Value Chain Finance

Value chain finance refers to financial products and services that flow to or through any point in a value chain in order to increase returns on investment and growth and competitiveness of that value chain. Whereas value chain finance transactions are not new (production finance could be considered “value chain finance”) the emphasis on improving finance at one point in the value chain to increase the competitiveness of the entire value chain. With value chain finance, the risks and returns of the finance provider are considered along with the risks and returns to value chain actors. As Figure 1 illustrates, value chain actors themselves, banks, microfinance institutions, other non-bank financial institutions, or a combination of these actors can provide finance to a value chain. These actors participate in the value chain for different reasons that distinguish their approach to value chain financing.

Some value chain actors finance others in the value chain as a means to off-set potential risk. For example, a buyer may provide working capital loans or advances 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. Traders can provide in-kind loans (in the form of inputs) to farmers as a normal business practice with clients that have limited liquidity. The trader’s goal may be to build trust and a stable client market, or the trader may recognize that obtaining inputs on credit is the only way the cash-strapped farmer will be able to make the purchase. A microfinance institution or bank may provide finance to 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. Lines of credit, factoring and warehouse receipts financing are other forms of value chain finance.

Value chain finance is important to help businesses meet market demands – whether that be to maintain or expand operations or invest in upgrading to access new market opportunities. 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. These examples show the importance and flexibility value chain finance offers. And, as a result of close working relationships (e.g., between buyers and suppliers), actual or perceptions of risk are decreased, and loans or input supplies are provided more readily than without this intra-chain information. So while financing might still come from traditional sources, it is based on value chain relationships or information.

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.^[1]

Through its ability to reduce risk and enhance incentives, value chain finance also lends itself to the sustainable delivery of its services,for example, ensuring that farmers and wholesalers have continuous access to a line of products they need that are delivered in a timely manner and meet certain specifications. The acknowledged interdependence of actors also reduces risks of non-delivery and non-repayment. These traits are critical to the sustainable delivery of finance and the overall competitiveness of a sector.

Value chain finance works best where the value chain is functioning well; that is 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.

Types of Value Chain Finance

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

The provision of credit, savings, guarantees or insurance to or among value chain actors.
The creation of strategic alliances through financing extended by a combination of value chain actors and financial institutions.
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. The analysis starts by examining end market opportunities for the products or services within the value chain. End-market analysis includes not only an understanding of trends, but also includes market segmentation to better high-potential segments, benchmarking to compare competitors in a given segment, as well as a positioning strategy comparing competitors strategy with the value chain under study. End-market analysis is followed by chain analysis, identifying actors are in the value chain, their constraints, inter-firm relationships (with whom they work together, compete, share information, etc), and how these horizontal and vertical relationships are limiting competitiveness. The analysis includes service providers that provide sector-specific and cross-cutting services.

Value chain finance analysis identifies the financial needs of a value chain if it is to take advantage of end-market opportunities and address key constraints to these opportunities. Value-chain finance analysis asks where in the chain finance may be a constraint, whether there are other pre-disposing conditions and risks impeding access to finance and what is the best of use of capital. In identifying financial constraints, a value-chain finance analysis also looks for incentive structures that facilitate and encourage financial access within the value chain. Factors regarding the enabling environment and financial sector issues that may impact the availability of financing should also be examined during the information-gathering stage. Importantly, the value chain analysis must identify key financial bottlenecks to growth of the sector.

Value chain finance analysis gathers information on financing—along with other value chain information—from industry stakeholders, firms and financial institutions, while focusing on the financing constraints to identified opportunities. Upon understanding (from the value chain analysis) the upgrading investments needed to take advantage of end-market opportunities and improve competitiveness, interviews are conducted with financial providers in and outside of the value chain to reveal the degree to which financing is already available and, if finance gaps exist, finance providers’ perspectives on why the gaps exist. Interviews should 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 which can constrain the prioritized improvements in performance of a value chain.

Financing gaps are further analyzed to determine why they exist. In general, financing is absent because potential cost is seen to outweigh the potential benefit. In some cases, financing is absent because of perceptions on the side of the finance providers, e.g., that the venture is too risky, or from the side of the potential borrowers, e.g., that the investment is a bad risk. Financing may be absent because the finance provider or potential borrower cannot accurately determine the benefits of increased investment, and in other cases the lender or borrower may correctly assess the risk of lending and investing. 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 opportunities for leverage within many value chains to reduce costs, manage risk and build trust. Three examples are:

Challenges

Value chain finance holds many positive attributes. These include ease of access, flexibility, the lowering of risk which can lead to the increased competitiveness of a sector. One challenge, however, 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 finance actors are also faced with challenges of working in a sector they know little about. Since their main driving factor is securing a product and reducing risk the specifics of the financial transaction can be mismanaged – with risks of non-repayment, lack of equity, and misuse of funds.

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.