Corporate Insights Podcast | An introduction to invoice discounting and structure finance

Transcript Charity Lockie: Hi. I'm Charity, and I'm a solicitor apprentice in corporate and banking. Deepak Purushothaman: And, I'm Deepak. I'm a partner in our banking and finance practice. My practice covers all aspects of debt financing, so syndicated bilateral lending, and I've advised borrowers, and banks on documentation, structuring, and enforcement strategies. A large part of my practice is focused on structured finance, factoring, and invoice discounting, and it's this aspect that, Charity and I wanted to talk about today. Charity Lockie: So let's start off with invoice discounting. Deepak, can you give us a brief description of what invoice discounting is and how it's used by businesses? Deepak Purushothaman: Sure. So invoice discounting is a financing tool that businesses can deploy or use, either alongside or instead of traditional debt in the form of a loan, and it's typically to improve their cash flow. So to paint a picture, imagine you're a business owner and your business has provided goods or services to your customers. So you duly you send out your invoices, but, typically, due to your terms and conditions, you have to wait 30, 60, 99 days for payment. And it's recognizing that delay in payment. That's where invoice discounting comes in. So instead of waiting, for the end customers to to pay, you sell your invoices to a financial institution, usually at a discount in exchange for immediate cash from that institution. Conceptually, the invoice is recognized as an asset. It's the right to be paid, and it's often referred to as a receivable. In accounting terms, that receivable sits on the balance sheet of the company as an asset, which is capable of being financed. Charity Lockie: You mentioned that this type of financing is different from a loan. Can you explain what you mean by that? Deepak Purushothaman: Yeah. Sure. So, in a traditional secured loan, the type of which is the type of lending that people are most familiar with, a lender, a bank, or financial institution agrees to advance funds to a borrower, and that borrower offers up security for that loan in the form of hard assets, and it agrees to repay the loan at schedule intervals or at the end of the term of the loan. Now if, for whatever reason, the borrower defaults in those obligations, the lender has the right to enforce its security, and they'll take control of and then sell the secured assets, and they'll repay itself out of those sale proceeds. So that's traditional secured lending. That's very distinct from invoice discounting or a factoring arrangement where the borrower has offered up its receivables for sale, and the financial institution has purchased those receivables at the discount that we described earlier, and then it advances the cash for those purchase receivables to the business. Now in this situation, if the borrower defaults, the financial institution's main recourse is to those receivables themselves. So what it's what it has to do is to wait for, what we refer to as a collector. So, its main recourse, as I say, is to the underlying customers, for repayment rather than to hard assets. Now in some situations, you'll find invoice discounting factoring arrangements. The the funders take security as well, but that is, that is sort of ancillary to the credit. The main credit recourse is to the is to the receivables rather than to to the hard assets. Charity Lockie: So in an invoice discounting arrangement, you get most of the cash right away instead of waiting for customers to pay. That must be a huge help for managing day to day operations. Right? Deepak Purushothaman: Yeah. Exactly. I mean, it allows businesses to maintain a steady cash flow. It's a real bonus for, for, CFOs, for for financial directors. So it allows businesses to pay their suppliers on time, meet their other financial obligations without delay. And it's particularly so it's it's traditionally very useful for small to business, small to medium sized businesses, typically in the manufacturing space historically, because those those types of companies, those types of businesses tend not to have large cash reserves. So by using a product like invoice discounting, it just allows them to to manage their cash flows on a bit more of a predictable basis. Charity Lockie: How does it differ from factoring? I know they're often mentioned together. Deepak Purushothaman: Yeah. That's a good question. So without going too much into the, you know, into the sort of nitty gritty legal details, both factoring and the invoice discounting involve the sale of an invoice. The key difference between the two is control and confidentiality. So in invoice discounting, a business will retain control over its own sales ledger and its underlying customer relationships. So in that situation, customers typically don't know that their invoices are being discounted. Contrast that with factoring where the factor will take over the sales ledger and might interact directly with the end customer. So it'd be the the factor takes over the credit control function of of the business. You might recall that, in you know, from a legal perspective, to perfect an assignment, you need to give notice. Well, in confidential invoice discounting, that notice is isn't given until there's a default, whereas in factoring and disclosed invoice discounting, notice is usually given upfront. Charity Lockie: That makes sense. So invoice discounting is more behind the scenes? Deepak Purushothaman: Yeah. That's right. It's more discreet way of managing finances. It means that from the perspective of the borrower, the underlying customers are unaware how the borrower is being funded. That's good from the perspective of most businesses because they don't want their, customers to know that they're, assigning their receivables to a third party funder. And another benefit of this type of funding besides improved cash flow is that businesses can also reduce the risk of bad debts because the financial institution that undertake this type of funding, often, have a stringent process to assess the credit worthiness of the invoices, and so they carry out, a good amount of due diligence on the underlying customer base. Charity Lockie: And what about the costs involved? How do lenders charge for the product? Yeah. Deepak Purushothaman: There are there are fees involved. I mean, as with a term loan where you where a fund or a bank will charge, a margin or interest rate, so a financial institution carrying out invoice discounting will want to charge. But that's usually done by way of, service fees, which are calculated as a percentage of the invoice value, and they're often calculated by reference to how long invoices typically are outstanding because that's a reflection of the credit risk. The business is finding that a worthwhile cost in exchange for the cash flow benefits and the, the ability to to capitalize on growth opportunities without waiting for for payment. Charity Lockie: Great insights, Deepak. Now switching to structured finance, what is it, and how does it fit into the broader financial landscape? Deepak Purushothaman: Yeah. So, structured finance, it's, it's a term of it's an umbrella term, used to describe the creation of complex measure products. Those can be tailored to the specific funding needs of businesses, and it's typically used as an option by larger businesses and corporates. So unlike traditional loans, structure finance involve the pooling of financial assets. So for example, credit card debts, leases, invoices, and then packaging them into securities, which can then be purchased, sold to investors, purchased by investors in order to raise capital. Charity Lockie: So it's like creating a new financial product from existing ones? Deepak Purushothaman: Yeah. That's right. So it can include things like asset backed securities or collateralized debt obligations. And and, typically, it allows companies to access the capital markets, and, in doing so, to manage their, their financial risks on a more effective basis. Charity Lockie: Why would a company choose structured finance over traditional financing methods? Deepak Purushothaman: Yeah. It's a good question. Number of ways, you can answer that. So structured finance can offer more flexibility and potentially lower costs, and in some cases, larger debt amounts so you can raise more on the capital markets that you might be able to do on a private basis with a bank. It can also provide access to a broader range of investors. So for businesses with unique financial needs or those looking to diversify their funding sources, perhaps they've already got, you know, a traditional debt package with a lender, and they want to broaden that, it can be an attractive option. So this type of funding is a different balance sheet analysis, both from the perspective of the funder and from and for the borrower. So from the borrower's perspective, the assets that it's selling are taken off balance sheet. And then from the perspective of the funder, they are buying or funding an asset rather than lending, against security. So from a funder's perspective, there may be preferential balance sheet treatment in the capital adequacy requirements for those for those types of, lending structures are reduced when compared to traditional debt finance. So there are benefits for both the borrower and the lender in that situation. Charity Lockie: With that in mind, how do these concepts of invoice discounting and structured finance interact? Deepak Purushothaman: Yeah. Again, really good question. So invoice discounting can actually be a part of structured finance. But what I'd say is that many of the concepts that you come across in invoice discounting, such as the sale of, a receivable, as an intangible asset, and bankruptcy remoteness are important factors in structured finance. So you can use the concepts in used in invoice discounting in structured finance just on a more complexly large basis. So for example, a company might bundle its discounted invoices into a debt security, and then sell that security to investors to provide liquidity to the underlying company, and thereby creates new investment opportunities. One of the key aspects of structured finance is the financial assets are transferred by the borrower or rather the originator into a special purpose vehicle, which is established for the transactions. And that renders those assets bankruptcy remote from the perspective of the originator. So in practice, what that means is that when you're investing into an SPV, that has issued these types of securities, the investors, don't have to concern themselves with the insolvency risk of the underlying originator because the assets once sold are remote from the from, from a bank policy perspective. Charity Lockie: That's fascinating. It sounds like these tools can really enhance a company's financial strategy. Deepak Purushothaman: Yeah. They offer ways to optimize cash flow, manage risk, access new funding. And as mentioned before, there are balance sheet benefits, for both parties and from the perspective of the borrower. It can have the added bonus of improves improving, financial ratios. Charity Lockie: So now that we have a good understanding of invoice discounting, let's dig into the key features of an invoice discounting agreement. Deepak, what should businesses expect when entering into such an agreement? Deepak Purushothaman: Yeah. It's a good question, Charity. An invoice discounting agreement, typically includes several key features, some of which are commercial, some of which are are are legal. And obviously, those that are commercial will be negotiated probably at the term sheet or preterm sheet stage, and then those that legal are typically handled by the legal advisers to both the borrower and the funder. So one of the commercial aspects that will be discussed is the advance rate. So that is the percentage of an invoice that is going to be funded by, by by the financial institution that's buying those invoices. And a and a typical, and a typical discount would be seventy to ninety percent of the face value of each invoice. That's a commercial discussion to be had between the finance director, the company, and the funder. But it's usually, as I say, it's a matter for negotiation, but usually, it's a function of the type and number of receivables and the perceived credit risk of the underlying customer base. Another aspect might be, sorry. Another aspect of the of the agreement is the mechanism for assignment of the invoices. And whilst that's not typically subject from negotiation, the agreement, will need to deal with whether the invoices are assigned by way of whole turnover. And what that means is, the borrower will assign all receivables that exist on day one one when it enters into the facility, and then all receivables as and when they arise to the extent they meet certain criteria. The alternative to that is an assignment by way of offer acceptance, so, you know, classic sort of law school stuff, where the borrower will offer receivables for sale and the funder will, will reference their eligibility criteria, and then determine whether they are acceptable for funding. Then, we touched on fees and charges before. That's obviously, a commercial function, to be discussed between the borrower and the lender, but there will be, fees charged for administration, for any credit control for the amount of time that receivables are outstanding. And then the borrower will charge something akin to, akin to interest. So a charge for the amount of debt that it's made available. And then,  I mentioned earlier the eligibility criteria. Now this is something that, is sometimes discussed at a term sheet stage, and it's often discussed, by the it's often negotiated between the legal advisers. But it is one of the key negotiating points because it dictates how many of the receivables that are off sale will actually be funded by the financial institution. Now not all invoices will be deemed eligible for discounting, but not all invoices are appropriate to be sold. So for example, if there are, credit notes or if there are, if there are con contested invoices, those aren't deemed eligible funding or if there's a prohibition on assignment, for example. So financial institutions typically have criteria based on the credit worthiness of the debtor, as well as the underlying customer base, and they'll have regard to the nature of the transactions, and the type of documentation that's being entered into. So these are all subjects for negotiation, and typically, yeah, are are well discussed between the borrower and its legal advisers. Charity Lockie: Interesting. So it sounds like there are many details to consider. Businesses should probably be prepared to negotiate terms that best fit their financial situation. Right? Deepak Purushothaman:  Yeah. That's exactly right. It's crucial to understand those terms, and to work with a good financial adviser or a legal expert who's familiar with this type of product to, to ensure that the agreement aligns with the business's needs and expectations, and its financial goals. Charity Lockie: Thanks, Deepak. That was a thorough explanation of what businesses should expect from an invoice discounting agreement. Before we wrap up, any final thoughts or advice for our listeners? Deepak Purushothaman: Yeah. I'd say if you're a business owner or you're thinking about utilizing these financial tools as a a finance director or a CFO, it's crucial. I think it's really important to work with advisers who understand, the intricacies of these products. They are different as we've as we've discussed from traditional debt financing. I'd suggest getting advisers involved early, and making sure your funder understands your business, and your customer base. Charity Lockie: Thanks, Deepak. This has been a great discussion, and thank you to our listeners for joining us today.