By Viacheslav Oganezov (pictured) — The sudden demise of Lex Greensill’s eponymous company makes for a riveting story that has mesmerised the financial media and public for most of this month. Filled with numerous plot twists, politicians and industry moguls, it makes for an interesting read. Yet, amidst all the noise, it is crucial to understand what really underpins this epic debacle.
By Viacheslav Oganezov (pictured) — The sudden demise of Lex Greensill’s eponymous company makes for a riveting story that has mesmerised the financial media and public for most of this month. Filled with numerous plot twists, politicians and industry moguls, it makes for an interesting read. Yet, amidst all the noise, it is crucial to understand what really underpins this epic debacle.
Greensill’s collapse had nothing to do with supply chain finance (SCF) itself, which financiers have practised for centuries as a type of trade finance product. The failure was rooted mainly in an overall lack of transparency and controls, its divergence into more exotic long-term financing structures and the way Greensill products were managed, which allowed questionable practises to pass unnoticed.
The rise of supply chain finance as an investable asset class
The rise of supply chain finance as an investable asset class is being driven by two main forces: a low yield environment that is pushing yield-seeking investors into alternatives and the increasing need for supply chain finance among corporates globally as they seek to optimise their working capital and accelerate recovery from the pandemic.
Large banks have historically been the main lenders in trade finance, including to SCF, funding more than 80 per cent of the flows. However, their partial withdrawal from this sector since 2008, as a result of the Basel III increase in capital requirements and the increasing complexity of operations if done manually, has resulted in a USD1.5 trillion trade finance gap arising. A number of alternative lenders have stepped into this sector, attracted by yields in the 6-10 per cent range that the strategy can typically provide, consistent historic returns, low volatility, and limited correlation against the broader financial markets.
SCF is a sub-product within the trade finance umbrella and is nothing new per se. The financing of payables is a centuries-old practice, whereby a corporate buyer partners up with a lender and/or technology provider to offer early payment to its suppliers in exchange for a discount. This provides both the supplier and buyer with improved working capital.
What is much newer is making SCF more widely accessible to non-bank lenders, a group that has been growing in the last ten years, and offering SCF to mid-market companies. The latter represent the largest portion of healthy credit profiles within the USD1.5 trillion trade finance gap. While supply chain finance is not rocket science, it does involve a significantly higher level of operational processing compared to, for example, a simple investment into publicly traded bonds. Given the higher number of counter-parties and related processing required, and in order to grow into a scalable and liquid asset class, robust processing technology is required.
For anyone who looked closely enough, and knew where to look, Greensill was littered with warning signs. The Greensill debacle has brought to the table a list of red flags to watch out for and has put the spotlight on an asset class that is currently being discussed in boardrooms all across the world. Greensill’s demise may prove to be the sector’s blessing in disguise if the lessons arising are learned and implemented, paving the way to a sustainable and transparent growth of the sector.
Performance
As SCF is not a publicly traded asset class, a useful proxy to gauge performance is theEurekahedge Trade Finance Hedge Fund Index, comprising 41 active funds focusing on trade finance strategies. The index returned 6.70 per cent throughout 2018, despite the escalating trade tensions around the world, particularly between the US and China. Trade finance funds in the index returned 5.34 per cent in 2019 and were up 0.82 per cent over the first five months of 2020.
Since the end of 2009, trade finance funds have generated an average return of 6.82 per cent per annum, outperforming both their fixed income counterparts and global investment-grade bonds which returned 5.43 per cent and 2.58 per cent per annum respectively during the same period. The high yield bond markets generated a marginally lower annualised return of 6.58 per cent over the same period while showing significantly higher volatility.
The exceptional risk-adjusted returns shown by trade finance as an asset class were mostly due to (1) low default rates characterising the asset class, (2) minimal volatility due to its short-term nature and (3) limited correlation to other assets.
Three lessons
Greensill, as an alternative asset provider, identified the demand for SCF and played an important role in bringing this asset class to non-bank investors. The problem lies in how Greensill provided and executed its offering. We highlight below three of the main lessons learnt from Greensill’s debacle, which should be understood and applied by anyone seeking to successfully invest in SCF.
Transparency above all
The first and most pronounced issue in the Greensill situation was the lack of transparency with regard to the underlying exposures and assets owned by the lenders. It seems that in the case of Greensill, the actual concentrations were not clearly visible to either the end lenders in the funds or the regulator, and perhaps not even to Greensill itself. Yet, without clear visibility, it is very difficult to manage a portfolio and understand its underlying risks.
Transparency should therefore be SCF’s guiding star if lending to the sector is to grow on a sound footing. The servicing platforms employed to provide the transparency required should provide for:
- Real-time granular data on exposure and transactions at the invoice/ payable level, allowing lenders to fully understand their risk exposure and manage their portfolios effectively.
- Segregated reporting and processing infrastructure that provides each lender with direct control over the funds used for transactions and assets owned, thereby removing the counterparty risk of the originator/servicer.
- Full traceability in real-time. A breakdown of the underlying receivables over which the lender has full ownership as well as supporting documentation such as actual invoices, re-assignment deeds and the real-time statuses of each transaction in order to provide full traceability.
Technology platforms such as Finverity’s are specifically designed to provide lenders with exactly this. The data provided allows lenders to view their exposure and concentration to each party being funded on the platform at both aggregate and granular levels. In our view, maximising transparency and giving lenders control through automation and top-tier infrastructure is the clear route to making SCF a truly scalable and liquid asset class.
Diversify, diversify, diversify
The second key issue was the level of concentration that Greensill had to some major clients. Around 90 per cent of its business derived from just five clients, according to court documents sourced by Bloomberg.
A much more sensible approach, and one that keeps liquidity in place to fund the growing demand for SCF, is to diversify more and to diversify better. Supply chain finance has traditionally been reserved by large banks for large corporate and investment-grade clients. This is a very crowded segment of the market, where diversification is difficult as origination is a long and complex process and there is only a limited number of companies that are not already well serviced. But with ticket sizes in the billions, focusing only on the largest companies allows large lending target volumes to be reached quickly, to the detriment of servicing mid-caps.
In contrast, providing lending to mid-market companies has been overlooked for far too long as an effective diversification strategy in SCF. The main reason is the high operational cost arising from each deal. In the absence of automation and technology, a large bank’s business model makes it economically unprofitable to engage with smaller ticket deals that do not generate as much revenue. This limits banks’ appetite for offering SCF to SMEs. The second reason is the “higher risk” label that has been traditionally associated with smaller entities. Yet, there are many mid-sized companies that have very strong credit profiles despite their smaller size. As history shows, bigger does not mean safer!
Finverity’s platform is designed specifically to offer lenders access to a pre-qualified top-tier deal flow of mid-market SCF transactions spread across markets and industries. By providing the necessary controls, transparency and automation required, the best of such platforms offer an attractive diversification tool for lenders, especially alternative lenders, who do not want to employ the large human operational resources needed to service such transactions at scale. Furthermore, deals sourced via a platform can be syndicated with other lenders to share risk, whilst credit rules can be hardcoded into algorithms that will ensure mandates are never breached. Finally, the risk-adjusted returns in mid-market SCF are also significantly more attractive, allowing more cushioning in case something does go wrong within the underlying portfolio.
Sustainable growth
The third key issue at Greensill was a hyper-growth mentality at the cost of sound due diligence and underwriting. This was driven by the pressure to sustain and increase the high valuations arising from Softbank’s USD1.5 billion investment in Greensill.
Around 2015, Greensill started to deviate from traditional SCF, which is essentially focussed on short-term exposure to creditworthy buyers, as the growth rate being generated was not fast enough and margins were thin. Greensill moved into long-term structured finance, which has a completely different risk profile and used an over-reliance on insurance wrapping, thus creating structural risk. At the same time, Greensill aggressively leveraged its network to produce higher credit risk clients such as Gupta or Norwegian Air but where execution could be fast. It is quite unfortunate that Credit Suisse and GAM allowed the mixing of such assets with traditional SCF transactions in their funds, or perhaps they were unaware of the full extent. In any event, if mandates had been strictly defined and hardcoded into a technological system that oversees lending deployment such a massive investment style drift would have been much less likely to have taken place.
A quote from Lex Greensill published in a Greensill white paper still available online sums up much of Greensill’s thinking:
“The structure is the same whether it’s a seven-day deal receivable or a 12-year aeroplane lease cash flow or indeed a payment 25 years into the future for hydroelectric power. It uses a combination of capital plus risk mitigants—largely insurance—to deliver to our investors a product that allows us to unlock working capital for our clients so they can put it to work.” – Lex Greensill
The above statement draws attention to the excessive over-reliance on insurance by Greensill, which led to a significant fall in underwriting standards across the company. This brings flashbacks to the 2008 mortgage crisis, whereby sub-par assets were bundled together and wrapped to obtain a better credit rating with very little knowledge or visibility into the underlying assets for the end purchaser of the security.
A lesson we should have all learnt over 10 years ago taught us this is not the way forward. Sound due diligence and a solid understanding of underlying risk have to be a given in any well-managed lending business, whether insurance is available as an additional credit enhancement or not. However, it becomes untenable for lenders to manually perform a high level of due diligence whilst growing their AUM at hyper-growth speed. The operational workload is simply too great.
One viable solution to the challenge of scaling up in SCF lies in working with platforms such as Finverity’s that offer both origination of high-quality SCF deals and technology-enabled servicing. By performing the data collection and a vast majority of analysis before a deal is matched with the lender, Finverity acts as a filtering mechanism, ensuring lenders only see deals that they are likely to fund, which significantly streamlines their due diligence. Deal acceptance rates at Finverity are below 20 per cent and the platform comes with automated risk monitoring tools and fraud prevention features such as automatic blocking of transactions arising from suspicious trading patterns. This allows lenders to sustainably grow their book without sacrificing underwriting quality.
Conclusion
Supply chain finance is at the start of its growth period as an asset class outside the traditional domain of banks. Given the increasing demand for SCF and the influx of capital into the sector from non-bank lenders seeking to enter the asset class in search of reliable, uncorrelated yield, we expect it to continue growing in size substantially. Furthermore, as a result of Greensill, we anticipate that lenders will gravitate towards those platforms that provide the highest level of transparency and controls to enable them to scale up their SCF allocations safely and sustainably while also directing liquidity in the real economy to where it is most needed.
Viacheslav Oganezov is CEO of Finverity, a cross-border supply chain finance platform for mid-market and alternative lenders.
