First Brands and the debt nobody saw

First Brands, a big car-parts maker, filed for Chapter 11 bankruptcy, and Tricolor, a subprime auto lender, had already collapsed into a Chapter 7 liquidation weeks earlier. The two failures exposed a form of hidden leverage that has spread across corporate America: supply-chain factoring facilities kept off the balance sheet.

First Brands, which owns brands of filters, brakes and wipers sold through car-parts retailers, filed in Houston at the end of September after lenders began asking questions its management could not answer. Its creditors are now trying to work out how much it owed, to whom, and whether some of its receivables had been pledged more than once. Tricolor's collapse raised a similar question about car loans allegedly pledged to more than one lender. Among the banks exposed to it, Fifth Third warned of a large loss tied to what it described as alleged fraud at a borrower.

Debt that looks like trade credit

Under normal accounting, bank credit lines and senior secured notes are disclosed prominently on the balance sheet. Reverse factoring and receivables discounting programmes let corporate treasurers turn payables into something close to debt while still classing them as ordinary trade credit. First Brands built up billions of dollars in undisclosed factoring liabilities, and its true leverage stayed hidden until the cash ran out.

How the trick works

The mechanics are simple. In reverse factoring, a finance provider pays a company's suppliers early, at a small discount, and the company repays the provider later, often months later than it would have paid the suppliers. On the company's books the obligation still looks like an account payable to a supplier. In substance it is a short-term loan from a financier, and it can be withdrawn as quickly as any other short-term loan.

Receivables factoring works from the other side. A company sells the invoices its customers owe it to a fund or bank for cash now. Done properly, that is ordinary and useful. The danger comes when a company sells invoices that do not exist, sells the same invoices twice, or keeps selling at ever larger scale to fund losses. Each round makes the company look more liquid than it is, and none of it shows up as debt.

Greensill and Carillion

This has happened before. Carillion, the British construction and services group, used an early-payment programme for suppliers that masked how much it effectively owed to banks, and its collapse in January 2018 left the scale of the obligation clear only after the fact. Greensill Capital, a supply-chain finance firm, failed in March 2021 after insurers withdrew cover. Credit Suisse had to freeze funds worth billions of dollars that had invested in Greensill's notes, and much of the exposure was concentrated on a single industrial group. In both cases the finance was presented as low-risk working capital, and in both cases it turned out to be hard-to-see leverage.

Regulators responded in part. American accounting standard-setters now require public companies to disclose the key terms and outstanding amounts of supplier-finance programmes. First Brands, being privately held, was not subject to those public disclosure rules, which is precisely why the private market has become the natural home of this kind of financing.

Private credit takes the hit

When it did, private credit funds and banks that had provided factoring lines with little oversight suddenly faced heavy write-downs. The failures show that this kind of shadow financing has grown up outside the covenants of the syndicated loan market.

Some of the exposure sat in unexpected places. Funds run by the investment bank Jefferies and by UBS's asset-management arm disclosed that they held receivables linked to First Brands, and Jefferies' shares fell sharply as a result. Investors in those funds had bought what they thought were short-dated, self-liquidating trade assets. They now face a long bankruptcy process to establish whether the invoices behind their investments were real and whether anyone else has a prior claim.

Why it grew

The appetite for such lending has an explanation. Private credit has grown quickly over the past decade, and much of the new money has flowed into asset-based finance, which lends against receivables, inventory and other collateral rather than a company's overall cash flow. The appeal is that collateral seems to reduce risk. The weakness is that it depends on the collateral being real, unencumbered and correctly valued, and verifying that across many lenders is harder than it looks. A company that deals with several factoring providers at once can exploit the gaps between them.

The case against contagion

The strongest argument against alarm is that these look like two frauds, or at least two badly run companies, rather than a system-wide problem. Most factoring is conducted honestly, most borrowers pay, and the losses so far are small relative to the capital of the banks and funds involved. That may well prove right. The difficulty is that hidden leverage is, by definition, hard to measure from outside, so investors cannot easily tell whether they are seeing the exceptions or the first of many.

The signals to watch are the findings of any examiner appointed in the First Brands case, write-downs disclosed by banks in their third-quarter results over the coming weeks, redemption requests at funds that hold trade receivables, and any move by regulators to require private borrowers to disclose factoring to their lenders. First Brands shows that some companies carry large debts that appear nowhere in their accounts, and lenders should assume that reported leverage understates the true figure until factoring is properly disclosed. Expect lenders to demand audits of receivables and to tighten terms on asset-based loans over the next few months, which will raise financing costs for smaller companies that rely on them.