Receivables at Work 

Corporate Finance

Receivables at Work

Securitization of trade receivables has become more accessible and can improve a company's working capital.

FROM: MAY-JUN 2005 ISSUE | BY ANDY DAYES

Accounts receivables (AR) securitization is a process in which a company's AR are sold to a trust in return for cash, typically on a revolving basis. This process has long been a preferred funding mechanism for large blue chip companies such as Shell Canada, Maple Leaf Foods, Canadian National, and Alcan, to name a few. AR securitization offers:

• reduced funding costs;
• an increased advance rate against receivables compared to a bank line;
• lower capital taxes where applicable; and
• a reduction in capital investment employed without reduction in operational capacity.

Since the securitization process results in a true sale of assets, there is generally a corresponding removal of those assets from the balance sheet. The company securitizing its AR — the seller — benefits from increased financial flexibility, as capital previously used to finance receivables can be re-invested in other corporate priorities.

But over the past few years, securitizations have become more difficult to structure than in the past, primarily as a result of new accounting guidelines introduced in response to the abuse of off-balance sheet funding techniques cited in high profile corporate failures such as Enron. At the same time, new structuring techniques have broadened the base of companies for which securitization is now an attractive option.

Dramatic Changes

The structuring of a successful securitization relies heavily on the input and judgment of accounting practitioners. Two accounting guidelines, AcG-12 and AcG-15, implemented over the past few years have significantly changed the way in which securitizations are structured.

AcG-12 – Transfers of Receivables

AcG-12, adopted in March 2001, lays out the criteria that determine whether a sale of receivables into a securitization vehicle qualifies as a true sale for accounting purposes and, thus, whether sold AR may be removed from the seller's balance sheet.

Prior to the adoption of AcG-12, the primary test for determining true sale status was that recourse to the seller could not exceed 10 per cent of the AR sold. Under AcG-12, the level of recourse to the seller becomes irrelevant. The criteria now revolve around the issue of who has control over a receivable once it has been sold. AcG-12 prescribes three main tests which an AR sale must pass before it can be confirmed as a true sale for accounting purposes:

1. Is the seller insulated from the receivable by selling it?
   • A legal "bankruptcy remoteness" opinion is necessary to confirm the reasonable probability that ownership of the receivable would not be affected by the potential subsequent bankruptcy of the seller.
2. Does the buyer have the unencumbered right to pledge or resell the receivable?
   • The seller cannot impose any conditions on the buyer's subsequent use of the receivable.
3. Has the seller retained effective control of the receivable by, for example, having the right to reacquire it by means of a call option?
   • Other than a clean-up call enacted at the end of a facility's life, the seller cannot retain the unilateral right to reacquire specific receivables.

AcG-15 – Consolidation of Variable Interest Entities

In response to the outcry from public and governmental bodies after Enron imploded, the Financial Accounting Standards Board in the United States adopted FIN 46, which provides an interpretation of GAAP related to the consolidation of assets sold to securitization conduits — sometimes referred to as variable interest entities (VIEs).

The ramifications of FIN 46 and its Canadian counterpart, AcG-15, are far-reaching. Prior to AcG-15, which came into effect November 1, 2004, a corporation could set up a special purpose entity (SPE) and sell assets to the SPE, taking the assets sold off the corporate balance sheet. In a post-Enron world, there is far greater emphasis on a corporation consolidating assets sold if it remains the prime beneficiary of that sale. The rationale is to preclude corporations from employing off-balance sheet funding mechanisms to hide potentially risky assets or business lines from investors or regulatory authorities.

At its most basic level, AcG-15 operates under two premises:

1. In any sale of assets to a funding vehicle, one party must deemed the prime beneficiary.
   • The rule of thumb is that any organization originating more than 50 per cent of the assets in the VIE is the prime beneficiary.
2. The prime beneficiary must consolidate the VIE.
   • For providers of securitization, the ongoing challenge created by AcG-15 is to ensure that corporations selling into a VIE will not have to consolidate.

Since one of the significant benefits of securitization is the ability to take assets off the balance sheet, any improvements in return on assets, return on equity, return on capital, etc. will typically be negated by consolidation. Consolidation may also have important implications for a company's other debt arrangements.

The implications created by AcG-15 for new and existing structures are still evolving. Securitization conduits can be classified as single-seller (that is, an SPE that has been created solely for the use of one company) or multi-seller (such as the securitization vehicles run by large broker/dealers in Canada and the United States). For multi-seller conduits, ACG-15 requires that all sellers into a VIE must each comprise less than 50 per cent of the total assets or risk consolidation.

For multi-seller conduits where this may not be the case, one potential solution is for the VIE to acquire other assets such as Treasury bills or other high-rated short-term investments to the extent that each seller then comprises less than 50 per cent of the assets. Of course, this adds extra cost to the structure. For single seller conduits, the extra costs of AcG-15 compliance may make the securitization exercise uneconomic.

Increased Accessibility

Traditionally, there have been high barriers for companies wanting to securitize, as sellers have typically had to have at least $100 million of AR available for securitization, and have had to carry an investment grade rating from a nationally recognized credit rating agency. Companies with concentrated customer bases and those with a large percentage of AR outside Canada have been excluded from participating in securitization.

That situation is swiftly changing as corporate finance firms use innovative approaches to address the funding needs of companies that do not fit traditional structures. These new facilities have been designed to accommodate:

• non-investment grade sellers;
• sellers with concentrated customer bases; and
• sellers with a large percentage of U.S. receivables and/or U.S. operations.

Best Candidates for Securitization

Most healthy wholesale companies with AR balances of $50 million or more could consider AR securitization. Best suited are companies with a broad customer base in North America, modest losses, and relatively low levels of write-offs relating to credit notes and customer disputes. Manufacturers and distributors of hard goods are typically good candidates, as are some contract service providers. It is essential that a company have strong administrative systems, credit, and collections practices in place to participate in an AR securitization.

One such company, Magellan Aerospace, recently implemented an AR securitization facility. Treasurer Steve Groot says that the aerospace manufacturer "adopted AR securitization in order to reduce the cost of borrowing and to decrease the company's investment in working capital including paying down some of our debt."

Another company in the IP telephony business chose AR securitization as part of a comprehensive re-financing of its entire balance sheet. The company's CFO explains the rationale: "We were seeking to reduce our costs for funding working capital, preferably while increasing the advance rate we received on our receivables compared to our existing banking facility," he says. "While traditional banking facilities often encumber your entire asset base, with a securitization facility we were able to free up other assets to enhance our overall borrowing capacity."

Since these two companies operate in both Canada and the United States, they benefit from securitization through the ability to:

• fund in the currency of the invoice;
• fund AR originated by U.S. subsidiaries, regardless of the percentage U.S. receivables comprise; and
• expect payment within 48 hours after securitized invoices have been issued.

Summary

The benefits of AR securitization are now available to more companies than in the past. By incorporating AR securitization into its capital structure, a company can reduce the cost of funds, maximize liquidity, increase financial flexibility, and dramatically improve operating and capital efficiencies. The challenge before accountants, lawyers, and corporate finance professionals is to structure financial vehicles that comply with AcG-12 and AcG-15 while still delivering the core benefits offered by securitization.

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Andy Dayes (adayes@efficientcapital.ca) is managing director and co-founder of Efficient Capital Corporation in Toronto. Elements of this article appeared in the October-November 2004 issue of Canadian Treasurer magazine.