Trends In Trade Receivables Finance – Finance and Banking

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With partners having over 30 years’ experience in financing
trade receivables and trade payables, Mayer Brown has a unique
insider’s view of the global trade finance industry. Emerging
from a tumultuous 12 months in the midst of a global viral
pandemic, we look back in wonder at the resilience and innovation
this industry demonstrated through exceedingly challenging times.
That resilience and innovation continue unabated, and we see
certain defining trends emerging for the near term. Given the
longevity of trade finance, its critical importance to businesses
around the world and a quickly changing and developing global
economic, political, regulatory, accounting and overall business
environment, it is no surprise to see ongoing innovation in
structural technology and disintermediation, the entry of new
players in the market, coalescence of thought on accounting
implications and broadened use of the product by companies in
varying states of the business and credit cycle.

While we could write volumes and fail to capture the nuances of
all the types of trade finance tools in the market today and the
evolution of such tools over the last 30 years, for the purposes of
this article, we will limit the discussion to four particular
trends that we have witnessed in the trade finance space in 2020
that seem likely to continue in 2021 and beyond:

  1. The convergence of “securitisation” structures and
    more traditional trade finance technology.

  2. The entry of private equity and credit funds and insurance
    companies as investors.

  3. Broader acceptance of US GAAP off-balance sheet structures that
    do not result in negative consequences under ASC 230.

  4. Increasing comfort by lenders and investors in structures that
    will not only survive but thrive pending and during insolvency

We will address each of these trends in turn below.

The Convergence of “Securitisation” Structures and
More Traditional Trade Finance Technology

The fact that trade finance has endured for many decades is a
testament to the value of business-to-business trade receivables in
supporting high credit quality and liquid investments.
Traditionally, trade finance can include: (a) investments,
typically in the form of factoring or other purchases of individual
receivables (or other financial assets created from or otherwise
supporting those receivables), whether to provide financing to
buyers or suppliers (or other intermediaries) in the supply chain
(which we will generically refer to as “obligor-specific
transactions”); (b) asset-based lending
(“ABL“), typically constituting loans,
provided to a supplier of goods or services and secured by a
revolving portfolio of short-term receivables and inventory; and
(c) securitisation of trade receivables (which we will refer to as
“structured finance”), which may be financed by banks or
more widely in capital markets, but always utilising a bankruptcy
remote structure. It should be noted that obligor-specific
transactions may provide financing to multiple obligors under the
same agreement but with underwriting of each included obligor.

Although obligor-specific transactions can be done in many forms
and on a one-off or revolving basis, disclosed or undisclosed, and
committed or uncommitted, the common thread in these transactions
is that the investor need only assess the credit (and short-term
credit at that, given that these assets typically mature in 90 days
or less) of one corporate entity – the buyer of the goods or
services at issue. Of course, structural elements could add
additional risks, such as potential credit risk with respect to a
supplier/seller if the transaction is not respected as a legal true
sale or if all dilution risk has not been eliminated, potential
credit risk with respect to an intermediary that takes title to the
receivables for financing purposes or potential credit risk with
respect to an insurer if a credit insurance policy has been
obtained to insure payment of the purchased receivables. Given the
short-term nature of the transaction and the limitation of
potential credit risks, pricing for these transactions will
typically consist of par minus some discount that reflects the
expected time to payment as well as the investor’s credit
assessment of the obligor.

ABL transactions are typically secured loans and, as such,
typically financed by banks and typically on a committed basis as
part of a company’s overall working capital management or even
as part of an acquisition financing. These transactions require
more sophisticated underwriting as they must assess the credit
quality of a portfolio of receivables as well as that of the
supplier/ borrower and its ability to continue to generate a
consistent portfolio of receivables to support the financing. These
facilities are typically longer term (normally over a year) and
will therefore often include triggers relating to the
supplier/borrower’s credit and the pool performance that will
stop the committed financing early. While pricing of these
facilities will typically be based on pricing the
supplier/borrower’s secured credit assessment, the amount of
funding available at any point in time will depend on the
performance of the portfolio of receivables and will take into
account the expected life of the portfolio in a run-off scenario,
as well as historical defaults and dilutions and obligor, and
perhaps other, concentration limits. The combination of all these
factors will result in a borrowing base to support the financing
but the financing will be full recourse to the supplier/borrower,
even if it turns out that, in retrospect, the borrowing base
calculation overstated the value of the portfolio of receivables
supporting the financing

Structured finance, like ABL transactions, requires investors to
underwrite a revolving portfolio of receivables based on historical
performance data but, unlike ABL transactions, is not full recourse
to the supplier. Like ABS transactions, structured finance
typically includes a dynamic borrowing base that takes into account
ongoing pool performance. However, these transactions are designed
to isolate the receivables portfolio from any insolvency risk of
the supplier by transferring the receivables portfolio to a
bankruptcy remote special purpose entity (an
SPE“). Consequently, structured finance
transactions can result in pricing that is better than that which a
supplier may be able to achieve in a full recourse transaction that
relies on its credit, even if secured. However, even with such
isolation, the transaction will expose investors to some credit
risk relating to the supplier, which may include dilution recourse,
indemnification for representations and warranties regarding the
nature of the portfolio, servicing of the portfolio as well as the
continued generation of new receivables to replenish collected
receivables in the event that collections are not immediately
segregated. Consequently, structured finance transactions in trade
receivables will normally include some triggers relating to
supplier credit issues that can have the effect of terminating the
revolving nature of the portfolio, starting cash trapping or
imposing other limitations on the ordinary servicing procedures of
the supplier. It is worth noting that in structured finance,
although recourse to the supplier for obligor credit performance is
typically quite limited in the sale transaction to the SPE, there
is no such limit on the recourse of investors to the SPE. That is
because the transaction between the SPE and the investors need not
be a legal true sale in order to provide investors with the
isolation in bankruptcy that they require. The SPE is designed
never to become the subject of an insolvency proceeding and the
SPE’s assets and liabilities cannot be substantively
consolidated with the supplier in the event of a supplier
insolvency proceeding. The advance rate (or borrowing base) in
these transactions will likely be the same or lower than in ABL but
with better pricing and, like in ABL transactions, the supplier has
no possibility of delivering any “upside” to its
investors because the discounting self-adjusts for historical
performance both prospectively and retroactively. The investors
cannot receive more than their investment and cost of carry for the
duration of their investment.

The types of convergence that we are seeing include: (a)
obligor-specific transactions that include higher levels of
recourse to the supplier that add stress to the legal or accounting
sale characterisation of the transaction and may correspond to
insurance coverage acquired by the investor; (b)
“securitisation-lite” structures designed to solve for
the higher levels of recourse by inserting an SPE between the
supplier and the investors, but without the more complicated
advance rate/borrowing base calculations included in ABL and
structured finance transactions; (c) the emergence of
“aggregation” entities sponsored by investment managers
or payment platforms, which seek to pool trade assets acquired from
multiple unrelated suppliers; (d) the inclusion of credit
insurance, traditionally endemic to obligor-specific transactions,
in structured finance transactions; and (e) investors financing
particular obligor “excess concentrations” using
obligor-specific transaction technology but from a portfolio
otherwise included in a structured finance transaction already, as
well as investors financing residual or subordinate interests in
structured finance transactions.

The first two types of convergence generally go hand in hand;
that is, the desire to increase recourse levels, even for
obligor-specific transactions, drives the securitisation-lite
structures that have emerged in the market. Suppliers can enjoy a
higher purchase price/advance rate if they provide some level of
guarantee of payment by their obligors, whether through an increase
in discount if the obligor pays late, or an absolute guarantee of a
certain percentage of losses. Because higher recourse levels can be
detrimental to obtaining a strong legal true sale opinion, which in
turn is generally required for off-balance sheet treatment under US
GAAP, and can result in non-US GAAP reporters failing to achieve
sale treatment under International Financial Reporting Standards
(“IFRS“), adding an SPE to the structure
can often result in the supplier and investors both “having
their cake and eating it too”. We will discuss current
off-balance sheet technology under US GAAP in more detail

The third type of convergence is a natural result of the
emergence of non-bank investors who want alternative avenues to
invest in trade assets outside of the traditional inter-bank
participation market.

There is also an increasing trend in the marketplace for buyers
of goods to want to engage in arrangements where they can arrange
for their inventory to be financed on an off-balance sheet basis.
This usually involves the imposition of a third-party entity
agreeing to purchase the inventory either from the buyer or
directly from the buyer’s suppliers and holding the inventory
on its own books. Often, the third-party entity will finance its
ownership of the inventory through one or more banks. These
arrangements involve complex accounting and regulatory questions
and are often highly bespoke in nature.

We have observed an increase in the inclusion of credit
insurance policies in trade finance transactions for several years.
Of course, a credit insurance policy can be used as an enhancement
to the credit risk of obligors in any of the trade finance
structures in the market. However, it has more recently found its
way into structured finance transactions. For many banks that are
not subject to US regulatory capital rules, credit insurance can
dramatically reduce the required capital to support these
transactions (although, unless cash collateralised, there is little
utility in such insurance in the US, outside the securitisation
framework). Although clearly beneficial to investors in these
transactions, regardless of the capital benefit, the motivation for
such inclusion often comes from the supplier. With an insurance
policy covering the portfolio, the supplier can obtain a higher
advance rate against its portfolio but also may be able to obtain
off-balance sheet treatment for a transaction that is otherwise
investment grade risk to its primary investors. That is because the
risk assumed by the insurer may be considered to satisfy the IFRS
requirements to have a significant risk transfer. Investors in
transactions with such insurance policies should consider whether
counsel should be charged with reviewing the policies in detail, as
structured finance transactions can result in complexity in
determining what entity holds the receivable and has an insurable
interest under local insurance law. Often, there may need to be
multiple insureds in order to ensure that the interests of the
investors and the SPE (as to its residual interest) are covered.
Also, the policy will normally need to be adapted to fit the
transaction to ensure that although the supplier may no longer own
the receivables, it is still the entity servicing them and
responsible for insurance reporting.

As we will discuss below, the level of interest from non-bank
investors in the trade finance space has increased rapidly over the
past several years. Given that many of the non-bank entrants in
this market are private equity, credit funds and other alternative
lenders that are not constrained by banking regulations and that
typically seek higher yields, it is not surprising that these
investors are finding ways to acquire residual or subordinate
tranches in existing and new structured finance transactions. Of
course, in new transactions, the structure can be designed to
accommodate subordinate investors through subordinated notes or
other similar mechanics. In existing transactions this can be
trickier but these new investors and banks are finding ways to make
it work, including by transferring subordinated participation
interests, acquiring financial guarantees or credit default swaps,
or by issuing credit linked notes that support a subordinated
tranche of the bank’s investment. We also see investors
applying obligor-specific technology to existing structured finance
transactions, by acquiring receivables owing by particular obligors
that are in excess of the amount of funding available against such
obligors in the structured finance transactions. These “excess
concentrations” can be financed by the supplier with other
investors but typically require the consent of the existing bank

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