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How can Off-Balance Sheet and traditional On-Balance Sheet Financing coexist?
As we collectively strive to achieve SDG7, a reality persists: Pay-as-you-go (Paygo) solar stands as our best bet to achieve universal energy access. But what has also remained consistent across the last years is how complex of a business model it is. Acting as a hybrid between last-mile distributors (LMDs) and microfinance institutions (MFIs), Paygo solar companies must grapple with the financing of inventory, credit and, for the most vertically integrated ones, even manufacturing (for a broader view on the complexity of Paygo operations, we invite you to read this article).
While barriers to growth and profitability remain, the industry is collectively committed to explore optimal ways to bring capital toward Off-Grid Solar (OGS) companies. Investment reports, task forces, and readiness programs are booming. In that emulation, a new contender has gained visibility: Off-balance sheet (OBS) financing.
How can this approach coexist with traditional on-balance sheet funds for optimal impact?
How can companies make the best of this evolving financial toolkit to boost their growth?
To answer these questions, we delve into the fundamentals of both financing approaches, illustrating the advantages, challenges and best practices for distributors looking to diversify their funding sources and generate a greater impact on their financial ratios, drawing on Bridgin's expertise and insights from key industry stakeholders, such as GOGLA, Azuri Technologies and The Electrification Financing Initiative (ElectriFI).
Back to Basics
On-balance sheet financing, often introduced as the “conventional” approach to fundraising, involves recording financial obligations or assets directly on a company's balance sheet through bonds, loans, or shares of stock. Both debt and equity financing offer benefits such as control retention or relief in cash flow pressure, yet they also pose drawbacks. Equity financing can dilute ownership and lead to fluctuating perceptions of the company, while debt financing can impose significant cash flow repayment pressure, which is particularly challenging for Paygo companies with volatile cash inflows. For a more interactive deep dive on that challenge, do not hesitate to watch our webinar.
Moving from on to off-balance sheet financing introduces us to a lesser-known but increasingly visible fundraising approach: receivables financing. In its off-balance sheet form, it involves isolating receivables purchased at a discount by an investor into a Special Purpose Vehicle (SPV). As discussed in-depth in our previous piece, this strategy offers several advantages. For distributors, it provides immediate liquidity in a cash flow-friendly and non-dilutive manner. For investors, it’s an opportunity to tailor exposure to specific aspects and assets of the business.
In 2017, Azuri Technologies, with support from the European Union's impact investment fund ElectriFI, launched one of the industry's first receivable financing programs. The innovative design of the debt facility allowed commercial investors to finance the growth of the sector in a targeted and sustainable way. Their CFO and lead of this initiative, Alex Brummeler, explains:
“In an SPV, you can build a very customised portfolio. Securitisation allows to tranche the risk according to investors’ tolerance. In our case, participating DFIs provided junior debt into the deal, which allowed us to attract more traditional lenders. This would have been much more difficult to do at company or group level.”
But like any financing method, receivables financing has its limitations. To be eligible for receivables financing, it is necessary to maintain investment-worthy books of receivables in the first place. Additionally, investment amounts will be capped by the liquidity trapped in those books. Regulatory environments can also impose high costs and limit opportunities for secondary markets, requiring collaborative and long-haul efforts to take it at scale.
Clearly, no method ticks all the boxes. Balance and diversification are key, but what do synergies look like in practice?
How Off-Balance Sheet and On-Balance Sheet Complement each Other
Complementary use cases
Paygo companies and lease-to-own businesses often face extended working capital cycles, which, in turn, delays their access to liquidity for reinvestment or debt repayment. However, both on and off-balance sheet financing can optimise these cycles.
Since inventory is quite predictable, it can be financed through on-balance sheet debt, boosting inventory turnover and cash-flow positions. In parallel, off-balance sheet financing can be leveraged to shorten the time of accounts receivables days and inject much needed liquidity for day-to-day operations and obligations, in line with revenue and growth objectives.
This makes for a balanced duo that can fasten cash flow conversion while building a stable track record of repayments over time. Drew Corbyn, Head of Investment & Performance at GOGLA summarises it this way:
“There is a strong synergy between off-balance and on-balance sheet financing for Paygo solar companies. On-balance sheet financing provides stability and control, and off-balance sheet provides access to new capital markets and improves risk mitigation. While the precise blend needs to be tailored to each company, the complementarity can enhance financial performance and power growth.”
Positive impact on financial metrics paves the way for cheaper capital
Unlike traditional debt, off-balance sheet financing does not constitute a negative impact on key financial ratios or investment metrics, which can ease access to traditional financing methods.
Let us ponder for a moment on Weighted Average Cost of Capital (WACC). Reflecting the overall cost of capital, WACC considers both debt and equity costs, with debt accumulation typically resulting in higher interest rates from lenders, thus raising WACC and signalling higher investment costs. For equity investors, a higher WACC negatively affects earnings perception and market valuations, leading to downward pressure on stock prices and expectations of higher returns on equity - as compensation for higher perceived risk. This restricts investment opportunities, as fewer companies meet qualifying conditions.
How does off-balance sheet financing help? By making debt and equity cheaper. Properly structured and transparent off-balance sheet financing can reduce distributors’ overreliance on expensive debt, making WACC lower, debt more accessible, and equity less expensive. For traditional investors, it widens investment horizons.
“Our general fundraising strategy served expansion objectives. But we wanted to avoid taking on new on-balance sheet debt, which would have made equity fundraising more expensive and difficult to secure. Setting up the off-balance sheet program presented challenges in tax and structuring, but it proved to be a successful financing approach, injecting liquidity into our operations and facilitating market diversification at manageable funding costs” - Alexander Brummeler, CFO, Azuri Technologies
Funding diversification
Diversification of funding sources is crucial for distributors seeking stability amidst fluctuations and uncertainty. A single source may suffice, but it can often fall short of meeting all the financial needs and constraints of the business. More importantly, using different funding sources, including on and off-balance sheet, can reduce dependence on a single lender or method and provide a mitigation strategy against associated risks – to cope with lender’s insufficient funding availability, strategic reorientation or declined renewals. Guillaume Cruyt, Venture Capital Officer at ElectriFI, acknowledges that:
“Although individual end users pose a risk, diversified pools of uncorrelated risks offer high predictability. With these dependable cash flows, various financial instruments can be meticulously blended to minimise risks. Leveraging this potential can be achievable through off-balance sheet receivable financing. Such structures can appeal to new pools of capital, including commercial/institutional investors or national banks lending in local currency. In parallel, it can reduce on-balance-sheet working capital needs, increase company cash flows and improve on-balance-sheet equity cases.”
With participation from local stakeholders, such as pension funds or local banks, off-balance sheet financing can also boost the availability of local currency financing.
Promoting best practices
Receivables financing is data-centric by design. What the investor really purchases is the performance associated with a bundle of assets. This can result in greater transparency and better practices, benefiting all the investment space.
Given investors effectively assess risk and returns through standardised data, the purchase price of receivables will drop if distributors issue below benchmark opportunities. As a result, companies are incentivised to enhance the quality of their receivables book by adopting proper credit management and scoring practices, which have long been promoted by traditional investors.
The result could be a healthier industry, with a positive impact on capital cost and availability of all financing methods.
Balancing Limitations
As always, not all paths are without hurdles. Making these approaches coexist poses certain challenges, mostly because resources at the disposal of distributors to secure these investments are limited:
On-balance sheet debt financing traditionally relies on receivables to secure loans. How will that happen if receivables are no longer on the balance sheet of distributors? What can be alternative solutions? Inventory may offer lenders recourse in the event of borrower default. But it can also be perceived as risky, if the product experiences market value fluctuations or is considered hard to liquidate.
In the anticipation of a default, off and on-balance sheet investors could compete in seeking priority of claims over a company's cash flows, assets and payment infrastructures (such as bank or mobile money accounts). Governance of these issues may also differ by jurisdiction according to legal considerations on creditor rights and enforcement procedures, adding a layer of complexity.
As basic as it sounds, fundraising takes time. To any company, this is a finite resource. Focusing on one fundraising approach will always take away availability from other fundraising endeavours.
Promoting best practices for off-balance sheet financing at industry level is vital for wider acceptance and success - distributors, for instance, would benefit from clear early guidelines regarding the eligibility criteria for selling receivables.
Moving Forward: How can Distributors Make Off and On-Balance Sheet Work for them?
Knowing the key benefits and synergies of both approaches, how should distributors play their cards to choose which method is the best fit?
Be clear on what this financing round aims to do, and what method(s) will work best to that effect. Ask yourself questions like:
-What do I need this financing for?
-Am I willing to dilute my ownership for this use case?
-What is the cost of capital for each method?
-What is my current financial position and how would each method impact it?
-How could that influence my future fundraising efforts?
-Is a combination of approaches worth exploring?
Think about resource allocation, and assess the opportunity cost of your decision. This is essential to balance competing demands and priorities within the company.
Start slowly. Learning to mix approaches can be tricky. Our industry has also been used to seeing off-balance sheet happen through complex securitisation programs at the benefit of big players. For most, this is out of reach – in terms of costs, ticket size and resources. But there are alternative methods that can be used to bring diversity into the financing mix:
If you contemplate setting-up your own off-balance sheet facility, you could first get familiar with relevant mechanisms through on-balance sheet ring-fenced debt.
“If you ensure that the portfolio designated for recourse is ring-fenced, with funds exclusively allocated to repay the lenders, there is limited complexity. You spare yourself some issues of general debt while building a track record: it will be a smaller step to take the assets off balance sheets afterwards” - Alexander Brummeler, CFO, Azuri Technologies
Save yourself the need to bear all the costs and complexity of off-balance sheet by using nascent aggregation facilities.
“All investors are looking for a decent size commitment to provide. Ticket sizes in the millions can be unattainable for a lot of individual companies. Aggregating portfolios is a nice way to bypass that issue. From the company perspective, it can solve some of the challenges associated with structuring off-balance sheet transactions. But it’s not without complexity, for sure. How do you aggregate, how many players do you need, how do you scale?”, Azuri Technologies’ CFO adds.
In conclusion, on-balance sheet and off-balance sheet financing should be seen as complementary tools for companies seeking financing. Sustainable growth relies on securing funding that facilitates repayment and ongoing investment. It is imperative to approach financing pragmatically, considering investor limitations and the availability of funding options. While in many cases today, off-balance sheet financing may be unavailable, this is a challenge that Bridgin is addressing.
These are the specific questions and pain points we aim to address with Bridgin, lifting off-balance sheet constraints off the shoulders of distributors and investors to make it widely available in OGS companies’ financial toolkit. We are committed to producing further content on the matter, while providing early onboarding to companies willing to start understanding how their receivables porfolios perform, and how they could benefit from aggregation in the future. Do not hesitate to get in touch.
About Bridgin
Bridgin is Solaris Offgrid's Receivable Financing Solution. Conceived as an online trading platform for accounts receivables, it allows distributors of essential services to unlock liquidity over assets through the sale of their outstanding invoices to investors, offering investors a unique chance to tap into a previously untapped asset class at a lower risk.