Disruption from the Covid-19 pandemic has shown how vital healthy global supply chains are to economies and to communities overall. Beyond the pandemic, a new rising issue in the form of inflationary pressures has intensified. This inflation is one of the most severe, virulent factors among those contributing to the disruption of global supply chains.
With supply chains suffering, companies are striving for resiliency, and many tend to hold more inventory. In a high-inflationary environment, the price of that inventory goes up and banks face a significantly higher demand for inventory finance than normal.
Industries Feeling the Squeeze
The demand for inventory finance is especially high in certain industry sectors, with commodity production and trading suffering from the highest level of squeeze. In metal commodities, for instance, large amounts of physical metal goods are being mined, shipped, and traded. A major commodity trader’s strategy is to go long on the physical and short on the exchange to hedge price volatility positions. Traders are totally focused on arbitraging dislocation of supply and demand, not speculating.
For example, between February and March 2022 the price of nickel doubled. The immediate consequence was that the amount of value to be hedged was also twice as much. In April, the price slightly dropped by 30%, but the volatility of nickel prices forced the London Metal Exchange and other exchanges to adjust the price margin to place against trade.
In any commodity market, the price margin is the minimum amount that allows a trader to participate in exchanging a commodity for money. Between February and April 2022, the trade margin price of the metal increased from about 12.2% to almost 88%, face value. When the price of nickel dropped back, it was still way higher than it was at the end of 2021, putting traders in the immediate need for something like seven times more working capital tied up in equity to do the margin trades and over 1.4 times the amount of dollar value (Figure 1).
Figure 1: Volatility of Nickel Prices and Trade Price Margins
The departure that took place a few years ago of commodity trade finance banks such as BNP Paribas, ABN Amro, Société Générale, and other commodity traders set the store for a brutal working capital squeeze in this part of the market.
The Commodity Market Is Evolving
With less supply in the face of a continuous, massive demand, everybody in the commodity market is now looking for additional working capital—and increasingly from non-bank financial institutions because banks are facing shortage of supply. This has created an opportunity for the big credit funds to start moving into this space.
One example is the establishment of Eliant—a combination of BNP Paribas in the senior funding tranche and Apollo Global Management and Athene Holding at the junior tranche (using the insurance subsidiaries with a lower cost capital). The combination of a big chunk of senior funding tranche from a commodity finance bank that was already in this space, but doesn’t want to take risk anymore, backed up by new capital from credit funds is rapidly changing how segments of this market work.
From recent conversations with one of the major players in the SCF space, Demica, Aite-Novarica Group’s advisors understand that there are billions of dollars of receivables finance transactions being negotiated between traders active in a wide number of commodities, such as oil, gas, wheat, nickel, and a broad range of non-bank financial institutions. The organization concurs with Aite-Novarica Group’s view that this is potentially the start of a major new trend in this sector.
Innovation in Supply Chain Finance
The shifts that Aite-Novarica Group’s advisors see in the commodity trade finance market are not unusual in receivables finance either. In a high-inflation environment, the pricing of receivables is rising rapidly. While the traditional supply chain finance (SCF) instruments offered to corporate clients remain predominant, they mostly resolve a liquidity play while corporate finance executives are also responsible for adjacent risk mitigants and hedging structures, whether on the FX side or on the price of goods. In a scenario of high price volatility, corporate people are much more likely to be hedging.
Aite-Novarica Group advisors anticipate that the use of SCF instruments—in particular approved payables finance—may be about to change. Historically, the product has been about the buyer extending its payment terms to the supplier, with the supplier discounting its receivables exposure from a bank at a preferential rate. Especially under rampant inflation, suppliers need to push up prices to offset the rising costs of materials and labor.
Some of Demica’s buyer clients are responding when suppliers ask to increase price by making the counteroffer to onboard the supplier into a SCF program and giving the supplier access to lower cost of capital in exchange for the supplier not pushing through as much of the price rise. The offer to onboard the supplier on the SCF program allows the buyer to prevent the price increase of goods. With an attractive lower cost of capital, the supplier also benefits as it gets cheap cost of funding in return for accepting a lower gross margin profitability.
Moving Forward With New Tactics
This shifts the motivation for the buyer to use SCF away from the balance sheet optimization of extending trade payables and avoiding financial debt using accounting technicalities. Instead, it’s all about driving EBITDA margin by keeping the cost of goods sold lower than market value. And that matters a great deal more to the CEO, as the company’s value is generally gauged using EBITDA margin. Furthermore, this type of benefit to the company’s financial results is continuous rather than a one-off result of improved liquidity that discounted payables bring to the balance sheet.
Aite-Novarica Group expects to see companies using SCF much more creatively to deal with a new inflationary environment that will likely remain persistent in the future. While procurement’s traditional principal job has been to reduce the cost of goods, not working with treasury to extend payment terms (at best a second order function for most procurement teams), this novel approach to SCF will align procurement and treasury activities much closer. In addition, the change in the motivation for dealing with inflation does not require payment terms to be extended, making the accounting treatment much cleaner without the need to “artificially” adjust financial debt into commercial debt.
Apparently very few trade finance players have yet offered solutions that face (and leverage) this high-inflationary environment, most likely because they have never worked under high-inflationary pressures. The last time inflation in Europe was over 5% dates back almost 30 years, in 1994. Banks now have the chance to resolve the disruptive impact of inflation that waterfalls from physical to financial supply chains. These banks can reengineer SCF-approved payables finance programs to deal with inflation and respond to the rising demand for inventory finance from corporate traders.
Inventory Finance Makes Supply Chains Resilient
Until now, inventory finance has been introduced heavily only in some sectors, partly because it’s very expensive for a bank to provide this form of finance unless it can hedge it up. It works well in the commodity space, but not that much outside, and mostly in North America as part of asset-based lending (ABL) structures.
Traditionally, inventory finance has been cash-based, with banks extrapolating from a company’s revenue how much inventory it should hold. Based on an average figure, the bank then decides how much to finance. Today, the unpredictability of the value of goods in inventory requires literally following them item by item, individually tracking goods in the warehouse to know the value of each. Supply chain traceability systems become very important assets to properly price and hedge inventory.
The key to profitably managing inventory finance resides mostly in understanding what drives the price in the inventory. If the goods are heavily manufactured for specific uses, then inventory finance is still very challenging for most banks. It’s much easier instead for a bank to finance rolled steel or aluminum that might be eventually converted back and sold as raw material. Aite-Novarica Group expects inventory finance to rise more in the early stages of the supply chain and much less in the later processes of manufacturing transformation and distribution.
Most inventory-based ABL have two different financing components. In the first, the amount of funding is around 65% of the lowest between cost and market value. So, with rising prices of goods, the financing is calculated on the cost and not on the value of the inventory in the warehouse. If supply chains are becoming more disrupted, there’s the need to hold more inventory, with the inevitable consequence that the stock days on the balance sheet are also rising, creating much more of a problem. It’ll take a long time before the new price of inventory flows through into the base cost, bringing up the value of the cost-based funding.
The second leg of the ABL pricing structure is determined by the inventory liquidation value, along with the haircut applied by the agents. When looking at liquidation value in inventory, somebody estimates what price they can achieve if they have to sell the inventory. They’re looking at both price volatility and cost of actual liquidation (i.e., selling cost, transport costs). If the prices of raw materials are volatile, the person calculating the net liquidation value (NLV) is going to choose the bottom of the volatility and then haircut from below that to be confident that the price can be achieved.
The amount of funding that can be provided under that financing structure produces much lower numbers than it would have historically (e.g., two years ago) when prices were stable because the cost and market value were almost the same and NLV was a much higher number in less volatile conditions.
All considerations feed together to say that traditional inventory finance solutions are producing much lower advance rates on inventory than they have historically. Aite-Novarica Group anticipates that corporations with highly volatile raw material values (e.g., metals) are going to break apart their ABL, leaving the financing of receivables to large partner banks and moving inventory to somebody who will finance it at a percentage of inventory value, typically 85% of market value instead of 65% of cost.
The funder can afford managing this new financing model only with the support of an IT platform to manage all the pricing risk. Aite-Novarica Group advisors had the opportunity to view a good example of such platform during the conversation with Demica. Rather than doing monthly inspections as was the norm with a stable value of inventory, traders have access to daily or weekly feeds of all the inventory line items on the Demica Platform, with the ability for it to revalue the inventory in real time. The bank will then hedge the exposure much more precisely.
To learn more about how banks can help their corporate clients during this time of disruption and volatility, please reach out to me at [email protected].