EBSI Tradebrief - Pumping private money into trade activities
May 2012, Article published in:  http://www.ebsi.ie/eBSI_Tradebrief_Issue_9.pdf

PUMPING PRIVATE MONEY INTO TRADE ACTIVITIES

Traditionally, trade finance has been provided to import/export companies by banks and/or other financial institutions. Such dependency of the financial sector adversely affects to both importers and exporters in their needs to get either funding or credit, especially in downturn times. Actually, in any financial crisis, the inevitable shortage of  cash and credit imposed by banks to their clients implies an additional burden to producers and/or manufacturers adding such lack of financing to the problems experienced by the effect of the crisis. We all know examples of companies that have been forced to reduce their activity, or even close, by the lack of liquidity or credit necessary to continue operations.

However, new players are entering the pitch. Private investors, knowing the benefits and relative safety offered by trade, are willing to support trade business and simultaneously get some return to their investments.

There are different options for an investor to finance trade operations; in this article we will mention one of the simplest.

All companies, regardless of the sector in which they operate, need to keep a stock in their warehouses. In some cases, inventories consist of raw materials purchased to its suppliers, or semi-finished products that need to incorporate into their production process. In other cases, major stocks are manufactured products which are deposited in warehouses waiting to be sent to the final purchaser, or any type of source of energy needed for the production.

In either case, the company has on its balance sheet the value of the stock which must be funded from its own resources or through a bank loan. In a situation of lack of liquidity or credit shortage, the problem is compounded when stocks have to be stocked for long periods of time, either by the nature of the goods themselves, such as timber that takes a while to dry, or product seasonality, for example, orange juice which has to be manufactured in accordance with the harvest season.

What is the role of private investors in this scheme?. They provide liquidity by temporarily buying the stocks and selling them later, in accordance to a previously agreed schedule to either the same producer or to the final purchaser.

Let’s put a practical example to understand the benefits:

A Spanish steel mill needs coal for its production process. Due to the high impact of transport cost in the purchase the company buys large quantities (e.g. 25,000 Mt) from Colombia in order to reduce the cost and get a better purchase price. The problem arises when the company verifies that 25,000 Mt covers its production needs for a period of 6 months and, therefore, it has to finance the stock – plus all the import and transport added costs – using either its working capital or a bank loan. Unfortunately, the option to buy a lesser quantity of coal implies a higher purchase cost.

The agreement between the investor – usually a pool of them acting through a Special Purpose Vehicle (SPV)- and the steel mill can be structured in many ways, depending on the time that both parties wish to finance stocks and the functions to be performed by each party, entering commercial aspects involved, image, cost, etc.

The easiest way is as follows: the investor buys the coal directly from the seller in Colombia in the conditions (price, quality, quantity, etc) previously negotiated by the steel mill and requests that the coal be delivered in the steel mill's warehouse.

The investor bears all the costs involved in the import transaction (purchase, inland transport, maritime transport, discharge, duties, etc.) and remains the wholly owner of the product that has been stocked in the steel mill’s warehouse.

As per their agreement, the steel mill takes daily from the warehouse the quantity needed for its production and, at the end of the month, pays to the investor the amount established in the agreement, i.e. purchase price + pro-rata of involved costs + percentage of profits for the investor (estimated in terms of time).

In fact, the investor becomes a “just-on-time” provider of coal to the steel mill.

Benefits for both parts are significant: the steel mill pays only when effectively uses the coal and only bears a small additional cost (i.e. investor’s profit) for the financing period (which in the traditional way equals the bank’s finance costs). Besides, its indebtedness ratio is lower, as no bank loan exists and the obligation with the investor is a commercial agreement.

For the investor’s point of view, he gets a profit for the period of time he bears the costs without taking a high risk because he’s at all times the owner of the coal until the moment he sells it to the steel mill.

There is a handful of options using such a collaboration scheme, covering several sectors, products and roles. In fact, each transaction is structured properly to generate profits for both parties. In future articles we’ll review different options on the same structure of collaboration between private investors and foreign trade companies.

Carlos A. Bacigalupe

cb@ebsi.ie