Receivables financing as a tool of acquisition finance is all the rage in Europe – not least because specialist US providers, with expertise in calibrating borrowers’ cashflow strength and creditworthiness, have been among those active in financing recent acquisitions and MBOs. This is because receivables financing reduces the need for working capital without affecting a borrower’s credit lines, so it is a useful source of additional liquidity.
“Asset-based financing as an adjunct to conventional acquisition finance is not new in the context of acquisitions and leveraged buy-outs,” says Andrew McLean, a partner at Nabarro Nathanson who specializes in structured finance. “What is new is the ascendancy of receivables financing to the point where the entire transaction could be financed on the back of the target’s debtor book.”
Traditionally, receivables financing – especially in the form of factoring – has been seen as a mundane commercial banking activity. But sophisticated forms carry their own legal risks. Banks new to the field need to be aware of these.
Factoring occurs where the bank buys a book of trade debts from a borrower (B) and provides B with a percentage of their value, say 80%. The bank then seeks payment directly from B’s customer (C). B gets his money up-front and the bank carries the risk that C won’t pay. The arrangement is disclosed to C who is told to make payment to the bank. Because the arrangement is disclosed and the bank has an interest in pursuing C for payment as soon as possible, factoring has tended to be associated with the smaller end of the market, where B may not have the administration to pursue its debts itself.
Where the arrangement is not disclosed to C, it is called invoice discounting. This is the form of receivables financing that has been developed in the US to become a sophisticated credit facility. B acts as agent for the bank in collecting and C pays into an account with the bank but without knowing it is for the bank’s benefit.
The stronger B’s creditworthiness, the less control the bank seeks over the book debts. The bank will generally make it a condition of the financing that it carries out a pre-completion survey of B’s credit-control and sales-ledger functions. The bank may specify that only “eligible receivables” (categorized by age and identity of the debtor) count towards the facility available. It may only allow drawdown in respect of debts individually identified in a “discounting application”. But where B is a strong credit, the bank may simply rely on self-certification by B.
The question for the bank is how to balance the need for security – in the event of B’s default – against non-disclosure of the relationship to C. In particular, a debenture holder or chargee of some other part of B’s business can appoint an administrative receiver or other receiver of assets under the terms of its security and obtain priority over B’s assets, including B’s trade debts. In English law, the giving of notice to third parties – for instance by way of a legal assignment or charge registered at Companies House – preserves the chargee’s position. But the giving of notice would disclose the bank’s position.
The particular solution is a combination of security devices. The bank will usually take an equitable assignment of the debt owed by C to B. Equitable assignments have one advantage over legal assignments: they can extend to future debts. Although not as strong as a legal assignment, they bind B and take priority over subsequent equitable assignments by B of the same debt. It is also usual to require B to sign but not date a notice of assignment addressed to C so that the bank can perfect the assignment by serving notice if it gets wind that B is about to default. The bank has to be sure that the contract between B and C can be assigned: if there is a stipulation (inserted by C) that it cannot be assigned, then an attempt to assign it without consent will be invalid. The pre-completion survey should reveal the extent to which this is a problem.
“With any financing structure involving security on the basis of an equitable assignment, there is an element of trust on the part of the bank,” says McLean. “It is reliant on the borrower paying the receivables into the relevant account and not diverting them elsewhere. The arrangement is susceptible to fraud as the borrower could subsequently legally assign the debts to another party to raise further amounts on the same debts. It is unlikely that this could continue for long, but as soon as a competing interest in the debts is introduced, the damage had been done. These are matters of trust which a bank can only get comfortable with by careful diligence and creating a close working relationship with its client.”
The bank may also take a fixed and floating charge over B’s existing and future book debts. The bank’s security will be strengthened if it extracts a negative pledge from B which is also the subject of registration. This is thought to be effective since, under the Law of Property Act 1925, which governs the validity of legal assignments, they take priority “subject to equities” which includes this sort of security. But not all lawyers agree.
Security is one issue. Another is the degree of control the bank has in encouraging B to collect C’s debt. If B is a strong credit and the bank a sophisticated provider of receivables financing, the bank will not want all the detail of B’s debts although it may well reserve the right to inspect as a guard against fraud. If C fails to pay, the bank may retain recourse against B by simply requiring it to repurchase debts that turn bad. B may resist this on the basis that it leaves B with the full risk which makes the financing no better but more expensive than an overdraft with the additional security for the bank over B’s trade debts.
The other extreme is for the bank to have no recourse to B at all but only to C. The problem here is that the bank may impose tougher restrictions on the terms B offers C and tighter terms on the debt’s payment, the effect of which is to put C off doing business with B; or the bank may restrict the facility to a point where it represents expensive money to B. One solution is to give the bank limited recourse to only part of the debt. This gives B an incentive to collect without affecting the way it does business with C.
“A further attraction of well-structured receivables financing is that it grows with the business,” says McLean. “A bank overdraft limit will be kept until the next review date and the company’s working-capital requirement may outgrow the amount its bank is prepared to fund. If that increase in working capital requirement is a corollary of increased business, then there is an expanding pool of assets against which a company may borrow.”
