Viewpoint: Crisis will take SCF beyond reverse factoring

Michiel Steeman

date: June 30, 2020

The Covid-19 global crisis could spark the acceleration of purchase order financing as companies urgently need cash to bring their supply chains back to life.

As some lockdown measures are cautiously eased around Europe, many businesses will be eager to re-start operations and revive their broken supply chains.

Yet, to restart almost from scratch – which is the case for those who had to suddenly close factories, warehouses, and physical retail outlets in March – is going to take a huge amount of liquidity or cash.

Many corporates, particularly smaller companies, have been pushed to their limits, making job cuts, sitting on expensive but potentially unsellable out-of-season inventory, and relying on government support to maintain staffing levels. With a protracted recession looming, manufacturers will be wondering how they will meet their immediate working capital needs to cover overheads and pay for raw materials before they begin to receive payment for their goods and services from their large customers – which could still be months away.

In this time of crisis, however, I see an opportunity – an opportunity not only for our industry to evolve, but also a possible way of easing pressure on small businesses.

It is a chance for us as an industry to start implementing supply chain finance products further ‘upstream’. We have talked about it for a while at numerous conferences and roundtables, and yet the concept of ‘purchase order financing’ – providing liquidity at the point of approved order rather than at the approved invoice stage – has not made any significant traction yet.

Today I see the conversation around the purchase order financing product beginning to heat up particularly among fintechs and other industry experts.

There is also an opportunity for large buyers to improve the way they look after their supplier network, particularly those with which they have a long-standing history. ‘Sustainability’ in supply chains has become a buzzword in our world recently, but now buyers can start investing in it and provide liquidity when it is needed.

Just as the 2008 global financial crisis provided a catalyst for the wider adoption of reverse factoring solutions due to a sudden urgent need for new sources of liquidity, this could be the opportunity for purchase order financing to take off.

I see similarities today to the financial crisis over a decade ago, when banks collapsed and the cost of financing – particularly for smaller companies – exorbitantly rose. Just as there is now, suppliers desperately need cash and large corporates want to minimise disruption to supply chains.

Back in 2008-09, the US supermarket chain Walmart stepped in to support their suppliers with the use of reverse factoring solutions, after a major bank that provided factoring facilities to its smaller suppliers collapsed. This is just one example of how the 2008 crisis encouraged large buyers to think of how they can ensure the security of their supply chain in a time of crisis.

Today similar scenarios could emerge. Consider, for instance, the textile industries where large retailers ceased placing orders and factories had to close earlier this year. If this industry is to be restarted, those smaller suppliers need immediate injections of funding so they can buy in the necessary materials and pay their workers to fulfil new orders.

Companies such as Zara or H&M and other large retailers could use forms of purchase order financing products as a way of restarting their supply chains and keeping their suppliers in business.

There are already signs of increased demand for typical reverse factoring around the world, with reports of more suppliers wanting to participate in SCF programmes.

Coupled with advancements in technology, the Covid-19 pandemic could also be the catalyst that takes supply chain financing techniques to the next level.

There are, of course, plenty of hurdles that may slow the uptake of purchase order financing.

Purchase order financing involves a lot of performance risk – the ability of the producer to fulfil the requirements of the order. Banks are notoriously reluctant to take on this risk as it rests with the often more poorly-rated smaller supplier.

Banks tend to prefer credit risk, and in the case of the more commonly used reverse factoring solutions, that risk usually lies with the larger highly rated buyer.

To ensure banks are comfortable with the risks of purchase order financing, the buyer might need to agree to an irrevocable commitment to pay the supplier. Yet, the buyer might be reluctant to do so as this may need to be recorded as debt on their balance sheet, depending on the way the transactions are structured.

While banks seem to be in more of a “wait and see” mode when it comes to developing purchase order products, it is the fintechs that I see pushing ahead.

Tech companies will play a vital role in encouraging banks and other financing parties to have a greater degree of comfort with taking on the risk of PO financing. Their ability to analyse vast amounts of data on the performance of suppliers will be essential in calculating how likely it is a supplier will fulfil an order.

The better quality the data and analysis, the easier it will be to assess performance risk and whether it is worth financing.

Developments in artificial technology could help here as fintechs will need to process large data sets gathered from various trigger points in a supply chain, including suppliers’ historic performance, the quality of products produced, and the time taken to deliver. In other supply chains, AI might not be necessary if the right quality checks are completed at the right time.

If the data is reliable enough, you could also see insurance companies step in to cover the performance risk aspect of the transaction, allowing the financing parties to focus on credit risk. You could segment risk and offload the risk to the party that is comfortable with taking it.

The other challenge will be to make purchase order finance a scalable product. It is currently difficult to turn a purchase order into pure ‘IOU’ as is the case in invoice financing or reverse factoring. A purchase order is not a financial instrument unlike a confirmed invoice.

This means you may need a different legal structure for each purchase order financing arrangement with a client, which prevents the product becoming a more “commoditised” solution that could fit any supply chain.

Will it end up being a “mini” structured finance project with each transaction? It will take some time to figure out a more scalable structure.

Despite the challenges ahead, I see momentum picking up, and just as in 2008 it may once again be adverse economic conditions that spark the needed growth and innovation within the supply chain finance industry.

Michiel Steeman

Professorship at Windesheim University of Applied Sciences

Michiel Steeman was selected in 2013 as the inaugural holder of the Supply Chain Finance Professorship at the Windesheim University of Applied Sciences in The Netherlands. He is also the founder and chairman of the Supply Chain Finance Community that has already brought together over 30 leading business schools from more than 20 countries around the world who actively collaborate with companies, banks and governments in the developing field of Supply Chain Finance.