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I am a CFA and FRM Charterholder. I used to work as a Portfolio Implementation Manager for Aviva Investors managing £3bn+in Assets Under Management in the UK. I am very passionate about educating people on how they can make more money with their existing investments sustainably.
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In this series, we cover all instruments, schemes and products in the alternative investment space available for Indian retail investors.
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Invoice Discounting (ID) is a popular unregulated alternative investment in the fixed income space, with recent innovations like Bank Guarantee (BG) structures offering more secure, risk-adjusted returns.
A Bank Guarantee is an enforceable commitment by a bank to honor a payment if the buyer defaults, providing security to sellers and investors in invoice discounting deals.
The process involves the seller delivering goods on credit, the buyer's bank issuing a bank guarantee, and the seller assigning the BG to an invoice discounting platform, which controls an escrow account for payments.
Risks in bank guarantee-backed invoice discounting include fraud, operational errors, and bank financial strain, though due diligence by platforms can mitigate these risks.
Companies use bank guarantees to secure better trading terms and prices, making it a win-win for buyers, sellers, and investors, despite being an unregulated instrument.
Invoice Discounting (ID) is still one of the most popular unregulated alternative investments in the fixed income space. We wrote a detailed article on ID last year in July 2023, and since then, a lot has happened with the product, including a couple of defaults on some major platforms like KredX, altGraaf, and others, hurting investor sentiment.
Some platforms have actively innovated to bring secured structures within invoice discounting, which offer a slightly lower yield than the unsecured structures but provide superior risk-adjusted returns. Most of these structures use either a Bank Guarantee or Trade Credit Insurance to reduce risk. The leader in bringing these structures to retail investors at this stage is altGraaf, so we will use their examples to discuss the different structures available to retailers.
In this article, we will be discussing the Bank Guaranteed structures and will write another one on Trade Credit Insurance. This is to ensure the article doesn't become too long.
To write this article, we had a quick call with a senior executive at altGraaf to understand the products and their nuances in depth.
The article assumes that you know about invoice discounting as an asset class. If you don't, it would be better to start by reading the tagged article first.
Bank Guarantee (BG) is an enforceable commitment or guarantee to honor a payment to the seller in case the buyer is unable to make the payment. Let's understand this with a simple workflow:
Buyer XYZ and Seller ABC agree to do business together, but Seller ABC wants financial security to ensure payment will be made a few days after supplying the raw materials. Buyer XYZ applies for a Bank Guarantee (BG) with their banking partner, who conducts an independent credit assessment of the buyer's financial statement and issues a bank guarantee with a specific sanctioned limit. The banking partner then provides this BG as security to the seller.
Seller delivers the goods/services to the buyer on credit and raises the invoice (“receivables”).
Buyer’s bank issues an unconditional and irrevocable bank guarantee to the seller (up to the sanctioned limit).
Seller assigns the bank guarantee to the invoice discounting platform and discounts invoices to investor(s) on the platform.
The ID platform takes control of the escrow account (designated account for all buyer repayments) to safeguard investors.
When the buyer makes a payment, it flows directly into the escrow account controlled by the platform. As per altgraaf, escrow control is an added protection and it may not be present in some deals on the platform. In the worst-case scenario of default, the platform invokes the bank guarantee with the bank to recover the amount.
Here is a simple workflow by altGraaf to show how the transaction works.
These types of deals currently offer anywhere between 10% - 11% on altGraaf, and while the structure mitigates most of the risks, some still exist, such as:
Fraud Risk: The buyer might have used forged documents to secure the bank guarantee, and in this case, the bank may pull the guarantee.
Operational Risk: Genuine errors in documentation, communication, or processes may lead to claim rejection.
Bank Risk: The possibility of the bank coming under financial strain and being unable to honor the BG. In reality, this risk is very low.
The platform's due diligence should essentially address all these risks and bring vetted buyers and sellers onto their platform.
Please click on the question to read the answer.
To write this article, we had access to a bank guarantee document from an industry source. We can't share that with you due to confidentiality reasons, but we have tried to cover all the relevant points from it in this article.
Well, obviously, the buyer who applies for the bank guarantee has to pay a premium to the bank for it and submit a lot of paperwork, so what motivates them to do this?
Lets understand this with a simple example:
Suppose the buyer is a mid-sized player wanting to work with a large seller, but the seller doesn't trust the buyer yet. So, they ask the buyer to get a bank guarantee at their own cost. The buyer agrees because they will get better trading terms, like better prices and access to raw materials. The seller is happy because they have a guarantee of payment and can get their invoice discounted at cheaper rates, like 11% instead of 15%.
So that makes it a win-win for everyone in the ecosystem including the investors who get to finance a secured structure.
In conclusion, Bank Guaranteed Invoice Discounting offers a more secure structure for investors seeking to mitigate risks while still achieving attractive returns. By leveraging bank guarantees, platforms like altGraaf can provide a safeguard against defaults, making it a decent option for those interested in fixed-income investments. While there are inherent risks, thorough due diligence by the platforms can significantly reduce these, creating a win-win scenario for buyers, sellers, and investors alike.
With that being said, I would still like to highlight that even this secured structure is still an unregulated instrument from the SEBI/RBI perspective, so invest according to your own due diligence and risk appetite.
In the next article, we will talk about the specifics of Trade Credit Insurance with a similar flow, discuss the specifics, risks, and why companies take the hassle of getting them.
That's it for this one. If you find this article helpful, please like it and share it on social media so our blogs get promoted more on Google searches. If you would like to join our India's first and largest community on alternative investments, you can apply here.
Please note that this is an opinion blog and not official research advice. I am not a registered RIA/RA in India. This blog aims to promote informed decision-making and does not discourage you from investing in any deals.
We plan to come up with more blogs discussing different types of instruments available in the world of startup investing, write on due diligence for some platforms, and also existing and upcoming alt investment deals in the Indian market. If you want to stay updated on the latest blogs, please subscribe to our newsletter so you get notified automatically.
