All eyes are on the U.S. Federal Reserve as it attempts what many are calling a tightrope walk: raising interest rates just enough to slow the economy without triggering a recession in the hope of achieving an economic soft landing. With the Fed doing everything in its power to make borrowing costlier, factors are facing a similar balancing act. On one hand, the interest rate hike presents tremendous opportunity, but on the other, seeking to capitalize too quickly could spell trouble down the line. In particular, factors face a tremendous opportunity to expand their business in the face of a tightening traditional credit market that looks less and less attractive to potential customers. However, with increased business opportunity comes increased risk. In this environment, it is essential that factors spend time and resources shoring up their risk mitigation efforts.
The Current Inflationary Environment
Although target inflation is around 2%, inflation in June was at 9.1%, according to the Bureau of Labor Statistics Consumer Price Index (CPI), marking a four-decade high. As of October, the CPI was at 8.2%. The source of the current inflationary environment is multifaceted, but most agree that the confluence of COVID-19 relief — the equivalent of $3.8 trillion in new liquidity released by the Fed in 2020 — along with supply chain issues resulting from the pandemic and a labor shortage played a substantial role. In addition, the global uncertainty of the war in Ukraine has only increased inflationary pressures.
Regardless of the causes, there is enormous pressure on the Fed to act to reduce inflation back toward the 2% benchmark, primarily by raising interest rates. The Fed has done just that. Starting in March, it increased the benchmark rate by 25 basis points, marking the first time it had raised interest rates since 2018. It raised rates by 75 basis points in June and then by another 75 basis points in July and again in November. With inflation proving to be somewhat resistant to the Fed’s rate hikes, many are wondering how much more aggressive it can be and how long borrowing will remain costlier than it has been in decades.
How do Interest Rate Hikes Affect the Factoring Industry?
In a nutshell, the demand for alternative commercial financing, including the demand for factoring, should increase. As interest rates increase, bank lending requirements will tighten. Interest rates for traditional loan products, such as SBA loans, will increase, raising the overall cost to businesses. As COVID-19 relief runs out, business will be hesitant to take out new debt, while banks and other lenders will be looking to exit under-performing deals. Likewise, business borrowers will want to offload variable rate debt as interest rates continue to rise.
In all, this presents an excellent opportunity for factors because, notwithstanding the challenges described above, businesses still need capital. According to Fundera’s 2021 Small Business Lending Statistics and Trends report, 29% of small businesses fail because they run out of capital and only 48% of small businesses have their financing needs met. In addition, the report says that 70% of small businesses have outstanding debt, while 36% of small businesses that were denied credit were denied funding due to a poor credit profile. Bottom line: There is opportunity in the market. However, with this increased opportunity comes increased risk. Against the potential of increased demand for factoring arrangements comes the risk of potential recession, continued geopolitical tension, strained supply chains, labor shortages, continued competition from merchant cash advance companies, a slow recovery from the COVID-19 pandemic, decreased consumer spending due to inflation and a range of other uncertainties. The key, therefore, to taking advantage of this unique economic environment will ultimately come down to how individual factoring companies operate to mitigate their risk.
Renew Focus on Underwriting and Due Diligence
It is almost certain that factors who find success in this economy will be the ones who think creatively and critically about underwriting and due diligence. In particular, factors should calibrate their underwriting to account for underlying systemic risks in the global marketplace. What is the customer’s role in the global economy? How is the customer’s supply chain situated and how healthy is its product pipeline? Have you carefully scrutinized the payment history of the customer’s potential account debtors? How are you monitoring for threats to your security interests, such as MCAs? How well do you understand the customer’s business? Are there licensing requirements? Bonding requirements? How well do you understand the customer’s tax burden? For instance, a freight broker or forwarder is going to have vastly different industry requirements than a healthcare or medical company.
Factors that succeed in this economy will have a deep understanding of their customers’ business operations, and they will have the contractual means by which to obtain information. Your deal documents should give you the right to ask for and receive information about anything you want to know.
Place an Increased Focus on Monitoring
Information is key in the factoring space — now more than ever. Factors that find success in this economy will have systematic UCC monitoring. Indeed, if a factor has deal documents that allow it to obtain information at any time, that factor should be able to quickly respond to any changes or issues that might arise over the course of the deal. Likewise, because federal tax liens typically gain priority 45 days after the federal tax lien filing, or when the secured party learns about the filing, whichever comes earlier, recurring federal tax lien searches for your most high-risk customers is essential. Keep in mind, though, that your pool of high-risk customers is likely much bigger now given the volatile state of the economy.
Likewise, because businesses remain in need of capital, there is risk that MCA companies will obtain access to customer operating accounts and skirt factors’ security interests. Monitoring your customers for evidence of MCA agreements is paramount, and seeking quick legal remedies when you have discovered the existence of an MCA agreement is necessary in this environment.
Given the potential increase in demand for factoring arrangements, there is the associated possibility that factors will sign additional deals, leading to additional workload for things like invoice verification and fraud management. There are, however, sophisticated statistical methods, regression analysis tools and red flag signals that factors can utilize to identify potential fraud. For instance, is there a large influx of new account debtors? Are you seeing 90-day terms where there used to be 30-day terms? Has there been a sharp increase in sales volume? In addition, factors should always perform KYC/AML checks and should continue to monitor longer-term deals for changes that might implicate the AML analysis.
The key — as with all of these risk mitigation tools — is information. Have you structured your deal so that you have the ability to obtain relevant information from your customers? Do you have the ability to analyze your customer’s business history so that you have benchmarks in place that allow you to act early when you see red flags?
Shore Up Compliance
Finally, for factoring companies operating in the United States, now is the time to bolster your compliance operations. There is a trend of increasing consumer-style regulation in the commercial lending and commercial finance space. Whether it’s new TILA-style disclosure laws, Dodd-Frank 1071 or the applicability of additional state licensing regimes, regulators and legislators no longer assume that business owners are sophisticated enough to render regulations unnecessary. Successful factoring companies will dedicate time and resources toward making sure that they have a competent compliance arm that is prepared to operate in the often fast-moving world of government regulation and compliance.
Republished with permission. This article, "Walking the Tightrope: How to Capitalize on Interest Rate Hikes Without Setting Yourself Up for Failure," was published by Commercial Factor on November 16, 2022.