Understanding Basic Trade Finance Structuring Techniques and Lessons from Failed Deals

1. Understanding Basic Trade Finance Structuring Techniques and Lessons from Failed Deals By Dr. B. O. Oramah* *Dr. B.O. Oramah is Executive Vice President at Afreximbank Opinions expressed herein do not necessarily reflect the views of Afreximbank

2. Preamble: • Major objective of this presentation is to refresh participants’ memories about the basics of Structured Trade Finance • To achieve the above objective, the paper is organized as follows: • Section One explains Risk, • Section Two defines Structured Trade Finance and the steps involved in Structuring, • Section Threediscusses Deal Breakers, • Section Four touches on Pricing issues, • Section Five discusses why some structured trade deals fail, while • Section Six concludes

3. 1. RISK IDENTIFICATION AND MITIGATION 1.1 What is Risk? Two Definitions: • Context in which an Event Occurs with some Probability or where the size of the Event has a Probability Distribution. • A Class of Uncertain Events which Affects the well-being of a decision maker or a class of Decision – Makers.

4. Definition No. 2 is more APPROPRIATE for what is Risk if there is no cost to it?

5. 1.2 Operative Words The Operative Words Are: • UNCERTAINTY • WELL-BEING • DECISION-MAKER In this case; • DECISION-MAKER= Bank • WELL-BEING= Bank’s Financial Health • UNCERTAINTY = Events Outside Bank’s Control

6. 1.3 Uncertain Events In Credit TransactionsArise Because • Banks are unable to determine client’s ability to meet obligation with any degree of certainty due to a variety of reasons, Such as: • Changes in Borrower’s Financial Standing • Changes in Borrower’s Business Environment • Changes in Country Conditions • Changes in the Financial Conditions of the Borrower’s Direct and Indirect Counter-parties

7. The above are usually aggregated into; • Credit Risk • Business Risk • Performance Risk • Counter Party Risk, and • Country Risk

8. 1.4 Key Characteristics of the identified Risks are that they are; • Separable • Transferable • Essentially Exhaustive • And Therefore Can Be Mitigated The above characteristics form the Foundation ofStructuring

9. 2. ROLE OF STRUCTURED FINANCE IN RISK MITIGATION 2.1 Structured Finance is the; • Art of transferring Risk in Financing Transactions from Parties less able to Bear those Risks to those more equipped to bear them in a manner that ensures Automatic Reimbursement of Advances from the Underlying transaction Assets

10. It encompasses: “Any structure whereby certain assets (inventory, contract, export receivables etc) with more or lessPredictablecash-flows can beisolatedfrom the originator,Pledged(Sold,leased etc) and used to support the Financing being raised (as collateral and/or source of reimbursement or repayment) or to substitute it” (Emmanuelle Moors de Georgio)

11. Accordingly, Structured Finance Converts Uncertainty to some “Certainty” (Predictable Cash-flow) and thereby Mitigates Risks. • Unbankable deals therefore become bankable.

12. Collateralized Lending • Assets other than commodities as: • Unconditional collateral (cash, treasury bonds, stock): • Collateral conditional on the performance of the party offering the collateral (irrevocable L/Cs) • Collateral conditional on the performance of a third party debtor (loan or contract/ Accounts receivables, Assignments of contracts): • Assets backing Special Purpose Vehicles (credit card receivables, road tolls). Commodities as collateral Indirect Use: Special Purpose Vehicles, issuing Bonds which are Collateralized by Commodity assets Direct Use Commodities Have been produced already Commodities not yet produced; Commodities In the ground or being grown are assigned as collateral Warehouse receipts Trust receipt: Used for Commodity processing Non-Negotiable: Used within a deal Negotiable: can be traded on a secondary market 2.2 THE COLLATERALIZATION OF CREDITS:A SCHEMATIC OVERVIEW OF STRUCTURED FINANCE Courtesy: L. Rutten, UNCTAD, Geneva Secured Finance: collateral is assigned Structured Finance: Collateral is assigned and an automatic reimbursement procedure is devised

13. 1. Understanding the envisaged physical transaction 2.3 Essential Steps in Building a Structure: 2. Understanding the Flow of Documents (Sketched if Possible) 3. Understanding the envisaged Funds flow arising from the physical (Sketch) 4. identifying key parties and entities involved, including countries of Domicile of the parties 5. Assessing the Risks 6. Identifying Mitigants 7. Developing the Term Sheet 8. Legal Documentation

14. 2.4 THE BUILDING BLOCKS: • Understanding the Physical Transaction: • What good is being shipped? • What are the contract specifications? • When is the good to be shipped? • Where will it be shipped to? • How is the good to be transported, any intermediate warehousing? Who is the w/house? • What is the cycle of shipment? 1 • Understanding the Nature and Flow of Documents: • The Sale contract (the parties involved) • Industry rules under which the contract was drawn (CAL, AFCC, FOSFA, etc) • The shipping documents • Quality certificates (who issues?) • Insurances (what do they cover?) • How are documents to be remitted and received? • The Export License and other official docs. required for shipment? 2

15. Understanding the Envisaged Funds Flow: • What are the sums involved? • How and when are they to be paid? • Where are they to be paid and received? • What currencies are involved? • Are any deductions to be made? • Are there provisions for Reimbursements? • What duties and taxes are payable? 3 • Identifying Key Parties and Entities Involved: • Who is the shipper (Exporter)? Based in which Country? • Who is the buyer (Importer)? Based in which Country? • Who are the forwarding Agents? • Who are the insurers? • Who are the warehouse men (if any?) • Who are the document remitting bank? • The L/C bank? • The Inspection Agents? 4

16. Assessing the Risks Evaluating the building blocks in steps 1 to 4 using certain Risk Acceptance Criteria 5 Identifying Mitigants Identifying securities, contractual obligations, etc… to deal with unacceptable risks as may be identified in step 5 6

17. The Term Sheet 7 • Legal Documentation • Generating the Legal documents to support (6-7) • Dealing with Legal Risks • Legal Opinions • Governing Law • Local Law/Regulation • Documentary Taxes in Security Perfection 8

18. 2.5 Arriving at the Structure:Risk assessment and Mitigation Risk Factor Credit Risk Character / Management / Financial Assessment Criteria • Is borrower rated, with investment grade rating? Or Are key individuals behind the Borrower of high integrity and: • have no record of corruption or fraud • no conviction for criminal offence • well respected in the trade for honesty and reliability

19. have risk appetite assessed to be moderate. In this regard, shareholding must be well spread, if not wholly owned by government. • Key officers must have the ability to withstand political and other pressures • Do internal controls evidence separation of powers and devolution of authority? • Are there no Board room squabble of significance? • Do key officers have relevant formal and/or informal training in the trade?

20. Do key officers have sufficient knowledge about the business? • Can key officers show evidence of satisfactory performance in past positions? • Does organization have a sound and documented corporate strategy outlining the vision of management? • Does the institution have a very good relationship with the regulatory authorities? • Is management turn-over high?

21. Does the organization maintain consistent profitability (over 3 years) (any decline to be explained by factors outside the organization’s control) • Is debt/equity ratio at least equal to the industry average or those of competitors in the country concerned. Where a monopoly is being assessed, the analyst should use his judgment to ascertain a prudential ratio to accept • Are the company’s assets mostly current? • Does it maintain a strong position among its competitors in market share and financial standing. • Is debt service coverage ratio greater than 2

22. Possible Mitigants that may be used to improve risk If Answers are NO, Risk may be transferred to other more credit worthy counterparties by: • In the case of a trading company, having a credit worthy and reliable local bank to on-lend funds. • Taking acceptable guarantees (corporate, local bank or reliable affiliates or holding companies). • Structure loan to make self liquidating by transferring repayment risk to other credit worthy entities with the Bank having title over the receivables, if ability to perform contract is adjudged “good”.

23. Risk Factor Performance Risk Assessment Criteria • Does the company: • have good track record i.e. has it exported successfully for at least 3 years? • Have necessary facilities vehicles, personnel, local supply network, warehouses, processing plants, to support transactions implied by the Facility amount being requested?

24. Is the company’s export market share in the business sizeable such that the company is perceived as being in general in the top 15% of its trade by peers? • Has the company good working relationship with the regulatory authorities of the trade? • Are there minimal social unrests, work stoppages, incidents of arson and theft of goods in warehouse or in-transit? • Is port infrastructure sound and adequate to support the trade? • No major adverse changes in the sector or company (by the government) is being expected?

25. Possible Mitigants • If answers are no; • limit the lender’s role to refinance of stock in third party warehouse or provide post-shipment credit only • poor performance risk can be transferred to a good credit risk of a bank, government or other entities. (if such risk is found acceptable) • explicit charge on marketable assets of the company located in acceptable jurisdiction. • Cash collateral to be taken

26. Borrower to take insurance coverage on stocks, if arson and theft are rife. Insurance to be assigned to the Lender. • Have acceptable Management Consultants/Collateral Agents monitor facility. Now Collateral Management companies abound and can assist.

27. Risk Factor Country Risk Assessment Criteria • Are there existing or potential political and social problems e.g. arbitrary government restriction or actions, or socio-political unrest? • Are there existing or potential economic/financial difficulties?

28. Possible Mitigants • Transfer repayment risk to a jurisdiction with better risk rating if other risk factors are found acceptable. • Take appropriate securities domiciled outside the country

29. Risk Factor Loan Purpose Assessment Criteria • Must be seen to improve profitability of the business • Must be seen to have economic benefit to the country Possible Mitigants • None. The Loans to be supported must have a valid purpose.

30. Risk Factor Price Assessment Criteria • Is price of the commodity volatile and uncovered? Possible Mitigants • Margin the financing sufficiently • Only accept firm fixed price contracts • Take a price Hedge (options, futures, forwards or swaps)

31. Risk Factor Exchange Rate Assessment Criteria • Is the currency of receivable different from currency of loan? Possible Mitigants • Enter a currency forward, swap, futures or option • Margin the financing sufficiently

32. Risk Factor Market Assessment Criteria • Is demand volatile? • Is buyer likely to renege on contract to buy ? Possible Mitigants • Enter only firm fixed price contracts with acceptable buyers • Use only Irrevocable L/Cs issued by acceptable banks

33. Risk Factor Buyer Assessment Criteria • Is buyer a reputable trading house ? • Does buyer have acceptable credit rating? Possible Mitigants • Use Irrevocable L/Cs’ issued by prime investment grade-rated banks • Use Credit Insurance • Bank Guarantees

34. 2.6 Typical Structure - Commodity Pre-Financing Figure 1: Commodity Pre-financing securitized by export flow 5. Buyer pays for exports as per assignment Buyer Lending Bank (Int’l Bank) 2. Exporter Assigns Export Contracts to Lending Bank (with notification to Buyer) 2. Buyer Acknowledges Receipt of Assignments notice 4. Exporter ships goods 1. Export contract with Buyer 3. Lending Bank disburses funds to Exporter Exporter

35. Key Features of Deal are • Performance Risk is Retained on Exporter • Payment Risk is Isolated and Transferred to an OECD Buyer • Price Risk is mitigated by pre-financing firm fixed price contracts or through a price hedge • Security and Repayment are Achieved through; • Assignments and acknowledgements • Charges • Pledges, etc

36. 2.7 Such Deals are Possible where: • Commodity involved is Exchange - Traded • Exporter has Good Track Record • Foreign buyers are diversified and are good names • Exporter’s country is reasonably stable (Politically and economically) • Underlying Contract is sufficiently Long, Binding and Enforceable • The Borrower is able to assign and/or transfer its Assets.

37. 2.8 Deals with Deviations from Typical 2.8.1 PROBLEM ONE IF EXPORTER CANNOT ASSIGN OR PLEDGE ASSETS DUE TO NEGATIVE PLEDGE CLAUSES SOLUTIONS • Use a Pre-Payment Structure (Figure 2) e.g. Cotton deals in Tanzania, Oil deals in Angola; • Use Irrevocable Payment Instructions and take all funds coming into collection account as repayment (because other creditors can attach the receivables and the Collection Account), e.g. Copper deals in Zambia in the 1990s.

38. Figure 2:Dealing with Problem 1:A Prepayment Financing Structure Buyer Lending Bank 2. Disbursement against assignment of Prepayment Benefits 5. Repayment, then Documents endorsed to Buyer 1.Export Contract, Foreign Currency Prepayment Agreement 3. Goods shipped to Buyer 4. Title Documents to Lending Bank Exporter

39. 2.8.2 PROBLEM TWO IF EXPORTER PERFORMANCE CAPABILITY IS IN DOUBT SOLUTIONS • Finance Against Stock in Warehouse under Third Party Supervision • Take Performance Guarantee from a Local Bank or Insurance Company (Figure 3) • Finance on Credit of Buyer Under a Red or green Clause Letter of Credit (Figure 4)

40. Figure 3: Dealing with Problem 2(b)Lending With Payment Guarantee 3. Guarantee (which may or may not be collateralized) a) Guarantor Bank b) Lending Bank 6. Repayment of principal and interest as per Assignment 2. Contract Assignment 4. Disbursement Importer Exporter 1. Commercial Contract 5. Goods • Securities taken include depositing of treasury bills, partial cash collateral etc. • Guarantor may be local or international bank, government, central bank or a multinational corporation which may be a major shareholder of the exporting company.

41. Figure 4 Dealing with Problem 2(c) Financing the Buyer Under Limited Recourse Structure 5. Repayment contingent on successful export of goods Buyer Lender 2. Limited Recourse Loan 1.Export Contract, Foreign Currency Prepayment 4. Goods shipped to Buyer Crude Supplier Exporter 3. Pays for and receives Crude

42. 2.8.3 PROBLEM THREE IF THE COMMODITY IS NOT EXCHANGE TRADED, e.g. Manufactured Goods SOLUTION • Obtain A Local Bank Guarantee Or Performance Bond From A Credit-Worthy Insurance Company • Finance only against L/Cs with Required Documents Clearly Specified • Use Twinning to reduce Performance Risk, e.g. as in Afreximbank Export Development Finance Programme.

43. 2.8.4 PROBLEM FOUR IF TRANSACTION INVOLVES PROCESSING RISK SOLUTION • Refinance Raw material stock in W/House under Third Party Supervision and sell stock forward through an option • Mitigate Processing and Payment Risks by allowing stock to be drawn under a “Buy-Back” Arrangement. (e.g. cocoa processing in Nigeria), i.e. stock under collateral management can only be drawn for processing upon receipt of sums of at least 125% of value of stock to be drawn.

44. 2.8.5 PROBLEM FIVE If Traded Good/Service Is Not Conventional, e.g. Trading Done On; • Consignment Basis (Flowers) • Through Agents (Diamonds) • Aircraft Purchase • Raw fish Export • Telecommunication • Power • Oil Services • Hotels

45. Product Country Transaction was Done What have been/ can be Assigned SOLUTION 1. Diamonds Guinea Sales proceeds due exporter from sales agent 2. Fish Namibia, Seychelles Fishing Royalties 3. Horticulture Zimbabwe/Kenya Book receivables from Flower Auction 4. Telecom Ghana, Nigeria, Zimbabwe, Sudan • Net Call receivables in USD • Roaming charges (GSM) • Air time revenues.

46. Product Country Transaction was Done What have been/ can be Assigned 5. Power Zimbabwe Proceeds of Power Purchase Contract with mining companies 6. Beef Zimbabwe, Zambia Sales proceeds collected by Sales Agent and covered by Credit Insurance 7. Aircraft Ghana, Nigeria Ticket Sales Proceeds, Airline Royalties 8. Airport Ghana Over-Flight-Fees

47. Product Country Transaction was Done What have been/ can be Assigned Nigeria, Angola Zambia, Ghana Proceeds of Service Contracts entered into with Major Companies 9. Mining Services 10. Hotels Eastern & Southern Africa, Nigeria, Ghana • Term room rentals with reputable corporates and tour companies • Financial Future Flow Structures (e.g. credit card payment rights)

48. 2.8.6 PROBLEM SIX WHAT OF INTRA-AFRICAN TRADE? SOLUTION • Cover Country Risk using Afreximbank Country Risk Guarantee Facility (See Figure 5)

49. Risk Period for lending bank AFREXIMBANK intervention as risk mitigant International bank assumes payment risk of an African entity (through L/C issuance/ confirmation or other forms of financing Afreximbank provides cover against certain country risk events Figure 5 AFREXIMBANK COUNTRY RISK GUARANTEE FACILITY FLOW OF TRANSACTIONS At maturity, International bank is reimbursed by obligor ? At maturity, International bank is reimbursed by obligor Yes Exposure Extinguished Yes No No Cause of Non‑reimbursement is determined and risk is shared Non‑reimbursement caused by commercial risk (credit, documentary/administration risks and fraud) events, force majeure and/or certain country risk events Yes Yes Afreximbank is discharged Lenders pursue security from Borrower Non‑reimbursement caused by certain country risk events (exchange. control regulations, moratorium on debt payment, change in law or policy affecting the timing currency or manner of debt payment No Yes AFREXIMBANK reimburses covered portion (80%) to Lender and pursues reimbursement with country concerned in accordance with Bank Membership Agreement On recovery of repayment. Lending bank is reimbursed the remaining 20%, less reasonable costs incurred by Afreximbank in pursing recovery

50. Use your country’s ECA cover, if available • Finance against Buyer’s Assignment of Export Receivable from a more secure country • Take out Country Risk insurance from ATI and Lloyds if there is availability