Vendor Finance in Infrastructure Projects

Debt and equity from investors remain the two conservative sources of funding when it comes to infrastructure financing. However, with the advent of time and financial innovation, newer sources of funding have now become available. Vendor financing is one such mode of funding which is now being widely used in infrastructure projects. The concept of vendor financing is gaining popularity since it is creating a win-win situation for both parties involved.

The benefits and issues related to vendor financing have been discussed in detail in this article.

What is Vendor Financing?

In the context of an infrastructure project, the engineering contractor firm is usually the main vendor. There are other smaller vendors who interact with the project company. Generally, these vendors provide limited credit to their buyers. However, in some cases, such as in infrastructure finance, they provide extended credit to their buyers. Simply put, the contractor firm may provide goods or render services today but may not expect payment until a year or even more. This extended credit is a useful source of working capital finance for the infrastructure project since it reduces the need for borrowing. However, it needs to be understood that when vendors provide such liberal payment terms, they inflate the prices in order to accommodate interest costs that need to be built into the price.

Advantages of Vendor Financing

The advantages of vendor financing are obvious. For instance, from the infrastructure company’s point of view, vendor financing agreements reduce the dependence on external lenders. Hence, it provides the company with added flexibility. Vendor finance, if received early on, can be particularly beneficial for a project. This is because obtaining finance at the early stages of a project is difficult for a project company. Hence, vendor finance can be used to get the project off the ground. Once the risk reduces, other sources of finances can be used to repay the vendors.

Vendor financing is extremely beneficial from the vendor’s point of view, as well. This is because vendors in infrastructure projects are generally selling commodities such as metals, cement, electric equipment, etc. Most of these products are commoditized. Hence, building any kind of sustainable competitive advantage is difficult. Vendor financing allows vendors to engage better with their customers and build a competitive advantage. Since infrastructure projects buy material in bulk, vendors don’t mind providing finance at discounted interest rates.

How is Vendor Finance Used in Infrastructure Projects?

Theoretically, vendor finance can be debt-based or equity-based. However, the reality is that very few vendors ever choose the equity model. About 95% of vendor finance is provided through the debt-based model. There are various alternate models within the debt-based model. Some of them have been listed below:

• Vendor financing can be given the status of senior debt or subordinated debt. This status is reached based on the agreement that the infrastructure company already has with its other lenders. In most cases, vendors have a subordinated claim on the assets of the company.

• In many cases, vendors may not have any recourse for the finance that they provided. This means that vendor financing often happens without any collateral. Vendor finance is basically a source of raising unsecured capital,

• In many cases, vendor financing is only used once cost overruns have already taken place. Vendor financing may be used as a cost overrun mitigation strategy. This is because in the event of a cost overrun, raising finances from external sources can be quite expensive. In such scenarios, vendor financing can prove to be cheap as well as effective.

The Disadvantages of Using Vendor Financing in Infrastructure Projects

There are several disadvantages to using vendor financing in infrastructure projects. Some of them have been listed below:

1. Firstly, when vendors also become financiers in a project, conflict of interest problems begin to arise. This is because financiers have a right to access sensitive information about a project before they invest their money. However, the infrastructure company may not be comfortable sharing this same information with a vendor. This creates a problem since information which should be provided for the due diligence process is not provided.

2. Secondly, investors gain voting rights in a project. If vendors become the major investors in a project, it is likely that they will misuse the voting rights. They could use their influence to give further contracts to their own company at inflated prices. This would mean that the vendor would end up gaining at the expense of all the other shareholders in the infrastructure project. This dilemma can be managed if vendors are willing to forego the voting rights that come along with making an investment.

3. The risk allocation is also negatively impacted when vendors are used as investors. This is because, in many cases, vendors may end up gaining priority over certain types of debt holders. It would be fair to say that vendor financing results in vendor debt, moving up the value chain.

To sum it up, vendor financing is a mode of financing that can be used in the event of an emergency. However, just like any other mode of financing, there are disadvantages to vendor financing too. Hence, the pros and cons need to be weighed before making the final decision.