LONDON  - Carillion’s collapse has laid bare a new form of bank folly. The failed UK contractor used lenders to finance hundreds of millions pounds of payments to suppliers when cash was running low. The process, known as “reverse factoring”, seems a lucrative way for banks to provide short-term credit. But insolvency exposes the true extent of the risks. Banks’ refusal to lend Carillion any more money pushed it into insolvency last Monday. Lenders including Santander UK , Barclays and Lloyds Banking Group are now facing minimal recoveries on the roughly 1.3 billion pounds they are owed. While much has been made of the British outsourcer’s debt, it was Carillion’s excessive dependence on a particular form of invoice financing that alerted investors to its plight.

To understand how reverse factoring works, first look at the technique from which it is derived. Factoring is a common financing method where a company sells an invoice it has issued to a customer to a bank, securing early payment in return for a small interest charge. It’s a popular way for smaller suppliers to get credit, because the bank is effectively lending to their often larger customers.

Reverse factoring turns this on its head. In this case, companies like Carillion use bank credit to pay invoices early. This allows suppliers to get paid within a few weeks, while the company conserves cash by not repaying the bank until later.

This arrangement only works as long as the company can repay the banks. In Carillion’s case, cracks started appearing when Carillion announced it would pay suppliers’ invoices after 120 days – an unusually long time. This pushed over 400 suppliers into the reverse factoring programme by 2015 according to the company’s annual report. This drove up borrowing through the facility. By June last year, Carillion was on the hook for an average of 412 million pounds.

Reverse factoring may look like a clever way for banks to earn a bit of extra margin in a low interest rate environment. But it requires companies to keep growing and eventually reduce their dependence on the technique, or a ready source of alternative financing if the banks pull the plug.

Carillion had neither. That should teach banks that, although they can make money from financing cash-strapped companies, there is a tipping point where clever financing can leave them facing a big loss. The end always comes sooner than expected.



CONTEXT NEWS

- Collapsed outsourcing company Carillion relied on an Early Payment Facility (EPF) which allowed its banks to pay suppliers before it was forced into liquidation on Jan. 15.

- The scheme, known as reverse factoring, reached an average total of 412 million pounds at the company’s half-year results last year, according to a company presentation published on July 10, 2017.



(Editing by Peter Thal Larsen and Bob Cervi)

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