Interest in distributor finance (DF) programmes appears to be growing among corporates. We examine what is driving this trend and what needs to happen for DF to gain further momentum.
Establishing a distributor finance (DF) programme may not be at the top of too many corporate treasurers’ to-do lists for 2014. But as many small and medium-sized enterprise (SME) distributors continue to struggle to find affordable and flexible credit, DF could be the key to unlocking growth for both the corporate seller and its distributors. So what exactly is DF and how does it work?
An alternative financing technique that can complement traditional supply chain finance (SCF), DF can be defined, according to Demica, as: “Financing solutions that support the working capital needs of a corporate seller’s distributors and potentially the distributors’ resellers, to ease the flow of product through the channel.” In other words, DF allows the large corporate seller’s bank relationships, credit strength and knowledge of its channel partners (in this case, distributors) to be leveraged in order to provide affordable finance to the downstream supply chain.
This is important because “a lot of these channel partners are typically less well capitalised than the larger manufacturing entity – what we call the anchor client – for this reason they really need more flexible working capital than they could normally access on their own,” says Jon Richman, Head of Trade Finance and Financial Supply Chain Americas at Deutsche Bank.
Often offered on a short-term basis, DF essentially allows corporate sellers to grow their sales by injecting working capital and liquidity into their distribution channel. This in turn allows the seller to improve its cash flow, and lower its risk while enabling its distributors to purchase more product by giving them access to an additional source of funding at a lower cost than traditional bank financing. DF can also reduce counterparty credit risk, and improves performance metrics, although this is not the primary reason that most corporate sellers turn to the solution.
There are three main types of DF solutions. The first is a receivables-based programme, which allows the corporate seller to receive early payment through the purchase or discounting of receivables – the benefit is then passed on to distributors in the form of extended payment terms (increased DPO). Another method sees distributors provided with direct loans or credit facilities that are backed (to a varying extent) by the anchor client. Finally, other asset-backed financing may be provided, again with backing from the anchor client. A good example of this is dealer floor plan financing in the automotive industry.
Early adopters of DF programmes included carmakers, technology companies (Dell and HP, for example, have well established DF programmes in place) and some industrial sectors, such as equipment manufacturers. Nevertheless, the range of industries in which DF programmes can be applied is wide – it includes consumer products, food and beverages, and chemicals companies.
“DF programmes are generally applicable anywhere where there’s an imbalance of power between the anchor and its distributors, where the anchor client – often a large manufacturer with a lot of leverage and a good credit standing – uses distributors who are not as well capitalised,” adds Richman.
“Industries where there is a tendency to outsource services, where there is a strong demand for stocks of spare parts in a short time, or cases where an original equipment manufacturer takes on a service guarantee for its own products, are likely to increasingly look to DF programmes in the future,” says Sigurd Dahrendorf, Vice President, Corporate Treasury at Knorr-Bremse. Rail companies operating in countries like Sweden and the UK, where rail traffic is liberalised, very often have these attributes.
“DF is most attractive to corporates with international supply chains, particularly those looking to expand into emerging markets,” says Phillip Kerle, CEO at Demica. Successful DF programmes can help propel corporates into markets or segments where they want greater reach, as well as allowing smaller distribution partners to grow in their own right. Demica identified Eastern Europe, Asia and Latin America as regions where there are already a number of DF programmes running in a DF report last year. It went on to say that Eastern Europe, the Middle East, Russia, South America and the Far East should provide scope for DF development in the future.
Despite the apparent usefulness of DF, the provision of services is still somewhat limited. “There are not as many providers as one would think,” says Richman. “Apart from those few, the options are limited to smaller, local banks that have traditional ways of extending credit, usually on a bilateral basis, to the local distributors they have established relationships with.”
But the big bank DF providers have a different approach. They look at the relationships their major anchor clients have with their distributors, financing only the transactions that take place between the two. “We take the view that if it’s a close relationship, and if the distributor is prioritising the obligations they have to the anchor over other obligations, then the credit risk we are taking in financing those transactions is less than the credit risk we’d be taking if we just had a traditional bilateral relationship with that distributor,” says Richman.
This effectively lower credit risk enables the DF provider to extend more flexible credit and more of it, often at better prices, than would ever be possible through a traditional bilateral arrangement.
Thomas Dunn, Chairman of supply chain finance company Orbian, agrees that there is still something of a dearth of banks providing DF programmes. “It’s a bit like supply chain finance services. A lot of the big banks tend to talk it up a lot, but the actual amount of dollars they are putting behind DF is still really rather modest.”
Rather than being offered as a standalone service, DF services are often combined with bank providers’ other products as part of their global relationship with clients, and are usually adapted to the nature of the industry concerned. DF schemes are typically funded on-balance sheet by banks, and can be syndicated with other banks if the deal is material enough to pose capital requirement concerns.
DF is principally the domain of global banks which have a highly developed trade finance business. This international expertise differentiates them from local, domestic banks who can find providing these cross-border facilities a challenge.
There are also non-banks that provide DF, who are typically big manufacturers that have developed their finance operations. The key advantage of these non-bank DF providers is that they tend to have a very strong understanding of the underlying goods involved. GE Capital, for example, provides customised DF programmes wherein it manages its manufacturing clients’ financial relationships with their distribution networks.
Furthermore there are a handful of technology and service companies in the DF space. These companies do not typically provide credit for DF, but rather facilitate programmes through a technology platform.
Dahrendorf believes the paucity of provision is to an extent due to the level of demand for such services. “The market for DF services is not as strong as for traditional supply chain finance solutions. There is perhaps the perception that DF programmes offer less benefits than traditional SCF solutions.”
What to look for in a DF provider
Choosing a DF provider with a robust credit process in place, one that takes the nature of the relationship between the counterparties into account, is key to addressing credit risk.
DF programmes can also pose a variety of operational risks to the provider, owing to the diverse funding flows, reporting requirements, activity reconciliation, and management of credit notes involved. Providers of DF therefore need to have a solid infrastructure, including a technical platform, in place to support this operational complexity.
However, the financial risks of DF are partly mitigated by the fact that the counterparties involved have core relationships with the underlying client. “There’s a high degree of operational integration and a far more profound relationship, so if there is any disruption on the credit side or on the financing side, it can be managed within the context of the corporate’s overall goods and services relationship with the distributor. There’s a lot less risk for the corporate than there would be, for example, for a financial institution that was trying to provide this directly to the distributors,” says Dunn.
This somewhat negative perception of DF is not helped by the fact that DF is often conducted on an international basis, meaning that there are certain compliance challenges. However, compliance is almost always handled by the DF provider, not the corporate client. For providers, KYC – the client, their industry, and their distributors – is essential. The challenge of collecting this data is amplified when especially large pools of distributors are involved.
Providers must be diligent in ensuring that central bank regulatory reporting requirements and tax considerations are taken into account. While major global banks offering DF programmes usually have the infrastructure in place to deal with cross-border compliance issues, this challenge is more difficult for smaller domestic banks to address. Corporates weighing up DF providers should bear this in mind.
“It really depends on the jurisdiction. Some countries, for example, have regulations covering the financing or purchase of receivables or inventory, while others may require you to have some kind of financing licence in order to have a DF programme. You need to look at it on a case-by-case basis,” adds Dunn.
Keeping an eye on risk
Richman’s advice in setting up a DF programme: choose the distributors you put on the DF programme carefully. Ideally they should be trusted partners the corporate intends to keep for a long time. This should keep the risk to the corporate seller to a minimum. A sound knowledge of the territories in which it has distributors can also help the corporate seller when it comes to arranging a programme with a provider.
Furthermore, once the corporate has chosen trusted partners, it should keep an eye on them. “Monitoring the distributor’s financial wellbeing at frequent intervals is crucial to a successful DF programme,” says Demica’s Kerle.
Corporates also need to make sure that taking the DF route does not negatively impact them from an accounting perspective. They should ensure with an accounting expert that they will still be getting the accounting treatment they are used to post-implementation. This is not normally an issue with a well-structured DF programme.
DF to take off?
So is DF the key to allowing corporate sellers and their distributors to grow and flourish together? Will it provide a helping hand to drive development in emerging markets? Or is it destined to be a niche service provision from banks with little interest among corporates?
Richman believes it is already on the up, and predicts it will continue to rise. “Corporate treasuries are much more focused on working capital management than they used to be. DF, which allows corporates to more effectively manage their working capital cycle and support their trading partners, helps them address this,” he says.
The evolving credit landscape is also driving the growth of DF. As distributors, particularly smaller operations, find it increasingly difficult to access flexible and affordable finance (partly due to changing banking regulations), DF can extend credit to them at rates that they would not typically be able to get from their relationship bank. It is important to note that DF is supplementary to the credit companies have with their relationship bank.
Another growth driver will come as major manufacturing companies look to expand on an international scale, often in emerging markets. Distributors in these markets often have a much greater need for access to capital to support their own working capital cycles. This trend shows no sign of slowing down.
A desire among corporate sellers to build longer-lasting, sustainable links across the supply chain is contributing to the rise of DF, too. “DF, just like supplier finance, is going to continue to grow as more of the world’s leading companies adopt a very much higher prioritisation for sustainability across their supply chains: both their supply relationships as well as their dependent distributor relationships. This is a theme that we see coming through constantly from the highest quality companies, and it’s actually become something that defines the true quality of a company: the extent to which they are focusing on enabling the greatest success, both upstream into their suppliers and downstream into their distributors and sellers. They want to make their dependent constituents – suppliers and customers – more successful,” says Dunn.
On top of these drivers, the increasing awareness of the benefits DF can bring should entice more corporates to seek out DF solutions. This interest should in turn encourage more banks to look into devising a DF offering.
Is DF right for you?
Are you a seller in an industry where a lot of SME distributors are key to your growth?
Do your distributors have weak balance sheets?
Are you looking to expand in emerging markets?
Do you have a long-standing, trusting relationship with your distributors?
Do you want to more effectively manage your working capital cycle?
Keys to a successful DF programme
Choose the right provider, preferably one with the infrastructure and technical platforms to support a complex DF programme.
Take care to monitor the financial well-being of your distributors closely.
Ask your provider to ensure you are compliant. Be mindful of regulatory reporting requirements and tax considerations in the countries where you have distributors.