Value chain fi nance can be viewed as a series of tools and mechanisms, yet, most importantly it is an approach that takes a systemic viewpoint, looking at the collective set of actors, processes and markets of the chain as opposed to an individual lender-borrower within the system. Decisions about fi nancing are based on the health of the entire system, including market demand, and not just on the individual borrower. This means that in order to offer value chain-based fi nance, knowledge of the agricultural system is required.
In other forms of fi nance, whether internal fi nancing within the chain, such as traditional trader credit, or fi nancing originating externally, such as conventional banking fi nance, the view is less comprehensive, and therefore incorporates signifi cant risk. The additional risk is due in large part to ‘un- certainty’; not being able to fully understand the risks and consequently not being able to assess and mitigate against those risks. Uncertainty also leads to a higher perception of risk causing conventional lending to the sector to be reduced.
Shwedel states, ‘Chain-based fi nancing requires the banker to see and under- stand the business in its entirety. It demands adjustment to new market condi- tions, more accurate pricing, a better understanding of risk, and consequently, a greater willingness to take risk’ (2007: 22). In his work as value chain fi nance specialist for Rabobank Mexico, he has learned that with a holistic understand- ing of the chain, there is potential to reduce risk and open up the doors to fi nance based on systemic knowledge.
Box 2.2 Flower chain fi nancing, Mexico
In the case of fl ower producers in Mexico, Rabobank fi nances their needs for working capital, equipment and technology. Closely aligned with this, Rabobank also fi nances the equipment distributor who provides needed technology to the farmers. The bank fi nances the farmers because the bank knows them and understands their marketing system. In fact, the farmers send their products to an auction market in Holland, and Rabobank fi nances the auction market and many of the buyers in the market. In this way, the bank has locked up the fi nancing of the whole chain and has intimate knowledge of the chain – production factors, equipment suppliers, and buyers. The bank also knows that the farm- ers receive their money as it is deposited in a Rabobank account, so that the bank can directly debit their accounts for loan payments.
Source: Shwedel (2007)
An example of the Rabobank approach is highlighted in Box 2.2 that de- scribes the fi nancing of fl owers which are considered a specialized, high-risk sector in Mexico.
As in the Rabobank case, a lender is more likely to give a loan to a farmer when that farmer is connected to a viable buyer, and when the buyer in turn has solid market access. Most businesses and fi nancial institutions do not have the global reach of Rabobank, but through strong linkages among partners and follow-up of fl ows of product and funds, they can achieve the necessary understanding and control needed to minimize risks and have competitive ef- fi ciency in their value chain fi nancing. In the past, without such value chain knowledge and interconnectivity, the farmers or small processors and traders may have been more readily refused a loan and therefore unable to fi nance their operations to take advantage of a market opportunity. The familiarity of the players in a specifi c chain with each other supports the promotion and de- velopment of effective arrangements that facilitate fi nancing. The main pur- pose is sharing risks among various actors, transferring defi ned risks to those parties that are best equipped to manage them, and as far as possible, reducing costs through direct linkages and payments.
Since value chain fi nance is built not only upon physical linkages but also through knowledge integration, a key to success for fi nancial institution is to
‘know the business’. Those who know the business the best are those persons and companies directly involved in the value chain. Having and using spe- cialized knowledge of the chain, fi nanciers and investors can understand the risks and work to mitigate them more easily than a conventional banker who works with all types of businesses and clients. This ability and commitment to analysing and using the value chain, enables fi nancial institutions to tailor appropriate fi nancial products and services to the participants in the value chain. Success in this fi eld depends upon making use of this collective body of knowledge followed by subsequent tailoring or structuring of traditional and non-traditional fi nancial mechanisms and tools to fi t the value chain. The main purpose is sharing risks among various actors and transferring defi ned risks to those parties that are best equipped to manage them. Hence, the value chain fi nance approach is a process of building and using knowledge to deter- mine fi nancial services and interventions. The actual fi nancing can be either direct from one chain partner to another, indirect by a third party fi nancial institution or ‘cascading’, meaning fi nancing enters the chain to partners at multiple levels according to the activities in the chain.
Whereas, conventional fi nancing relies heavily on the creditworthiness of the client and business, value chain fi nancing focuses more on the payments to be received from activities, such as production and value-added transac- tions. This allows for increased access to fi nance for those without suffi cient collateral but with predictable fl ows of goods, and strong partners in the chain. Moreover, in many cases, the transactions can be structured such that the repayment of a loan is automatically made via the transaction proceeds.
This direct form of loan repayment, reduces both repayment risk as well as
transaction costs of loan repayment. Each participant in a value chain has a different capacity to obtain fi nancing and the conditions vary accordingly.
Their common interest is in obtaining fi nance easily under favourable condi- tions; whether it comes from a bank, supplier or trader is not important. If, for example, a major buyer can obtain fi nancing and advance funds to others in the chain at less overall cost, everyone benefi ts.
Following a value chain fi nance approach, the loan analysis for a spe- cifi c borrower comprehensively considers the many aspects and processes of the value chain, including who within the chain is best placed to be the borrower(s), and what are the fl ows of funds and from whom. Kariuki states that the key issues for consideration in value chain fi nance in the Cooperative Bank of Agriculture are: 1) the strength of the value chain and its opportuni- ties and challenges; 2) the risks; 3) the technical, business and fi nancial ser- vices and support, and 4) the business model for value chain fi nance (Mwangi, 2007). In essence, the process involves a combination of value chain assess- ment, fi nancial assessment and securing agreements. A few key steps that can be employed by such an institution are:
1. Understand the value chain:
o Enabling environment – international, regional and domestic en- abling environment, regulatory constraints and opportunities for support;
o Vertical and horizontal relationships – linkages between levels of the chain and competitors and with those on the same level, their interests and commitment;
o Support markets and services – fi nancial and non-fi nancial services, and input supply markets;
o End market – market potential, consumer demands and chain risks (adaption from Coop, 2008).
2. Identify the value chain model that currently exists – lead actors, busi- ness model and sustainability strategy;
3. Identify the transaction processes – value added in the various stages of the product up the value chain;
4. Determine actual and critical points of fi nance – the current fl ows of funds and their sources of fi nancing, what is needed and in what point in time;
5. Analyse and compare fi nancing options – their relative strengths, risks and costs of fi nancing for each level of participant in the chain;
6. Design fi nancing according to the best option(s) to fi t the chain – draw up agreements for fi nancing between parties.
While much of the emphasis in a value chain fi nance approach is on the health of the chain and its value-adding transactions and linkages, a well- rounded assessment of all borrowers is still critical. This borrower assessment can be undertaken by looking at key areas commonly called the 5 C’s of loan assessment. These refer to: 1) character; 2) capacity; 3) capital; 4) collateral;
and 5) conditions (Miller, 2008a). Banks have typically given highest priority to collateral and in microfi nance the focus of priority is to character and ca- pacity. These remain important in loan assessment but, as shown in Box 2.3, their relative level of importance changes as does the breadth of the assess- ment to go beyond that of the immediate borrower.
In value chain fi nance, increased importance is given to the conditions of both the market outlook and the fi t of the fi nancial requirements to the needs and fl ows of the chain. The ‘fi t’ of the fi nancial conditions and cash fl ows to those clients within the chain is critical and assessment of the risks of break- downs in the chain form part of the analysis. The cash fl ow of the value chain must be suffi cient and in total synch with that of the loan conditions. The capacity of the partners as well as the borrower is also importance. Hence, a risk assessment moves well beyond client credit risk and requires assessment of the risks of market, price and production.
Does this mean that the bank or fi nancier must assess and fully understand everything in the value chain? No, most do not have such capacity except in the chains with which they are dealing closely, but rather they can often rely in part on the strength and reputation of the strongest actors in the chain.
Most often these are larger businesses farther up the chain with strong credit histories who are experts in the chains in which they operate.