A Demica senior director explains how trade receivable securitization programs can be used as a valuable alternative to other funding solutions, especially in cross-border or challenging credit environments.

Trade receivables securitizations (TRS) may be less well known to certain asset-based lending or factoring practitioners, but TRS can deliver a funding solution where other structures cannot be implemented. With a well-established position in international markets, and significant benefits for corporates, TRS should be part of every advisor and corporate toolbox.

Priorities Drive Funding Choices

In a TRS, the costs are pre-agreed, and funding availability is based on a set mechanism driven by overall portfolio performance – in comparison to less-transparent and availability-dependent factoring. The receivables sale to a TRS vehicle has no, or limited, recourse to the seller and, if required, can be structured as off-balance sheet – in comparison to a full-recourse and consolidated ABL.

From Dutch Taxes to U.S. Commercial Mortgages

Securitization, in its purest form being the transfer of assets into a vehicle that issues securities, started as early as the 16th century, with Dutch provinces issuing bonds secured by tax-revenue receivables.1

This financial technology was expanded to all types of assets including trade receivables, commercial and residential mortgages, auto loans and credit cards, with over $1tn issued in 2018 alone2. Trade receivables securitization, mostly financed privately by bank conduits or specialized

lenders, performed notably well during the financial crisis with no conduit defaults and very few back-up servicer interventions. This is in stark contrast to certain well-known mortgage securitization programs.

Corporate Benefits and Expanding Abroad

TRS programs are highly valued by corporates. Firstly, they significantly reduce their funding costs, especially for non-investment-grade rated companies, by accessing capital markets investors, in particular the very liquid commercial paper market.  Access is granted by adherence to specific and transparent risk methodologies and precise legal structures that will ensure that investors will take the risk on the receivables portfolio (as opposed to risk on the corporate originator). Secondly, programs can diversify their funding sources, leading to a more sustainable capital structure with receivables financing committed over several years.  Finally, the ability to deconsolidate the receivables from their balance sheet, and associated debt, can deliver significant financial benefits.

Corporates with more challenging credit positions, high leverage and large working capital requirements will find the most value in launching a TRS programme. Private equity-backed companies or levered public companies are strong users of TRS programs that reduce their cost of funds.

For corporates with cross-border trade receivables portfolios outside of common law jurisdictions, or low-rated debtors, TRS can be used as a financing alternative. Certain jurisdictions present significant challenges on recourse enforceability, application and enforcement of security, and complex insolvency regimes. These challenges can be mitigated, or even fully resolved, through a securitization structure. An international TRS program can also be used to complement a local ABL facility.

Not so Fast: Key Requirements

To ensure a TRS program delivers the benefits of a diversified portfolio, debtor concentrations should remain low (think below 5-10%), especially for non-investment grade debtors. It is also important the receivables are fully transferable, without any restrictions due to the underlying contracts or debt covenants. The service or product needs to have been fully rendered or delivered to ensure the debtor has a full contractual obligation to pay and the receivables have limited offset risk.

Seller risk is also important. Corporates that are well below investment grade will need to work around the risk that they may not exist in the future to collect the receivables. This can be done through specific triggers where the receivables can be perfected (including debtors notified of the receivables sale) and the presence of a back-up servicer to ensure continuity of receivables management and collections.

Building Blocks

The core TRS structure is simple.  It is fundamentally a sale of receivables to a special-purpose entity, funded through the issuance of senior debt instruments. The sale of receivables needs to be structured as a legal true sale, and the special-purpose entity needs to meet certain governance and structural requirements to ensure bankruptcy-remoteness from the corporate originator.

Funding of the trade receivables purchase price is done through the issuance of a senior note or loan, together with an equity tranche, sometimes also mezzanine, a deferred purchase price, or a combination of these. The collections and distributions from the vehicle are governed by a pre-agreed schedule, also called a waterfall.

The distribution of risks and rewards, bankruptcy remoteness or non-consolidation, and level of control, will be key factors auditors will consider in determining if the receivables, and underlying debt, is de-consolidated from the corporate’s balance sheet. The results of this analysis will vary significantly depending on what GAAP standards are applicable.

Team Effort

The special-purpose entity is frequently managed by a corporate services provider, who will ensure the entity is filing all required returns, paying relevant taxes and meeting applicable local regulatory and legal requirements. Most structures will also require a security trustee, vehicle account bank, cash manager (to manage the waterfall payments) and reporting agent. In addition to this, an auditor will be appointed to perform an annual review of the corporate’s underwriting, collections and arrears-management procedures.

Using a reporting agent that can connect to the corporate’s ERP system for automated processing and performance reporting can help drive higher utilization and lower funding costs. Having the data sourced directly and automatically from the ERP system can significantly lower fraud risk, reduce reporting costs and optimise advance rates. It should also be noted that the advance rate and all parameters of TRS are formula-based and therefore highly predictable and expressed in a detailed documentation.

Getting Started

An initial assessment of the receivable portfolio, including consolidated aging balance and rollforward, can help confirm if the portfolio is suitable for a TRS. Reviewing the underlying contracts and seller and debtor jurisdictions involved can also increase certainty of execution.

Once commercial terms and advance rate methodology is agreed, the most intensive workstream will be drafting documentation. Appointing experienced trade receivables securitization drafting counsel is key to ensuring a robust structure and timely execution. There are many important and jurisdiction-specific pitfalls that a good firm will help you navigate, especially in cross-border transactions.

Closing thoughts

TRS programs can be used as a valuable alternative to other funding solutions, especially in cross-border or challenging credit environments. With a long history and an established and transparent framework, TRS can drive significant benefits for corporate clients.

www.demica.com