Greensill - lessons in structuring and due diligence


The collapse of Greensill Capital and the ripple effects from it caused multiple questions about underlying structures, roles of different participants, regulatory frameworks, and much more.

In this article, Igor Zaks, President of Tenzor Ltd. focuses from an investor standpoint and underlines what checks need to be in place to avoid such situations.

Two (perfectly legitimate when used correctly) areas that draw attention thanks to the crisis are supply chain finance (SCF) and credit insurance. It is essential to understand how each of them works, the limitations of each technique, and what due diligence needs to be done to detect its misuse.

Supply Chain Finance

Let us start with SCF. Despite somehow confusing efforts to introduce broader definitions (such as by Supply Chain Finance Forum), most practitioners talking about SCF refer to approved payable finance. It provides a fundamental advantage compared to other receivable finance techniques by relying on a buyer confirmation that the invoice is valid, conditions are met, and payment is approved, instead of the seller's claim of the same. SCF shifts the risk profile from a mixture of performance risk and credit risk (Was the invoice valid? Has the seller performed? Was the buyer correctly identified? etc.) to essentially the buyer's credit risk. Additional controls also provide significant mitigation of fraud risk (not all fraud types, but many). One of the critical controls for SCF is the independence of the parties (buyers and sellers) - verification of a claim between related companies may have limited value (it is alleged that a lot of Greensill transactions were along these lines).

The SCF provides a reasonably robust structure for creditworthy buyers - this is where it is actively used by banks, with high competition and low margins. There are fundamentally two ways to increase the return of such a product: it is either to take more credit risk (i.e., to go to smaller non-investment grade buyers) or to move from traditional SCF to other supply chain-related products (non-confirmed receivables, PO financing, inventory financing, etc.). In the case of Greensill, it appears the company went both ways by accepting high-risk clients and going all spectrum of performance risk, even beyond the widest definitions of SCF.

Credit Insurance

The purpose of credit insurance is to mitigate the risk of a buyer not paying a valid invoice. This means that in order to trigger a claim, the seller needs to comply with its contract with the buyer (i.e. supply goods and services, present required documents, etc. - whatever the agreement requires) and with the terms of insurance policy (i.e. pay premiums, make appropriate notifications, etc.). There are also more generic terms like "act prudently as uninsured," minimise the loss, etc. There were initiatives to make wording more lender-friendly (such as by BAFT), but both wordings and actual practices vary.  Most of the policies are risk attached, covering the claims for goods invoiced during the policy period, even if the policy is terminated. Some policies will offer non-cancellable (within insured period) limits - how non-cancellable are in reality depends on the policy wording (for example, in case of buyer bankruptcy or known severe distress, it may be very difficult for the seller to justify their continuing supply).

The other important feature of an insurance policy is how the third party (like an investor) can benefit from it. In Greensill's case (based on public information) it appears Credit Suisse was listed as a Loss Payee, meaning they can benefit from the insurance when the claim is paid, but not otherwise are involved or have control over the policy. Another structure when the investor is co-insured means they can be involved throughout the policy.

Fit between financing and credit insurance

Credit insurance is a very powerful tool when used appropriately, as it allows using a significant risk-taking capacity of the insurance market to enhance the transactions. It should, however, never be the first line of defence; prudent risk assessment should be. Even if the claims are going to be paid, cost and ability to access the insurance market will be severally affected on repeat issues (from public sources, it looks like it's what happened in the case of Greensill with some carriers exiting, culminating with Tokyo Marine being the last major source, withdrawing). It is also vital that insurers usually do not cover the performance risk of the supplier (i.e., contractual disputes, etc.). This makes "traditional" supply chain finance a good match, as the properly structured buyer confirmation eliminates possible defense of contractual dispute, buyer identification, and some other risks - for different types of financing used, it may present significant risk (yet to be seen when Greensill cases will come to claim, but there are endless possibilities non-traditional SCF transactions will lead to insurance disputes). Another issue may be high concentrations - credit insurance works well as portfolio enhancement, less so when there is a highly concentrated risk. And most importantly, when using credit insurance to cover future risk, one needs to keep in mind that it is only covering risk on non-payment of valid future invoices: it does not cover the risk of supplier not being able to perform, risk of the buyer going bankrupt before supply, and multiple other risks. Having the ability to enhance the credit of given buyers for a period of time does not necessarily mean the risk of such transactions (even if there is a long-term contract and future orders are assured) is mitigated the same way. In Greensill's case, it appears they went even further in financing future receivables without a pre-existing contract (meaning not only supplier may not perform, but the buyer may never order) and going beyond the insurance period (meaning the largely unknown risk of future renewal).

Conclusions:

There are multiple opportunities for investors within supply chain finance-related assets, and credit insurance may play an essential role as a credit enhancer. This, however, requires an investor to deeply understand structural issues and conduct detailed due diligence to avoid costly mistakes, like ones related to the Greensill case.