Why Factoring Must Evolve

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Update (Sept. 14, 2016)

In retrospect, I crossed the line with the title and rhetoric in this piece, trying to have fun while also making a point about factoring and the future of P2P- and fintech-enabled lending models. I am sorry for offending the factoring community with my choice of words. That was not the intent. My full apology is here.

Earlier this year, I gave an invited talk at a CFA event with the rather humorous name of “Factoring World.” The event brought together just about all manner of old school factoring organizations — from banks and larger independent lending companies to dozens of smaller mom and pop factoring firms that form the backbone of the industry, as well as the occasional tech savvy new entrant to the market.

For those who don’t know what factoring is, I like to describe the traditional practice as the second-oldest profession in the world. From a supplier perspective, factoring is essentially the equivalent of needing to feed your working capital belly as the requester in an “I’ll gladly pay you Tuesday for a hamburger today” scenario, but in this case the chef won’t provide you with the burger (factoring is not actually a "loan") under most circumstances unless he:

A) Can reduce his risk of not getting paid back through guarantees (i.e., recourse)

B) Won’t forward advance you the capital unless he knows he’s loaning against future cash flow he can see, such as a PO or invoice (collateralization)

C) Knowst he’ll make materially more money from the deal than other risk-adjusted returns will pay him while also factoring in the typical manual labor involved in factoring-based lending models (let’s call this the factor’s cost of human capital + NPV calculation on the deal)

Another way of looking at factoring is as a form of alternative borrowing — “banking the unbanked,” if you will, although it should be said the vast majority of factoring customers have mainstream banking relationships as well.

Indeed, factors almost always bank those with banking relationships (at least suppliers in non-third-world countries). But in the case of a need for factoring-based lending, the banks will typically not extend the credit required to help a supplier navigate its operating capital requirements (e.g., via a revolver or other credit facility).

From this, you’ve probably come to the conclusion that factors are just filling a void that’s necessary to keep cash and products flowing through the supply chain, albeit via a higher rate of interest than typical credit cards, merchant cash and ACH advances, etc. (note the latter of which, especially, come with their own set of challenges and issues).

But I look at factoring in a different way. And in doing so, I’m certainly not passing judgment that the practice “takes advantage of suppliers.” Heck, if suppliers are willing to take a multi-or even double-digit (in extreme cases) point discount off a PO or invoice, there's a reason for it in their mind, regardless of what you might say as an outsider. Instead of complaining or crying to the local regulators about factoring practices, I say go read “Atlas Shrugged.

Philosophical perspectives aside, my view of offline factoring models is that they are the equivalent of burning coal with turn of the early 20th century technology for power or heat when we could be splitting atoms or using wind or solar power instead. Like using coal for energy, factoring is wasteful, inefficient and generates unintended side effects (including, in many cases, bludgeoning or killing off a supplier’s overall operating margin, and its enterprise value as a result, much as heavy air pollution is a surefire way to cause respiratory illness and even cancer).

But what’s the solution, you ask? Easy.

It’s replacing the manual factoring back office with technology that provides insight and visibility across transactional information between buyers and suppliers. In short, it’s taking the “art” out of factoring and replacing it with big data science based on the ability to answer questions like, “With what exact probability can we determine that a PO issued from a specific buyer to a specific supplier will ultimately be paid at face or a specific partial value?”

Some factors are already moving in this direction. And alternative models, which can also be seller-led, require visibility into transactional or what is often known as “procure-to-pay” (P2P) information. Along with my colleague David Gustin at Trade Financing Matters, I’ve been an enthusiast for new forms of P2P-enabled trade financing models for a number of years. These approaches provide for much lower advance APRs for suppliers of all sizes while at the same time reducing risk for lenders and providing unprecedented transactional and financial supply chain visibility for procurement organizations to reduce supply risk.

Today, few of these programs rely on big data science (in the future more will). But even with only basic transactional visibility through supplier networks and other new forms of supply chain transactional marketplace models, they can serve as a foundation for much more efficient lending models for suppliers through enabling new levels of shared document visibility (for supply chain participants and lenders), accelerating approval times (e.g., for invoices) and reducing the chance of supplier or procurement fraud.

Granted, many of these programs are scaling slower than many first thought. I believe this is happening for several reasons, which I will explore in a future column. But despite low adoption to date, the benefits of tech-enabled payables and receivables financing are undeniable for all parties involved.

Ultimately, I believe new trade financing models starting with P2P networks and marketplaces and progressing through to big data models (relying on network data) will kill off much of the old school factoring books of business. And I’d bet more than a hamburger today that they will take a material dent out of the the offline part of the factoring industry in the next decade or sooner. 

Want to learn more or get smart on the “post-factoring” receivables and payables financing possibilities?

We’ve spent thousands of hours with private funds, banks, card companies, trading firms, logistics providers, procurement and finance organizations and technology vendors exploring the art of the possible and evaluating different opportunities, as well as teaching the basics of the different models today and how they might evolve in the future for those just coming up to speed.

Give us a shout: jbusch (at) spendmatters (dot) com or dgustin (at) tradefinancingmatters (dot) com.

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