Supply Chain Finance & Portfolio Investors – Where are we now?

A truly well-diversified portfolio that outperforms the market is a sweet spot to which many investors aspire but is hard to achieve consistently for the vast majority. The job becomes even more challenging when markets start whipsawing between strong bull and bear signals, never mind the added challenges of powerful, unexpected forces such as Covid-19.

The debate around central banks' ability or willingness to significantly raise interest rates in 2022 is intensifying, with many observers believing government bond yields are likely to remain negative in real, inflation-adjusted terms for years to come. Nevertheless, given rising inflation, it has become harder for central banks to further ease monetary policy. Meanwhile, a wall of money continues to circulate around the global financial system in search of yield and superior returns.

Bonds and bond-like returns are a core component of a traditional, diversified portfolio. The low or negative real yields available from government and corporate bonds is driving a growing pocket of investors to seek alternative proxy strategies that generate the regular income stream their portfolios need. One such proxy are so-called trade finance investment strategies, which tick the boxes of providing a regular income stream, decorrelation to traditional markets and low volatility.

Trade finance has historically been the specialist remit of banks, who use their proprietary capital to finance trade transactions for their corporate client base. Access by portfolio investors to this attractive and established asset class has historically been limited for a number of reasons, namely the lack of an operational infrastructure to identify and process suitable investments. As a result, the trade finance asset class is still viewed as an "alternative investment" strategy by most portfolio investors and has some way to go before it becomes mainstream. Avantgarde portfolio investors, however, are moving fast and taking advantage of the new operational and processing infrastructure now offered by pioneering fintech companies. This is dramatically broadening the set of investors able to invest in SCF.

Many types of financing fall under the trade finance umbrella. Supply chain finance (SCF) is the largest segment by volume, amounting to US$26.6bn in 2020 according to S&P-owned Coalition and making up well over half of global trade finance revenues, as research by Oliver Wyman indicates. The size of the SCF segment, coupled with strong demand from corporates, is now attracting a new wave of fintech-enabled investors.

In essence, SCF is a form of short-term lending to corporate buyers. It enables corporate buyers to pay their suppliers early, resulting in improved working capital positions for both buyer and supplier. The supplier gets earlier access to cash, and the buyer benefits from increased flexibility to allocate capital where it's most needed in its business. The lender's role is to pay the supplier earlier at an agreed discount. The lender is then paid the full amount by the buyer at a later, agreed date. The discount reflects the return generated by the lender.

With current tightness in supply chains, cash is king and there is stronger demand than usual from corporate buyers for SCF solutions. For corporate buyers, being able to pay suppliers earlier ensures stronger and more reliable supply chains. This leads to higher quality revenue growth. SCF sectors currently favoured by investors include hardware distributors, electronics and FMCG. These are sectors experiencing strong demand and showing strong credit records.

How can portfolio investors access SCF?

Supply chain finance is undergoing intense disruption as a result of fintech innovation. Fintech has seized the opportunity to create digitalised, safe and scalable ways for portfolio investors to access SCF, in contrast to the old, largely paper-based traditional methods requiring large human resources. Three main factors have been supporting portfolio investors to access SCF more easily.

First, the Basel III rules require banks providing trade and supply chain finance to hold higher amounts of regulatory capital than previously. This has led a number of banks to reduce or close their trade finance activities and continues to exert restrictive pressures on banks' trade finance activities. This reduction in the supply side has worsened the global trade finance gap, a gap that has been growing steadily year on year. In contrast, portfolio investors are not bound by Basel III requirements. Entering SCF when the sector is currently under-supplied places portfolio investors in a strong position to cherry-pick the better deals to finance.

Second, the advent of SCF platforms is making it much easier for investors to identify suitable SCF investments thanks to streamlined and in-built investment matchmaking features. Platform solutions such as Finverity's act as aggregators of investment deals. Corporates publicise their financing requirements, and investors are able to review the different yields and terms on offer to identify mutually suitable matches. This platform model is an essential step towards increasing the volume and diversity of deal flow. This in turn generates the liquidity needed to attract larger investment flows. As the variety of SCF deals available on platforms increases, the diversity of investor profiles rises in tandem. Depth and variety boost liquidity.

Third, fully digitalised operational infrastructure is now available for investors to transact in SCF efficiently, reliably and transparently. Finverity's platform enables end-to-end client onboarding, due diligence, and operational processing. Integrated risk management is also available to actively increase or reduce exposure in real-time.

The growth of SCF into a mainstream alternative asset class for portfolio investors is showing promise, and we predict steady growth as investors gradually become more familiar with its modus operandi. The example of the trading infrastructure required for bonds and equities comes to mind. A massive trading infrastructure was honed and refined over decades, moving gradually from paper-based to electronic systems, in order to provide the depth and liquidity required by investors. The difference today is that much faster technology development times are leading to digital SCF trading infrastructure being developed in a fraction of what legacy trading systems took to evolve.

What yields and quality of returns can investors expect from SCF?

Depending on the geography, size and business sector of transactions, a wide range of yields are currently being generated by SCF portfolio investors. In developed markets, a yield of 4-6% is currently being generated, rising to high single and lower double digits in advanced emerging markets. Finverity specialises in serving mid-market corporates in emerging markets, one of the largest, fastest-growing and most under-served sectors in SCF. Investors who choose to access emerging markets through Finverity's platform benefit from the best of both worlds: higher yields available in emerging markets and the transparency, risk management and due diligence that a sophisticated platform provides. One of Finverity's core markets at present is the UAE, which boasts strong demand for SCF and high levels of regulation whilst generating high single-digit yields on average.

Portfolio investors would do well to consider as well the returns being generated more broadly in trade finance strategies. The Eurekahedge Trade Finance Hedge Fund Index returned 6.82% per annum from the end of 2009 to June 2020, outperforming both its fixed income counterparts and global investment-grade bonds, which returned 5.43% and 2.58% per annum respectively. The high-yield bond markets generated a marginally lower annualised return of 6.58% over the same period, weighed down by the rout in the sector following the escalation of the Covid-19 pandemic in the first half of 2020.

In addition to real yields, investors in SCF are attracted to the low correlation and low volatility on offer. The Eurekahedge Trade Finance Hedge Fund Index shows correlation values of 0.20, 0.36 and 0.41 against the three above-mentioned indices for the same period.

Supply chain finance furthermore offers a safe and stable investment universe. Data by the International Chamber of Commerce in September 2021 showed that default rates on common trade finance deals remained extremely low in 2020 despite the economic effects of Covid-19 — with impairments registered on less than 0.3 per cent of all transactions globally.

​​Which are the main investor groups in SCF?

The types of investors currently tapping into SCF fall into three main categories.

First are the alternative asset funds with a flexible investment remit and able to deploy capital to a range of strategies. These types of investors generally look to allocate capital directly via a platform. These include specialist hedge funds, multi-asset managers and private credit specialists. Within this category, we also find pockets of specialist family offices, typically those with an industrial and corporate owner background who understand supply chain finance from the inside and readily recognise the value of investing into it as portfolio investors.

Second are the institutional fund managers who need to deploy allocations in the tens of millions of dollars, given the size of their assets under management. Achieving sufficient diversification across investments is fundamental for these investors. In order to meet their end investors' objectives, they are likely to require deploying capital across a number of SCF platforms and appoint specialist sub-funds to manage part of their portfolios.

The third group comprises banks that use platforms to access a wider number and variety of corporates. This trend speaks to platforms' growing distribution power. Platforms enable corporates to access a range of banks and to do so through a single operational and transaction point, rather than dealing with each bank's different transaction management processes. This creates a much more level and efficient playing field between bank and borrower.

Up until now, investing in SCF was not a straightforward or seamless path for portfolio investors. This was largely due to the lack of appropriate operational infrastructure and the difficulties in identifying a suitable investment universe. The advent of sophisticated and transparent platforms is rapidly changing the previous dynamic. Platforms that seamlessly connect the various entities along the transaction chain are providing the infrastructure required for SCF to grow into a much larger asset class. As the SCF investment sector continues to grow, working with the best in class platforms will be essential to producing strong returns.

"Fintech is finally enabling a larger group of investors to access SCF and the benefits it offers positive real yields, low volatility and low correlation.”

Viacheslav Oganezov, CEO and Co-founder, Finverity