Factoring can be categorized as a private debt niche strategy within alternative investments. It is typically, the process of a company selling their accounts receivables to an external party (called a factor) at a discount to its original value. This solution improves competitiveness on a global scale. It solves short-term liquidity needs of small and medium-sized enterprises (SMEs), which are often describes as the backbones of the economy.
This financing solution has been in place since the beginning of trade, but with the exponential growth of industrialization and supply chain specialization, the factoring industry has grown rapidly at a global level. In developed countries, only a few industries appear to rely on factoring as a primary way of funding. In some developing countries, however, the scarcity of traditional funding such as bank loans means that many smaller, low-cost manufacturers rely on factoring and the appetite for factor financing as has surged over the last years. This working capital can be raised from different sources, ranging from transport companies to asset management funds specialized in alternative investments.
The benefits of Factoring:
- Receivable taken as collateral:
Lenders have the advantage of a deeper due diligence process and better protection. The underwriting process is much broader. The credit analyses is complemented with a deep analyses on the accounts receivables. Generally speaking, the creditworthiness analysis of a particular company is not sufficient when analyzing the risk-return of a specific account receivable. The investment analyses is more robust because it considers not only the creditworthiness of a firm but also the specific underlying fundamentals behind the debt. A factory producing RX filters for Apple, for example, would be considered low risk. Broadly speaking, the credit risk can be shifted from a small producer to a large buyer with a strong balance sheet. In this example, it is unlikely that Apple would default on a relatively small invoice.
- Cashflow enhancement:
Factoring allows businesses to improve their cashflows and better manage their inflows and outflows. In fact, taking as an example a milk producer selling its products to large multinationals, would usually obtain paying terms of 90 days. In other words, the milk producer would receive its payment 90 days after delivering its products. This gap in between delivery and payment creates a serious issue for the milk producer. Indeed, the milk producer still has to pay its own bills such as employee wages, utility bills, feed his cows etc. The milk producers can sell its invoices at a discount to a factor company. This reduces its margins but allows to keep the company to free up cash. This can be used to show a stronger balance sheet or new investments.
This analogy can virtually be expanded to any company. A factoring investment can therefore be tailored to the investor’s specific vision. There are very few SMEs in the secondary sector that could not benefit from one. This offers a vast array of investment opportunities. It ranges from a company shipping electronics in the Netherlands to one roasting coffee in Brazil and everything in between.
- Time efficient:
A great advantage for companies using factoring is the amount of saved time. This is first facilitated thanks to the improved cash flow. Secondly, by factoring in their invoices, companies do not need to establish the creditworthiness of their client and can instead leave that to a factoring business. Thereby, every resource can be used wisely, and overall efficiency is increased.
- Not related to credit rating:
Furthermore, by engaging in factoring, the debtor does not see their credit rating change, only a reduction in paper profit. This is because this way of financing will not appear as debt on the company’s balance sheet. This makes sense as the risk is born by the factoring firm securing the account receivable. Therefore, as an excellent example of optimal division of labour, we observe the factoring firm specializing in the debt and the debtor focusing on what they produce, innovate, invest in R&D, get traditional loans to expand.
A bright future for Factoring:
Sectors such as healthcare are expected to be experiencing considerable growth. Despite the stagnation in trade due to the pandemic, growth is expected to remain strong and steady. As western customers return to normal and consume imported goods coming from Asia, these manufacturers will continue to build up the demand for factoring. Additionally, the soaring demand for medical professionals and healthcare solutions has put some pressure on the healthcare industry. They also suffer from differed payments, as manufacturing drugs take time and are very onerous. The global market value of factor financing in 2020 was USD 3.3 billion. And it is projected to increase to USD 5.4 billion in 2027.
Factoring is a short-term solution for companies in need of liquidity. They need this capital to continue or start some operations often related to the invoice they are selling. This limited time frame usually means traditional lenders -banks- are either unwilling or unable to provide a line of credit for this process. Therefore, this economic demand is filled by other agents, usually private debt funds investing in alternative investments. Such funds can provide a very fast and effective response while being able to answer their investor’s requirements.
Factoring directly helps SMEs to improve their cash flows and focus on their long-term strategies. For certain firms, this capital is paramount for their long-term success. It allows them to palliate the harmful effects of the account receivable sitting in their books. Indeed, such future cash flow can be a drawback to certain companies, preventing them from meeting their immediate liabilities. By choosing a competent factoring partner, debtors are also sheltering away from bad debt and securing their liquidity stream. For private investors, this strategy offers great liquidity and returns while minimizing risks, thus getting strong and steady returns on investment.