The Rate Arbitrage Trap

For the great enemy of truth is very often not the lie- deliberate, contrived and dishonest- but the myth- persistent, persuasive and unrealistic. Mythology distracts us everywhere. – John Kennedy

Most buyers who implement Supply Chain Finance do so to support a term extension or term harmonization initiative and the results can be compelling. At PrimeRevenue, many of our clients have reduced their working capital by over $100M. Usually, buyers aren’t quite sure how to leverage SCF in their supplier negotiations and, unfortunately, most SCF solution providers don’t know how to use it either. These SCF providers have little experience working with Procurement professionals on supplier negotiations and usually recommend that term extension discussions take place on the basis of the rate arbitrage between the SCF rate and the suppliers cost of funds. For example, the buyer might say Supplier X, your cost of funds is 6%, the SCF rate we are offering is 3.5%. You will pay less to finance a 75 day receivable at 3.5% than a 60 day receivable at 6% so you should happily accept a 15 day term extension in return for access to SCF‰Û. I’ve participated in many supplier term extension negotiations over the course of the last 9 years and I can tell you that this approach will not succeed in meeting the buyer’s objectives except for the most financially distressed suppliers and even in those cases it can be problematic. This approach gives the supplier the impression that if they can demonstrate there is no value in SCF then they won’t have to accept the term extension. There are several issues with this approach, including:

1. The specific rate differential exists at only a single point in time. Supplier X may indeed have a cost of funds of 6% today and Supplier X may acknowledge this but it may not be 6% next month or next year. Suppliers always believe their business and the credit markets will improve so they think their cost of funds will be lower next year while the term extension is forever. This leads them to reject a term extension based on their current cost of funds which they believe will go down over time.

2. The Buyer opens themselves up to constant term re-negotiation. Linking the amount of the term extension to the rate differential implies that if the rate differential goes down then the supplier’s term will decrease. If next year the supplier’s cost of funds goes from 6% to 3.5% will the buyer rescind the 15 day term extension? The buyer does not want to be in the position of constantly re-negotiating terms based on the interest rate differential.

3. It puts the buyer in a poor negotiating position because the supplier will always have better information than the buyer about their own cost of funds. Negotiating from an information deficit is always sub optimal. The rate differential approach to negotiating term extensions gives the supplier the impression they can avoid the term extension if they can convince the buyer that SCF has no value and that they have a lower cost of funds than the buyer assumes. Even for public companies the supplier can point to some obscure financing vehicle as being cheaper than the SCF rate. In addition, suppliers may not consider all of the costs associated with their current financing arrangements. For example, often suppliers do not include many of the transaction costs associated with factoring or asset based lending.

4. It forces your Merchandising/Procurement team to become experts in corporate finance. They get dragged into discussions with the supplier’s finance staff about long term bond rates, commercial paper, asset based finance, factoring, balance sheet impacts, secured vs unsecured financing, etc.

5. The buyer winds up with a lower cash flow gain than an approach which negotiates payment terms based on business reasons customized to supplier characteristics and payment terms benchmarking. First, the rate differential approach eliminates term extensions for 40% – 50% of the supply base from the start. There will be little to no rate differential opportunity for suppliers with investment grade credit ratings That is generally about 40% – 50% of the supply base (by spend). Second, the rate differential approach generally uses the supplier’s cost of debt as the basis for the supplier’s rate. Some suppliers will value cash closer to their Weighted Average Cost of Capital (WACC) or their investment hurdle rate than their cost of debt and others will find significant value in other aspects of SCF financing (eg off balance sheet, next day financing, etc.). This is why half of the top 10 suppliers on our SCF platform (by early payment activity) are investment grade companies, including A and AA- rated firms.

Buyer’s need to use a much more sophisticated approach than rate arbitrage when using SCF to support a term extension initiative. The rewards will be compelling.