Another Supply Chain Finance-Enabled Crisis Hits, This Time in Brazil

“Discovery” of multi-billion dollar “inconsistencies” on Brazilian retail giant’s balance sheet is a timely reminder of the risks posed by supply chain finance, especially in a heavily weakened business environment such as today.

On the second day of this fledgling year, the Brazilian seasoned business executive Sergio Rial was appointed as the new CEO of Americanas, the parent company of one of Brazil’s largest grocery chains, Lojas Americanas. Alongside him, André Covre took over as chief financial officer. But their stay was to be exceedingly short. Just ten days later, both had resigned after discovering accounting “inconsistencies” on the company’s balance sheets to the tune of no less than 20 billion real (US$ 3.87 billion).

No “Material” Impact

In a statement cited by Reuters, Americanas said the inconsistencies were a result of “supplier financing operations” that were not adequately reflected in its accounting. It described the cash impact of those “inconsistencies” as “not material” — a curious choice of words given the amount involved not only dwarfs the company’s net equity (US$2.9 billion), but was almost twice the size of its market value (US$2 billion) at the time the statement was made, on Wednesday afternoon.

Following the news, the company’s bonds plunged 38 cents on the dollar in trading on Thursday, according to Bloomberg. By the end of trading, Americanas’ shares had slumped by a whopping 77%. That’s after falling by around two-thirds last year, despite posting its highest net sales since 2013. The company’s entire market value is now roughly a tenth the size of the so-called “inconsistencies” on its balance sheets.

The company’s cash flow situation is now “much more delicate than anticipated,” said analysts at JP Morgan. Other banks including Morgan Stanley, Bradesco BBI and Itau BBA scrambled to place their forecasts for Rio de Janeiro-based Americanas under review. A group of lawyers representing minority shareholders has filed a complaint against Americanas for what it called a “multi-billion fraud,” while also asking regulator CVM to investigate the retailer’s auditor, PwC.

Americanas’ new management has called for an internal inquiry and work by independent auditors to determine the impact of the “inconsistencies” on the company’s financial statements (just in case it isn’t immaterial, presumably), which begs the [largely rhetorical] question: what has the auditor, in this case PwC, been doing until now?

In every high-profile business collapse caused (or at least exacerbated) by supply chain finance issues, auditors have failed to spot (or at least report) any of the glaring irregularities, until it is too late. In the case of Spanish green energy giant Abengoa, a 17-year old student in Barcelona who chose Abengoa as the subject of his high school economics project noticed serious flaws in the company’s accounting — a full year before Deloitte’s auditors finally blew the whistle.

“The big surprise was that negative profits were being converted into positives,” Baltá told the Spanish daily El Mundo.

It was a similar story at the now-defunct UK outsourcing firm Carillion. In its last ever annual report, the firm’s auditor, KPMG, approved Carillion’s viability statement, certifying it as strong enough to survive for “at least three more years.” Within less than three months, Carillion’s management was forced to admit it had significantly overestimated revenues, cash and assets, prompting a stunning stock market meltdown from which it would never recover.

A scathing letter to the Financial Times at the time called for Carillion’s directors and KPMG to be investigated for the company’s collapse. Martin White, of the UK Shareholders Association, and Natasha Landell-Mills, of Sarasin & Partners, wrote:

Although fingers are being pointed in all directions, most are missing the real culprit: faulty accounts appear to have allowed Carillion to overstate profits and capital, thereby permitting them to load up on debt while paying out cash dividends and bonuses.

All of it on KPMG’s watch.

Now, back to the present. And Brazil.

Lojas Americanas boasts around 1,950 stores across Brazil and employs 40,000 workers. For decades the retail chain was controlled by three of the billionaire co-founders of the Brazilian-US investment fund 3G Capital, including Jorge Paulo Lemann, the world’s 72nd richest man. 3G Capital owns (among other things) food and beverage conglomerate AB InBev whose holdings include Budweiser, Stella Artois, Corona and Becks; Big Food behemoth Kraft Heinz and Restaurant Brands International (Burger King, Popeyes, and Tim Hortons).

In 2021, the three billionaires reduced their stake in Americanas as part of a merger/restructuring to 31%. But they have told the board they plan to keep supporting the company, and they certainly have the money to do so. Rial said he’ll work with the trio of longtime investors to help steady the ship and said he has a “moral obligation” to lend his support while apologizing to investors.

Supply Chain Finance Strikes Again

Right now, this story is young and the details are still coming to light. But the story forms part of a much broader saga that has been unfolding for years, with disastrous consequences for companies, their employees and investors across at least three continents (Europe, Australia and now the Americas). It has the potential to magnify corporate debt crises, particularly in a weakened business environment such as today’s.

At the core of the problem is a widely used supply chain finance technique called reverse factoring, which ratings agency Fitch described as a “debt loophole” in 2018, following the sudden collapse of  Carillion. My former colleague at WOLF STREET, Wolf Richter, wrote the following at the time:

Supply chain finance in general describes working capital management techniques with which a company extracts financial benefits from its supply chain. The “most publicized” of these techniques is reverse factoring. Fitch explains how it works and the reasons for doing it:

Company A, the buyer, purchases goods in the normal course of business from company B [often not rated or junk rated]. Company A, typically a large well-rated corporate, will arrange a reverse factoring program with a financial institution.

Once it has been on-boarded into the program and negotiated terms with the bank, B will be able to submit the invoices it has issued to A, once A has validated (or confirmed) them, to the bank for accelerated payment. It could get paid after 15 days rather than its usual 60 days.

The supplier benefits because it gets quicker access to cash but at the lower borrowing cost associated with the stronger credit rating of its customer.

The buyer benefits because reverse factoring allows it to borrow without disclosing it as debt:

As part of this process, the bank will also often allow company A longer to pay the invoice than B would have accepted without the supply chain finance arrangement. So rather than paying in 60 days it may pay only after 120 days. This is effectively using a bank to extend payment terms….

Thus, the buyer is borrowing 120 days of its accounts payable from the bank, while the bank pays the supplier. None of this debt that the buyer owes the bank shows up as “debt” on the buyer’s balance sheet but remains in “accounts payable” or “other payables.” The money borrowed from the bank becomes cash inflow on the cash-flow statement. And the highly touted figure “cash” increases. Hallelujah.

This is the biggest problem with (and attraction of) reverse factoring: the debt is not disclosed, which means that investors, creditors and regulators have no idea how much debt a company is actually carrying. It also means that investors and creditors end up bearing much larger losses when the company finally — and often very suddenly — collapses, as has already occurred with Abengoa, which defaulted on its debt for the first time in 2015, Carillion (2018) and NMC Health (2020).

Supply chain finance — particularly the more traditional and less controversial practice of “factoring”, when an intermediary agent provides cash or financing to companies by purchasing their accounts receivables — has generally been the preserve of large commercial banks. But in recent years, enterprising fintech start-ups have got in on the game.

They include, of course, the Softbank-backed fintech “unicorn” Greensill, which collapsed in March 2021 after its main insurer, Tokio Marine Holdings Inc, refused to renew its policy, with very ugly consequences for its investors and creditors. They included, most notoriously, wealthy clients of Swiss TBTF bank Credit Suisse, which poured $10 billion of their money into supply-chain finance funds that the Swiss lender sold as safe alternatives to cash.

Spreading the Risk

Within the space of just a few years Greensill became one of the world’s biggest providers of supply chain finance. Before hitting the dust, the UK-Australian company claimed on its website that it had issued over $143 billion in funding to over 10 million customers in 2019 alone. Rather than wait for companies to repay that funding, Greensill was bundling the invoices into securities and selling them to largely unwitting asset managers, insurers, and pension funds all over the world.

Greensill is not the only financial institution that has been doing this. In fact, the securitization of receivables is pretty common, though no one really knows how much of the estimated $1.31 trillion funds in the market has been chopped, diced and bundled into securities, and then sold to (largely unsuspecting) asset managers, insurers, and pension funds around the world. According to a November 2021 report by S&P, “existing lenders are ramping up their capabilities while new players are entering the market.”

In the case of Greensill, one of its biggest buyers was Credit Suisse, which itself is in a battle for survival, in part due to the fallout from Greensill’s collapse. Even one year on, $9.3 billion of the supposedly short-term assets Greensill had sold to investors as notes were yet to pay out.

Much of the money is owed by companies controlled by Sanjeev Gupta and U.S. miner Bluestone Resources, both of which are trying to restructure their debts. Just yesterday (Jan 12), Gupta’s Liberty Steel announced plans to cut 440 jobs in the UK as well as slash production. The UK’s Serious Fraud Office and French police are investigating GFG Alliance companies over suspected fraud and money laundering.

The wide-ranging fallout from Greensill’s collapse also splattered Germany’s private banking association, which had to pay out around €2.7 billion to more than 20,500 Greensill Bank customers as part of its deposit guarantee scheme. The British government was also rocked following revelations that it had allowed the fintech to access COVID-19 emergency business loans the fact the company: a) wasn’t a bank; and b) was quite clearly already in deep financial trouble. It would later emerge that former UK PM David Cameron had earned around $10 million for frantically lobbying for the company as it teetered on the edge.

Greensill may have met its maker but supply chain finance still has the potential to wreak further havoc upon an already heavily weakened, debt-distressed global economy. In the US at least, some action has been taken. A new Financial Accounting Standards Board (FASB) rule will require users of supply chain finance to disclose the payment terms of the transactions, the amounts of the invoices in the program as well as any guarantees or assets pledged. But it falls short of requiring users to classify the payments as short-term debt.

In Brazil, the economy is stagnating following two years of high inflation and an 11.5 percentage-point rise in interest rates since the Spring of 2021. That may have helped to tame inflation somewhat — the CPI reading in December was at its lowest level since February 2021 — but at the cost of creating serious economic pain, particularly for low-income families and struggling businesses. Hiking rates as quickly as this squeezes yet more life out of the economy by making it even harder for heavily indebted businesses and consumers to service their debts.

News of the $3.9 billion hole on Americanas’ balance sheets will no doubt raise concerns about just how many other companies are in the same or a similar predicament, and not just in Brazil.

“This is awful news for the retail sector, especially considering it happened with a large company such as Americanas”, said Fabrício Gonçalvez, CEO at Box Asset Management, before adding: “How can $3.9 billion escape from auditors?”

That is a very good question.