Introduction – The Crisis of Greensill Capital
Firms come and firms go, some find long-lasting success, while others start from bright start-up ideas but end up in the graveyard of business ideas in a matter of years. Greensill Capital had the potential to be in the first group, but through a combination of bad decision making and a controversial business practice now finds itself in the latter.
Established in 2011 by Lex Greensill, an Australian investor with deep ties with the political elite of the United Kingdom, Greensill specialised in supply-chain finance, discounting invoices of the suppliers of large businesses for a margin. In the words of his founder, Greensill was “making finance fairer” for firms in need of clearer and simpler ways of raising capital through the method of reverse factoring, an already established practice that Greensill intended to modernize.
One key aspect of said method, however, is the need of a fresh cheap capital because the notionals are in the range of billions of dollars and require a lot of capital reserves and hybrid notes. For this, Greensill contracted with the Swiss investment bank Credit Suisse, who had over 1000 clients with funds invested in Greensill securities, with a total value of $10bn. It also attracted the attention of investment funds and asset managers around the globe; private equity firm General Atlantic invested 250 million, whereas the Japanese giant Softbank brought a much heftier 1.5 billion dollars to the table. Everything was looking well just several months ago, as Greensill was looking to raise funds at a valuation of $7bn and was preparing for IPO.
In a matter of days, however, everything went south. On March 1st 2021, Credit Suisse froze 10 billion dollars of assets linked to Greensill. The reason, while not explicitly acknowledged by Credit Suisse, is likely that the insurance policies covering defaults in a portion of Greensill’s assets lapsed and were not renewed. Additionally, an audit by KPMG has raised flags regarding the firm’s exposure to British-Indian steel magnate Sanjeev Gupta’s GFG alliance, a loose union of metal factories and mining businesses. As Greensill’s main client, Gupta’s firms conducted some opaque and confusing transactions; in one instance even lending 74 million dollars to a company that did not exist. Greensill called it a “computer mistake” but not before being uncovered by a Financial Times investigation. Deprived of their main source of liquidity and with a bleak future, Greensill engaged in acquisition negotiations with asset manager Apollo but the latter was aiming to pick out the most lucrative parts of the company rather than its entirety. Eventually the talks did not produce a result.
On March 3rd, the financial regulation authority of Germany filed a criminal complaint against Greensill Bank, on the grounds that the management engaged in balance sheet manipulation. All operations of the bank were suspended.
GFG alliance was also experiencing financial difficulties and defaulted on debts owed to Greensill, who on March 8th filed for administration, a specific type of bankruptcy under British law, and announced it was in severe financial distress.
Although the primary culprit of this debacle is over-dependence on a single client and suspicious activities of the management, even the business model itself was put to question. Reverse factoring itself, with its opaque nature and controversial effects on the financial statements, received its fair share of criticism. Now, let’s take a closer look.
Supply chain finance: What are factoring and reverse factoring?
The business model of Greensill was focused on working capital solutions, or more specific on supply chain finance. Supply chain finance is a variation of the more traditional factoring that is a widely used practice in global trade finance.
The term factoring (or invoice factoring) stands for a short-term financing form through the sale of accounts receivables. The structure involves three parties: a supplier, a buyer and a bank (called factor or financier). First, the supplier sells and ships products or materials to the buyer, usually a large corporation needing the purchased parts for its production, with an expected payment in 30 to 120 days. The delayed payment constitutes a credit creating a liquidity shortage on the supplier’s end, who needs to pay its own suppliers or banks. Financing the void via short-term loans would worsen the supplier’s net financial position. Therefore, the supplier decides in the second step to sell the credit to a specialized bank, the factor, at a discount (often called factoring fee). The discount reflects the buyer’s risk and some additional risk on the supplier’s side. Third, in the case of a not defective delivered good, the payment is made at the end of the period. Usually, the buyer gets notified and will pay the factor directly. In contrast, in a non-notification factoring the supplier acts as agent for the factor. The details of international factoring contracts depend on the legal framework of the country which the involved parties choose depending on the structure of the transaction.
An important distinction must be made between contracts with and without recourse. In the case of contracts with recourse, the bank takes action against the supplier if the buyer doesn’t pay and, therefore, the risk is on the supplier. In contrast, if the contract is without recourse, the bank has to bear the loss if the buyer doesn’ pay. As a result, the credit risk is fully on the buyer and thus consuming the buyer’s credit lines. For this reason, corporations usually contractually prohibit factoring without recourse without their explicit approval.
Supply chain finance’s most common structure is reverse factoring, a variation of the above-mentioned mechanism which is initiated by the buyer (debtor of the payables) this time. In this kind of transactions, the buyer is in a dominant position and can support strategic suppliers by declaring payability of invoices to the factor. The suppliers then chose which invoices they want to be paid by the factor. The factor pays the amount at a discount to the suppliers and receives the payment of the buyer directly at the time specified. Therefore, the transaction is without recourse and the commercial risk is on the buyer. Furthermore, the buyer often has to pay a small fee to the factor and can delay his payment beyond the terms of the invoice. In general, reverse factoring requires more collaboration than traditional factoring. It constitutes a fast-growing market although it currently accounts only for a small fraction of the whole factoring market.
Participating in a reverse factoring transaction is generally advantageous for all participants. First, the supplier can more easily manage its cash flows, gets paid earlier and benefits from a lower discount (as the buyer is usually better rated). Furthermore, the structure allows the inclusion of smaller suppliers who would not have access to factoring on their own because they are unrated or generally too small. Second, the buyer has additional financing possibilities through delayed payments and can improve his negotiation position and relationship to suppliers. Last, the factor, besides generating a profit, benefits by reaching suppliers more easily and transforming fragmented credit risks to one unique larger counterparty.
A key element in the reverse factoring business model that is often overlooked is credit insurance. From the bank’s perspective setting up a revolving credit facility requires to build up significant capital reserves as its risk-weighted assets (RWAs) increase. To relieve capital in order to expand the business, the bank can mitigate its risks by buying credit insurance from well-rated insurance companies. Furthermore, the bank can securitize and sell parts of its credit portfolio to investors with the help of an investment bank. To this aim, it is crucial to reduce risks by insuring the portfolio. Additionally, the insurance makes the factoring bank more competitive as it can expand business with existing clients and reach certain buyers and suppliers that otherwise they could not.
While reverse factoring has many benefits, its most critical point is the accounting treatment. Even though the buyer owes money to a financial institution, the outstanding amount is usually classified as accounts payables and not as debt. Furthermore, there is no requirement to disclose the amount of account payables which is owed to banks. This lack of transparency and consistency makes it possible for struggling companies to hide their debt as commercial risk when it is actual financial risk.
The controversies behind supply chain finance
According to the committee of the IASB (the accounting committee behind the IFRS framework), an entity shall decide whether to present liabilities in reverse factoring arrangements within the trade and other payables, within other financial liabilities, or as a line item from other items in its statement of its financial position. Moreover, firms are obliged to consider such items separately only when “the separate presentation is key for stakeholders to understand the entity’s financial position, considering the amounts, nature, and timing of those liabilities”, which in practice is never used. It is clear that there is ample space for firms that use such tools to sugar-coat their financials.
This piece of regulation not only makes the balance sheet opaque but has several implications over valuations and cash flow statement analysis affecting creditors and investors. Indeed, it can allow for a further increase in their leverage and lead to highly indebted companies. Critics claim that reverse factoring allows companies to prop up failing business models. As a result, a disclosure of these facilities could lead to many companies de facto breaching their contractual covenants and leaving them without further financing sources.
Insurance plays a key role in factoring since in order in order to protect itself, the bank insures the revolving credit towards the Buyer. In some cases, as happened with Greensill, the bank could be left unprotected by the Insurance Company when the over reliance of the Factor induces to lend too much money to unworthy debtors. In Greensill’s case the Insurance company (Tokio Marine) withdrew from the agreement with Greensill because of the dropping credit quality. It is evident that insurance is a double edge sword, necessary to grow fast and steadily, but a significant risk factor if the underlying credit quality drops.
The role of auditors and regulators in this issue is of paramount importance given the difficulty in judging companies purely on the basis of their financial statements with the current level of disclosure. Indeed, as a result of the letter sent by The Big 4, they have paid more attention to the problem and have recently sent letters of comment to registrants to better understand the situation. For agencies like the SEC, the big issue will be to determine how these financial arrangements can affect systemic risk and subsequently how to regulate the industry. For example, the SEC staff have asked companies about increases in the length of their accounts payable periods and why the amounts were classified as accounts payable instead of bank financing. Staff comments have also asked companies to disclose the terms of their supply chain financing arrangements. The aim would be to force the companies to disclose the extent of their involvement in Supply Chain Financing.
This initiative will likely be met with strong opposition by involved financial intermediaries that are already mounting a lobbying campaign against it.
It is also interesting to point out that, already in the past years, the involvement of public institutions has been relevant. In the UK, the founder of Greensill was advised by former British Prime Minister David Cameron in 2018. Before the company collapsed, he lobbied the UK government to increase state-backed emergency Covid-19 loan schemes. This relationship with the Prime Minister, Greensill’s adviser and shareholder helped the company to tap cheap, 100% government-backed loans through the Covid corporate financing facility (CCFF). For instance with this move Greensill has been able to lend more money to its borrowers including one of its largest clients, the metals magnate and Liberty Steel-owner Sanjeev Gupta. David Cameron was considered by the firm the most valuable asset for this move considering his experience in the political arena and his understanding of the “political market”.
Several challenges will be here to stay for many actors involved in this increasingly controversial industry, and the issues are far from being overcome. The case of Greensill is just the trigger to what could be the beginning of a new era for the supply-chain finance industry. Greensill’s demise is due to their particular faulty practice rather than a structural issue, however it should serve as a warning for the other banks to avoid making the same mistakes. A clear disclosure of the bank portion of trade payables could help solving the Insurance problem decreasing information asymmetries and the risk premium required, but on the other side could also decrease the use of factoring by banks and companies because overall it could seem less attractive without the debt masking effects. Overall, the future remains to be seen, but for sure now it will be harder to sweep the dust under the rug.