Summary

Excerpted from "What Every Lender Needs to Know About Working Capital Lending"

Collateralizing a Working Capital Loan Portfolio

The proper way to collateralize a working capital loan portfolio is to tie the portfolio to short-term collateral. This is true regardless of whether it is a line of credit or an accounts receivable purchase transaction. Collateralizing a working capital portfolio in this way ensures that liquidity of the collateral is at its highest and its value most certain. Lenders should therefore secure their working capital loans with liquid collateral and support the overall customer relationship with longer-term collateral as ancillary collateral to the transaction.

Before securing working capital loans with short-term collateral such as accounts receivable, however, a lender must ensure the following, pre-funding:

• The receivable is "real" — Verification
• The information on the receivable is accurate — Validation
• The entity paying the receivable is creditworthy — Credit Evaluation

The implementation of the pre-funding verification, validation, and credit evaluation would need to be automated as much as possible so as not to become an administrative nightmare for the lender. Therefore, a flexible system set up with manual and electronic pre-funding verification, validation, and credit evaluation methods would need to be used.

Additionally, an invoice-specific system would need to be used to enable verification, validation, and credit evaluation to take place at the individual invoice level since each receivable is a separate piece of commercial paper with its own defined characteristics. Such a system must be able to read the invoices in electronically so as not to burden the lender with such administrative processes.

Unlike a batch system, which provides no real security since the lender has no visibility into the individual pieces of the commercial paper that make up the batch, an invoice-specific system with line item information would provide complete visibility for the lender. Such a system with automated verification, validation and credit evaluation would provide the security needed to properly collateralize a working capital loan portfolio.

Keeping a Working Capital Loan Portfolio Regulatory Compliant

In the working capital arena, compliance is critical and there are many regulations that must be adhered to in order to safely administrate a working capital portfolio. Compliance proof is only provided by documentation of visible information. This information must be auditable and traceable.

There is no way to do this in a batch system where only the face amounts of the invoices that make up the batch are visible in the system. A lender must use a system that will readily provide the auditability and traceability necessary to successfully comply with all lender regulations on an invoice-specific basis.

Regulations set the stage. Therefore, the procedures and business rules that a lender provides to its working capital lending program should provide “compliance” fences that keep the lending program constantly on the regulatory stage. These procedures and business rules should be programmed into the working capital system used by the lender in order for strict compliance to occur. Therefore, the lender must choose a system that allows their unique procedures and business rules to be programmed in and efficiently automated.

Once again, visibility is critical in keeping a working capital lending portfolio regulatory compliant since visibility ensures that compliance is actually occurring and will identify any weaknesses that might exist in the compliance environment created.

Risks versus Rewards

Risk mitigation creates successful lending margins, or profit margins. Losses in a portfolio eliminate margin gains. Therefore, the mitigation of risk should be of paramount importance when setting up a working capital loan portfolio. This risk mitigation must include verification, validation, credit evaluation, and visibility on an invoice-specific level. The proper mitigation of risk will ensure increased profit margins.

Pricing and Structuring a Working Capital Loan Portfolio

Proper pricing protects a profit margin by providing adequate coverage for all foreseen operational costs incurred through verification, validation, and credit evaluation. Pricing a loan portfolio using a graduated discount fee pricing model will work hand in hand with the velocity of money to ensure that the projected loan portfolio profit margins are actually realized in cash. It is important to remember that the velocity of money only works when a portfolio is priced in such a way as to increase the return to the lender over the length of time the loan is outstanding.

Bringing It Home

Working capital lending provides the highest margin lending in a lender, and when tied to pre-funding verified and validated collateral, it can be the safest type of lending in a lender. This is particularly true if the collateral is validated, verified, and credit evaluated prior to funding and the portfolio is managed with the proper type of operational system that keeps it in the regulatory compliance environment at all times and is flexible to any pricing or structure required by the lender’s customer. Working capital lending is the key to providing your customers with the lifeblood of business – cash!