April 2013

PO Finance — From Mainstream to Alternative Funding and Back

As purchase order finance has become more mainstream, Paul Schuldiner describes two types of PO finance used most often by borrowers — and points out that providing these products comes with a high degree of risk requiring a skill set not usually found in a factoring or ABL environment.

If you were to take a poll of most U.S. lenders with regard to when they first heard about purchase order finance as a funding option for businesses, you would probably receive a response they have known about the product for as long as 20, 10 or 5 years. In other cases, lenders would say they have never heard of the product at all, or they think it is factoring.

Factoring, purchase order finance (PO finance) and trade finance are somewhat inter-twined and all have roots that go back maybe as long as the Dutch East India Company, or banks in 13th century Italy and 17th century Great Britain. Credit guarantees, such as what a factor provides, as well as the use of letters of credit (LCs) have always been essential tools facilitating trade between buyers and sellers of products around the world. Without these financial instruments, the evolution of trade, credit protection and working capital financing for importers, exporters, wholesale distributors and manufacturers would not exist as we know it today.

My first encounter with PO Finance was in 1990 working at a commercial finance company. We had an outerwear importer selling products to retail stores. The company was a highly seasonal business and profitability was “make or break” in the fourth quarter. However, the company had to secure payment to overseas factories via LCs during a time of the year when its collateral position provided the least borrowing availability. There was a factoring facility in place financing accounts receivable and providing credit protection on the end-customers’ receivables. The finance company I worked for provided LCs requiring a one-third margin from the borrower. The rationale for providing the trade cycle financing was that the goods were presold with a healthy gross margin. For several years, the company was able to receive a $1 million advance payment (try getting this from a retailer today!) from the retail chain for the season’s orders. The advance payment would be used as collateral to open $3 million of LCs. Well, we know all good things come to an end — and in this case a crashing end! There was a change in financial management at the retailer, and they stopped providing the advance payment.

My client now had a liquidity crisis. Discussion revolved around raising capital, (not a preferred option), open credit terms from foreign suppliers (not available) and, lastly, financing of purchase orders at a 100% advance rate of the cost of required inventory (i.e., no margin requirement). Reviewing the options, my client selected PO finance, as it was a better alternative than an equity partner and it could coexist with my financing and the factor. The PO finance option was used for two seasons until the business was sold. Without PO finance, the company would not have survived.

Some 23 years after my first encounter with PO finance, there is more capital than ever in the market. Banks are providing asset-based lending, asset-based lenders are providing cash-flow pieces, factoring companies are experimenting with PO finance, hedge funds and the like are employing hybrid funding across the entire spectrum of the capital structure.

Despite the abundant liquidity, PO finance remains a great tool for fast growing companies and those in a turnaround. It rapidly employs 100% of the transaction capital and is a cash-flow creation tool for companies that make, buy and sell a product. Closely held businesses avoid bringing in an equity partner to solve short term cash-flow problems. If the business is owned by a private equity group (PEG), it does not have to put more of its own capital into a deal and can leverage off the PO finance source’s capital. It frees up the PEG to utilize capital in other investments.

The most usual comment I hear is PO finance is a great product, but it is expensive. My answer is — that is right! It is a great product, and although it may be expensive, it must be compared to other available options. It will be less expensive than raising permanent capital as the borrower pays only for what it uses in PO financing, and more importantly it doesn’t require a company to give up equity. It matches short-term funding with a short-term need.

There are two primary types of PO finance utilized by borrowers:

Purchase Order Financing for Finished Goods

The borrower is outsourcing manufacturing of the product. Some form of credit enhancement such as LCs or cash funding is required to pay the contract manufacturer for the finished product.

Some of the transaction risks include:

  • Credit worthiness of the end-buyer
  • Sufficient gross margin in the order
  • Ability to verify the order (i.e., is it a firm order, forecast, letter from the buyer, guaranteed sale or something in between)
  • Managing the quality control/inspection aspects of production
  • Managing the logistics and physical control of the product being funded (i.e., can delivery times be met?; what happens if the goods are in control of the borrower and they use the products for orders not financed by the PO finance source?)
  • Order cancellations; ability to sell the products to another party
  •  Factor or ABL’s advance rate — adequate to repay PO finance source? Inter-creditor issues?
  • Will the supplier accept an LC, cash upon shipment or require cash in advance (essentially an unsecured loan)?

Two specific scenarios funded with finished goods PO finance:

  • An accessories importer started with a $3 million PO finance facility and rapid growth required an increase in funding to nearly $15 million within two years. The company was ultimately bought by a PEG at a substantial premium.
  • A furniture importer was in a turnaround due to problems transitioning from domestic manufacturing to importing. A $2 million PO finance facility was established at the suggestion of the turnaround consultant to fund production of foreign produced goods presold to credit worthy buyers. After two years using PO finance, the company was able to obtain open terms from its overseas suppliers and be fully supported by its asset-based lender. Shortly after, the company was sold to a large strategic buyer at premium.

Production Purchase Order Financing (a/k/a Work in Process Finance)

This is utilized by domestic manufacturers or assemblers that procure the necessary components and/or raw materials to “make” or “build” a finished product either in their own facility or using sub-contractors or assemblers.

Elements of production PO Finance:

  • Need for proven history of producing the product, available capacity and the cash-flow to cover other non-direct costs. PO finance can include the cost of materials, parts and direct labor to fulfill the order.
  • Is the company profitable or cash-flow neutral? The order being financed should represent incremental sales to the company (i.e., if the company lost the sale, it would still be a going concern).
  • Number of suppliers being utilized in the transaction? The greater the number, the more due diligence required to qualify the suppliers and control the collateral of raw materials/parts delivered to the company.
  • Length of the production cycle? Days and weeks are much better suited for this type of financing. If the production cycle is more than 90 days, the cost of PO finance and the risk associated with the longer exposure of employed funds might not make economic sense for either party.
  • What does the company do in production? Fabricating, cutting, sewing, mixing, packaging, etc. are usually acceptable. Production involving tooling, molding, milling, etc. in producing a finished product is more challenging.

Two specific scenarios funded with production PO finance:

  • A 60-plus-year-old government contractor manufacturing safety equipment sold to the U.S. government was forced to stop production due to cash-flow issues despite having $2.5 million in open, unfulfilled contract orders. A PO finance facility was structured to provide various raw material suppliers with payments needed to restart the supply chain allowing the company to fulfill the orders. Due to the flexibility of the PO finance structure, the company continues to use PO finance to help fill cash-flow voids and produce and ship under U.S government contracts.
  • An exporter of post tensioning system components received a $4.3 million, multiple-year contract from a contractor in Kuwait. Export LCs were issued to the exporter, but it had no availability under its credit line. The senior lender suggested it utilize PO finance to carve out the production and fulfillment of the contract. Upon successful completion utilizing PO finance, the senior lender increased the existing credit facility as a result of improvement in the exporter’s balance sheet.

What is the common element among the scenarios? The substantial economic value creation for the borrower that used PO finance and the stake holders (other lenders, vendors and customers) involved in the transaction.

What is not PO finance? PO finance is not an over-advance on inventory, nor is it utilizing the factor credit balance and thus lending more on accounts receivable. Finally, it is not obtaining outside additional collateral to support the existing senior lender’s rationale to lend deeper into the credit. While these may be satisfactory solutions, it may not be enough for the borrower and use of these items may end up reducing the cushion the senior lender relied on in the event of a downturn in the borrower’s performance.

In conclusion, PO finance has become more main stream. However, providing PO finance comes with a high degree of risk requiring a skill set not usually found in a factoring or ABL environment. While the need to employ capital (driven by impatient investors as part of a financier’s capital structure) and generate higher returns are a challenge, the senior lender should consider teaming up with a PO finance specialist that is reputable, highly experienced, well capitalized and has demonstrated the staying power to support small and large transactions across a variety of structures and industries. By sticking to one’s skill set — the bank, factor or ABL and PO finance company each doing what it does best — a solution can be provided for the borrower that also leads to a more safely managed transaction to everyone’s benefit.

Paul D. Schuldiner is the managing director of business development and partner in charge of the New York office for King Trade Capital. He was previously SVP and business development manager of the purchase order finance group of Wells Fargo Capital Finance.