Saturday, May 17, 2008

Receivables Financing, "Usury" and "Loan Sharking"

I've taken a decidedly libertarian bent over time - particularly in my approach to microfinance. This has been sorely tested (ok maybe not that sorely) as I've been seeking non-recourse receivables financing from banks so that we have a "scalable" operational model. Some clients are rather (and understandably) shy about forking out cash upfront for goods before they have an opportunity to examine them in their own facilities.

Further, and even more importantly, clients are conditioned to paying for goods 30 days or more after delivery. In the case of buying overseas, buyers are often asked to pay an initial deposit before production starts + payment upon shipment - which is often 30-40 days prior to even receiving the goods. Financing is a cost that often gets forgotten when pricing product but that's a post for another day. But these days I've been finding that clients are increasingly demanding credit terms.

One problem is that we're really not a bank and the other is that our cost of capital isn't unlimited nor cheap. This is to say that if we lend based on our own capital, comprised mostly of equity, it means that we have to get returns of at least 30%, and secondly, we don't have an ever increasing abundance of it - which means if we can't keep lending, we can't grow.

We also don't have the tools to assess and manage financial risk and enforce terms (many a company have followed their clients into bankruptcy) - and in this, I'm a big fan of the idea of "selling" our receivables to a party that both has capital and is in a position to manage risk - ie using financial institutions then bridge that gap buy "buying" our receivables at a small discount/cost so that we continue to have the funds to grow. We thought we had a solution with a hedge fund backed financial services guarantor in China but based in the US, but the hedge fund partners backed out. This has left us scrambling for alternatives. Because of the relatively short notice, we were forced to raise money and finance some shipments ourselves.

The problem with receivables financing for banks is that there is "performance risk" and risk related to the geographic differences. Performance risk is related to the concern that rocks/substandard products are shipped versus in our case, generally aluminum extrusions. And so the costs of financing are high - and then some. Generally speaking, the costs are broken up into three parts - insurance against default, fees related to collecting funds from the client, and the cost of borrowing itself. In one case, the effective cost was 5%/month (I emphasize this as I know most of our clients are not exactly high risk)! There is however some glimmer of hope in that it would appear that we are about to be able to get financing from an established bank with a cost more in line with an effective 15-17% APR that I would expect. We should know soon - this would of course go a long ways to alleviating stress levels.

In the meantime, I've made the case for "loan sharking" and "usury" on the "backs of the poor" here (Nabble/MicrofinancePractice). A point to emphasize is that there is empirical evidence borrowers still benefit if voluntarily entering into loans that carry massive levels of interest rate as evidenced by a study in South Africa (Volokh): "Applicants who were randomly approved for a loan had higher incomes, less hunger, better credit scores and more positive outlooks than their control group counterparts -- even after paying the high interest rate. Though they had higher than normal default rates, the borderline loans were also profitable for the lender." I should note further that I neglected to give credit for the two Fed studies cited in my posting which I found at Division of Labour.


paulellisnoe said...

You should check out The Receivables Exchange at Giving companies the power to set prices and offering transparency to investors.

Clement Wan said...

This is pretty cool. Thanks! I added it to my list of webservices for startups (link on left).