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The Hidden Risks Of Supply Chain Financing And Partial Asset Selldowns

Recent financial difficulties at supply chain financier Greensill Capital highlight nascent risks associated with the use of supply chain financing (also known as factoring or reverse factoring). The sudden and unexpected withdrawal of these short-term financing arrangements can create a material working capital squeeze and pressure a company's balance sheet and credit quality. The rapid demise of U.K.-based construction company Carillion plc in 2018 was precipitated, in part, by the withdrawal of supply chain financing.

S&P Global Ratings may consider supply chain financing as debt where it accelerates the monetization of receivables or allows a company to extend its creditor payment credit terms to derive a material working capital benefit. This is because the working capital benefit arising from these arrangements will generally need to be refunded if the financing arrangement becomes unavailable.

Here's an example of how we may adjust debt for supply chain financing (see chart 1). Let's assume the industry has standard creditor payment terms of 90 days. Any material working capital benefit derived by the customer from extending payment terms beyond 90 days may be added to the customer's debt. Similarly, any material working capital benefit derived from the supplier by receiving payment within 90 days may be added to the supplier's debt.

Chart 1

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Like other forms of short-term funding, supply chain financing is subject to refinancing and liquidity risks. If facilities are not rolled over or withdrawn, the supplier would be left with a working capital shortfall and would subsequently seek to reinstate shorter payment terms that existed before the supply chain financing facility was established. By doing so, the supplier would effectively transfer part of the working capital shortfall to its customer. The original benefit to customer and supplier would, therefore, unwind.

The risk of withdrawal of supply chain financing facilities is generally lower for more creditworthy customers and their suppliers. Although these facilities are often evergreen with no maturity date, financial intermediaries are generally under no obligation to provide ongoing supply chain financing. Facilities are most likely to be withdrawn in response to a deterioration in the customer's credit quality. However, funding can also become unavailable for other reasons, such as problems at the financier (such as in Greensill's case) or broader credit market disruption.

Importantly, poor accounting disclosures can mask the existence of supply chain financing. This can obscure a company's underlying financial health and frustrate like-for-like comparisons. Accordingly, improved disclosures are encouraged to ensure that the risks are properly understood by creditors and other stakeholders.

Partial Asset Sell-downs--No Free lunch For Creditors

In recent years, a growing number of corporates have looked to divest a minority share of some of their most creditworthy businesses. This includes Australia-based Telstra Corp. Ltd., through its partial divestment of its telephone exchanges, and Ampol Ltd., through its partial divestment of its convenience store network. We understand that more companies are considering similar transactions, primarily to access the lower cost of capital of potential acquirers.

On the face of it, the idea seems compelling. Companies divest less than 50% of their best assets while continuing to consolidate 100% of the assets and associated cash flows. Voilà! The seller realizes significant cash proceeds from the sale while the financial statements and key credit measures remain intact. The cash leakage to minority interests is buried deep "below the line."

However, the accounting optics often bely the underlying economic reality of such transactions. Creditors are clearly worse off when part of the borrower's best assets are sold to third parties and the proceeds are, in some cases, distributed to shareholders. This is akin to you selling 49% of your mortgaged home and expecting your mortgage provider to be indifferent when you spend the proceeds on an extended holiday. This is particularly the case when you continue to occupy the entire house and are obligated to pay rent to the new minority owner.

Our analytical approach attempts to capture the loss of ownership of these high-quality cash flows in various ways. Accordingly, we may partially deconsolidate the asset from the seller's financial statements to reflect a "true sale" of the monetized portion of the asset. Where a true sale best represents the substance of the transaction, we must also assess its impact on the seller's business risk or debt capacity.

Consider, for example, a company that has two similarly sized business: one business is high risk and one is low risk. If the company permanently divests 49% of the low risk business, two-thirds of its future owned cash flows will be derived from the higher risk business, compared with 50% previously. Accordingly, these types of transactions can meaningfully degrade the quality of a company's future cash flows and therefore its debt capacity at a given rating.

In other cases, the substance of the transaction may not reflect a true sale. This is particularly the case where a company continues to control and substantially benefit from the cash flows generated by the monetized asset. Here, the partial sell-down is often structured more like a sale-and-leaseback or financing transaction. In such cases, we may leave the asset on the balance sheet and the business risk remains unchanged. However, we adjust the seller's financial statements for the debt-like lease obligation associated with the divestment. This approach was applied to Telstra's financial statements when it sold a minority interest in a portfolio of telephone exchanges.

We acknowledge that these types of transactions are often effective in maximizing shareholders' value. However, the risks to creditors can be material. Accordingly, we capture the substance of these transactions either via our credit metrics or business risk assessments. Neither is a recipe for a free lunch.

Related Criteria

Related Research

This report does not constitute a rating action.

S&P Global Ratings Australia Pty Ltd holds Australian financial services license number 337565 under the Corporations Act 2001. S&P Global Ratings' credit ratings and related research are not intended for and must not be distributed to any person in Australia other than a wholesale client (as defined in Chapter 7 of the Corporations Act).

Primary Credit Analyst:Paul R Draffin, Melbourne + 61 3 9631 2122;
paul.draffin@spglobal.com
Secondary Contact:Graeme A Ferguson, Melbourne + 61 3 9631 2098;
graeme.ferguson@spglobal.com

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