FORFAITING MARKETS: Forfaiting as an Instrument of Portfolio Management

Feature

posted 15 Mar 2002 in Volume 5 Issue 6

FORFAITING MARKETS: Forfaiting as an Instrument of Portfolio Management

Various international banks and financial institutions have been the traditional players in the forfaiting market. They offer export-driven companies a range of different solutions to take risks off their balance sheet and to bring in additional liquidity. However, things are changing: some multinational companies have entered the forfaiting market and have made other players very much aware of their presence, according to Dirk Budach, responsible for the forfaiting business at Siemens Financial Services GmbH, based in Munich, Germany.

Almost all multinational industry groups deliver a certain part of their goods and services under deferred payment terms. Due to the fact that financing conditions of supply contracts play an important role in investment decisions for larger projects, many producers have to provide their clients with supplier credits, often with lengthy tenors and unfavourable payment conditions. The need for additional liquidity and an elevated uncovered risk position are consequences of this practice.

The traditional way

Up to now and continuously so, in many cases, a treasury department - either centralised at the headquarters or decentralised in several divisions of the group - has been the way to finance these transactions. At the same time, a portion of the accounts receivable was sold to third parties by making use of an established factoring and forfaiting market.

However, the increasing demand for supplier credits in an increasingly competitive market environment has forced many companies to put a greater emphasis on the professional management of the credit assets in their balance sheets. To cope with this challenge a different approach was used: new divisions were set up whose main objective is to manage outstanding receivables effectively. In-depth-analysis of credit risks inherent in every asset in the books is definitely the main task of these units.

Another approach

Step 1: The creation of a separate legal entity

Another strategy is the creation of a separate legal entity in the form of either a financial services institution or even a bank. Within this new institution a carefully defined credit strategy provides the necessary framework and guidelines for the purchase of receivables, no matter if they were originated in various divisions and affiliated subsidiaries of the mother company or from external markets. A credit department will provide detailed risk assessments of the obligors and the underlying transactions. The decision if a specific asset can be purchased or not and at what price, should be taken at arm’s length: Pricing can be related to prevailing market prices but also to risk-adjusted pricing tools based for example on the credit value at risk (CvaR) model taking into account internal/external rating results, maximum tenor and repayment structures, among others.

The arm’s-length-concept along with bank-like processes, IT-support and the credit function, enable significant savings in cost of capital for the industry group due to much lower equity requirements at the new financial entity. Precondition to these effects, however, is a structure of the entity being similar to that of a bank - even in the case that it is 100% owned by its mother company and fully consolidated in the group’s balance sheet. Obviously this would not be the case if the financial unit were taking over assets at a subsidised price not comparable to external market conditions, only in order to facilitate equipment sales of the production units of the group.

The new financial unit buys short, medium and long-term trade receivables principally on a non-recourse basis. It takes over the entire credit default risk and pays the nominal amount minus a discount margin. However, risk-sharing solutions tailored to specific customer needs are also feasible. As the seller of the products and services, the client retains complete contact with his client, but transfers the risk of credit default. The purchased medium to long-term assets are often documented in the form of letters of credit, promissory notes or bills of exchange, in selected cases also by confirmed invoices. The latter is more common in short-term transactions. Receivables with terms of 180 days or less are often purchased in the form of whole portfolios - in these cases the transfer of electronic data files -evidencing the underlying transactions - is highly recommendable, although a thorough due diligence process must be applied. Revolving facilities are possible, too. Tailor-made tools, electronic devices and systems will be used in order to assure the correct processing of bigger volumes in a very short period of time.

Step 2: Building up the portfolio

Once a certain number of receivables is purchased, a portfolio of different asset classes builds up step by step. The degree of diversification within the portfolio depends obviously upon the variety of assets included. They can be distinguished by tenor, repayment structure, rating of the obligor, country risk, underlying documentation, etc. To increase diversification and benchmarking, and to balance the portfolio, the purchase of assets from external sellers - who do not belong to the group - has proved to be most effective. A ratio of, say, 50% internal/50% external origin of the receivables might be a good approach. Easy access to not-company-related deals offers the well-established international secondary forfaiting market, but in the long run the direct purchase of trade receivables from other exporters can be an attractive alternative.

Step 3: Active credit portfolio management

While during the build-up-phase of the business a ‘buy and hold’ strategy seems appropriate, a constantly growing portfolio will almost automatically increase the need to use different placement channels: concentrations of risks in various categories (industry sectors, certain countries and regions, even specific debtors) must be adjusted to balance the portfolio, and naturally the overall size of the portfolio is not unlimited but depends eg, on the disposable/available risk capital. Active credit portfolio management includes assessing and grouping the assets as well as using different ways to shift risks out of the portfolio onto the market:

Selecting, grouping and securitisation of the receivables held in the books (assets-backed securitisation).
Credit risk insurance.
Credit default swaps (physical settlement or cash settlement).
Outright sale of the assets.

The latter includes - once again - the secondary forfaiting market and is often the fastest way to place risks. However, the new business unit may not be considered as a typical forfaiting market trader since the overall strategy is clearly based on the idea of professional credit portfolio management.

The benefits

The industry group benefits in several ways from the activities of its own financial institution. First of all, transparency of the different business activities in the group will increase and the operating divisions can focus on their core business that is the production and delivery of goods and services and not the management of accounts receivables. Second, assessments of the risk profile of the group become much easier for shareholders, stakeholders, analysts, rating agencies etc that will undoubtedly improve the general standing of the company in the market. There is also an additional potential for new business opportunities as the lower equity requirements of the financial entity allow reallocation of shareholder capital to other business units within the group. And finally, the financial activities themselves can definitely be a new source for income and profit.

A live example

Siemens AG followed the concept of establishing its own separate legal entity. Siemens Financial Services GmbH (SFS) was formed as an operational spin-off of the central corporate finance department in 1997 and has been operating as an independent legal entity, wholly owned by Siemens AG, since April 2000. One of SFS’s core activities, concentrated in the organisational unit ‘Equipment & Sales Financing’, has its focus in the management of short, medium and long-term, trade-related receivables. Those originate from Siemens’s operating divisions and affiliated companies as well as from external clients. More than €3 billion of these trade finance assets are currently carried on the books of SFS, almost exclusively non-recourse to the original seller. In addition, SFS also manages the portfolio of the lease receivables originating from its own leasing transactions with external and internal clients and transfers concentration risks to the bank market. The customer portfolio of SFS concentrates on B2B, but handles B2C as well: It includes the consumer business sector as well as worldwide operating industrial and service companies and public sector clients. SFS has its own credit department which analyses carefully the characteristics of the transaction, the obligor’s share structure, and its financial strengths and weaknesses. At the end of this concise internal credit analysis stands a rating, which is the main input for the applicable risk-adjusted pricing model, along with the maximum tenor, the repayment structure, the country risk, and other influencing factors. Internal and external statistics about default probabilities in relation to input parameters are the basis for SFS’ calculation of the necessary risk capital coverage for every single asset.

The asset portfolio spreads across various risk categories. It encompasses a high degree of diversification due to strict credit policy guidelines for the purchase of risks, a wide-spread range of original receivables sellers and the active use of several placement channels including ABS transactions set up by SFS itself - a product which is also offered to external partners. The international secondary forfaiting market plays an important role on the acquisition side as well as on the placement side. The risk approach differs considerably from the typical bank perspective, eg, it allows not only the purchase of bank-confirmed transactions but also various corporate credit risks, and the pricing requirements may also different. This approach opens opportunities in a wide range of markets makes SFS attractive for other players in the forfaiting market.