take on the financing of agricultural production or the shipping of perishable foods. In addition to our practical experience, our trade process has evolved with the market. It is key to adapt to the needs of our clients as they grow.
The four primary levels of the value chain are: input; production; processing; and distribution. Our philosophy is to provide capital to the buyer/importer at the latest and safest stage of the value chain. An optimised value chain makes businesses more efficient and delivers the highest-value product at the lowest costs.
The input phase is the very beginning of the value chain. This is where the raw materials are acquired from external suppliers and sources. Inbound-phase value-chain activities include buying, cleaning, receiving and storing input pieces for the production process. Extractors or suppliers require pre-shipment credit or an open account.
Let us look at the inbound phase in the precious-stone or diamond industry which begins with sourcing the raw diamonds. In the input phase, workers source the raw stones from the earth. The value of the plain, uncut stone may vary but from this point, value keeps being added to the product.
Next comes the production phase. Artis does not typically get involved in production. In this phase, the raw materials are prepared, modified and assembled. There isn’t much for us to finance at this level as it requires working capital, customarily provided by the company’s own funds (equity) or bank loans.
In the third phase, the production phase, the raw precious stones, which could be diamonds, emeralds, rubies or aquamarines, to name a few, are cut by specialists. Raw diamonds are romantic but not widely sought after by paying customers. The diamond’s true romance resides in a sparkling cut, brilliant colour and perfect clarity.
Diamonds today are cut primarily in Belgium, India and Israel and significant financial value is added once this stage is complete – or destroyed should the cut fail. It is the superbly cut stone that makes diamonds a girl’s best friend, at least according to Marilyn Monroe’s iconic movie song. Minute imperfections or a flawed cut devalue the priciest stone.
Now comes the processing phase. In this phase, multiple materials from various industries are now combined in a single location and assembled. In our fictitious, precious-stone business, loose stones are put together to create a piece of jewellery, such as an elegant ring, a glittering necklace or a breath-taking pendant. This phase often requires a variety of talents to bring the product together − goldsmiths for engagement-ring settings, for example. Delicate chains are delivered with clasps and polished ready for use. For this stage of the value chain, funding is required to purchase parts or more materials. In the processing phase, trade finance uses open accounts, which are often reimbursed in less than 30 days. All parties rely upon speedy trade and reliable deliveries.
The fifth and final phase is the distribution stage. After the product or service has been packaged, bundled and perfected, it is ready for distribution and customer purchase. The distribution phase includes warehousing, logistics, trading and transport.
The levels of return vary by industry but hinge on the level of the value chain that is being financed. Not all levels in the value chain are equally financially attractive to outside investors. As the entire value must be funded, it is the obligation of the company to ensure adequate financing across the whole value chain. Broken value chains do not produce a saleable product.
With the pandemic disrupting value chains in different parts of the world, the risk of supply-chain disruption has become a globally pressing matter. The temporary pause of the global supply chain at the beginning of 2020 was dramatic. The disruptions had the most noticeable effects on small retailers with no plans in place to help soften the blow.
The process of deciphering the most robust deals for each specific party comes from comprehensive value-chain analysis, providing complete information on which sections of the value chain are most valuable in each industry segment and which financing solutions are the most appropriate. If we conclude that open credits do not work for exports or are continuously riskier, we do not engage.
At Artis, we extend the working-capital cycle to importers at most levels of the value chain. Open accounts in this context are the most secure for the enterprise and the investor. For exporters, we shorten the working-capital cycle by providing pre-shipment advances. Just as open accounts are the most secure and lucrative for import financing, the same is true for export pre-shipment funding.
Investing in the Value Chain
Value-chain investing upholds the entire value system, impacting global trade and the world economy. For investors, it is essential to understand how the value chain works, so that you can be de-risked and ultimately funded.
The parts of a value chain that are habitually funded are: the equipment required to operate; mining or extraction where appropriate; manufacturing; purchase of raw material; the process of converting raw material into semi-finished or sellable goods; and the process of bringing the sellable goods to the market.
With each funding opportunity there are subparts that can also be funded. Each possible investment, however, has a different risk and return profile even if you are looking at different parts of the same level in the value chain.
Even though trade-finance companies ensure that risk is mitigated to the utmost degree, a residual risk remains which can cause problems to arise. An unreliable trucking company or logistics company can bring an entire supply chain and sales cycle to a halt.
The impact of the 2021 semiconductor shortage on the car industry provides a vivid example. Without each piece available, production halts and the delay ends up costing all participants of the value chain. One slip up affects the chain and ultimately the brand’s reputation. For established large enterprises, such production delays might be financially digestible, but SMEs or emerging markets don’t have the cushion of additional resources and workforce to help alleviate such pressure.
Let’s revert to our precious-stone business. In the diamond industry, the diamond itself is rarely the final product, except for collectors; diamond jewellery is the final product.
Every delivery driver and company that employs them needs to be reliable. Every dock shipment needs to be guaranteed, and every cargo count needs to be uniformly trustworthy. Reducing the risk of fraud or theft in the trade-finance industry remains a top priority. As we know now, trade finance used to be rife with fraud before technological advancements of the twenty-first century, and it has been reduced dramatically with the implementation of fintech. In addition to those advancements, rating agencies have helped to evaluate the parties being financed to demonstrate the level of reliability of that company.
Various regulatory bodies were enacted as early as 1913 with the creation of the US Federal Reserve System (in short: The Fed). The idea behind regulatory agencies was to create transparency within a somewhat opaque system. Regulatory agencies can make it easier for investors and SMEs taking on financing arrangements.
The history of an enterprise is another key factor considered by rating agencies. An all-inclusive view of the people running the business which we intend to finance is pertinent. Rating agencies take the enterprise’s history a step further, also looking at the industry in which the company operates. This includes the company’s projected impact on a particular industry and on the economy. Rating agencies validate the SME looking for financing from a third party, so investors, private or corporate, can proceed with confidence that the business will honour its financial obligation and repay the funds borrowed.
The Fed today is still the most influential of all policy-making monetary bodies and its influence stretches around the globe. Its decisions are closely monitored by banks, corporations, markets and governments. The Fed is often criticised in the media for influencing monetary policies, credit conditions and overall lack of liquidity in the worldwide market. As much as the Fed comes under scrutiny for its work, the board, also makes its fair share of positive market contributions. The Fed supervises the US banking system and in extremis the international banking system, and helps provide stability to the financial markets, also overseeing other regulatory branches.
We have outlined the rigorous process that trade-finance companies go through prior to onboarding a new borrower and we don’t come to decisions purely based on risk or bottom line. Now, more than ever, investors prioritise investing in companies with acceptable environmental and socially responsible standards, abbreviated to ESR. ESR has become an important benchmark for investors and borrowers alike.
In chapter three we discussed our pre-deal evaluation criteria which include whether a company has an ESR policy in place, for example is going ‘green’; is aiming to become carbon neutral; undertaking water saving and recycling initiatives; composting on-site; using renewable energy; and cooperating with other socially responsible companies.
This includes paying workers living wages or ensuring that everyone from truck drivers to dock loaders have appropriate working conditions. From responsible farming to trustworthy manufacturing, responsible investors request that their money is helping responsible business owners to create sustainability for their merchandise and their workers.
Consistent with a recent ICC trade register report, trade finance has an average default rate of 0.02 per cent across the entire global trade market. The same report found that, on average, general (non-trade) lending is five times riskier than trade-finance lending. The combination of international regulators, rating agencies and the trade company’s proprietary due diligence on both borrowers and lenders make this process as secure as it can possibly be.
For the reader new to trade finance, all of this − the multiple moving parts and the different levels of the value chain may seem somewhat overwhelming. While it is essential to understand how each level works, it is as important to keep it simple.
As a trade-finance investor, you are invested in one of the levels of the value chain by either supplying a pre-shipment advance to exporters or an open account to importers. In either arrangement, the importer and exporter can get the capital they need upfront and repay later. Now that we have explored and demystified the intricacies of the value chain, let’s talk numbers.
