Piecing together inventory finance

Feature | 30 May 2017
Puzzle

Gianluca De Stefano offers a breakdown of three widely used inventory financing techniques and the costs and benefits they each present to lenders and borrowers

Working capital management is crucial for smooth operations at any company. Businesses use working capital to fund their daily operations, in an effort to balance growth, profitability and liquidity. Managing it efficiently allows a business financial stability in the short term. Contrarily, ineffective working capital management can lead to insolvency and potential bankruptcy.

A big part of a business's success, is its ability to effectively operate its inventory. Businesses incur daily costs to track, store, finance and insure inventory. Mismanaging inventories can lead to inventory shortages or gluts, resulting in potential financial distress.

Here are three options commodity firms have to finance their inventory.

Warehouse receipt under collateral management agreements

This type of structure provides secured financing against a pledge of commodities. In this scenario, commodities are used as collateral and stored in a third party warehouse or at the borrower's warehouse. As commodities are stored, a warehouse receipt is generated to create collateral for the financing. Usually, and rightly so, the goods are stored under the supervision of a third party operator (also known as collateral manager) who verifies and validates stock levels, as well as the quality of the stored goods in order to meet regulatory requirements.

In a typical bank warehouse financing, the lender, the borrower and the independent warehouse inspector would enter into a tripartite agreement, known also as a collateral management agreement (CMA). The lender takes comfort thanks to the role of the inspector who guarantees smooth handling of quality and quantity. The inspector issues a warehouse receipt following the lender's instructions. And a loan is issued on the back of the warehouse receipt. Advance rates vary, but it is generally in the range of 80-90%.

When structuring such a transaction, it is important to keep in mind the legal implications. In some countries a warehouse receipt is seen as a title transfer document and proof of ownership. In case of a borrower's default, the lender can dispose of the collateral to recover their funds. Yet, this is not always the case. In some jurisdictions a warehouse receipt is not proof of title. This can lead to headaches for the lender in a recovery scenario. Note that in this structure, the commodity must be clear of third-party liens and pledges, cannot be co-mingled and should be identifiable at all times.

Figure 1: Warehouse

Notes

1. Lender and borrower set up a facility agreement and sign a collateral management agreement with a collateral manager (CM)

2. CM issues a warehouse receipt to the lender

3. Lender funds the borrower based on the warehouse receipt and product in tank

4. CM monitors and updates the lender on quality and quantity of product in tank

5. Borrower repays the lender as commodity is sold

Advantages for the borrower:

  • Monetising the value of static inventory.

  • Higher level of financing by leveraging the underlying commodity (up to 90%).

  • Financing is linked to the value of the inventory rather than debt metrics.

  • It is available to counterparties with lower credit who are in possession of the commodity.

Advantages for the lender:

  • Loan secured by commodities supervised by a reputable third party inspector.

  • Lender controls the release of commodity from storage.

  • Goods are generally insured.

  • The loan is repaid as the supervised goods are released by the independent inspector.

Repurchase agreement

Following the Qingdao fraud, repurchase agreement (repo) structures have come under enormous scrutiny and some changes to the legal framework had to be made to incorporate events of fraud. The accounting treatment was reviewed. Repos are still widely used but in most cases are re-characterised as secured financing, rather than an off-balance sheet true sale (via old call options). Off-balance sheet structures are still possible under International Financial Reporting Standards (IFRS) for the time being, yet are more difficult under US General Accepted Accounting Principles (GAAP).

In a typical repo structure the lender purchases the commodity (title transfers) and
the hedge from the seller who monetises the value of the inventory minus the lender's fees. The lender retains the option to buy back the inventory, but not the obligation. At maturity the borrower pays back the lender using future prices and receives the inventory and title to the commodity. In a tripartite agreement between lender, seller and ultimate buyer, at maturity the parties may agree to sell the commodity directly
to the ultimate buyer.

In this structure a lender usually gets comfortable based on the 'true sale' nature of the transaction reducing re-characterisation risk, the logistic services agreement, liquidity of the commodity, the reputation of the independent inspector and safe harbor protection (US only).

One important legal point to keep in mind when structuring a repo is what constitutes a sale and what constitutes a financing. Generally speaking, it becomes a financing when the lender is given the option and obligation to repurchase or substitute the commodity. In a true sale, the borrower will only have the option to repurchase. Nevertheless, this point is still very much a grey area, and needs further clarification.

Figure 2: Repurchase agreement

Notes

1. Lender and borrower enter into repurchase agreement

2. Lender purchases the inventory, takes title, enters into a short hedge and funds the borrower

3. The borrower transfers title to the inventory and receives funds minus lender’s fees

4. Lender transfers title back to the borrower and closes the short hedge position

5. Borrower repays the lender using an agree future price

Advantages for a borrower:

  • Higher advance rates than a standard asset based loan.

  • Low pricing.

  • Right way risk between customer exposure and collateral.

  • Generally no variation margin is required.

Advantages for a lender:

  • True nature of the sale and ownership of the collateral.

  • Facility is uncommitted.

  • Enhanced language including events of fraud.

Borrowing base

This type of facility is one of the most secured forms of financing. In this financing a lender provides the borrower with a revolving credit facility (with recourse), secured against the borrower's current assets, stocks (raw material, in progress, finished goods) and its account receivables. The borrowing base is linked to the borrower's current assets. Through this facility, a borrower has the option to finance individual deliveries by drawing down under the borrowing base. The proceeds of sales are then used to repay the facility, hence why this structure is also referred to as 'self-liquidating'.

Advance rates under a borrowing base will vary depending on various factors, among which is the price volatility of the underlying commodity and the risk profile of the borrower. The value of the facility is adjusted at different intervals, depending on the change in the borrower's current asset value as a direct result of changes in commodity prices. The lender may be required to top up or partially repay. One of the drawbacks of this facility is its uncommitted nature and lenders are under no obligation to lend, possibly creating funding gaps for the borrower.

The collateral is monitored via a borrowing base certificate issued by the borrower. The lender holds security interest in the collateral.

Transmar's bankruptcy, and the disappearance of US$300m of collateral, will raise questions about how these facilities are structured in the future.

Figure 3: Borrowing base facility

Notes

1. Lender and borrower enter into a borrowing base facility agreement

2. Borrower provides inventory as security

3. Lender funds the borrower based on an agreed advance rate

4. Borrowing base is monitored and recalculated if necessary

5. Borrower repays the lender

6. Security is released back to the borrower

Advantages of a borrowing base for a borrower:

  • Funding can be used against early production stage.

  • Monetisation of unprocessed goods.

  • Monetise static inventory in advance.

  • Opportunity to finance every step of the trading process.

  • The facility allows price fluctuations.

  • Borrower pays no commitment fees.

  • Optimises balance sheet.

Advantages to the lender:

  • Facility is uncommitted.

  • Short term and self-liquidating nature of the facility partially mitigates price risk.

  • Security package includes inventory as well as all of the borrower's current assets.

  • Flexibility to readjust or partially repay the borrowing base should the value of the borrower's current assets drop.

  • Day one haircut.

  • Reporting and monitoring system of the borrowing base.

Due diligence: defining collateral

When implementing an inventory financing solution, an important part of the due diligence is the ability to define what good collateral is (ask subprime lenders). At the height of the 2008 financial crisis, the A4 piece of paper used for the contract was worth more than the underlying collateral. As you can imagine, in such a scenario, recovery can be an ordeal.

Good collateral has many different characteristics:

  • The quality of the product should be certified by an independent inspector.

  • Is the product illiquid? Can it be readily monetised? Commodities quoted on an exchange are easier to finance. Price risk of the underlying commodity can be partially mitigated by hedging the inventory using futures contracts.

  • What are the liquidations costs in case of a borrower's insolvency? Is a credit spread applicable to the borrower? These factors should be carefully understood and included in the day one hair cut.

  • The location of the commodity. Remote locations carry a higher risk.

  • Perfection of the legal title, local rules and regulations. This can be understood by obtaining legal opinions from international or local legal houses.

Oil and gas companies operate in dynamic environments and face constant challenges when it comes to managing their inventory and working capital. In volatile markets, some turn to lenders to either manage their price risk for pure financing needs, or to take advantage of contango structures. Managing inventory is an effective way to reduce costs and increase profitability.

Borrowers have access to different types of financing structures depending on their objective, their credit rating and the underlying commodity to be financed among other factors.

For a lender, successful implementation of these facilities comes down to the quality of the collateral, the perfection of title, geographic location of the inventory, and legal and operational implications. Details in the due diligence can be the difference between success and a hole in your books.

Gianluca De Stefano is a former structured finance manager at Noble Americas and Glencore

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