In recent years, two things have changed in the investment landscape i) investor preferences ii) increasing tilt towards alternative asset class for investment. Both these changes are interrelated.
India has witnessed a rise in young investors in the past couple of years. In March 2021, accounts held by investors between the ages of 18-20 were 3.4 million, which increased to 16.1 million in September 2023. Additionally, with the Fintech revolution, there has been a spike in available investment platforms and innovative investment options. This has increased accessibility for young investors who prefer new asset classes by getting attracted to higher return promises even if they come with a “high risk” tag. Read more: Asset Location is as important as Asset Allocation
However, financial planning and investments are long-term concepts and investors should not overlook the associated risks as well as investment suitability based on their needs. This is especially true for India, where many alternative investment assets are not regulated as much as equity and fixed-income tools. This leads us to think about whether one should invest in the alternative asset class or not.
This is the second article in the series “Alternative Investment Options in India”. In today’s article, we will talk about invoice discounting in India as an alternative investment option and what are the factors that investors should consider. Read More: Your Ultimate Guide to Alternative Investment Funds (AIFs)
What is invoice discounting and why is it becoming popular?:
While invoice discounting is not a new concept for businesses, for retail investors, it is still in the nascent stage. Earlier, this facility was offered by banks only, but Nowadays this tool is also offered by new-age investment platforms where they act as a mediator between businesses and investors.
These platforms allow retail investors to fund the invoices of different businesses and earn a return on the same. In simple words, they pull investor money and fund the working capital requirements of businesses. Also Read: Peer to Peer Lending – A New age way to Borrow or Invest? Should you?
Invoice discounting is a short-term investment option, usually 30 to 90 days and offers returns of around 10% to 15% based on the investment platform selected. Some platforms also offer 20%+ returns, but the risks should be assessed for such a higher yield. The minimum ticket size can be Rs. 50,000 to Rs. 3 lakh, but again, this is dependent on the platform selected by investors.
Companies, typically Small and Medium Enterprises (SMEs) and startups have higher working capital requirements and they offer goods and services on credit to suppliers. This means they will have to wait a long period to get their payments, which results in a cash crunch.
To fund their business during this period, these companies use payment invoices as a collateral tool and get funds in the form of working capital loans from banks. In this route, businesses need to pay a higher interest rate, moreover this is not open to all the businesses and also the process with the banks is tedious to follow.
However, new investment platforms have made it competitive by offering these loans at a comparatively lower interest rate.
These investment platforms onboard verified companies, source invoices from them and invite retail investors. Investors receive a return known as the internal rate of return (IRR) for the invested capital which they receive up to maturity. The funds received from investors are distributed among different invoices to diversify the credit risk. When the businesses receive payment from suppliers, they pay off the platform along with interest, and the platform pays capital + interest to investors, after deducting their commission.
Let’s take a hypothetical example. Suppose an investment platform provides funds to a business at 16% interest and offers investors 13% IRR. When the platform receives funds at the end of the maturity period from the business, it pays off the investors. The difference of 3% is the commission that the platform earns. So, for all the parties involved, there is a win-win situation.
Some platforms such as the Trade Receivables Discounting System (TReDS) by the Reserve Bank of India offer high-rated invoice discounting portfolios which adds a layer of safety for investors. However, a majority of platforms fall outside the regulatory purview and have their own credit rating system, which may not be accurate from the investor’s perspective.
Also, while invoice discounting is claimed to be a high-return, low-risk investment, many factors need to be considered such as taxation, investment horizon, invoice portfolio diversification, regulatory compliance and more, which we will cover next.
Factors to consider for investing in invoice discounting
Here are the top factors for invoice discounting as an alternative investment option.
Returns and investment tenure
Investment in invoice discounting is typically for a short period of less than 90 days. As a result, investors do not have to wait for a long period to realise their capital and earn a higher return compared to fixed deposits or stocks (stocks offer good returns in the long term but short term say less than 90 days, it is a risky option).
However, the return percentage depends on the investment platform as well as the credit ratings and track record of businesses. For example, the IRR is on a pre-tax level. Investors need to pay taxes based on their slab rates along with a 10% TDS, which is charged by investment platforms. These charges and taxes can lower the real returns and investors must account for the same while making a decision.
Invoice discounting can be used to diversify the existing portfolio. However, this is a short-term option so investors need to analyze their preferences and risk tolerance level to invest.
Additionally, diversification needs to be there for the available invoice discounting options. For example, if a platform offers invoices of the same 2-3 companies to retail investors, it creates a concentration risk. A large exposure to limited companies creates a huge risk on investors’ part in case the companies default or face financial difficulties. This is more concerning for those invoice discounting options that lack regulations.
There are certain inherent risks involved in bill discounting:
- Credit risk: This includes evaluating the payment track record of a business for which one is undertaking invoice financing. A poor settlement ratio or inability to pay can result in a loss of initial capital. There are credit ratings in place to ensure the viability of businesses and the risk the invoices carry. However, the credit rating can differ across different platforms. This discrepancy raises a question about the methodology and credibility of the credit rating given, which further increases the credit risk.
- Dispute risk: This is the risk that arises when a business and its supplier face a mismatch in the business terms, which results in a payment dispute. If the business does not receive payment, the chances of investors getting their funds and returns become thin.
- Default risk: This is the risk if a supplier defaults in payment and as a result, the business defaults or the business faces financial difficulty to stay afloat and files for bankruptcy. Now understand that while investors have contracts in place with the investment platform, when a business files for bankruptcy, the capital funded by investors is termed “operational debt” and receives lower priority in terms of payment compared to other loans.
- Fraudulent risk: This is the risk of funding spurious invoices generated by a business. However, investing via a credible platform reduces this risk.
- Co-mingling risk: This is very similar to fraudulent risk wherein a business and supplier collaboratively create fake invoices for funding. Read more: Types of Risks in investments and how to manage them
Investors need to check the information available on the investment platform of their choice and focus on investing in high-rated instruments with a proven record of returns to avoid the risks involved in invoice discounting.
How to undertake due diligence for investing in bill discounting?
There are three important points that investors need to undertake for due diligence.
Invest as per your risk appetite
Yes, invoice discounting is a high-yield investment option but it contains certain risks, which need to be considered. It is an investment option for a very short duration. Thus, it is only suitable for a certain category of investors. Also, it is a lump sum investment with a minimum ticket size of Rs. 50,000 to Rs. 3 lakh. Some investment platforms such as Invoice X by Grip offer investment tenure of 9 months, but the minimum ticket size increases significantly to Rs 10 lakh. Also Read: Investment options in falling interest rates scenario
Check the viability of the platform offering this instrument
This is another step that holds significance. In India, invoice discounting at large stays unregulated. While there are government-regulated platforms like TReDS by the RBI, the same is not true for all the platforms. Thus, investors need to check the Terms & Conditions, investor safety protocols, and available invoice diversification (in how many companies’ invoices the platform invests). Choosing a high-rated invoice discounting portfolio from a credible and regulated platform should be a go-to practice.
Compare the charges vs. returns
As mentioned earlier, invoice discounting IRR is before tax. You need to pay taxes on gains and TDS. This can reduce the overall return on your investment. Also, some platforms advertise a certain percentage of return, say 13%. However, reinvestment options (if chosen) may have a different yield say 12.60% (hypothetical). This minor percentage change can have an impact on the overall return and this misinformation can prove beguile. So, this is a crucial step in due diligence. Read more: Form 15G and 15H: How to Avoid TDS on Interest income?
Invoice discounting can suit investors looking for short-term options and have a higher risk profile. Also, investors need to have a certain level of understanding to know how invoice discounting works.
Invoice discounting offers an innovative investment option to investors along with diversification. It also proves beneficial for start-ups and SMEs to receive the working capital requirements at a competitive interest rate. However, since alternative investments lack adequate regulations, one needs to invest according to the individual needs, risk profile, understanding of the instrument, and conducting thorough research.