Bank Guaranteed Invoice Discounting Explained

Invoice Discounting (ID) is still one of the most popular unregulated alternative investments in the fixed income space. We wrote a detailed article on ID last year in July 2023, and since then, a lot has happened with the product, including a couple of defaults on some major platforms like KredX, altGraaf, and others, hurting investor sentiment.

Some platforms have actively innovated to bring secured structures within invoice discounting, which offer a slightly lower yield than the unsecured structures but provide superior risk-adjusted returns. Most of these structures use either a Bank Guarantee or Trade Credit Insurance to reduce risk. The leader in bringing these structures to retail investors at this stage is altGraaf, so we will use their examples to discuss the different structures available to retailers.

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This is not a sponsored post in any form, we have written the article based on our understanding of the product and can be wrong as well. If you think something is factually incorrect, please message us and we will be happy to correct it.

In this article, we will be discussing the Bank Guaranteed structures and will write another one on Trade Credit Insurance. This is to ensure the article doesn't become too long.

To write this article, we had a quick call with a senior executive at altGraaf to understand the products and their nuances in depth.

The article assumes that you know about invoice discounting as an asset class. If you don't, it would be better to start by reading the tagged article first.

https://thealtinvestor.in/exploring-invoice-discounting-alternative-investment-in-india

Bank Guarantee ID Deals

Bank Guarantee (BG) is an enforceable commitment or guarantee to honor a payment to the seller in case the buyer is unable to make the payment. Let's understand this with a simple workflow:

Buyer XYZ and Seller ABC agree to do business together, but Seller ABC wants financial security to ensure payment will be made a few days after supplying the raw materials. Buyer XYZ applies for a Bank Guarantee (BG) with their banking partner, who conducts an independent credit assessment of the buyer's financial statement and issues a bank guarantee with a specific sanctioned limit. The banking partner then provides this BG as security to the seller.

How it works?

Seller delivers the goods/services to the buyer on credit and raises the invoice (“receivables”).
Buyer’s bank issues an unconditional and irrevocable bank guarantee to the seller (up to the sanctioned limit).
Seller assigns the bank guarantee to the invoice discounting platform and discounts invoices to investor(s) on the platform.
The ID platform takes control of the escrow account (designated account for all buyer repayments) to safeguard investors.
When the buyer makes a payment, it flows directly into the escrow account controlled by the platform. As per altgraaf, escrow control is an added protection and it may not be present in some deals on the platform. In the worst-case scenario of default, the platform invokes the bank guarantee with the bank to recover the amount.

Here is a simple workflow by altGraaf to show how the transaction works.

Risks in BG backed Invoice Discounting

These types of deals currently offer anywhere between 10% - 11% on altGraaf, and while the structure mitigates most of the risks, some still exist, such as:

Fraud Risk: The buyer might have used forged documents to secure the bank guarantee, and in this case, the bank may pull the guarantee.
Operational Risk: Genuine errors in documentation, communication, or processes may lead to claim rejection.
Bank Risk: The possibility of the bank coming under financial strain and being unable to honor the BG. In reality, this risk is very low.

The platform's due diligence should essentially address all these risks and bring vetted buyers and sellers onto their platform.

Other FAQs on BG backed Invoice Discounting

Please click on the question to read the answer.

Can the Bank Guarantee be revoked by the bank?

There are two types of BGs: one is revocable, the other is irrevocable. Ensure the invoice discounting deal you invest in has an irrevocable BG. altGraaf only deals in the latter ones. Some BGs may also have certain conditions under which they can be revoked, which need to be scrutinized.

How quickly can the BG be invoked if the buyer is unable to pay?

The seller/platform has to send a written notice to the issuing bank, specifying the grounds for invoking the BG and providing all details such as the invoice, purchase order, lorry receipt, and a copy of the original BG. The bank will verify and immediately release the payment.

How does the bank define the sanction limit for the BG?

Just as a bank decides how much loan to give you based on your financial condition and CIBIL score, they also conduct a similar assessment for the buyer and define a limit they are comfortable with.

Have there been any cases where BG has been invoked?

Yes, BGs have been invoked by multiple sellers across sectors. This is a very common practice in the trade finance industry and should not stop investors from investing since they are protected by the BG.

Does the buyer get penalized in anyway if they are unable to pay?

Not immediately, but the bank will start scrutinizing the books of the buyer to understand why they were unable to pay and may report it to the CIBIL authorities or even liquidate some other assets they might have kept with the bank as a guarantee.

How long is a BG generally valid for?

BG is generally valid for maximum 1 year. If any platform claims to say it's more than that, please scrutinize it further.

Is the invoice discounting interest also covered by the BG?

Generally, the platform wouldn't discount the whole invoice. For example, if the invoice value is INR 3 Crores, they would discount INR 2.8 Crores. However, if the BG is invoked, the bank would pay INR 3 Crores, covering the discounting interest as well for the investor.

Can I verify the BG issued by bank?

The Indian government has launched the NESL E-BG portal (https://nesl.co.in/e-bg/) to verify these bank guarantees; however, only a few do this in electronic format yet. To verify the physical BG, one needs to contact the issuing branch.

To write this article, we had access to a bank guarantee document from an industry source. We can't share that with you due to confidentiality reasons, but we have tried to cover all the relevant points from it in this article.

Why do companies get bank guarantees?

Well, obviously, the buyer who applies for the bank guarantee has to pay a premium to the bank for it and submit a lot of paperwork, so what motivates them to do this?

Lets understand this with a simple example:

Suppose the buyer is a mid-sized player wanting to work with a large seller, but the seller doesn't trust the buyer yet. So, they ask the buyer to get a bank guarantee at their own cost. The buyer agrees because they will get better trading terms, like better prices and access to raw materials. The seller is happy because they have a guarantee of payment and can get their invoice discounted at cheaper rates, like 11% instead of 15%.

So that makes it a win-win for everyone in the ecosystem including the investors who get to finance a secured structure.

Conclusion

In conclusion, Bank Guaranteed Invoice Discounting offers a more secure structure for investors seeking to mitigate risks while still achieving attractive returns. By leveraging bank guarantees, platforms like altGraaf can provide a safeguard against defaults, making it a decent option for those interested in fixed-income investments. While there are inherent risks, thorough due diligence by the platforms can significantly reduce these, creating a win-win scenario for buyers, sellers, and investors alike.

With that being said, I would still like to highlight that even this secured structure is still an unregulated instrument from the SEBI/RBI perspective, so invest according to your own due diligence and risk appetite.

In the next article, we will talk about the specifics of Trade Credit Insurance with a similar flow, discuss the specifics, risks, and why companies take the hassle of getting them.

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Please note that this is an opinion blog and not official research advice. I am not a registered RIA/RA in India. This blog aims to promote informed decision-making and does not discourage you from investing in any deals.

We plan to come up with more blogs discussing different types of instruments available in the world of startup investing, write on due diligence for some platforms, and also existing and upcoming alt investment deals in the Indian market. If you want to stay updated on the latest blogs, please subscribe to our newsletter so you get notified automatically.

Understanding How Bank Guaranteed Invoice Discounting Works