The hot commercial-finance market has spurred more banks to take a look at factoring, a form of asset-backed lending popular in the retail industry.

The trouble is that a host of companies not subject to banks' strict lending and capital rules — from huge private-equity and venture capital firms to tiny financing shops — have also decided to pour their energy into factoring, making competition extremely tight.

The factoring business has grown with barely a hitch through the financial crisis and its aftermath, with annual volume reaching $100.1 billion last year, up more than 50% over five years. However, while several large banks like Wells Fargo and BB&T remain secure in the top tier of the industry, the lower end is increasingly under pressure from less regulated competitors.

"Given banking regulators' very strong focus on any risk in the banking system, there's more appetite for factoring and other asset-based lending outside the banking industry," said Bob Trojan, the chief executive of the Commercial Finance Association, a trade group that represents nearly 300 asset-based lenders.

Banks are still looking to expand their factoring businesses, of course. Last month, for instance, Sterling Bancorp in New York and Seacoast Banking Corp. in Florida announced they were each buying a factoring unit from First Capital Holdings, a nonbank finance firm in New York.

But the bellwether for the industry will be the sale of General Electric's factoring operations, and many observers think the buyer will come from outside the banking sector. GE's commercial-finance businesses are the big factoring M&A prize because they enjoy a large market share in Europe, where factoring is a much larger business than in the states. Two nonbank investment firms are considering bids on its Italian commercial-finance unit, Bloomberg reported last week.

Fewer lending restrictions on nonbank factoring firms give them a "small advantage" over banks, says Michael Stanley, head of factoring at Rosenthal & Rosenthal, the largest nonbank in the industry.

He said his firm has access to high-quality clients that nonetheless have an apparent blemish — off-balance-sheet collateral, say, or an issue with their financial reporting — that makes banks skittish.

"If a client has any type of issues that the regulators view as a challenge or a risk, they're not going to be able to be funded by the banks," he said.

Federal banking regulators, including the Office of the Comptroller of the Currency, have raised concerns that commercial lending may be overheating. The Commercial Finance Associationis working with banking regulators to convince them that factoring is relatively safe, Trojan said. Banking regulators generally focus on cash flow rather than collateral, and so"do not fully appreciate the low risk" of asset-backed lending, he said.

Others misunderstand factoring, too, people in the business believe. The general public, and even people who work in financial services, often see factoring as a risky form of high-cost credit for businesses that cannot get bank loans — an outdated and unfair stereotype, according to Trojan.

"Nothing could be further from the truth, given how factoring has evolved over the last 20 or 30 years," he said. "Very few people know that factoring is the lifeblood of the retail industry in the United States."

An Old Art

In factoring — which in North America dates back to the Pilgrims — the financer, called the factor, advances cash in exchange for the right to collect a company's receivables. Technically, the factor usually buys the receivables, but in practice the transaction functions as a short-term loan, usually 30 to 180 days, backed by money owed to the borrower.

In a typical deal, the borrower — say, an apparel company — benefits by passing on to the factor the downside risk that its client — a department store, for instance — will not pay.

Recent troubles at large retailers like J.C. Penney, Kmart and RadioShack have made factoring look risky, but actual losses have been rare for factors in recent years, people in the industry say. Even during the financial crisis, loss rates stayed around 1%, Trojan said.

Another reason for low loss rates is that large factors do extensive underwriting. There are as many as several thousand smaller, privately held firms that provide cash backed by receivables, but the bulk of the market rests with a handful of so-called old-line factors, which provide a broader set of services, including credit analysis.

In these cases, the borrower essentially outsources the collection of its receivables and the credit analysis of its counterparties to the factor, for which it pays a relatively small premium over an ordinary business loan. Loans ordinarily charge a few percentage points above Libor, plus a "factoring commission" of roughly 20 basis points to 1%, factors say.

The half dozen old-line factors that provide all these services make up "sort of a closed club," Stanley said.

"Building a factor sounds good on paper, but how do you do it? It's very hard — you have to have a whole army of credit analysts, a platform, a whole staff," Stanley said.

It is more common for banks to get into the business by acquiring established factors. The regular churn of companies entering factoring and then selling out has been going on for years, said Stuart Brister, president of commercial services for Wells Fargo Capital Finance.

"People rush in, people rush out," he said. "People come into it, and because factoring is a little bit of a different animal than traditional banking, they sometimes don't price the risk accordingly, and then they sell."

The Big Players

The result has been extreme consolidation over the past several decades, and a gradual decline in the number of banks with large market share.

When Wells Fargo started factoring in the early 1980s, there were 33 companies each doing more than $1 billion in annual sales, and 22 were owned by banks, according to Brister. Now, there are just six companies that exceed that threshold, and four are owned by banks, he said. Each of the six is said to hold a considerable chunk of the overall market.

Precise volume figures for individual companies can be hard to come by, because many of the factors are not public and banks do not usually break out their factoring cash flows. People in the industry say that Wells Fargo Capital Finance and CIT Group are the largest factors, followed — in varying order, depending on the source — by Rosenthal & Rosenthal, BB&T, Sterling Bancorp, and Capital Business Credit, which is owned by the investment firm Perry Capital.

The market is growing, but, as with much commercial lending, yields are shrinking. The CIT Group, for instance, last year earned $120.2 million in commissions on a factoring volume of $26.7 billion, according to its latest annual report. Commissions were down about $2 million from the previous year, despite higher volume.

In such a competitive environment, winning new clients is extremely tough. Because factoring is a deeper relationship than traditional business lending, it is especially difficult to pry clients from the factors they are using, people in the business said.

"You're not just doing lending — they're outsourcing their collections and back office to you," Brister said. "It's sticky and you don't get people changing that often."

Wells Fargo Capital Finance's factoring clients have been with the company for an average of 11 years, he said.

For winning new business, banks have some advantages over less regulated competitors, according to Robert Fentress, president of commercial finance for BB&T. These include lower cost of capital and better credit-underwriting platforms.

BB&T, which entered the market 22 years ago through the purchase of a North Carolina-based factor, has a different geographical focus than most competitors. Factoring has traditionally been concentrated in the Northeast, while BB&T focuses on its footprint in the Southeast and Mid-Atlantic, and works with a broad range of industries including automotive, technology and staffing firms, Fentress said.

The bank is planning to expand its factoring business in the Northeast once it closes its deal for Susquehanna Bancshares in Lititz, Pa., he said. Whatever challenges there are in the industry, Fentress thinks factoring is a valuable addition to BB&T's product offerings.

"It differentiates us from some other banks that don't have a full suite of working capital products to offer," he said.

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