Factoring: An Alternative Investment Play
Most of our focus is on commercial real estate value-add niches like apartments, self-storage and manufactured home communities, which in our opinion, is the core of safe and profitable investing in real estate. On occasion, our trusted partners in these niches network and meet with very bright people in other industries. I’ve been exposed to their ideas but have been very selective on what we may want to introduce to a segment of our investor base that would like to try another non-correlated asset or business.
The business of Factoring has been around a long time since the 1600s. Factoring is simply a company that steps in between two parties to a transaction where an invoice is involved and takes a small fee for paying the other party faster than the terms of the invoice. One party, typically a larger, higher credit rated company owes payment to another, smaller company for services rendered by the smaller company. The small company has more urgencies and usually less of a financial cushion to be delayed payment too long.
For example, a large oil and gas company has service work done by one of these smaller companies. The terms may be to pay the smaller company over 60 to 90 days for a $100,000 invoice presented by the smaller company. The smaller company, not as well off financially, has normal business expenses like payroll. They might take a smaller payment, say $97,000 if a “Factoring Company” was able to pay them say 90% of that $100,000 within a day or two of the invoices being presented by the larger company. Once the invoice is paid by the larger company in 60 to 90 days to the factoring company, the factoring company will release the other $10,000 less a fee for taking on the risk and time value of money, paying out before they get paid.
In the oil and gas business in Texas, banks have been loathe to step in and provide this gap financing so factoring has been common in this industry. It does involve some degree of risk and care is required in the factoring company doing the underwriting conservatively to ensure they can manage the risk of not being paid by the larger company. The factoring company will reduce its risk in a variety of ways so that loss of not being paid by the larger companies is very, very small. They also buy a lot of invoices to spread risk and underwrite the credit worthiness and risk of each invoice. The business is steady, and returns can be quite attractive.
There is now a fund that we can participate in run by a very experienced factoring company that oversees the business operations. They are interested in growing their fund, providing more investors an ability to participate as limited partners, while they (general partner) manage the business. We can create a fund to funnel investor money to the factoring company to provide it liquidity to buy up more invoices. Over time after some seeding, the investors can typically start getting distributions say after 18 months. They can also re-invest into the fund.
Typical funds are set up for a 5-year hold. As of this writing, we are seeing one operator in west Texas that caters to the oil and gas industry and has significant factoring experience totaling over $1B in factored invoices projecting returns in the high teens to low 20% IRR and 25% to 28% annualized returns which is quite impressive. The key is having a lot of invoices to spread risk and to underwrite each company and invoice conservatively to keep losses in the targeted ¼ of 1% level. With an experienced team, we feel that this is a fairly low risk and highly profitable opportunity one may consider investing a small portion of their assets. The business is not correlated to the financial markets which can provide more diversification to one’s portfolio with the potential of improving returns.