A ticking time bomb in the corporate books?

British consulting services firm Carillion, Spanish engineering firm Abengoa and UAE healthcare supplies provider NMC Health might not seem to have much in common, but they actually share three important similarities:

1. They were once all publicly traded multinational corporations that employed tens of thousands of people and sported market capitalizations in the billions of dollars.
2. They have all filed for bankruptcy within the past five years, defrauding their employees and shareholders in the process.
3. And most importantly: all of their disappearances involved unmanageable debts hidden by a controversial accounting trick known as reverse factoring.

NMC Health is the most recent, and perhaps most visible, reverse factoring implosion. The company’s market capitalization fell from nearly $6 billion to next to nothing in December after short seller Muddy Waters Capital released a report accusing it of improperly funding itself and hiding hundreds of millions of dollars. dollars of debt through this technique.

Abengoa and Carillion met similar fates, having filed for bankruptcy in 2015 and 2018, respectively, after being exposed to hiding hundreds of millions of dollars in bad debt through reverse factoring.

More recently, rumors have surfaced that these unscrupulous practices may be far more widespread than previously thought and that several large multinational financial institutions have aided and abetted them in businesses around the world.

But before we look at these developments, let’s answer some more fundamental questions. What exactly is reverse factoring? Why is it such a dangerous tool in the hands of unscrupulous accountants? And how can you spot it when doing stock due diligence?

Like any good act of accounting chicanery, reverse factoring relies on its highly technical and somewhat boring nature to fly under the radar of investors, regulators and journalists.

What is reverse factoring?

In order to define reverse factoring, we should probably start by defining usual factoring.

Many businesses, especially those that provide wholesale goods and services to other businesses, frequently receive large orders from customers who pay in installments over a long period of time.

Factoring involves selling these unpaid or partially paid customer invoices to a third-party financial institution at a slight discount. This third-party institution can collect the full invoice value from the customer while the factoring company receives immediate cash payment without having to worry about collections.

Reverse factoring it’s when a company uses a similar type of informal financing process to reimburse its suppliers, rather than collect outstanding invoices from customers.

A company that engages in reverse factoring asks a third-party financial institution to pay its invoices to its manufacturers or wholesalers in advance with a slight discount, and then reimburses that financial institution in full over time. The financial institution can then bundle these unpaid bills into securities and sell them to other investors, just like any other type of debt.

The technique is popular for companies with complex supply chains, as it often allows them to borrow money for their operations at a lower interest rate than conventional debt would provide. And, perhaps more importantly, accountants do not classify reverse factoring liabilities as debt, but rather as operating costs.

How out-of-control reverse factoring can destabilize a business

Herein lies the potential for abuse of reverse factoring by spendthrift companies.

This technique allows malicious actors to borrow huge sums of money and hide these borrowing costs in the “other liabilities” section of the company’s balance sheet rather than listing them as debt, which distorts the company’s debt ratio and credit utilization ratio.

In the cases of NMC, Carillion and Abengoa, these hidden liabilities ultimately led to collapsing cash flows, insolvency and forced liquidation. But investors had no idea anything was wrong until these companies were unable to pay their bills because they were looking at the wrong part of the balance sheet.

As if the practice wasn’t shady enough, a tangled web of interdependent financial institutions is today promoting it around the world and lining their pockets in the process…

Why reverse factoring is spreading and how to protect your portfolio

At the center of this tangled network is a British specialist financial firm called Greensill. This SoftBank-backed startup provides reverse factoring services, and it once counted NMC and Abengoa as its biggest clients.

Greensill also securitises and sells liabilities created by its operations.

In 2017, the startup joined Swiss credit (NYSE:CS) to launch a multi-billion dollar fund made up almost entirely of these reverse factoring securities. SoftBank, in addition to backing Greensill, is one of the biggest investors in this fund, having invested more than $500 million in it.

Does this seem like a conflict of interest to you? Because it certainly is. SoftBank is essentially buying its investment in Greensill by creating a market for its dodgy reverse factoring securities by investing in the Credit Suisse fund.

But that’s not even the worst.

Since SoftBank invested in Greensill, the finance startup primarily offered its reverse factoring services to other companies in which SoftBank has invested. In fact, Greensill’s marketing materials reveal that it has provided nearly $1 billion in funding to just four SoftBank startups – two of which, auto startup Fair and hotelier Oyo, are already in financial dire straits.

In other words, SoftBank is artificially exploiting Greensill by helping it pump its other portfolio companies (including several large, well-known tech stocks) full of potentially unaffordable reverse factoring liabilities, then buying and profiting from the created securities. by these dangerous transactions.

This complicated circular relationship has not only implicated SoftBank and Credit Suisse in extremely unsavory self-dealing practices.

It also fueled fears that many large SoftBank investments, like Uber (NYSE: UBER) and Soft (NYSE: WORK), may have huge previously invisible debts that have been hidden from investors through Greensill’s reverse factoring services.

How can you spot this dangerous process when performing due diligence on your own investments?

A sign that a company may be engaging in irresponsible borrowing through reverse factoring is a strangely large year-over-year jump in the “accounts payable” or “other payables” line items on its balance sheet , indicated by the number highlighted in blue in the example below.

Source: Investopedia

As we discussed earlier, this obscure post is where the burdens of debt created by reverse factoring lurk. So if it suddenly doubles or triples year over year and the company can’t explain why, then be prepared for the possibility that it could become the next victim of SoftBank’s reverse factoring scheme. and Greensill.

Only time will tell how widespread this convoluted but nefarious funding system is or how many more NMCs or Abengoa it might bring down.

But as Daily Wealth reader, you are among the first individual investors to be made aware of this potential threat. And if it does indeed cause more damage to the stock market in the months or years to come, hopefully this knowledge will help you stay ahead of the game.

Until next time,

Samuel Taube

Samuel Taube brings years of experience researching ETFs, cryptocurrencies, cash bonds, value stocks and more Daily Wealth. He has been writing for investment newsletters since 2013 and has written articles accurately predicting financial market reactions to Brexit, the election of Donald Trump, and more. Samuel holds a degree in economics from the University of Maryland, and his investing approach focuses on finding undervalued assets at each stage of the business cycle, then reaping big returns when they do. straighten up. To learn more about Samuel, Click here.

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