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Understanding Accounts Receivable Monetization: Factoring vs. Asset-Based Lending

As a business, having steady and predictable cash flow is critical to funding operations, growth and investments. However, many companies often find themselves in situations where their receivables - the money owed to them by customers - are unpaid for extended periods of time. This can put a real strain on working capital.

To improve liquidity and accelerate cash flow, an increasing number of companies are turning to accounts receivable monetization. Two main options exist for monetizing receivables: factoring and asset-based lending. While these terms are sometimes used interchangeably, there are important differences between them that any business considering AR monetization should understand.

Cash Flow Lending vs. Asset-Based Lending vs. Factoring

Before diving into factoring and ABL, it's useful to examine the broader landscape of options for obtaining capital based on assets or receivables:

1. Cash flow lending - This is traditional lending where a financial institution evaluates the overall creditworthiness and cash flows of the borrower to size and price a loan. The loan can be unsecured or secured by a broad set of the borrower's assets.

2. Asset-based lending (ABL) - With ABL, the loan is always secured and is sized specifically against a defined pool of assets, typically receivables and inventory. The focus is on the ability of those assets to generate cash to repay the loan.

3. Factoring - Here the transaction is structured as a true sale of receivables, not a loan. The company sells its invoices or receivables to a factor at a discount. If structured properly, the sale shifts credit risk to the factor and allows the seller to remove the receivables from its balance sheet.

4. Securitization - This involves pooling receivables into a bankruptcy-remote special purpose vehicle (SPV) which then issues debt backed by the receivables. The securities can be structured into different risk tranches. Securitization aims to insulate investors from the bankruptcy and financial risks of the operating company originating the receivables.

Comparing Asset-Based Lending and Factoring

While ABL and factoring both involve funding based on receivables, there are crucial differences between them:

Asset-Based Lending

- Lender makes a secured loan based on a pool of receivables

- Loan is typically revolving so borrower can redraw on it

- Loan amount constrained by a borrowing base and advance rates against eligible receivables

- Lender focuses diligence on collectibility and dilution of the receivables

- Loan is a liability of the borrower, receivables remain on borrower's balance sheet

- Interest rates comparable to other secured loans (e.g. L+300-500bps)

- Governed by UCC Article 9 and standard secured lending laws

- Borrower retains servicing and collection of receivables

- Lender has a blanket lien on all company assets and often tight covenants

Factoring

- Factor purchases receivables at a discount, it is a true sale (if structured properly)

- Typically non-revolving, each batch of invoices sold separately

- Amount of funding driven by credit quality of account debtors, not borrower

- Diligence focused almost exclusively on receivables, not as much on seller

- Sale removes receivables from seller's balance sheet (off-balance sheet financing)

- Factor's return based on discount and tied to expected duration of receivables (e.g. 2-4% for 30 days)

- Not a loan, so not subject to typical lending regulations, usury limits, or licensing rules

- Factor often takes over servicing and collection directly from account debtors

- Factor usually doesn't have a lien on seller's other assets or require tight covenants

The key distinctions are that ABL is a loan that sits on the seller's balance sheet, is priced like other debt, and involves extensive diligence on and monitoring of the seller itself. Factoring, in contrast, is an off-balance sheet true sale of assets, priced based on expected duration of the receivables, and entails underwriting the receivables and account debtors more than the seller.

For the end customer, factoring is often "invisible" - invoices show payments should be made to a new lockbox or account, but otherwise it is seamless. With ABL, sellers usually retain customer billing and collection in-house.

Benefits and Risks of Factoring

Factoring is an attractive option for certain businesses and situations. The key advantages include:

- Shifts credit risk and servicing burden to the factor

- Faster access to cash, since factor advances funds immediately on purchase

- Ability to obtain financing for companies that may not qualify for traditional loans

- Can potentially allow for significant growth in scale without straining company's own balance sheet or cash flows

- Off-balance sheet treatment can improve financial ratios and valuation

However, factoring also has drawbacks and risks that any company must carefully consider:

- Cost is higher than traditional loans, especially for companies with strong credit

- Establishes precedent that customers should direct payments to another entity

- Risk of damaging customer relationships if factor takes an aggressive collections approach

- Less recourse and protection for seller if disputes or issues with receivables arise

- Potential accounting, tax and legal challenges in maintaining true sale treatment

Key Considerations in Structuring Factoring Arrangements

To preserve true sale treatment and protect the interests of both seller and factor, it is critical that factoring transactions be structured and documented properly. Some of the most important considerations include:

1. Non-recourse - To be a true sale and avoid borrowing treatment, the factor cannot have recourse to the seller for credit losses. Repurchase should only be required for breach of reps & warranties about the nature/validity of receivables.

2. Servicing - Many factors want to take over servicing and collection of receivables after purchasing them. However, sellers with the ability to efficiently collect and manage customer relationships may negotiate to retain servicing.

3. Notifying account debtors - Factors will require customers be notified to redirect payments after factoring. This can be done with individual notices as batches are sold, or by having customers always pay a lockbox which then remits to the factor.

4. Seller risk retention - While most risk is shifted to the factor, the seller often still bears some exposure for dilution, disputes and invoicing errors. These are typically handled through reserve accounts, recourse for breach of reps, or indemnities.

5. Monitoring and reporting - Factoring requires robust processes to track invoices, payments, and account debtor creditworthiness over time. Sellers must supply accurate data and factors must have strong systems and controls.

6. UCC and legal protections - Factors must ensure proper documentation of the sale and file appropriate UCC financing statements to protect against other creditors of the seller. Eligibility criteria and "clawback" periods help factors manage bankruptcy risks.

Factoring as Part of a Broader Financing Strategy

For most established companies, factoring is not a complete substitute for cash flow loans or ABL facilities. Instead, it is commonly used to supplement these tools or to address specific constraints:

Overadvances - If a company has hit its borrowing base limits but needs more funding for growth, factoring a portion of receivables can raise cash without violating ABL covenants.

Segment finance - Some lenders cannot or will not finance certain segments like government, healthcare, or foreign receivables. Factoring these out separately allows a company to maximize its total funding.

Smoothing seasonal flows - Retailers and some manufacturers have large swings in receivables balances. Factoring can help reduce volatility and provide a more steady source of cash.

Restructuring situations - For distressed companies, factoring may be the only source available for additional liquidity, especially if assets are already fully pledged to secure existing loans.

Supply chain finance - Factoring can grease the wheels of commerce by allowing suppliers to get paid more quickly without forcing customers to actually part with cash faster than they want to.

The Outlook for Factoring

The global factoring market has steadily grown in recent years, topping €2.6 trillion in 2018 according to industry group FCI. This expansion has been driven by technology, more competitive offerings from bank-owned and independent factors, and greater awareness of the product among businesses.

Some key trends shaping the future of factoring include:

- Adoption of digital invoicing and cloud-based financing platforms

- Emergence of non-notification factoring to reduce impact on customer relationships

- Specialization of factors by industry, geography and deal size

- Tighter integration of factoring, ABL, and supply chain finance products

However, factoring faces potential headwinds as well. Concerns over accounting treatment, especially regarding balance sheet presentation and risk transfer, have grown since the 2008-09 financial crisis. Regulation of factors and their clients' disclosures is also likely to increase.

Additionally, factoring volumes are highly tied to overall economic conditions. In recessions, companies often extend payment terms and dispute invoices more aggressively. This increases dilution risk and losses for factors. Factored receivables are also the hardest hit in bankruptcy situations.

Despite these challenges, factoring will likely remain an important cash flow tool, especially for small-to-medium enterprises and industries with long cash conversion cycles. As global trade flows become more complex and working capital optimization grows in importance, demand for smart receivables finance solutions will only rise.

By understanding the benefits, risks and key structuring issues involved, companies can determine how best to deploy factoring as part of a comprehensive approach to liquidity and balance sheet management. Whether on a spot or strategic basis, unlocking the value of receivables will continue to be a critical treasury priority for years to come.