I NVENTORY F INANCE Nickolas Budd Consultant, IFC Ulaanbaatar, December 15, 2014

Insert Logo(s) on Interior Slide Master, Financing Facilities that can potentially be offered to Commercial Entities in Mongolia Including: Importers and Exporters, for the purchase of equipment and consumer goods for resale Manufacturers and processors, for the purchase of raw materials for transformation, processing and resale Distributors and wholesalers for the purchase of vehicles, capital equipment, and consumer goods for resale Retailers, for the purchase of equipment and consumer durable goods such as vehicles for resale to consumers (sometimes described as “floor plan financing”). 1 INTRODUCTION

Insert Logo(s) on Interior Slide Master, An Inventory finance is a line of credit or short-term loan made to a company so it can purchase products for sale. Those products, or inventory, serve as collateral for the loan if the business does not sell its products and cannot repay the loan. Inventory financing is especially useful for businesses that must pay their suppliers in a shorter period of time than it takes them to sell their inventory to customers. It also provides a solution to seasonal fluctuations in cash flows and can help a business achieve a higher sales volume - for example, by allowing a business to acquire extra inventory to sell during the holiday season. 2 INVENTORY FINANCE

Insert Logo(s) on Interior Slide Master, INVENTORY FINANCE BASIC STRUCTURE (I) 3

Insert Logo(s) on Interior Slide Master, INVENTORY FINANCE BASIC STRUCTURE (II) 4

Insert Logo(s) on Interior Slide Master, Inventory loans are short term and self-liquidating (repaid by application of sales proceeds) Inventory loans can be geared to high seasonal borrowing requirements without reliance on land or equipment security Inventory loans become receivables loans when the inventory is sold (much easier for banks to finance) Inventory can be liquidated by the bank if the borrower defaults 5 INVENTORY FINANCE-THE ADVANTAGES

Insert Logo(s) on Interior Slide Master, Inventory is fast moving and value and quantity can be difficult for a lender or trader to verify If the borrower is dishonest or is under severe financial pressure, he may sell the goods without repaying the loan Inventory values, especially for commodities, can be volatile 6 INVENTORY FINANCE-THE DISADVANTAGES

Insert Logo(s) on Interior Slide Master, 1.CREDIT FACILITIES CAN BE CONTROLLED TO ENSURE PRODUCTION Loan can initially be geared to cover costs of production and inputs (raw materials, parts, packaging, transport, etc. and only increased once the products are finished) Loans can be disbursed directly to suppliers wherever possible. 7 RISK MITIGATION

Insert Logo(s) on Interior Slide Master, 2.CREDIT FACILITIES ARE MONITORED TO ENSURE PRUDENT LOAN-TO-VALUE RATIO Inventory value should be adjusted daily for volatile commodities The lender must be able to verify location, quantity and quality of the inventory 8 RISK MITIGATION

Insert Logo(s) on Interior Slide Master, 3.COMPREHENSIVE INSURANCE COVERAGE Insurance policy covering the inventory against fire, flood, theft, losses in storage and transit and other usual risks Claims under the policy should be payable to the lender Policy premiums are paid in advance 9 RISK MITIGATION

Insert Logo(s) on Interior Slide Master, 4.VALUE FLUCTUATION If the inventory is pre-sold the lender should take an assignment of the sale contract and all sales proceeds If the inventory is a traded on a commodities exchange, the borrower could enter into a futures or forward contract to hedge against a decline in the market value 10 RISK MITIGATION

Insert Logo(s) on Interior Slide Master, Procedures to monitor existence, value, title, quality and quantity of inventory and receivables collateral Can be continual or periodic Can be carried out by the lender or by a collateral management company Can be limited to monitoring activities (a stock monitoring agreement, or SMA), or extended to a custodial role (a collateral management agreement, or CMA). 11 THE ROLE OF COLLATERAL MANAGEMENT

Insert Logo(s) on Interior Slide Master, Assure Physical Availability of Collateral Assure Legal Security of the Collateral Provide Practical and Cost-Effective Procedures for Monitoring Collateral 12 THE ROLE OF THE COLLATERAL MANAGER

Insert Logo(s) on Interior Slide Master, STOCK MONITORING AGREEMENT Periodic visits to a storage location and certification of the stock quantity, quality, value, and other agreed matters but without any responsibility for subsequent releases. No storage or other custodial documents are issued to the bank COLLATERAL MANAGEMENT AGREEMENT Continual and exclusive custody by the CMC of goods in a storage location temporarily leased by the CMC, with signs posted and locks in place. The CMC will usually issue a custodial document to the bank that may not have legal validity, but the CMC will take responsibility for the control of the goods under the Collateral Management Agreement. 13 SMA COMPARED TO A CMA

Insert Logo(s) on Interior Slide Master, ADVANTAGES OF AN IN-HOUSE COLLATERAL MANAGEMENT DIVISION Good training for junior bankers if the bank is active in SME secured lending sector Staff have career path in the bank and motivated to protect the bank’s interests Misconduct by bank employees covered by banker’s blanket bond or similar anti-fraud policy Costs can sometimes be covered by separate loan administration fee 14 LENDER COLLATERAL MANAGEMENT

Insert Logo(s) on Interior Slide Master, DISADVANTAGES OF AN IN-HOUSE COLLATERAL MANAGEMENT DIVISION More difficult where inventory requires expertise to assess grade or value or where inventory is significant distance from the bank Normally the in-house option is impractical where full-time custodial arrangements are required In-house monitoring requires commitment to commercial credit as a core business 15 LENDER COLLATERAL MANAGEMENT

Insert Logo(s) on Interior Slide Master, Advantages of Collateral Management Company (CMC) CMC will offer insurance covering negligence and employee fraud in significant amounts If the CMC is affiliated to an inspection company or accounting firm, it will have staff in many major cities and ports, reducing travel expenses If the CMC is working in the trade or industry involved, it may have useful information to share regarding the grade and quality of the inventory and reputation of the customer 16 THIRD PARTY COLLATERAL MANAGEMENT

Insert Logo(s) on Interior Slide Master, Disadvantages of CMCs CMC services are costly and the customer may object to reimbursing the bank Customers will be concerned about the confidentiality of market sensitive information If the CMC is doing business with the customer (as an inspection company, for example) there will be a direct conflict of interest with the bank 17 THIRD PARTY COLLATERAL MANAGEMENT

Insert Logo(s) on Interior Slide Master, Terminal Warehousing Field Warehousing Non-Custodial Verification Receivables Certification and Control 18 WHAT ARE THE BASIC COLLATERAL MANAGEMENT SERVICES?

Insert Logo(s) on Interior Slide Master, International Terminal Warehouse Companies such as Steinweg International Inspection Companies such as SGS Local Bank-Owned Field Warehouse Companies (none in Mongolia) Dedicated Collateral Management Companies such as CWT and Drum 19 MODERN COLLATERAL MANAGEMENT SERVICE PROVIDERS

Insert Logo(s) on Interior Slide Master, Is the warehouse receipt recognised under Mongolian Law? Is the possessory pledge recognised under Mongolian Law? Is a CMC licensed to issue warehouse receipts? If the CMC is not a warehouse operator, are the procedures sufficient to create a possessory pledge? 20 PARTICULAR INSURANCE AND LEGAL ISSUES

Insert Logo(s) on Interior Slide Master, Are the Goods Covered Against Fire, Flood, Theft and Other Casualty Risks? Will the Theft and/or Professional Liability Coverage Protect against the appropriation of the goods by the Borrower? Does the CMC has adequate local Supervisory Staff to regularly Audit the account? 21 PARTICULAR ISSUES (CONTINUED)

Insert Logo(s) on Interior Slide Master, Financing of Inventories is necessary for the development of manufacturing and distribution businesses, especially SMEs Collateral Management in some form is necessary for safe inventory financing The legal and insurance foundations must be examined by both the bank and the collateral manager 22 SUMMARY AND CONCLUSIONS RE: INVENTORY FINANCING AND COLLATERAL MANAGEMENT

Insert Logo(s) on Interior Slide Master, 23 Thank You !