Business Money – Finance and Banking for Business

Factoring in change

January 2006

A Demica research study on the evolving factoring and invoice discounting market in northern Europe and its technology requirements

Factoring and invoice discounting companies across Europe now turnover in the region of 612bn and the market continues to grow. Finance secured against invoice debt has become increasingly popular in a business community that has been subject to a tightening credit squeeze since the turn of the millennium. The availability of unsecured lines of credit, especially for firms with pressurised cashflow cycles and/or significant leverage, has simply dried up or simply become unaffordable. Availability of lower cost unsecured credit in the UK and France has tightened in the market over the last few years, however Germany has recently become subject to sudden shut-down, as artificially inexpensive borrowing through the state-supported Landesbank system has been withdrawn country-wide.

Across northern Europe, with the exception of the UK, full factoring (where the lender also collects the invoice payments) has been the main available non-bank cashflow finance product until recently, as there remained concerns about proving primary legal title to invoice debt in continental European civil code jurisdictions in the “arms-length” invoice discounting process. These legal problems have now been overcome, and both factoring and invoice discounting are now strong products throughout the region.

Whilst take-up of both these secured financing products is growing, invoice discounting, where the borrower collects the invoice debt, is seeing the strongest growth levels. In the more mature UK market, full factoring makes up around 15% of the overall market. The balance between full factoring and invoice discounting is reversed in other northern European countries. Growth in the total market varies between the major northern European economies. The UK is the largest marketplace (turnover in 2004 – 184.5bn) with a 14.7% growth rate. France starts from a lower base (turnover in 2004 – 81.6bn) but growing at an annual rate of around 11.5%. Germany, where the market is yet young (turnover in 2004 – 45bn) is booming at some 28.5% per year.
In times of rapid market growth, players who can introduce business efficiencies or competitive advantages stand to attract the lion’s share of the emerging customer demand. In finance, this either means reducing cost of business (and being able to share part of those savings with customers), or understanding and managing risk better so that previously untenably risky companies can be financed, or at the very least compress the lending to collections cycle to improve profitability.

Research results
In order to better comprehend trends currently taking place in the northern European factoring and invoice discounting market – particularly the trend towards invoice discounting and the use of technology to improve business outcomes – Demica commissioned research amongst the factoring communities in these countries.

The research, which ended in November 2005, looked at three specific areas. Firstly, the trend towards offering invoice discounting was examined, looking at financier and customer motivations. Secondly, questions were asked about the capabilities of current technology, and the ways in which technology take-up would develop. Thirdly, the specialist area of securitisation was examined, in order to calibrate likely use of this refinancing technique over the next two years.

Drivers for invoice discounting growth
According to the research, within the next two years some 86% of factoring companies will be offering the invoice discounting option. This complements available statistics on the very strong growth of invoice discounting in northern Europe. For the remaining 14% who do not offer invoice discounting, there is also the emerging option of confidential factoring, where the factor carries out collection under the client’s company name.

The main motivation behind companies demand for factoring also threw light on the trend towards invoice discounting. Only 21% of customers were thought to be principally interested in an outsourced collections service, whereas 62% were motivated primarily by access to non-bank cashflow finance (17% were interested in both to an equal extent.) So it would appear the collections element of full factoring is not the main driver of the adoption of this technique. When queried why invoice discounting is growing at a much greater rate than full factoring, respondents cited the lower cost of invoice discounting (45%), the saturated, fiercely competitive full factoring market (37%), and the increasing desire for companies to keep control of their sales ledgers (28%).

Whereas invoice discounting was historically a product that was only offered to firms with a turnover in excess of 2m per annum, competitive pressures have now forced financiers to significantly lower this to a 750,000 turnover level. This subsequently requires more sophisticated technical and systems support in order to manage risk better when dealing with smaller, less established companies, as well as to mitigate fraud. At the other end of the spectrum, invoice discounting is also beginning to appeal to larger firms. In recent years, the average turnover of invoice discounting clients has risen considerably and is now between 8m and 10m. However, approximately 90 invoice discounting clients have annual turnovers in excess of 130m, according to FDA quarterly figures.

The confidentiality element of invoice discounting is often cited as another key advantage for the client, however is this really the case? The answer from our research is a resounding “yes”. On a scale of 1 to 10, where 1 = not important at all and 10 = of vital importance, respondents gave the confidentiality element of invoice discounting an importance ranking of 7.4.

So what exactly were the obstacles that financiers saw to converting customers from factoring to invoice discounting?
After registering the 25% who saw no obstacles at all to this customer conversion, the majority of respondent opinion focused on the view that there would remain a significant group of customers who were simply too risky (either in terms of credit status or collections processes) to be in receipt of an invoice discounting service. This obviously represents a sizable proportion of clients who would never be eligible for invoice discounting. Other obstacles cited were merely temporary ones: 21% held the view that technology improvements would be required before offering invoice discounting; and a further 16% felt that a staff skills gap would have to be closed.

Technology support requirements
Moving on to the topic of technology support, our survey investigated the current and future capabilities of systems support and performance. Critical to any factoring and invoice discounting business is the ability to understand how well invoice payment is performing, down to the level of each individual invoice (so that rapid remedial action can be taken where necessary). Of the industry 32% is thought to have real-time information systems that give a completely up-to-the-minute view debt collection. Of these 55% are able to view this data on a daily updated basis while 13% only report payment performance on a weekly basis. However, these statistics do not give a real idea of exactly how automated these viewing facilities are. Updates could be occurring in real-time, but may only be obtained by looking through a networked spreadsheet.

There is evidently an appetite in the industry to take on board increasingly sophisticated technology support to improve business effectiveness and efficiency. Respondents felt that 60% of the industry is currently using technology to report invoice level payment performance data, a proportion which is expected to rise to 83% in two years time. Our next question revealed what the nature and capabilities of that technology was likely to be.

When asked what principal advantages technology investment would provide over the next two years, we received two main views. The majority of respondents (79%) cited the notion of better risk management, especially the ability to receive early, pro-active alerts in order to predict impending bad debt or spot possible fraud. This reflects concerns described by BCR Publishing in its regular reports on the industry: “Cases of fraud are still on the up. There are a number of reasons for this; firstly more companies are using invoice discounting, a service more commonly used in fraud; secondly, increased competition means that factors may be responding to the race to sign up new customers by cutting back on due diligence and underwriting more marginal business, although there is little evidence to support this view.”

The remaining 21% said that they were looking to technology to deliver greater efficiency, lower cost of doing business and compressed payment cycles. In other words, the larger group wanted technology to assist them extend their ability to take on clients and do business with them, whereas the smaller (but no less important) proportion wanted to focus on improving profitability from their current market share.

In all events, the technological capability required by the majority already exists in the capital markets, and is known as exception management. However, this is not enough for the growing invoice discounter to be able to view transactions and obtain aggregated reports. Most transactions pass straight through the business process without a hitch. The problem (or potential problem) transactions however, are those which demand speedy resolution as they could actually end up costing significant amounts of money. It is therefore apparent that the key technological capability that the industry is seeking, is the ability to automatically spot and escalate the first signs of impending bad debt or fraud.

Securitisation
Interestingly, this leads us on to our final area of enquiry – namely the securitisation of the invoice pool. In the last two to three years, systems have been developed that allow pools of invoice debt (even from multiple companies over multiple geographies) to be transferred to a legally independent vehicle and then issued onto the capital markets as notes or bonds. Because the credit rating of the debt is determined by the rating of the debtor (rather than the company that issued the invoices), this pool can be offered to the capital markets with an ‘A’ rating, attracting a considerably lower financing cost over alternative refinancing methods.

The technology required to achieve a successful securitisation enables and automates the stringent data entry and reporting standards required by the market regulators. This technology underpins pro-active bad debt/fraud alerts and escalation features, which will emerge as prerequisites the factoring and invoice discounting industry over the next two years, whether or not it is decided to securitise all or part of the invoice pool. Our survey does indicate a significant “early adopter” community, interested in proceeding with a securitisation transaction, with 20% of factors and invoice discounters expecting to securitise all, or at least part, of their invoice pool over the next two years.

Features

Factoring in change