Since the earliest days of human trade, buyers and sellers of goods have been pitted against each other. Suppliers want cash paid up front or on delivery. Buyers want to pay when it suits them. That was true for Mesopotamian farmers, fifteenth-century English weavers and American fur trappers. All wanted to be paid for their goods as soon as they were shipped or earlier. Often, merchants wanted to drag out payment until they’d sold the goods on again to their own customers. It’s a deep flaw in the system of trade where it ought to be in everyone’s best interests to keep the cash flowing.
For millennia, the ‘factor’ – a kind of banker that specializes in trade finance – played a critical role in bridging the divide. Factoring has underpinned local and global trade since well before Cosimo de’ Medici created one of the first truly international banking empires, which expanded from Florence and Rome across all the great commercial centres of fifteenth-century Europe. It works because it is in everyone’s best interests to have a healthy, smooth-running supply chain, with cash getting to where it’s needed, when it’s needed.
This is how factoring works: a supplier is owed money by its customers. These IOUs are called receivables, and until they’re paid up, the supplier doesn’t know how much they will eventually collect. Some customers will pay everything on time. Some will pay but maybe not for a while. And others might not pay at all. The factor buys the IOUs, or receivables, paying a small discount to the invoiced amount and then chases the customer for the full amount later. Sometimes the factor loses out if the customer never pays up. Mostly they make a small profit.
In the past few decades, factoring has evolved. Rapidly.
Starting in the 1980s, economies quickly globalized, seeking out cheaper workers and means of production. That led to more complex, longer supply chains, spanning several countries. There were more components, more suppliers, more transactions. The consultants McKinsey & Company estimate that a single car manufacturer such as Ford or Volkswagen might have 18,000 suppliers, spanning just about every continent on the planet. Production will grind to a halt if the suppliers are not in sync. Everyone in the long, twisting chain wants to be paid on time, to keep the machines running, to make sure workers keep showing up.
Banking is nothing if not innovative. A whole slew of financing techniques has also sprung up, with names like dynamic discounting, early payment discounts, accounts receivable financing, letters of credit.
A version of factoring called supply chain finance – SCF, or sometimes ‘reverse factoring’ – emerged within the last few decades. Some in the industry trace its beginnings to developments in the auto industry in the 1980s. Others say it started in Spain around the same time.
In 1998, a mid-ranking executive at Chase Manhattan bank filed a US patent, now lapsed, for a supply chain financing technique. The wannabe inventor was Roland Hartley-Urquhart, one of Lex’s colleagues at Morgan Stanley, who’d run the US side of that business. He also became one of the first and longest employees at Greensill Capital. His 1998 patent explained SCF like this:
A method for financing a supply of goods (a supply chain) from a supplier to a buyer in which the buyer has a lower cost of funds than the supplier . . . The buyer generates a purchase order for the goods which is forwarded to the supplier who in turn ships the goods to the buyer. The supplier sends an invoice to the buyer which stores the invoice in a database. The financing institution electronically accesses the database to retrieve the daily invoices. The financial institution then calculates the financing applicable to the shipped goods and forwards a payment to the supplier. Upon maturing of the financing, the buyer settles with the financial institution by remitting the gross proceeds.
There were versions of SCF popping up everywhere. Robert Cleland’s OzEcom was in Australia, and TRM was in the UK. Whoever invented it, SCF involves a contortion of the original, simple approach to factoring. Instead of the supplier approaching the factor, it’s the buyer of goods who makes the move.
Here’s how it’s explained in a July 2021 paper titled ‘The determinants and consequences of reverse factoring: Early evidence from the UK’ by Chuk, Lourie and Yoo of the University of California, Irvine:
To illustrate with a brief stylized example, suppose that Procter & Gamble purchases certain raw materials from small and mid-sized local suppliers. Further suppose that a fictitious company XYZ Inc. is a small supplier that has recently sold some raw materials to Procter & Gamble for an invoice price of $100. In this fictitious example, Procter & Gamble would typically remit a cash payment of $100 to XYZ 60 days after receiving the raw materials from XYZ. Now suppose that Procter & Gamble offers a reverse factoring program [sic] using a bank as the financial intermediary, and XYZ has decided to participate. Under reverse factoring, Procter & Gamble would pay the full $100 to the bank later, which is likely later than the typical payment period in the absence of reverse factoring (i.e., later than the 60 days in this example). In turn, the bank would pay XYZ earlier than 60 days, but the payment amount would be lower than the full invoice amount. For example, the bank might pay $98 to XYZ, such that the bank earns a $2 fee in exchange for facilitating the transaction and for bearing the risk of non-payment by Procter & Gamble.
Reverse factoring may be seen as a ‘win-win’. The bank decides how much to charge for its service based on the credit rating of the buyer, not the supplier. Because the buyer tends to be a bigger company, it usually has a stronger credit rating, meaning that there is a lower risk that it will fail to pay up and the bank can provide cheaper financing.
The use of SCF has grown quickly. By 2017, about two-thirds of the biggest companies in Europe ran a supply chain finance programme, according to accountants PricewaterhouseCoopers (PwC). But there’s room to grow further. For the most part, banks that offer SCF programmes have stuck to their investment grade corporate clients – big companies that are less likely to default on the loans. That’s a tiny proportion of the companies that theoretically could become SCF customers.
McKinsey say that the use of SCF could grow at 20 per cent a year through 2024, and that there is a potential pool of annual revenue tied to SCF of $20 billion.
At the same time, rule changes after the financial crisis, and the tendency for banks to tighten up their balance sheets, led some banks to curtail their commitment to exactly this kind of business. That opened a gap for specialized firms, often using new technology, to enter the market.
ROBERT J. COMERFORD IS a partner with accountants Deloitte and previously a Professional Accounting Fellow in the Office of the Chief Accountant at the US Securities and Exchange Commission (SEC). He’s not famous. He wasn’t even especially senior at the SEC. But in the SCF world, a speech Comerford gave in 2003 at the thirty-first national conference of the Association of International Certified Professional Accountants is seminal. It is the Gettysburg Address of SCF.
In the speech, Comerford discussed ‘certain transactions involving trade account payables’ that were being used to circumvent existing rules on balance sheet disclosures. Comerford goes on to describe the transactions that have caused his consternation, and what he describes is a kind of SCF deal. The SEC, he said, believes that the substance of these transactions is that the buyer has borrowed money to pay its bills. The financing should be recorded as debt.
The speech is so important because one of the appealing things about SCF for many big companies is that it isn’t debt. Proponents of this view argue that the financing is given to the small suppliers, who are getting their invoices paid early.
Remarkably, for years following Comerford’s speech, there was little movement from the usual financial gatekeepers – the accountants and regulators and rating agencies. It sat in an accounting grey area. It wasn’t clear how it affected the creditworthiness of a company. It wasn’t clear if SCF was debt or not.
As the use of SCF grew and grew, the amount of financing that simply wasn’t being recorded anywhere on anyone’s balance sheet was growing and growing too. The accountants, regulators and other gatekeepers that guard global capital markets had started to worry about what might happen if this money stayed in the shadows.
In 2015, Moody’s, the rating agency, issued a report on Spanish energy group Abengoa that said its ‘large-scale reverse factoring programme has debt-like features . . . Moody’s notes that the practice is likely widespread.’
Lack of disclosure rules on reverse factoring make it hard to measure, while the supposedly short-term nature of the financing means it can unwind quickly and leave a borrower suddenly facing a shortfall. A few months after that Moody’s note, Abengoa was forced into a painful restructuring and narrowly avoided going bust, though only for a few years. It filed for insolvency in early 2021.
SCF burst into the headlines for the wrong reasons again in 2018. Carillion, the construction and facilities management company, collapsed into bankruptcy that year, in one of the biggest corporate failures in the UK’s history. At its heart was a kind of SCF programme, promoted by the UK government and based partly on advice it received from Lex Greensill, known as the ‘early payment facility’. Carillion had used the SCF programme to stretch out its payment periods to 120 days, giving suppliers the option to get their money within thirty days if they paid a fee to the banks behind the programme. The construction firm was building up debts that were hidden among ordinary trade creditors on its balance sheet – meaning it didn’t affect the company’s credit rating.
The same year, Fitch, another rating agency, also weighed in. Fitch said companies were using SCF as a ‘loophole’ to hide borrowings that ‘may have negative credit implications.’
The SEC also began to sniff around. Since 2019, the US regulator has asked several big US companies about their use of reverse factoring, including Coca-Cola, Procter & Gamble and Boeing.
The Big Four accounting firms have piled in too. In October 2019, Ernst & Young (EY), Deloitte, PwC and KPMG took the unusual step of sending a joint letter to US accounting regulators, seeking guidance on how they should treat SCF in the accounts of companies they audited. A couple of years later, their collective prayers were answered. Sort of . . .
In September 2021, the Financial Accounting Standards Board, the authority for US accounting standards, proposed new rules for SCF. The proposal would require companies to disclose if they use SCF, and details about the size and key terms of the programme. Finally, almost twenty years after Comerford’s warning, it looked as if the gatekeepers might have come up with some rules.
Back in 2011, however, there were no obstacles in Lex’s way. When his efforts to turn Citi and Morgan Stanley into giant SCF shops had run aground, Lex set up his own firm, Greensill Capital.
He added a few twists to the reverse factoring mix. For starters, he didn’t have a giant balance sheet like the big banks had to fund all their deals, and he didn’t want to rely on the vagaries of the asset-backed commercial paper market. Instead, he would tap other people’s money in a more direct way.
Since the global financial crisis, central banks around the world had flooded the market with cash and forced down interest rates to try to get the global economy back up to speed. Lex bet he could tempt investors to fund his supply chain finance loans if he offered just a little more than they would get leaving their money in the bank. He sought out giant fund management houses that ran billions of dollars in investments for wealthy clients like company pension plans and super-rich individuals. He sold some of his supply chain finance loans, the best stuff, to big European and Japanese banks. He also tapped corporate treasury departments; the biggest global companies like Vodafone or Boeing often sat on big pools of cash that were not earning much. And he wanted a bank of his own that would collect deposits from customers and use them to pay for SCF loans.
The second twist he added was to wrap the whole scheme in insurance. Regulations prevented many investors from putting their money into all but the very safest investments. But Lex knew the companies he would have to lend to were not all top grade, especially at the start. After all, who would work with ‘Greensill Capital’? The solution was to buy trade credit insurance. This is a type of insurance policy that pays out when there is a default on the loans Lex was planning to finance. If the loans made by Greensill Capital were covered by a policy from an insurer with a strong credit rating, then investors would treat the loans themselves as though they had a good rating too. That meant Greensill could access a much broader group of investors to fund the loans. It was reminiscent of the years leading up to the financial crisis, when pools of low-grade assets were mixed with better-rated investments and sold as low risk. Not wrong exactly, but you had to look closely to see what you were investing in.
The final Lex twist was to add new technology. In the wake of the financial crisis, there had been an explosion in new financial technology companies, or fintechs. Some of these were in the payments processing space, and included PrimeRevenue, Orbian, Taulia and Demica.
Lex was no techie. Instead, he hooked up with a series of other aspiring entrepreneurs who carried the bulk of the technology he needed to run the business. And then he liberally applied the fintech tag to Greensill Capital too.
To make it all work, Lex created a tangle of special purpose vehicles (SPVs), trusts, offshore companies and subsidiaries that each played a critical role. In essence, he’d taken one of the oldest, simplest forms of banking, and supercharged it for the twenty-first century.
Greensill Capital was up and running. But the seeds of Greensill’s problems were sown. It was complex. It loaned money to the riskier end of the market. The clients in Greensill’s reverse factoring programmes often didn’t have great credit ratings. The funds Lex created masked low-grade corporate debts with insurance, which made it look as safe as putting money in the bank. And Greensill was touting itself as a hot new fintech, when in reality Greensill was a financial intermediary with an appetite for convoluted corporate chicanery.