Letter number 8 of July 2005
- QUESTIONS & COMMENTS
So, the act of selling, which traditionally brings together two parties, the seller and the buyer, gives rise to a receivable when it is payable by a given date. In the case of factoring, this receivable, which recorded on an invoice, will be transferred by the seller to a third party – the factor. A contract is drawn up between the factor and its client (the seller), which sets out the terms for the provision of the following three services:
- A management service, providing administrative and accounting support in handling accounts receivable (book-keeping, recovery, collection, etc.)
- A guarantee against bad debts (commercial information, solvency guarantee)
- A financing function – selling accounts receivable to the factor results in quickly available funds, with no need to wait for customers to pay their invoices
There are two types of commissions that cover the cost of a factoring service:
- The factoring commission, which covers the management and guarantee services provided by the factor. This commission is a percentage of the amount of the invoice sold (VAT included), usually between 0.2% and 2%. The exact percentage is determined by various factors – the type and size of the risk taken on the customer base, the volume of bad debts and non-payment during the course of previous financial years, number of customers managed and number of invoices and credit notes submitted.
- The financing commission, which covers the advance provision of funds. This commission changes in line with the money market (3-month Eonia or Euribor) plus a percentage that may be as much as 2.5%.
Over recent years, the factoring sector has become highly competitive and factors have had to cut their margins. This has forced them to focus on the quality of the services they offer (easy-to-use web sites) and on the diversity of customised offers, rather than on price. They are seeking to win the trust of companies that are economically sound, in order to improve their image with corporate executives and to increase their market share.
How things have changed! To think that not all that long ago, factoring was a last resort for companies experiencing difficulties in obtaining financing. Such companies obtained financing on the basis of the factor’s assessment of the risk on the final customer, and not on the company itself. The company did however pay a high cost for this financing.
Today, with falling costs, it's not just companies in financial difficulty that are making use of factoring. Factoring has become a tool that provides the company with the possibility of financing its operations in on a regular basis.
Factoring enables the company to recover its receivables in advance, which provides it with more cash and reduces its short term debt.
The operation more or less eliminates the “accounts receivable” line item, improves the balance sheet, and results in lower accounting leverage (debt to equity). Analysts who know their stuff will however adjust the balance sheet to measure the company's sales policy. Also, under IFRS, deconsolidation is only allowed if the sale of receivables is none recourse against the seller.
Factoring is an efficient way of freeing up working capital.
The financing, which can be for as much as 90% of the value of the invoices sold, is constantly in line with the change in sales and provides the company with the cash it needs to expand, even in cases of high growth.
This technique is particularly well suited to companies that are not involved in very seasonal activities and do not record major changes in inventories from one month to the next. Service providers, which need to pay their staff's salaries every month, find factoring very useful. Even though a company sells its receivables on a recurring basis to meet its short-term financing needs, factoring provides it with financing on a permanent basis. The company can even use factoring to generate working capital, which will give it greater negotiating power with its suppliers (discounts for cash payment).
A 2003 survey of 1,350 companies employing between six and 500 people, carried out by the Institut Louis Harris, came up with the following statistics for the way companies manage their accounts receivable:
The average payment period for accounts receivable generates a large inter-company credit, which results in financial costs for companies. Furthermore, one quarter of bankruptcies can be attributed to bad debts. This is why factoring looks like a way of controlling risks on accounts receivable. It provides the business with protection, through guaranteed payment of receivables, and enables the company to keep control of its margins.
In practice however, although the financing role of factoring has proved to be very effective, the quality of the recovery and collection services provided by factors does not always quite meet client expectations. Factors are thus going to have to get better at meeting the specific requirements of their clients and of the final customer. It would also be a good thing if factors could be more efficient and if there were more transparency in their relationships with their clients. Leveraging new technologies could help them achieve this.
To conclude, factoring can be considered to be of a structural nature. Companies use factors as a means of permanent financing and to optimise management of their trade receivables.
Source: “The ultimate ownership of Western European corporations”, M. Faccio, L.Lang; Journal of Financial Economics; 2002. Study based on 5232 listed companies in 13 countries
The figures in this table are correlated with how long it has been since the economy moved from a debt-based economy to a financial-market economy. Unsurprisingly, the UK, whose financial market continued to expand after the second world war (unlike France’s, which lost its macroeconomic importance), has the most widely dispersed shareholders.
In the Eurostoxx 50 very few firms have a controlling shareholder we have nevertheless spotted the followings :
LVMH, family owned,
L’Oréal held at 27% by the Bettencourt family and 27% by Nestlé
Olimpia holds 21% of Telecom Italia
The French State owns c. 41% of France Telecom, the Italian State 30% of ENI and 32% of Enel and the German State 23% of Deutsche Telekom
Regional banks (Caisses Régionales) 52% of Credit Agricole
For more information, see chapter 41 of the Vernimmen.
Since the legal environment and corporate governance in a given country will limit any such friction to greater or lesser degree, it is likely that they will have a major impact on M&A activity in the country. Two researchers from the London Business School (1) studied the validity of this assumption on a sample of 45,700 M&A deals between 1990 and 2002 in 49 countries.
Relying on the work of La Porta, Lopez-de-Silanes, Shleifer and Vishny (2) on the international comparison of financial governance systems, the authors look at the influence of the level of shareholder protection and the quality of accounting and financial information on M&A activity in the 49 countries studied. The authors analyse five determinants of M&A activity in each country – total volume, volume of hostile bids, percentage of cross-border deals, level of acquisition premium and payment methods used. They obtained the following results:
- There is a strong correlation between the volume of successful acquisitions in a country, measured as a percentage of listed companies that were targets in successful acquisitions, and the quality of the accounting and financial information, the quality of shareholder protection and the level of shareholder concentration in the country in question.
- By studying acquisitions that were considered to be hostile, the authors find that the main results previously obtained are confirmed. Better quality financial information and higher levels of shareholder protection are associated with a larger number of hostile acquisitions in the country. Contrary to previous findings, concentration of the shareholder base no longer plays a major role in encouraging hostile takeovers.
- The number of cross-border takeover bids as a percentage of all acquisitions is higher in countries where the quality of accounting and financial information is poor, and where there is less investor protection. Additionally, if we look at the country of origin of the buyer and that of the target in a cross-border takeover bid, we note that disparities in the quality of financial information and disparities in shareholder protection are major drivers behind these deals. What happens is that companies in countries where high quality corporate governance is an entrenched business practice tend to take over companies in countries where corporate governance has not yet been established.
- Acquisition premiums are higher in countries which offer better shareholder protection. The reason behind this is the greater competition among buyers in the country, combined with a more diffuse shareholder base, requiring higher returns.
- The preferred form of payment for an acquisition in a country providing low levels of shareholder protection is cash. Payment in shares is more frequent in countries providing the best shareholder protection, since there is a low risk of minority shareholders being expropriated. In cross-border mergers, payment in shares is an indication of high levels of shareholder protection in the acquirer's country.
All of these results are in line with the principles of agency theory (3), according to which the personal benefits and perks that individual managers enjoy through their control over a company (possibilities of expropriation, extravagant expenses, etc.) are generally fewer in countries where levels of shareholder protection are high, than in countries which afford shareholders little protection. Following a takeover, the manager of the target is generally required to relinquish control over the company and make way for the new owners. It follows that in countries where shareholders enjoy high levels of protection, the target’s management will not be as reluctant to handover control of the company, and will not demand as much financial compensation, since they will be giving up fewer personal advantages. Accordingly, it stands to reason that the M&A market will be more fluid in countries offering better shareholder protection.
Similarly, rules governing the disclosure of financial information are of particular importance when it comes to planning takeover bids, especially unsolicited or hostile bids. In such cases, figures disclosed in the published accounts of companies are the only source of information that can be relied on for identifying targets and formulating a bid.
The principles of agency theory also go some way to explaining cross-border acquisition flows. Companies in countries affording shareholders better protection have access to cheaper financing, which facilitates their acquisitions and enables them to persuade the target's shareholders to accept payment in shares rather than in cash. The target’s shareholders end up better off and it would appear that the buyer exports its country’s good corporate governance practices to the target.
In the light of these results, the authors show that cross-border M&A activity is fostering the worldwide convergence of systems of corporate governance. What appears to be happening is that companies in countries offering shareholders better protection are gradually buying up companies in countries where the interests of shareholders are relatively less protected.
(2) La Porta R., Lopez-de-Silanes F., Shleifer A. and R Vishny, “Law and Finance”, Journal of Political Economy, December 1998.
(3) For more information, see chapter 32 of the Vernimmen.
During the 1950s, two very fertile areas for research were financial markets and corporate finance:
- In 1952, Harry Markowitz (1) developed his portfolio theory, by demonstrating mathematically that diversification was to the investor’s advantage, as it reduced risk for the same level of returns (or improved returns for the same level of risk) (see chapter 21 of the Vernimmen).
- In 1958, Franco Modigliani (1) and Merton Miller (1) opened up a field of research into corporate finance, by demonstrating that in efficient markets, there is no optimal financial structure that will minimise the cost of capital, and accordingly, maximise enterprise value (see chapters 33 and 34 of the Vernimmen).
Since then, huge strides forward have been taken, mainly in the field of capital markets, with a strong emphasis on mathematics, a result of the educational backgrounds of the researchers – Modigliani the economist and Markowitz the statistician.
- In 1964, William Sharpe (1) established that no portfolio is capable mathematically of beating the market, and that the return that should be required on any financial security is linked to the risk free interest rate and the market risk of the security via the famous Beta ratio, thus creating the capital asset pricing model (CAPM) (see chapter 22 of the Vernimmen).
- In 1970, Eugene Fama (2) demonstrated the efficiency of markets. Since all new information is immediately integrated into share prices, it is impossible to predict future share price movements (see chapter 15 of the Vernimmen).
- In 1972, Fisher Black (3) and Myron Scholes (1) introduced the formula used for valuing options which is named after them (see chapter 29 of the Vernimmen).
- In 1977, Richard Roll (2) proved that it was not possible to demonstrate that the CAPM was false, although working with Stephen Ross, he came up with a more general model, the Arbitrage Pricing Theory, which has not, as yet, really taken off (see chapter 22 of the Vernimmen).
In the late 1970s, the reintroduction of the human element into economic models that had turned out to be highly reductionist, opened up new avenues for research which have proved to be very fruitful:
- Signal theory, based on the work of Stephen Ross (2) challenges the premise that information is shared by all at the same time and at no cost. He shows that on the contrary, some financial decisions (borrowing, paying dividends, etc.) are not necessarily taken on the basis of their own merits, but in order to pass on new information to the market in a way that is credible (see chapter 32 of the Vernimmen).
- Agency theory is based on the work of Michael Jensen (2) and challenges the premise that the company is a black box in which all stakeholders are working together to maximise value for shareholders. Some financial decisions (borrowing, diversifying, whether to list, paying dividends, etc.) are not necessarily taken on the basis of their own merits, but in order to ensure as much overlap as possible of the interests of shareholders, managers and creditors (see chapter 32 of the Vernimmen).
- Finally, in the 1990s, behavioural finance showed that homo economicus, who constantly minimises and maximises everything, is a mythical figure. Behavioural finance looks at what impact the factoring in of the partial rationality of the individual has. Richard Thaler and Hersh Sherfin show that there are pockets of inefficiency, but that these are not deep enough for arbitrage gains to be made on a systematic and lasting basis. Well that certainly comes as a relief to us economists! (see chapter 15 of the Vernimmen).
(2) Deserves the Nobel Prize in Economics.
(3) Died too soon to be awarded the Nobel Prize in Economics.