Little-Known Technique of Forfaiting Offers Big Benefits

Does the word forfaiting mean anything to you? If so, you understand one of the best-kept secrets of international trade financing, and you have a leg up on American exporters who know nothing of this powerful tool.

Common in Europe but not in the United States, forfaiting eliminates the cash-flow problems, not to mention the collection uncertainties, that come with long-term foreign sales. Indeed, it allows the exporter to collect all the money due on a long-term overseas sale as soon as the foreign customer accepts shipment.

Put another way, forfaiting enables you to get immediate cash for goods sold overseas on long-term contracts--the most favorable terms you can offer your foreign customer.

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Better yet, it allows you to do business with customers in Third World countries, and if you understand how to use it, it costs you little or nothing.

How does forfaiting work?

The term derives from the French faire forfait, meaning roughly “to surrender rights.” The familiar cognate in English is the verb forfeit, meaning to yield something of value in compensation for a crime or breach of duty.

But forfaiting has nothing to do with shady doings. When you finance a foreign transaction through forfaiting, you give up your rights to a future income stream in exchange for immediate cash. In many ways, forfaiting resembles what people do when they sell their rights to receive periodic payments from an annuity in exchange for immediate cash.

There’s a difference, however. You can turn your annuity income into immediate cash, but only at a discount representing the current value of money payable in the future, plus profit for the buyer.

Selling your annuity rights, in other words, means taking a big hit. In forfaiting, you don’t.

Say you want to ship goods to a foreign customer who asks to pay your invoice in 10 semiannual payments, beginning one year from now.

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You know your customer is good for it, and you want to make the sale. But you can’t wait six years to collect on your goods; you will spend money preparing them for shipment, and you don’t want the squeeze on your cash flow.

Your first move is to contact someone who can broker your forfaiting arrangement--and you want to do this before you negotiate a final price for your goods, for reasons that will become clear in a moment.

A handful of private firms broker such arrangements in the U.S., including Meridian Finance Group in West Los Angeles, British American Forfaiting Co. in St. Louis, London Forfaiting Americas Inc. in Chicago and San Francisco, and McKinney American Inc. in Houston.

Many international banks operating in the United States also broker forfaiting arrangements, along with domestic giants such as Wells Fargo and Bank of America.

With help from whoever brokers the arrangement, you get your foreign customer to agree to pay you with promissory notes guaranteed by a bank in the customer’s country. This is less complicated than it sounds; indeed, if your foreign customer has trouble getting a guarantee, you probably want another customer.

In any case, what you get is a foreign receivable evidenced by promissory notes and supported by a bank guarantee, and it’s worth money. Bankers call the guarantee an aval--the key element in forfaiting.

Your broker shops the deal, most often to banks and other financial institutions in Europe, which buy these instruments at discounts ranging to 4.5 points over the London Interbank Offered Rate--the rates European banks charge one another for dollar-based loans. As a rule, LIBOR closely reflects the rates on one-year U.S. Treasury bills.

Then your broker gives you a commitment letter detailing the discount and a “commitment fee”--usually 1% of the value of the deal per annum, pro-rated for the time it takes to fund your transaction.

You now know what forfaiting your sale will cost, so you negotiate your final sale price with your foreign customer. You may, of course, share the costs with your buyer; more likely, you will pass on the entire amount.

“Once you decide how you want to structure it, you make your goods and get them ready for shipment,” said Gary Mendell, president of Meridian Finance Group, an export finance and credit insurance broker who arranges forfaiting deals with a number of European banks and other financial institutions.

“The agreement between the exporter and the forfaiter spells out the forfaiter’s commitment to purchase the notes from the exporter--and you need a broker’s help in finding a forfaiter with competitive rates, negotiating the terms of the commitment agreement, and making sure that the notes from your foreign customer are in proper form.

“In reality, the process is quite simple,” Mendell says. “Upon shipment or delivery--or at any time agreeable to you and your customer--you receive the promissory notes, which you can endorse and immediately present to the forfaiter for payment.”

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Forfaiting is also fast, says Charles Grimes, vice president of Wells Fargo HSBC Trade Bank, a unit of the big bank that specializes in trade financing, with offices in downtown Los Angeles.

“Forfaiting is a new idea to most American exporters, but it’s catching on,” Grimes says. “You get your cash when your buyer accepts shipment, and it’s non-recourse financing--which means that the forfaiter accepts the risk that your customer will default.

“All of the world’s major currencies can be forfaited, and there are no restrictions on the goods or services involved. We broker forfaiting deals on sales down to $250,000.”

Grimes’ group began brokering forfaiting arrangements for Wells Fargo only six months ago; he expects to arrange some $40 million in forfaiting this year. Given the growth of exports from Southern California, there’s no predicting how much forfaiting the economy here will support in the future, he says.

“It really is a matter of how fast we can educate business owners about this technique,” Grimes says. “Once they know about it, they see its value.”

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Freelance writer Juan Hovey will be featured at The Times’ Small Business Strategies Conference Oct. 17-18 at the Los Angeles Convention Center. He can be reached at (805) 492-7909 or via e-mail at jhovey@gte.net.