Identifying Lender Risk – Identifying and Mitigating Risks in Lender Finance

by Jeff Wright

Lender Finance: A Fast-Paced Frontier in Lending

Lender Finance

All financing institutions know that they must accept a certain amount of lender risk when lending to factors, asset-based lenders, and entrepreneurs. But in the fast-paced environment of lending to factors and asset-based lenders, evaluating potential clients requires thorough investigations of their assets and company holdings to identify and mitigate potential lender risk. Because of the pace in which funds are dispersed by factors, it is incredibly important that factors understand everything at play in a company’s books before lending.

Lender Risk for Factors

There are several different categories of lender risk that factors must take into account before lending to a fellow factor. First, conducting basic background and financial checks can help to mitigate risk and avoid high-risk agreements.

Before entering an A/R lending agreement, factors should take multiple aspects of a company’s overall state of financial health and viability into consideration:

Counterparty Credit Risk

Counterparty risk is defined as the possibility that a debtor you do business with will be unable to meet the obligations that they have agreed to. If a debtor is unable to fulfill their obligations in some way, it is important that a plan is set in motion to mitigate and minimize losses. Counterparty risk can present a serious problem for factors and can be difficult to foresee due to its technical nature. Typically, A/R lenders see increases in counterparty risk when customers and those with outstanding invoices start behaving differently than they have in the past. They may begin paying late, avoid paying at all, or have sudden changes in their credit status. Counterparty risk is always present for factors, who should remain vigilant in identifying potential situations that could increase counterparty risk.

Fraud Risk

For factors, there is always the risk that a company you reach an agreement with may commit fraud in an effort to avoid paying the agreed upon amounts. Reducing the risk of fraud begins with evaluating the company’s character, but even that can only produce so much faith. For larger agreements, lenders may want to consider performing in-depth audits, as well as ensuring that your organization has the proper fraud insurance policies in place to mitigate risks.

According to an IFA Business Profile and Performance Survey for Factoring Firms, in the US, 83% of factors reported that they had encountered some sort of fraud within the last five years of operation. Only 17% of all factoring firms reported that they had never encountered fraud at all. There are a few ways in which factors typically see debtors committing fraud:

Fake invoicing. Creating invoices for services or products that were not actually delivered in an attempt to secure larger sums of cash from a lender. This is a common practice among fraudulent borrowers and can typically be spotted with an audit, or by digging deeper into their accounts receivable history. Fake invoicing is only worthwhile to fraudsters when done to facilitate large increases from a factor. Keep an eye out for clients with large invoices that are out of character for their clients, based on their history with a company.

Misdirected payments. Misdirected payment fraud typically takes place when a debtor instructs their clients to post their payments for products or services rendered to someone other than the lender to whom they sold their accounts receivable obligations. These misguided attempts are often easily spotted as the factor begins to reach out to parties to settle their invoices, only to find that they believe that they have already paid.

Pre-invoicing. Pre-invoicing is a very common form of fraud that factors deal with on a regular basis. This occurs when a company creates invoices for future products or services before they have been delivered and before they have officially reached an agreement with a company. In the case of a manufacturing company, they may create invoices for customers that have yet to place their order, but are planning on placing it in the near future. Pre-invoicing can also include real invoices that have been backdated to fall within the scope of the agreement with a factor.

There are multiple steps that any lender finance company can take to mitigate fraud and lender risk.

At Hitachi Business Finance, we work with factors to help them to identify and mitigate potentially risky situations with clients. Fraud is more common in certain industries. According to an IFA Business Profile and Performance Survey, transportation is the largest industry for factors, accounting for more than 26% of invoices funded during that year. The simplest way for factors to mitigate fraud risk is to ensure that they have secured a fraud insurance policy that covers these common types of fraud. Many factors also institute policies that require full audits of clients prior to entering an agreement.

International Legal Risks

Another common risk for business financing companies that offer their financing services to companies in other countries is the instability and lack of familiarity of foreign laws and regulations. Before entering into an agreement with a company in any foreign country, it is important that you are able to identify the potential legal risks that A/R lending creates, and speak with qualified legal experts in the region to gain deeper insight. It is important for factors to seek out legal representation with knowledge of the lending laws in a specific country before entering into any lending agreements.

Operational Risks

Operational risks are a common risk for lenders, but can be avoided or mitigated with excellent planning and client onboarding processes. Most operational risks come in the form of contract disputes, and can occur between both a factor and their client, or a factor and invoiced debtors. By taking time to go over agreements line-by-line with clients, you can ensure that both parties are aware of the details of the contract and avoid potential contract disputes before they arise.

IRS Lien Risk

When clients are forced to pay IRS liens associated with payroll taxes, it can negatively affect your ability to collect on outstanding debts from customers. A pre-agreement audit can expose when a business is at risk for IRS liens and allow you to avoid potential risk.

Avoiding Lender Risk

Evaluate a Company’s Character

Although factors typically lend based on accounts receivable assets, evaluating a company’s character is always a worthwhile step before entering into an agreement. We go through an in-depth vetting process when evaluating clients, including lender finance companies that we partner with. You must have faith that a company has been honest about their business and has not “cooked the books” in some way to make their accounts receivable seem more valuable than they actually are. Just taking a small amount of time to get to know a company and better understand their business processes can help limit bad loans.

Conduct In-Depth Audits

Although many factors will perform an audit of any business before entering into a lending agreement, not all go to great lengths to ensure that they know each client inside and out. An in-depth audit of accounts receivable and other relevant portions of the business can help expose risks and allow factors to make smart decisions regarding which companies they enter into agreements with. Audits can expose companies that might be in poor financial positions, which may increase their likelihood of committing fraud or placing a factor in a risky situation.

All lending companies must agree to take on certain levels of lender risk when entering into agreements with borrowers. The risk profile of a specific borrower will affect the agreement in place and the control over collateral that is exercised by factors. Accounts receivable lending services often require that lenders and borrowers enter into agreements more quickly than traditional loans would allow in order to provide a stimulus of cash flow that allows a business to grow and reach their goals. The speed in which this lending takes place can lead to lenders overlooking potential risk factors. However, with in-depth evaluations and audits, factors can mitigate lender risk and identify exceptionally risky borrowers.

Hitachi Business Finance offers a full complement of lender finance solutions for factors in the manufacturing, staffing, and transportation industries. We focus on educating our clients so they can maintain a strong portfolio of healthy loans. Call us today to see which of our flexible lending solutions is a good fit for you and your clients.

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About the Author
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Jeff Wright has been with the Hitachi team since 2006 and contributes more than 30 years of experience in the banking and commercial finance industry. He is currently responsible for business development in the Midwest region, and works with businesses and their trusted advisor network to provide factoring and asset-based lending services. Contact Jeff at (248) 259-3749 or jwright@hitachibusinessfinance.com.
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