What is performance risk in trade finance?
Investors who finance a portfolio of trade receivables or an individual trade receivable face performance risk.
Performance risk is the risk that the buyer, who owes the money, can legitimately avoid paying because the supplier has failed to do a good job.
Give me some examples
A trade receivable is an “invoice”. It represents a charge made for the provision of goods, commodities and / or services. It will be governed by a contract between the buyer and his supplier – which will most likely set out what the supplier has to do in order for the buyer to be obliged to pay. If the supplier, somehow, fails to perform all his obligations, then the buyer’s obligation is reduced or even can be zero. This is performance risk.
- A commodity is purchased but found, on delivery, not to conform to the specification in the contract.
- There is a short shipment (meaning less is delivered than expected).
- There are quality problems with a manufactured product – eg: wrong labels, wrong colours, wrong sizes, defective parts.
In these situations, the buyer will normally raise a credit note and pay less than the face amount of the invoice, so less than the expected amount of the receivable.
In our experience, performance issues are common. Sometimes it is a minor matter amounting to a few per cent. adjustment on a trade. It can, rarely, be significant and affect a whole shipment.
How is performance risk mitigated?
Performance risk is mitigated using a number of techniques:
- The supplier is usually paid less than the full amount upfront of the receivable (the invoice). This creates a reserve that can be used to absorb credit notes that the buyer legitimately issues.
- If the amount of credit notes exceeds the reserve, then there can be a claim on the supplier for the shortfall.
- If the supplier is not a good credit, or is located in a country where creditors have little protection, then the buyer can be asked to waive his right to dispute trades with the financier (PrimaDollar). This does not affect the buyer’s ability separately to negotiate with his supplier, but does mean that he has to pay the financier in full.
Is past performance relevant?
In many respects, past performance can be a good guide to the level of performance risk in a given supply chain.
Analysing the historical level of credit notes can provide a good indication of the reserve level that would be appropriate for the “business-as-usual” situation of small issues that commonly can arise.
Past performance data may not useful to predict if entire shipments might be written off – a high impact but low probability event. A buyer who experiences this kind of situation will usually drop the supplier immediately. Historical information on performance for current suppliers is likely to show no major issues.
How do I understand performance risk as an investor?
Any investor in trade receivables should aim to see a diversified portfolio of both buyers and suppliers. But importantly, he should analyse how large individual shipments and individual invoices are relative to the whole portfolio.
Generally, the minor “business as usual” level of performance issues will be dealt with by the reserve that the financier creates when he pays less than the face value of the invoice to the supplier upfront and by the paperwork put in place with the buyer. So there should be little chance of these performance risks causing an issue for an investor.
The very rare situation of a failed shipment usually leads to the buyer dropping the supplier. The contractual position then becomes important. In this situation, there are usually long negotiations and recovery processes for the financier. Selecting an experienced financier who works with reliable supply chains involving professional counterparties is the best way to avoid this kind of high impact but low probability event.
How can I find out more?
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