Trade Credit Offsets

Summary:

The purpose of this documentation is to describe a rational approach to economic transformation and development.  While there are those who may suggest that the only solutions to economic systemic transition require a wholesale rejection of legacy systems in favor of entirely new frameworks, at M•CAM and The Global Innovation Commons, we see that every component of the present system is a latent opportunity to serve as an agent of transformation.  The challenge is not to imagine a different world alone.  Rather it is to repurpose existing resources and utilities for transformative outcomes while working on the evolution of new models.  In this explanation, we discuss the use of Trade Credit Offsets as a principle economic development tool for expanding ethical markets.

Trade Credit Offsets are a contractual obligation that occurs when a business domiciled in one country signs a contract to do business in another country.  If the transaction represents a significant component of the GDP, as part of the agreement, a percentage (usually between 20-30%) of the total contract value is obligated to be paid from the company to the foreign country during the term of the contract.  In this regard, offsets are essentially like coupons.   Offsets can be repaid to the country in three ways: cash, training/capacity building (3X cash value multiplier), and proprietary technology transfer (10X cash value multiplier).  Companies prefer to transfer technology or do capacity building rather than transfer cash as, in many cases, it is not profitable to send (up to 30% of) a cash flow back to a customer.  In order to identify offsets, we start by tracking international business procurement contracts which can be input into the Trade Credit Offset form.  Identifying offsets, countries, national development goals, and Global Innovation Commons Challenges give commons users a path to form relationships with companies, countries, innovators, knowledge, markets and capital.  Procurements of almost every kind relate directly to the main innovation areas in the Global Innovation Commons.  For example, one might think a nuclear submarine is completely unrelated to agriculture, water, clean energy or health.  However, a submarine contains very high tech water desalination, purification, and treatment technologies.  It contains air filters, pumps, food storage/safety and power conservation technologies.  These technologies can be transferred as part of a Trade Credit Offset and provide a country immediate access, know-how, training and technology.

A Simple TCO Example:

Trade Credits are an economic system put in place when very large companies engage in commercial transactions where the commercial transaction represented a significant component of the GDP of a country.  When the British or Americans sold fighter airplanes to Saudi Arabia or to Egypt, they needed to get something in exchange.  For example, if the US sold aircraft to Egypt, Egypt, because of the GDP adjusted impact of that contract, in effect said, "you've got to do something for my economy because I can't just have $1,000,000,000 flow to the US or UK."  So, they build into the contract, a Trade Credit Offset, which is kind of like a rebate or coupon. Continuing with the aircraft example, if the US sells an aircraft for Egypt for $1,000,000,000 they would then buy $300,000,000 of Egyptian cotton.  In a natural resource world view, at a certain point in time, the numbers got too big and selling countries couldn't buy enough “cotton” or substitute commodities in other countries to satisfy whatever the offset obligation was.  So a decade an a half ago, Trade Credits included an offset obligation in capacity building.  This is when we started monetizing the concept of knowledge.  We were starting to experiment with a new form of currency, because there is no actual money being transferred between parties. But, when an industrial organization taught a group in the recipient country how to manufacture something or service something, the knowledge transfer had explicit value and therefore was part of the offset obligation.  

TCO Video:

 

TCO In Depth:

For the past five decades, Trade Credit Offsets (or TCO) have become commonplace in sovereign procurement.  A TCO is a contractual consideration which arises from the purchase of goods or services from a multi-national corporation (MNC) by a government wherein the size of the transaction represents a consequential proportion of the purchaser’s economic output.  Simply put, a TCO is a mechanism that “rebates” a portion of the purchase price to the buyer in the form of commodities, in-country contract manufacturing, knowledge or technology transfer or other consideration.  Barring extenuating circumstances, the seller cannot fully recognize the revenue derived from the contract until the offset obligation has been satisfied.  In many instances, offset satisfaction is a precondition to subsequent contract awards. 

While TCO are ubiquitous in most procurement activity, their utility has been vastly under-leveraged by the very countries who seek their benefit.  Lack of effective clearinghouse functions that reliably harmonize buyer and seller expectations lead to delays in negotiations, pricing, procurement and offset settlement.  From the buyer’s perspective, this lack of clarity can lead to abuse and corruption.  From the seller’s perspective, opacity in expectations leads to the risk of damaged reputation and dissatisfaction on the part of the customer. 

TCO are determined in part based on precedent transactions and in part based on a nation’s perception of the market attraction their procurements command in the global market.  TCO requirements commonly range from 25% to as much as 100% of the face value of the contract.  In countries including India, Taiwan, China, Brazil, South Korea, Saudi Arabia and others, unfulfilled (and in many instances, ill-defined) offsets exceed $50 billion in FY 2009.  The majority of offset obligations came from contracts in the sectors of defense, communications, transportation, infrastructure, power, and logistics.

In most emerging market countries, TCO represent the largest untapped engine for economic development and stimulus capital.  Development of coherent strategies for integrating TCO into national investment strategies can lead to acceleration of innovation and entrepreneurial activity while building a viable environment to evolve capital markets.

“Access to capital” is the feeble excuse given by development policymakers and professionals to explain why the “next Silicon Valley” promises have been empty in countries spanning the globe.  Without exception, in every instance where this tired mantra is chanted, we have never heard a single policymaker or professional even know what a TCO is, much less know how to effectively deploy TCO in an intelligent fashion.  While grossly inefficient capital “solutions” such as angel and venture capital are advocated in markets where there is NO liquid merger and acquisition (M&A) or middle market equity activity, both the purveyors of, as well as the local deployers of entrepreneurial advocacy are silent on this massive capital market opportunity.  Worse yet is the recognition that angel and venture capital solutions, when operating at their best in industrialized and sophisticated capital markets barely achieved a 10% success rate – a luxury that no emerging market can afford.

While the strategic options derived from TCO are numerous, we would like to highlight a few fundamentals of an intelligent TCO strategy.  This plan can vastly accelerate economic activity and vitality while significantly reducing the capital required in-country for investment stimulus programs.  Further it can place the appropriate focus on revenue and profit rather than investment and venture capital. 

  1. Latent Technology Transfer– Without exception, every TCO originator country has an expansive vision of building new, high technology businesses employing its citizens in jobs of the 21st century.  At the same time, none of them have fully integrated TCO into that vision.  The mechanism, developed herein, allows the following steps to be taken.

    A complete identification of all research, development, and state-sponsored business incubation in technology or service areas which cover the same, or similar, technology development and intellectual property efforts of TCO obligors.  This process takes the description of activities at national laboratories, research parks, business incubators and small and medium sized enterprises (SME) and matches them to intellectual property and business disclosures in MNC holdings.

    Once identified, we develop a technology transfer suite which includes unused or sub-optimally used patents, non-core business unit legacies from M&A activity,[1] and in-process research and development which can be transferred to, and super-charge the development of in-country research or entrepreneurial endeavors.  This matching process immediately enhances the profile of the local venture in both explicit (access to later stage innovation and market readiness) and implicit (reputational association to international “partner” identification) ways.

    This technology transfer approach is highly desirable to the obligor company as they have the ability to achieve higher multiple (up to 10 X market value) offset credit in most TCO environments.  Ironically, this mode of satisfaction is derived from “assets” that the obligor company has no ability to value on its own balance sheet under traditional accounting.  Additionally, knowing that an in-country enterprise is familiar with technology from the MNC creates a logical counterparty for future research or subcontracting business partnerships. 

    Ironically, most TCO obligors have incomplete international patent and intellectual property coverage for their core and non-core technology.  As a result, the offset holder theoretically could simply identify proprietary filings which are unprotected within its borders and use them without consideration to the foreign supplier.  In fact, the Global Innovation Commons which identifies proprietary filings which are available as open source options for third parties around the world using this model.  However, in many instances, the proprietary filing or patent is not entirely adequate to replicate a business enablement.  Therefore, under this program, a MNC can receive technology transfer offset benefit by offering training or deployment advice (often credited at a 3x multiple of offset value) thereby receiving benefit for an unprotected “proprietary” right.

    Finally, it is imperative to note that these offset obligations can be aligned with social priorities.  For example, if an offset obligation is created by a $1 billion defense procurement, the $300 million offset can focus on civilian fields of use of technology and proprietary holdings of the defense contractor.  The manufacturer of warships also has excellent technologies for desalination and communications which can address public utility and civil service markets in country.  The manufacturer of weapons guidance systems has optics and detector technologies which can enable medical and specialty manufacturing businesses.  Productive business and investment engagements arising from the reconciliation of offsets with non-aligned market options is ALWAYS possible and frequently unconsidered.  A manufacturer of power systems has advanced materials and lubricant technologies that have a myriad of non-core business applications that can be pursued.  Importantly, the government buyer moves from a passive recipient of ill-defined offset benefits to an explicit consumer role of identifying and requiring technology as optimized assets in TCO agreements.  
     

  2. Cash Flow Optimization– The “Silicon Valley” illusion in economic development uniformly ignores the fact that Silicon Valley was built on government-subsidized procurement preference, not on venture capital.  For SME markets to emerge and flourish, local acquisition preference must be integral to an economic plan.  Profits derived from bona fide revenue, not equity capital, are what build businesses.  As such, TCO can include a process whereby the obligor can satisfy the obligation by preferentially looking to in-country research laboratories, universities, incubator companies and SME where local proficiency can be contracted for collaboration.  No large system integrator MNC would be opposed to out-sourcing information technology and materials capacity if there was an efficient way to match local capacity to MNC service demands.  Every MNC would benefit from an efficient process that would show in-country entity-by-domain capacity which could be accessed for offset resolution and strategic subcontractor partnership.   This focus on cash-flowing contracts rather than equity investments in no way precludes investment – it simply makes the local enterprise credit-worthy with profitable, investment grade revenue streams.
     
  3. Collateral Enhancement– In most emerging markets, credit providers are in place.  However, most of them have little to no capability to extend credit into the SME marketplace rendering them reliant on government guarantee credit enhancement programs.  Regional development banks, including the World Bank and the IFC, may offer a modicum of credit but it is done with considerable restrictions and political concessions. Using a  TCO transition model developed by M•CAM Inc., a combination of the Latent Technology Transfer and Cash Flow Optimization provides the environment into which regulated banks and credit providers can operate.  Local enterprises equipped with latent technology transfer or orphaned businesses from MNC, optimized by partnership, service, or supplier contracts from obligors, and often qualify for M•CAM’s Intangible Asset Risk Transfer collateral enhancement.  This allows credit-acceptable, collateral insufficient prospective borrowers the ability to receive a purchase guarantee on the intangible assets used as collateral thereby qualifying them to access lower-cost capital.

It is helpful to demonstrate the manner in which this program works using the following hypothetical case, an expanded version from the summary:

Let us assume that the government of Brazil seeks to purchase a $500 million maritime and Amazon basin radar and communications infrastructure.  It identifies candidate MNC contractors – two U.S., one French, two German, and one U.K. – all who are capable of meeting the specification with little modification.  Brazil asks for a 30% offset pegging the value of return business at $150 million.  Prior to award, Brazil can profile all Latent Technology Transfer options held by each candidate contractor and identify desirable technology qualifying for national research priorities, academic research programs, or SME transfer.  The optionality of Latent Technology Transfer optionality can inform contractor selection and negotiation.

Brazil selects a contractor with specialized capabilities in naval equipment.  The contractor, in addition to its radar and IT systems, has substantial intangible assets (proprietary rights and post-M&A orphaned business units) in technology including computer simulations, materials science, RFID, water desalination, and nuclear reactors.  Brazil determines, in advance, the complete resolution of the offset – at contracting – linking these technologies to researchers and entrepreneurs in country who will serve as research recipients, research partners, and subcontractors to the project.  The SME in country selected as a subcontractor becomes the beneficiary of both technology sourced from the MNC and investment grade cashflows.  The benefit to the country exceeds the TCO alone as the ecosystem effect benefits local employment, collateral businesses, and banks.  At no point does the Ministry of Finance or the Trade Promotion Authority need to offer expensive credit guarantees.  They simply need to insure that the contracts on asset and knowledge transfer are complete and that the deliverable contract is robust and assignable so the cash-flows can be used for receivables financing.

This model is desirable as both the procuring country and the MNC have clearly defined performance obligations and expectations.  The in-country MNC has become more financeable and, in the long term, the capital market flexibility for the SME increases.  TCO creates transformative, accelerating economic development requiring NO NEW capital injections.  Simply aligning EXISTING contract and procurement obligations to innovation and development priorities provides visibility to the buyer and seller and launch and growth capacity to in-country SME.  With NO NEW RESOURCES, economic empowerment – not wealth re-equilibration – is derived from existing systems.



[1]During the past two decades of M&A consolidation in the U.S., Europe and Asia, large system integrator companies (e.g. Siemens, Alstom, General Electric, Boeing) have acquired smaller companies for strategic business growth objectives.  These acquisitions are typically justified around core business propositions and fail to effectively identify, recognize, or value smaller business or research interests in the acquired entity and these “assets” (when acknowledged) are viewed as “non-core”.  This designation leads to an abundance of “widowed and orphaned” business opportunities which are ignored in the acquiring company but may represent millions of dollars of research – and in some instances, revenue – that can be recycled using TCO.

**Another linked Offset Description/Resource - http://www.epicos.com/Portal/Main/AerospaceDefence/ICOffset/Pages/default.aspx