2.5.1. Value Chain Finance

What is Value Chain Finance?

Value chain finance refers to financial products and services that flow to or through any point in a value chain that enable investments that increase actors' returns and the growth and competitiveness of the chain. Whereas financial transactions within a value chain are not new (production finance could be considered "value chain finance"), several emphases distinguish a value chain finance approach. These include improving finance at specific points in the value chain to increase the competitiveness of the entire value chain and involving multiple actors and leveraging relationships to lower or mitigate risk. Taking a value chain approach entails considering the risks and returns of the finance supplier along with the risk and returns of the value chain actor demanding finance. As Figure 1 illustrates, value chain actors themselves, banks, microfinance institutions, other non-bank financial institutions, or a combination of these actors can provide or facilitate financing to a value chain. These actors may participate in a value chain financing arrangement for different reasons, and these reasons determine the ways in which they are willing to facilitate financing for a value chain upgrading investment.

Image

Often in value chain finance, some form of strategic alliance is established between the financial provider and one or more value chain actors to reduce transaction costs and lower risks that otherwise impede access to traditional financial services. In such arrangements, private sector actors may directly finance a particular investment or cash flow need, or they may help facilitate financing from a more formal financial institution. It is important to understand how value chain governance, relations and linkages are structured to respond to market opportunities, because these factors will determine the viability of a financing arrangement. Value chain finance works best where there is strong end-market demand, as well as transparency, trust and strong and repeated inter-firm transactions. The stronger the relationships, the more readily players in the value chain can rely on their relationships to facilitate access to finance. The most common ways value chain actors facilitate financing include:

• Screening Borrowers: Value chain actors may have useful information about potential borrowers. This information can help financial institutions screen for reliability, evaluate profitability and/or assess the risk of default.
• Disbursement/Repayment of Loans: Value chain actors may play a direct role in loan transactions. They may be positioned to disburse loans on behalf of the financial institution (in-kind or cash) and loan repayments may be channeled through them as well. These roles can help to lower transaction costs and reduce likelihood of arrears and default.
• Default Risk/Collateral: Value chain actors may provide a form of "soft" collateral. Unlike "hard" collateral such as land titles, "soft" collateral can be in the form of direct (formal or informal) guarantees or co-signing, assigning value to inventory in a warehouse, etc. Value chain actors may also provide some alternative which is acceptable to a financial institution in the case that legal collateral is not available to secure the loan. Purchase orders and buyers' contracts may provide a reasonable guarantee of repayment to the extent that a financial institution would waive traditional requirements. Even when buyers' contracts are not transferable (and thus are not truly a substitute for collateral), they can be important nonetheless to the lender, since they signal creditworthiness and thus decrease the default risk[1].

 

Demand for Finance within Value Chains

Value chain finance is useful for ensuring that businesses have liquidity so they can meet market demands - whether that be to maintain or expand operations or invest in upgrading to access new market opportunities. The demand for financing by businesses can be varied. For example, a farmer may borrow against a warehouse receipt to purchase a new tractor; a shoe maker may take a forward contract to produce a new line of shoes; or an industrial tire manufacturer may access a line of credit in order to increase production to meet a lucrative order under a tight deadline. It is important to consider both the financing needs of a value chain actor as well as their ability to access financing from traditional providers. Some actors may not be well served by the formal financial sector because of atypical financial demands, lack of collateral, perceived or actual high repayment risk or cost of outreach. As an example, in the cases above, the farmer may have lacked collateral to qualify for a loan, the shoe maker's business may have been perceived as too risky and the industrial tire manufacturer may not have been able to rapidly access credit needed to meet tight deadlines.

Rural and agricultural enterprises commonly have the greatest difficulty in accessing financial services from traditional providers for the reasons mentioned above. This makes any production-level demands for financing challenging and can limit value chain development and growth. Many of the financial innovations which comprise "value chain finance" were developed specifically to bridge this financial gap by lowering costs and risks of financing for value chain upgrades. However, a recent stocktakin [2] of rural financial innovations revealed that the most effective mechanisms were structured to address financial gaps that are broader than a specific value chain financing requirement. In cases where the production unit is a household, there are often financial demands beyond the value chain enterprise. These demands impact household liquidity as cash resources are allocated across a set of interlinked production and consumption needs. In such cases, value chain competitiveness can be indirectly tied to the ability of the household, as a production unit, to access financing for other investments and purchases and manage their overall household cash flow needs.

These financial demands can relate to both consumption and investment related. Households have financial commitments for both regular and unexpected consumption and social expenses such as food, school fees, health care and funeral expenses. Without some form of additional financing to provide liquidity, households sometimes must divert cash from their enterprises to meet these immediate consumption needs. This is especially true during "lean" times of the year when household revenues are low. This also characterizes the ways rural households manage their own on-farm and off-farm productive activities, since rural households typically operate enterprises not related to agricultural production in addition to their farm activities. Off-farm enterprises such as trading and processing farm produce or non-farm enterprises that supply households with goods and services are important providers of rural household income. They can also have investment requirements that conflict with agricultural production, and farms may have to choose between the two and in turn limit their potential returns, as well as the competitiveness of that value chain.

As Figure 2 illustrates, the financing demands of a rural household should therefore be viewed holistically. A financial analysis that fails to recognize the fungibility of cash between these competing demands often results in improperly designed financial products, low repayment rates, and perpetuation of the perception of rural producers as poor credit risks. On the other hand, a holistic approach to financial demands will supply finance that allows households to comfortably meet household and non-farm enterprise expenses as well as make investments that will increase both their incomes and value chain competitiveness. Innovative products such as self-managed savings and credit associations, as well as credit products that consider an entire household's income and expenses, have helped rural and unbanked populations to meet household demands. In other cases of value chain finance, interested players such as buyers may feel sufficiently compelled to help producers through advance or early payments.

 

Interests and Incentives to Provide or Facilitate Financing

Value chain finance implies that private actors are either providing a financial service directly or facilitating finance from formal financial suppliers. As a rule of thumb, private sector partners tend to be willing to participate only in financial arrangements that advance their own self-interests, usually by either improving the supply of inputs they need for production or by securing a strategic or profitable market channel. Some value chain actors finance others in the value chain as a means to off-set potential risk. For example, a buyer or trader may provide working capital loans, advances or in-kind loans to farmers to ensure the timely delivery of a final product. Their incentive to lend is not the profitability of the loan itself but securing the delivery of a promised good. The goal may also be to build trust and a stable client market, or a recognition that obtaining inputs on credit is the only way a cash-strapped farmer will be able to make the input purchase needed to ensure quality. For similar reasons, an input supplier may provide a line of credit to buyers to help market their products, gain new customers, or retain existing ones by providing credit as an extra service. A microfinance institution or bank may provide finance to actors in a particular value chain as part of a larger strategy to diversify their portfolio and lower overall risk due to the downturn in one sector versus another. In addition, a producer is in effect providing financing to a buyer by delivering their products and trusting that payment will be received once the buyer herself or himself has been paid.

 

Capacity and Constraints to Provide or Facilitate Financing

As noted, both financial institutions and private sector players (e.g. buyers, input suppliers) are potential providers of value chain financing. There are advantages and disadvantages to both. It is quite common for buyers and input suppliers to directly supply financing to others in the value chain because of the close commercial relationships they already enjoy. But their ability to directly provide funds can be limited, particularly if doing so places an additional burden on their own cash flow. At the same time, these actors may be able to play a facilitative role in bridging gaps in access to financing by other actors in the value chain. Essentially, the commercial incentives are the same, but the requirements of facilitating rather than supplying finance may align better with the limited capacity of these actors. As noted above, strategic alliances are viable mechanisms to lower costs and risks by facilitating client screening, loan disbursement/repayment and providing some alternative collateral or collateral substitute. In contrast, financial institutions are the most logical financial services providers, since lending is their core business — but they have often been slow to enter agricultural markets. Their capacity is often limited for reasons such as geographic isolation from clients, weak internal systems or limited skills and capacity of staff (particularly with regard to lack of knowledge about a particular sector, market or business). Agreements between producers and buyers — to the extent that they signal creditworthiness to lenders, have perceived value between agreeing parties and lead to a high likelihood that the parties will fulfill obligations — are useful channels for advances, embedded loan disbursement/repayment functions or to serve as collateral substitutes. Input dealers who know their clients and are credible to lenders can assist with screening of reliable and creditworthy producers as well as assist with (usually in-kind) loan disbursements. Producer associations with strong internal management may access wholesale funds from financial institutions and on-lend to members. In the case of inventory credit, producers may pledge the value of their production, which is stored in a warehouse, as collateral for a loan. Increasingly sophisticated inventory credit arrangements (such as warehouse receipts) may also be possible.

Example: In Peru’s artichoke sector, the use of written contracts between farmers and buyers has facilitated access to formal finance for many smallholders. The use of contracts between processors and wholesalers, and processors and farmers clarified and documented pricing and selling arrangements. Several formal financial institutions lent to artichoke producers because the growers had defined sales terms and fixed market prices for their products. In these cases, the lender saw that the risk of lending was reduced, because the contracts indicated a known buyer and stable market prices. Without a contract, most farmers said they would have no access to formal finance.[3]

 

Types of Value Chain Finance

Value chain finance can be grouped into three main types of vehicles: Click here to read more about each.

1. The provision of credit, savings, guarantees or insurance to or among value chain actors.
2. The creation of strategic alliances through financing extended by a combination of value chain actors and financial institutions.
3. The offering of tools/services to manage price, production or marketing risks.

 

Value Chain Analysis

Value chain analysis is a process for identifying opportunities for and constraints to increased competitiveness of a sector. Value chain finance analysis prioritizes the financial needs within the context of specific upgrades of a value chain if it is to take advantage of end-market opportunities. This is a critical element of determining where expansion of financial services is tied to the growth and competitiveness of a value chain. A value-chain finance analysis looks not only at demand, but also the incentive structures and capacities of actors to deliver or facilitate financial access within the value chain. Additionally, constraints within the enabling environment and financial sector as a whole that may impact the availability of financing should be examined during the information-gathering stage. Importantly, as financial service delivery is rarely specific to one value chain, the value chain finance analysis should ideally identify key financial bottlenecks that affect the growth of multiple value chains.

Value chain analysis provides information on the upgrading investments needed to take advantage of identified end-market opportunities and improve competitiveness. Building on this, it gathers information on financing constraints to market opportunities from industry stakeholders, firms and financial institutions. Interviews are conducted with financial service providers in and outside the value chain to reveal the degree to which financing is already available. If finance gaps exist, the analysis probes finance providers’ perspectives on why the gaps exist. Interviews include formal financial institutions, (microfinance institutions, banks) as well as input suppliers, brokers and dealers that may provide working capital loans or input supplies on credit to their clients.

Once information is obtained on the availability of and/or gaps in financing, a schematic can be developed showing product and financial flows. This schematic helps identify overall finance gaps that can constrain the prioritized improvements in value chain performance.

Financing gaps are further analyzed to determine why they exist. In general, financing is absent because potential cost or risk is seen to outweigh the potential benefit. Financing may be absent because the finance provider or potential borrower cannot accurately determine the benefits of increased investment, or because the lender or borrower correctly assesses the risk of lending and investing as too high. The analysis of financing gaps can inform donors about what type of intervention may be needed, and whether the interventions should be on the financial side, the enterprise side, or both. A challenge for donors and governments is identifying ways to support a value chain without undermining or crowding out private-sector solutions. Interventions should be geared toward facilitating private-sector solutions, addressing market failures and ensuring a functioning enabling environment.

 

Lessons Learned in Value Chain Finance

Opportunities

There are multiple benefits which flow from successful value chain financing arrangements. Through its ability to reduce risk and enhance incentives, value chain finance can enable the sustainable delivery of services, for example ensuring that farmers, brokers and wholesalers have continuous access to a line of products they need that are delivered in a timely manner and meet certain specifications. These arrangements can also improve working relationships (e.g., between buyers and suppliers) and facilitate intra-chain information that lowers the actual or perceived risks of lending. A successful arrangement can often provide a demonstration effect which may prompt larger-scale players and formal financial actors to enter into a new market once the investment opportunities are realized.

Example: In Ethiopia, financial institutions were unwilling to work with agricultural cooperatives until a bank tapped a Development Credit Authority mechanism which shared the risk of loans to cooperatives that provided advances against products deposited by their members. After a successful collaboration, the bank obtained a second guarantee, but did not use it, going on to lend to agricultural cooperatives using their own funds. The bank considered the partnership to be successful on its own merits and continued their on-lending to cooperatives for subsequent on-lending to its smallholder members.

Challenges

One challenge for value chain finance actors is the provision of longer-term loans for capital investments. Most value chain actors supply short-term working capital to clients that require limited monitoring, collateral or paperwork. As with formal financial institutions, value chain actors often struggle with weighing the risks and rewards of offering investment loans. Value chain actors who directly provide financing are also faced with challenges of working in a sector they know little about. There may be costs associated with becoming involved in the lending process; they assume risks for repayment if a guaranteed borrower does not fulfill the repayment obligation; and they risk diverting time and resources away from other activities that might provide a greater return and in which they have more skills and experience. Furthermore, value chain finance takes place within a market system and is based on commercial transactions between value chain actors. The viability of many value chain finance mechanisms can be limited by low or unreliable end-market demand for a product, mistrust among actors, and unsupportive regulatory and policy environment. Contract enforcement and side-selling are common issues that undermine many buyer-based finance mechanisms. Additionally, production and price risks can be major deterrents to finance if they are not provisioned for with other risk mechanisms.

 

Implications for Design and Implementation

Value chain financing offers a variety of opportunities for creative program design, including opportunities for interventions that strengthen linkages between producers and buyers; encouraging banks to lend to value chain actors; organizing smallholder producer associations to enable production of high value crops; and outreach to financial institutions to design warehouse receipts loan products.

A challenge for donors and governments is to determine ways to support a value chain without undermining private-sector solutions. Interventions should be geared toward facilitating private-sector solutions, addressing market failures and ensuring a functioning enabling environment – not becoming a player within the value chain itself. Below are some general implications for program designers interested in expanding financial services to value chain actors.

1. Design sustainable value chain finance interventions.
2. Facilitate information flow from the value chain to financial markets.
3. Design interventions with ‘integrated components’ that focus on increasing access to finance.
4. Identify sources of risk reduction and new incentives.
5. Provide training and technical assistance to value chain connector firms.
6. Introduce and link value chain firms with financial institutions.
7. Identify ways to improve access to longer-term agricultural finance.
8. Recognize the limits as well as the benefits of financing by value chain actors.
9. Look for solutions for gender-based constraints to finance.

For more information on these recommendations, click here.

Footnotes

1. Value Chain Finance Guide: Tools for Designing Project Interventions that Facilitate Investment in Key Value Chain Upgrades. ACDI/VOCA, FHI 360 and USAID. 2012.
2. Rural and Agricultural Finance: Taking Stock of Five Years of Innovations. microReport 181. USAID. December 2011
3. Financing Artichokes and Citrus: A Study of Value Chain Finance in Peru. December 2006