Proof of Concept

Dateline: Tel Aviv

After seven months of active trading on The Receivables Exchange I can say that a number of significant “proof of concept” questions have been answered in the affirmative; both at the level of the Exchange operations and from my own point of view as a Buyer. Some questions are still open, of course, and will be answered with more time and experience (and money).

This will not be a long post, partly because I’m here to visit family and not to write blog posts, and partly because I’m writing on an HP Mini that has a keyboard that is friendly only to fingers the size of my 4-year-old granddaughter Emma’s.

But this has been my first opportunity to run a significant test of an important (to me) attribute of the TRE platform and process.

In my normal business of buying invoices it is important that I be in close contact, frequently in person, with those I’m buying from. An attraction of the TRE process for me is that it shouldn’t matter whether I’m in New Jersey or Tel Aviv (except for the circadian disruption of a 7 hour time difference). I ought to be able to do anything I need to do to be an active and effective Buyer from any location, or from a different location every day, if I should choose.

I’ve now proven to my own satisfaction that that element of the concept is valid.

I’ve bought two auctions in the last two days using a wireless high-speed internet connection and this almost toy-like little netbook.

Admittedly, the administrative part of things is a bit more cumbersome than if I were in my office with all of my files and support equipment. But the short-term essentials, including buying, record-keeping and moving money around can be done quite readily via wireless connection.

If my business were strictly TRE-based I would have no problem making a permanent location change over a week-end, whether I was moving across the street or from one continent to another.

That’s cool.

May 2010 be a healthy, happy and prosperous year for us all.

A Comment on Risk

I heard a marketing presentation not long ago in which it was asserted that that “only three-tenths of 1% of invoices ultimately go unpaid”. The unspoken but implied conclusion was that buying invoices involves only minimal risk.

I asked for the source of the statistic quoted and was told that it came from the Credit Research Foundation. I contacted the CRF and obtained a copy of the quoted report, which is entitled “National Summary of Domestic Trade Receivables: 2008 Annual Bad-Debt Report”.

The top-line analysis is provided in two statements:

1) “Net bad-debt write-offs during 2008 totaled $30.00 per $100,000 of sales. This is a net change of $0.00 over 2007, and

2) Allowance for uncollectables during 2008 was 1.00% of receivables. This is an increase of .50% over 2007.”

(Not to be picky, but $30 per $100,000 is actually three one-hundredths of one percent, not three-tenths.)

A few observations:

• The number of respondents to this survey was 555. It is not clear how large a part of the overall economy this sample represents.

• The figures quoted in the summary statements above represent the median responses.

• While the write-off figure did not increase in 2008 over 2007, the allowance taken in 2008 was double that of 2007.

• In the case of the write-off figures, the upper-quartile break-point of the sample was at .19%, or about 6 times the median level.

• In the case of the allowance for uncollectables, the upper quartile break-point was at 3% of sales---100 times the level of the median write-off reported!

So you can choose to highlight the finding that the median write-off remained the same from one year to the next. Or you can take note that the expectation of losses, captured in the allowance figure, increased by 100%.

Or you can acknowledge that the upper-quartile, forward-looking statistic is 100 times the median backward-looking statistic.

The waters might not be as placid and shallow as they appear!

There’s another source of data that is more relevant to the operation of The Receivables Exchange. It is collected by The International Factoring Association. For 2008 this data represented the experience of 120 companies in the factoring business.

• The median write-off experience of that group in 2008 was .3% of gross invoices purchased, 10 times the median of the CRF sample. The average write-off experience was 1.3% of gross invoices purchased, more than 4 times the median.

• The IFA presents results broken down by size of respondent. The largest companies providing data; those with $100 million or more in gross receivables purchased; had the lowest loss experience, at .6% of invoices purchased. The smallest companies, buying less than $5 million per year, had an average loss experience of 2.5% of gross purchases.

• These figures, from companies actually involved in the industry, are far higher than those reported by the CRF. But more importantly, I think, these figures represent the experience of companies that KNOW the risks of buying invoices and take all of the normal precautions against losses.

I’ve detailed in other posts the ways in which the Exchange’s practices in qualifying Sellers, in obtaining security and in verifying invoices fall short of those in common use among buyers of individual invoices. (I've also pointed out some unusual benefits of the TRE process as well, however.)

I’ve argued that the TRE Buyers are exposed to incremental loss levels because of those shortcomings in risk mitigation.

It’s too soon to say what level of incremental return should be required by TRE Buyers to adequately offset the added risk.

It is not too soon to say, though, that the increment should be added to the IFA experience, not to the much lower CRE numbers.

And I would argue that the baseline point of the analysis should not be the experience of the largest companies but rather of the smallest, recognizing that the majority of TRE Sellers would not qualify for funding by the largest factoring companies.

We've all heard the one about the guy who drowned in a river that was only 6 inches deep, on average! Some statistics can be correct and irrelevant. Some can be correct and dangerous.

It's only coincidental that the first three letters of Treasuries, are TRE. We're not buying Treasuries here!

It's BLT or Toast!

I was talking with a man a couple of days ago who runs a factoring company. He called to ask about my experience with The Receivables Exchange. Before I could begin to really answer he launched into a bit of a diatribe regarding the impossibility of TRE’s ever becoming successful.

As he delivered his “I know more than you do” lecture I thought of that wonderful quote from Hebert Spencer:

“There is a principle which is a bar against all information, which is a proof against all arguments and which can not fail to keep a man in everlasting ignorance—that principle is contempt prior to investigation.”

Now this man had done some investigation and he’s a bright and experienced person. But he has a view of what is possible that is strongly influenced by a desire to maintain the status quo.

The problem is that once the genie is out of the bottle, the status quo cannot be maintained. The nature of a disruptive idea, process or event is that it DISRUPTS, no matter how inconvenient that disruption might be.

I believe that the IDEA of TRE is disruptive.

The question, in my view, is not WHETHER there will be a successful online auction market for accounts receivable. Now that the idea is out there, the question becomes whether the specific TRE model and process will be the one that survives and prospers or, if it fails, what changes to the TRE model will be necessary for the NEXT such venture to succeed.

As much as the traditional factoring industry pushes back at the TRE model, I haven’t heard anyone say that the basic idea is a bad one. The devil is in the details. Those who offer opinions that the Exchange can never work often point out perfectly valid weaknesses in its process.

But anyone can do that! I’ve done that; often and publically. It’s not hard. But they tend to stop before suggesting a solution. And there ARE solutions. They might be hard. But a lot of things are hard; that doesn’t make them impossible.

Here’s what’s hard, in my view.

To think BIG, not small. To think LONG TERM, not short.

Federal Reserve data suggest that about $18 Trillion of B2B receivables are created in the US each year. That’s a BIG market. The factoring industry touches less than 3% of that volume. It might be threatening to suggest that a highly professional and well-developed financial market is actually quite small compared to its potential. Especially if the idea comes from a source outside the industry!

In this case, thinking BIG is not a matter of a few percent points change in growth rate. Thinking BIG requires conceiving of exponential growth!

When you’re ass-deep in alligators, as many have been over the past year or two, short-term thinking is critical. Survival is the priority. And in that kind of environment it’s very hard to shift gears and think long-term. But when confronted with a disruptive idea, the only way to craft an appropriate response is to detach from the present crisis and look out to the horizon.

Is it possible that there is room in the industry for a very different model to work? And not only to work but to add value in an important way? Not to replace the current model, which is probably the best one for many clients. But to provide a solution for those whose needs are best met with a different approach.

There’s no question that there are many elements of the TRE model that deserve to be addressed in a critical way and a few of them might well be make-or-break practices or polices.

But in the long term let me suggest that it doesn’t really MATTER whether TRE gets it right or not …or even if TRE itself survives or not.

What matters is that the idea is now out there and the real-time, real-money, market experiment is well underway. If TRE fails it will leave behind valuable evidence of the cause of failure and the next venture will have a much better chance of succeeding.

I’ll get back to criticizing in my next post. Today’s message is to those who practice the Spencer principle of contempt prior to investigation.

In the face of disruption think BLT (Big and Long-Term) or (risk becoming) toast!

For the Record

Just for the record, this afternoon we bought our fiftieth TRE auction since going “live” as an active Buyer.

We’ve bought from sixteen Sellers.

We’ve bought invoices due from twenty-nine Account Debtors.

Thirty-five of our auctions have been paid-in-full.

I’ve been targeting 50 purchases for a while now as a kind of milestone. It's just cool to have hit it. That's all.

Next stop = 100!

I'll write on a subject of broader interest over the week-end.

The Quality Rating Question

The credibility of credit rating agencies has taken a major hit during the financial turmoil of the past year. In most cases the credit rating agencies had before them audited financial statements to work with in making their judgments.

In some cases, the judgments themselves seem to have been faulty. In others, the data given the agencies has been faulty, even if audited.

PriceWaterhouseCoopers recently published its “Global Economic Crime Survey 2009”.

Quoting from their report: “…nearly one in three organisations around the world reported they were the victims of economic crime during the past 12 months. Of those, 43 percent said that the incidences of fraud in their organisations had increased during the period…Asset misappropriation or theft, cited by 67 per cent of those who reported crime, was the most pervasive, followed by financial statement fraud, cited by 38 percent…”

A representative of the accounting firm commented: “The global economic downturn has heightened the pressures and incentives to commit fraud…In these tough times, the temptation to inflate results or take part in other forms of financial statement fraud may overcome ethical values…”

If there is pervasive opportunity for misstatements among larger, more closely-scrutinized companies, how much greater is the opportunity among smaller, privately-owned businesses whose financial reports are not audited, or in many cases, even reviewed?

Add increased opportunity to increased incentive and the tests of “ethical values” are likely to be even more severe.

We’ve commented more than once in past posts about the fact that most TRE Sellers do not provide audited or reviewed financial statements. We’ve also made the point that it is the SELLER that makes the promise to re-purchase an unpaid invoice. The credit of the SELLER is actually more important in the TRE format than in many other factoring formats.

It is the nature of privately-owned businesses, many of which are in S-Corp or LLC formats for tax purposes, to allow tax considerations to influence financial reporting practices. It’s not unusual or even unexpected to be told that getting a picture of the “real” operations and profitability of such a company requires the books to be adjusted.

Some of the financial statements provided by TRE Sellers show obvious signs of such “adjustments” and some of those adjustments appear to be made clearly in order to present a more palatable view of their operations to TRE Buyers.

There’s not necessarily anything wrong with that!

The picture that a privately-owned business presents for tax purposes might actually be a seriously unfair view of it as an operating entity for any number of reasons.

But, to the extent that getting approved as a Seller on the Exchange provides incentive for erring on the side of optimism, the prospective Sellers have both opportunity and incentive to overstate their financial health. And that clearly increases the risk to the Buyer.

TRE has, on its staff, former FBI experts in detecting financial fraud. That’s a good thing.

A better thing, in my opinion, would be to also have a third-party rating entity on contract to examine all of the financial statements provided by Sellers and prospective Sellers and to attach quality ratings to all Sellers posting auctions for sale on the Exchange. Since Buyers are prohibited from contacting Sellers directly, there is little realistic opportunity for Buyers themselves to question financial statements provided by Sellers.

The Sellers have a conflict of interest that is clear.

The Exchange itself has conflicting incentives: a) it needs to bring in a substantial volume of new Sellers and so it needs to make the process as easy as possible for them, and b) it needs to protect against embarrassing defaults and losses.

A third party, without such conflicts, would provide the more credible solution.

Does the admittedly tarnished reputation of rating agencies, in general, damage the credibility of that suggestion?

I don’t think so.

There’s no Fannie Mae or AIG or Lehman Brothers, with the clout to bully a rating agency, among the smaller, privately-owned TRE Sellers. If anything, the balance of power between the rating agency and the Sellers would probably invert the opportunity for pressure in the process.

Any Buyer that has looked closely at the financial statements provided by TRE Sellers would, I wager, agree that a third-party assessment would be both welcome and valuable.

Maybe there's a Smyth Solution possible?

Credit Where It's Due

In my last post I said that TRE had, in its effort to meet volume goals, tilted its policies and procedures in favor of the Seller community. That is both a strategic and tactical decision whose logic I think we can understand whether or not we like it or agree with it.

Today I’d like to put issues of Exchange strategy aside for a moment and make a few points about nuts and bolts.

Today marks my six-month anniversary as an active Buyer (following two months acquiring some education as a very active observer).

And I have been an ACTIVE Buyer during that period.

As a percentage of the total dollar volume of auctions my activity hasn’t been a very significant factor. But as a percentage of the actual number of transactions, my activity has been significant. I say that to make the point that I speak from experience.

I’d like to share a bit of that experience:

--About two-thirds of the auctions I’ve purchased have, as of today, been paid-as-agreed; closed-out without the need for any action on my part after purchase.

--None of those that remain open give, as of today, any sign that there is a cause for concern.

--The auction platform, itself, works very well. It has been improved significantly during the past six months. There are many enhancements that could, and hopefully will, be made in the future. But the fact that it works as well as it does at this stage of the Exchange’s life is a tribute to its creators and to TRE.

--The Liquidity Desk operation in New York is professional and responsive. Questions are answered quickly and issues that need to be addressed get addressed.

--The Member Services group in New Orleans provides excellent service. They send out all the reports of awarded auctions, coordinate the flow of funding for auctions, report on payments received from Account Debtors, and generally act as the interface for all financial and accounting matters from the purchase of an auction until it is closed out.

Counting all of the individual transactions and reports generated by our trading activity over the past six months there have been literally hundreds of opportunities for errors in the accounting and funds-flow systems. There have been less than a handful of minor issues and not all of those were the responsibility of Member Services. In each case, the Member Services people have been responsive, professional and diligent in finding and correcting the problems.

--The Operations Department, as a whole, has also been quite helpful. I’ve had occasion to ask a number of questions that have been referred to Operations for response and the responses have been timely and to the point.

What’s MY point?

The TRE trading platform and its operations system WORK!

That’s a BIG thing and the Exchange is to be commended on its accomplishment.


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Half a Bubble Off Plumb!

In my “Happy Anniversary!” post of November 23, I wrote:

“From my point of view, the Exchange has tilted significantly toward the Seller community as it has attempted to bring on sufficient product to meet its volume targets.”

The degree of tilt is probably more than just “half a bubble”.

What has the Exchange done to “tilt” the playing field to favor the Sellers?

First let’s review where we began. From inception TRE:

--Has not required personal guarantees from the principals of Sellers,

--Has filed UCC Financing Statements encumbering ONLY the receivables sold on TRE (as opposed to getting a blanket lien on all receivables), and

--Has accepted internally-generated financial statements, frequently without any evidence of independent review.

Since the Exchange’s operations began, there have been a number of changes in policy or process that are good for Sellers but bad for Buyers.

What are some of those changes?

--Initially, invoices were to be verified by a third-party service provider. Now, the Exchange itself handles verification.

--Initially, the verification process was to include confirmation that goods had been delivered or services performed to the Account Debtor’s satisfaction. Now, verification is limited to obtaining confirmation that there is an invoice in the Debtor’s accounts payable system that matches the number, date and amount of the posted invoice. No actual affirmation of satisfaction is obtained. (Note that invoices from members of The Ariba Network do meet a more stringent standard.)

--Initially, all invoices were to be verified. Now, there is a sampling system.

--Initially, progress billings, which are common in the construction industry but present unusual risks, did not qualify for posting on the Exchange. That prohibition appears to have been relaxed.

These are significant procedural changes and they clearly increase the level of risk borne by Buyers on the Exchange.

I think it is clear that the changes have been made to allow TRE to attract more Sellers.

It might seem counter-intuitive that relaxation of procedural safeguards has been necessary to attract Sellers in the economic environment of the Exchange’s first year. After all, the papers have been full of stories about how difficult it is for businesses to find financing. But I don’t think the message is ambiguous.

TRE needs to ramp up volume to reach a level that makes it economically viable and proves to its equity investors that it is a viable operating entity for the long haul.

If the problem were attracting Buyers, any procedural changes affecting Sellers would be in the direction of tightening standards and procedures; making the risk profile more attractive to Buyers.

Changes in standards and procedures that increase risk to Buyers seem clearly to signal that the imbalance is on the Seller side.

The TRE calculus seems to be (this is my speculation only) that the Buyers will tolerate the increased risk as long as the risk is “potential” rather than “experienced”. That is, there are no significant Seller defaults and subsequent losses to Buyers. The implicit hope is that the Exchange can somehow control matters in the short term, avoiding any serious risk-related problems until it reaches its equilibrium level of volume.

At that time, maybe the process of moving back toward a level playing field can begin. If that IS what’s going on it’s a delicate and potentially perilous process.

On the positive side, while TRE will not hit its publically-stated volume targets this year, the volume HAS been ramping up significantly over the past few months and if we were to annualize current levels, the Exchange would come close to its volume goals on a run-rate basis.

If TRE can make meaningful progress on some of the impressive and important Seller-attraction initiatives already in place; including alliances with The Ariba Network, The American Staffing Association and Smyth Solutions, it is possible that it can reach a volume level in 2010 that can sustain its operations.

As it is approaching that critical volume level, however, it’s going to need some luck. The single greatest risk that it faces, I believe, is a nasty default and a public squabble over losses.

The additional risk in the system is real and “half a bubble” of tilt toward Seller-leniency is probably all the system can tolerate. Ultimately things will have to move back toward balance.

In the meantime: see my posts entitled “Caveat Emptor”.

Happy Anniversary!

The first auction of invoices on The Receivables Exchange closed on November 24, 2008.

The Exchange has gotten its share of “bashing” in the industry and, to be fair, it has earned some of that bashing.

But it has also earned, and not always received, clear and unambiguous recognition of the daring, and I think ultimately disruptive, innovation it has created in the receivables-finance industry.

The people who conceived of TRE didn’t come from the factoring industry. Maybe that’s why they COULD conceive of it: they didn’t know the sixteen reasons it could never work!

The Exchange has not yet proven itself to be a survivor. Adoption has been slower among both Sellers and Buyers than I am sure the founders had hoped. Quite a few early-stage assumptions and decisions have had to be jettisoned or modified. And that process is not yet over.

From my point of view, the Exchange has tilted significantly toward the Seller community as it has attempted to bring on sufficient product to meet its volume targets. And I’m not even close to being finished with the points that I’ve been addressing in my last two blogs on the subject of risks to the Buyers. Nor am I finished with offering my own views on structural and procedural changes I think TRE should pursue.

But I think we all should take just a day off from fault-finding and congratulate all of those who have worked so hard to turn a tremendous idea into a functioning reality.

All beginnings are hard.

Happy anniversary to all at TRE!

Caveat Emptor # 2

In our post of June 20: “Blanket Security vs a Security Blanket” we discussed the fact that a Buyer of invoices on The Receivables Exchange obtains, via TRE, a lien on the receivables purchased and on any excess cash that might be available in the Seller’s lock-box account.

This is in contrast to the blanket lien on all of a Seller’s receivables that is often acquired as security by a factor or invoice purchaser; or, short of that, to the lien on all receivables due from one or more named Account Debtors.

The actual collateral providing security to a TRE Buyer is minimal relative to the industry norm.

The TRE Seller does provide an unconditional guaranty to repurchase a receivable sold on the Exchange if payment is not made to the Buyer by a date certain, which provides additional security to the Buyer. But that security is only as good as the Seller’s ability to perform.

So the importance of an accurate assessment of the Seller’s financial capacity actually increases in the context of a TRE transaction; because the specific collateral provided is more narrowly defined.

We’ve noted that the Exchange requires certain financial information to be provided by the Seller and that the TRE trading platform makes access to that information convenient. The Exchange itself, however, takes no responsibility for the accuracy or adequacy of the information provided and makes it clear that Buyers are responsible for their own due diligence and decisions.

As I’ve said before---that's fair enough, as long as we know the rules.

Those who have been in the business of buying receivables for any period of time will probably have had experience with transactions “gone bad”. Most would agree that more can be learned from one bad deal than from dozens of deals with which there have been no problems.

One of the things that I’ve learned is the importance of knowing whether I’ve really got a good, clear lien on an asset, and who else might pop up to make a claim on assets if things go bad for the debtor.

Not long ago an auction was posted on TRE by a first-time Seller. Besides financial statements, TRE makes available on its Seller Profile pages, a record of a UCC lien search. This tells us what claims have been recorded against the assets of the company and so has direct bearing on the strength of a Buyer’s collateral position.

In the case of this Seller, the prior UCC filings ran to 78 pages!

Now that, in itself, doesn’t mean that the position of the Buyer in the specific receivable being posted for sale is jeopardized.

It DOES mean, however, that the Buyer CANNOT know that its position is NOT jeopardized without devoting some significant time and attention to analyzing the prior filings. This is especially true because, in this case, there was no separate release of lien or subordination document provided for Buyer review.

A Buyer might have thought: “well let’s see if the financials are really strong and maybe I can take a chance making a bid even before I have the time to analyze the UCC filings”.

In this case it happened that the Seller’s most recent financials were noted as “internally prepared for use by management”. OK, that’s not really unusual, especially for interim accounting periods.

But in this case it happens that there is a single, large, intangible asset on the balance sheet that is roughly double the size of the company’s net worth. So, without that intangible asset, the net worth of the company would be negative rather than positive.

What’s my point?

I am NOT saying that this Seller shouldn’t be selling receivables on TRE.

I am NOT saying that TRE has failed in any way to provide what it has committed to provide to Buyers.

I AM saying, however, that TRE has made it clear that it is the BUYER’S responsibility to analyze the potential transaction and determine whether it has enough information to bid.

TRE has said “Caveat Emptor!”

I am willing to bet that in the period of time between the posting of the first auction by this new Seller and the time the first bid was recorded, no Buyer would have had time to analyze the 78 pages of UCC filings provided and determine whether or not the collateral provided was likely impaired by prior claims.

I am relatively sure that TRE will do all it can at this point in its life to try to work out any problems that arise with transactions on its platform.

But when TRE says, as it clearly does, that the Buyers and not TRE are responsible; it just makes sense to believe them.

The Buyer's first recourse is to the Seller, no matter who the Account Debtor might be and no matter what TRE might be willing to do to help out at this point.

So, indeed, let the Buyer beware!

Caveat Emptor #1

In our post of November 3 we urged The Receivables Exchange to adhere to its policy of requiring quarterly updated financial statements from TRE Sellers and posting those statements to the TRE Platform.

In early posts on this blog (see particularly those in June and July) we made the point that TRE, itself, takes no responsibility for the accuracy or adequacy of the information provided to Buyers. It is the Buyer’s responsibility to perform whatever due diligence it considers appropriate.

Caveat Emptor: “Let the Buyer Beware”; is the position taken in the TRE documents.

Fair enough--as long as we know the rules.

On the other hand, while I stand by my compliment to the TRE Seller-sales staff in our last post. And, while I understand that bringing more product to the market is a critical TRE objective at this point. It is also in the long-run best interests of the Exchange to balance its attention between the interests of the Seller community and those of the Buyers.

Providing updated financials would be one way to illustrate that balance. The basic point I made on November 3 was that it is important to Buyers to track changes in the financial condition of Sellers after their initial qualification.

I had a reminder of that this morning.

One of my disciplines as a Buyer is to get third-party credit information on all Sellers that make it through my initial analytic filters. Some providers of credit information send out “alerts” to those who purchase information, communicating subsequent changes.

I received such an alert this morning on a company that is a TRE Seller.

This company has completed a number of transactions on TRE since the spring, apparently without problem. The financial statements made available at the time of its first transaction were as of April 30. No updates have been provided.

As a Buyer, I would hope that the Seller’s use of TRE would have allowed it to better its financial position over the course of its experience with the Exchange. But I got an alert this morning that it’s rating for “risk of late payment” has deteriorated and that a state tax lien had been filed against it.

Now, neither of these alerts constitutes a “life threatening” event. But both convey information that is important to me.

If an auction by that Seller is posted today I will have to approach it more cautiously than I would have last week. Until I can see updated financial statements I will have to assume that they would be weaker than those I have in hand.

That might be fair, or it might not. But that’s the position that “caveat emptor” requires.

It's a Page Turner!

There are some things that just shouldn’t pass without comment.

When I arrive at the office each morning I print and record the details of all auctions completed on The Receivables Exchange on the previous day. And I print and log the listing of all auctions that are “live” at the beginning of the new day.

Volume on TRE has been increasing significantly in recent months and the trajectory seems to be steepening as we move into fall. That’s a very good thing.

The Exchange’s Seller-marketing team has clearly been working hard.

But today, for me, was something of a milestone in TRE history. One that I think should be noted,

This morning, for the first time, the list of “live” auctions took more than one page to print!

Maybe I’m easy to impress; but I thought that was very cool!

Congratulations, guys!

Let's See the Numbers!

Companies that sell their invoices on The Receivables Exchange are required to provide two years of financial statements as a part of the Seller qualification process. Once approved as Sellers they are also supposed to provide quarterly updates to their financials.

Those updated financials are supposed to be posted to the Seller Profile pages, allowing Buyers to update their due diligence analysis.

As we approach the anniversary of the first TRE transaction I think it is appropriate to point out that the Exchange does not appear to be enforcing the requirement to update financial statements.

If it IS enforcing the requirement, it is NOT posting the updates to the Seller Profile pages.

The most recent financial information available, in many cases, is still as of year-end 2008. In nearly every case, the statements provided at the time a Seller posted its first auction are still the only ones available.

Given that the great majority of Sellers provide only internally-generated statements, it can hardly be argued that there hasn’t been time to update statements through at least the second calendar quarter.

As important as I think it is to Buyers to be able to make decisions on the basis of appropriately current information, the Exchange itself should also be looking closely at the changes in Sellers’ financials.

TRE has a significant stake in the impact of Seller use of the Exchange on Seller financial health.

I would hope, in fact, that the management of the Exchange has already made an arrangement with a credible third-party; perhaps a well-known business school, for instance; to study the impact of TRE’s unique platform on the subsequent financial health of its Sellers.

The job of attracting good-quality Sellers has been difficult. TRE does a good job of quantifying the theoretical value of accelerating cash receipts in its marketing efforts. If the theory is borne out we should be approaching the time when some ACTUAL value-added can be empirically demonstrated.

It would be a shame if the experience of the first TRE Sellers was not used to make the job of attracting subsequent Sellers easier.

Ultimately, proof of the value of TRE to its Sellers should be apparent in the analysis of subsequent financial results. If subsequent statements are not obtained by TRE and made available for analysis, not only will TRE Buyers be inappropriately under-informed, but a key analytical and marketing tool will be lost to TRE management and marketers.

The transparency of the auction process should be matched by transparency in the information flow.

So, let's see the numbers!

The Short of It Again--With a Twist

In our October 6 Post we commented on the fact that an auction of short-duration invoices had been closed at a price that seemed to reflect an increased awareness of the cost, to both Buyer and Seller, of delaying the closing of transactions that will have a short life.

That particular auction broke a pattern of prices that had held for 15 straight transactions by that Seller of invoices due from the same Account Debtor.

Our friend “Oldschool” commented that the transaction represented “randomness pure and simple”. And in fact the next three transactions did revert to the old pattern, all selling on the same “pre-anomaly” terms.

However……….there have now been 8 transactions in a row at return levels that are HIGHER, on average, than the “anomaly” that spurred us to write on October 6.

To be fair, there are other dynamics that seem to be affecting pricing in the past couple of weeks; but the break of this long-term price level for this particular Seller/Debtor pairing does not actually seem to be random.

To make the point again---the more quickly the Debtors pay, the greater the impact of the fixed TRE fees on annualized return. Auctions that are bought at low return levels face significant effective return dilution if they are paid too quickly. Full stop, as the Brits say.

Here’s another twist on the same theme.

There is a regular Seller on TRE that groups the invoices of three Account Debtors in its auctions. The average days-to-pay of two of those Debtors exceeds 40 days. The average days-to-pay of the third is less than 20 days.

In this case, holding constant the assumed auction parameters, the composition of the auction will significantly affect the ultimate effective yield. The greater the weighting of invoices due from the short-duration Debtor, the greater will be the dilution effect of the rapid payment.

Until now there has been no evidence that Buyers have been considering the weighting of the invoices of the three Debtors in determining how to approach bidding on a particular auction.

It now appears possible that an auction heavily weighted with invoices from the faster-paying Debtor is being looked at more closely and that the pricing is being affected. It’s too early to really tell…but it WOULD be appropriate.

We’re all learning things as this first year of TRE operation draws near its end: Buyers, Sellers and TRE, itself.

How could it be otherwise in such an innovative environment?

Is it out of line to suggest a TRE-sponsored gathering on the anniversary of the first transaction? There's still time!

The Ariba Distinction

In our last post we addressed recent changes to the TRE invoice verification procedures. Two thoughtful and important comments have been posted in response and I’d call your attention to both.

The second of those comments, by Drew Hofler of The Ariba Supplier Network, highlights an issue that will (I hope) become increasingly important to all TRE Buyers.

Because a Seller that belongs to The Ariba Network brings added value to the table.

First of all--what is Ariba?

Quoting here from a press release:

“The Ariba Supplier Network is the world’s leading business collaboration platform, which combines technology and services to better match buyers and suppliers, automate transactions and optimize payments. Buyers and suppliers in 115 countries leverage the network to engage in transactions worth more than $110 billion a year and process one purchase order every two seconds. Leveraging the reputation and power of the Ariba Network, suppliers can lower the cost, risk and time associated with accessing capital.”

So, for our purposes, Ariba represents a VERY substantial volume of B2B receivables-creation, with a payment process that incorporates an automated, controlled, protected, invoice approval process.

Ariba and TRE have had a strategic alliance for some time now but the volume of Ariba invoices offered for sale on TRE has been minimal. That might be because of a lack of Ariba member education. It might be because the actual mechanics of uploading member invoices has not been as user-friendly as it might be.

In any event, Drew posted welcome news yesterday that I’d like to make sure to highlight. I quote from his comment to yesterday’s post…..

“This issue brings to light even more the value of invoices that are uploaded to the TRE platform directly from a supplier network such as Ariba. In the case of an Ariba supplier selling an invoice processed via the Ariba Network, both the issue brought up in the blog (verification) and the issue in the comment (quality of invoices/errors) are rendered moot.

1) Verification: When the next release of the Ariba Network (AN) comes out (4Q09), Ariba suppliers will be able to click a button and directly upload their approved invoices for sale to the TRE platform. Approved invoices are delivered directly to the AN from the Obligor's ERP, and are then transmitted directly to the TRE platform with no opportunity for the supplier to change any of the data contained within. Given the unbroken electronic chain of data, the need for verification is obviated.

2) Quality of Invoices & subsequent error correction: The nature of the Ariba Network is such that buyers/obligors set parameters up front that suppliers must meet in order for a submitted invoice to be considered in good order. This systematic quality control ensures that the vast majority of quality issues are filtered out before an invoice is even received by the Buyer/Obligor. So the issues brought up by Mr. Schmidt are largely removed for Ariba invoices.

Combine the above with the fact that eInvoicing via Ariba reduces invoice approval times down to an average of less than 5 days, and invoices sold by Ariba suppliers directly from the Ariba Network will offer TRE Buyers a qualitatively better option to reduce risk and extend returns.”

The critical issue to highlight in Drew’s comment, I believe, is that the Ariba system will actually provide a MORE robust verification process than had been offered by TRE even BEFORE its recent changes.

If I understand the mechanics of the network correctly—and I invite Drew to correct me or to amplify here—the invoices posted by an Ariba Seller will not only have been verified with respect to authenticity i.e. that there IS an invoice matching the Seller’s posting in the Account Debtor’s AP system, but the Account Debtor will have ACKNOWLEDGED that the goods provided have met the conditions of the agreement AND that the amount of the invoice is payable as and when indicated.

This provides a significant level of additional security to a TRE Buyer, which should result in preferential pricing of invoices originated by Ariba members.

A substantial increase in Ariba Seller activity would be a very good thing for TRE and, I suspect, for Ariba also. Let’s hope all interested parties work hard to make that happen!

Whose Ox is Gored?

In July I wrote two posts on the “inconvenient essential” of invoice verification. (Please see the posts dated July 5 and July 8.)

I acknowledged at that time that many elements of a typical invoice verification process were sacrificed by the TRE model but I also pointed out that there were mitigating factors that, in my view, balanced the risks.

TRE has recently changed some of its invoice verification procedures, reducing the extent of the actual verification process and substituting, in some cases, a statistical sampling approach.

To its credit, TRE provided a comment period for all Members to give their opinions of these changes prior to implementing them. My own opinion was, and is, that the changes served only the purposes of the exchange itself and of Sellers in a hurry to get invoices to market. There is no credible argument, in my view, for a benefit being afforded the Buyers.

I quote below some passages from my comment letter:

“I understand that continuing to verify each invoice in cases where there might have been dozens if not hundreds of invoices paid without incident in a given Seller/ Account Debtor relationship might seem to be a waste of resources. I can also see that some Account Debtors might begin to complain when the number of verification requests begins to get very large.

I can also understand that, absent any problem, a substantial history of successful transactions between a Seller and an Account Debtor makes the probability of the nth invoice of the same type being problematic quite small. In such cases a sampling system can certainly make sense.

However:

 I think it’s a little disingenuous to present this change of process as an “enhancement”…

 It just can’t be argued that this is not a further weakening of the verification process.

 What began as a third-party function, providing some level of independence in the process, morphed quickly into an internal TRE function of limited scope. Even though the scope was limited, it still applied to all invoices. Now the scope remains limited and the application will not be to all invoices.

 I can see that it will help Sellers get deals to auction more quickly and I can see that it will reduce the TRE workload and expense. The only group that I can’t find a benefit for is the Buyers!

 I’m certainly mindful of the need to ramp up volume and to bring on new Sellers and...I think there are situations in which some “sampling” activities might be justified. But based only on what I’ve seen, this makes me nervous...because of what it does to reduce the strength of the process...”

My comments also included reference to some details of the TRE process that Members are required to keep confidential but I think my concern about the changes comes through in the sections I have quoted above.

The Exchange, again to its credit, did follow up with a conversation addressing my concerns. I expect that all who submitted comments were given the same courtesy.

There is no indication that anyone’s concerns had any impact on the procedural changes, however.

I think it is important to point out a fundamental disconnect between the apparent analytical approach of the exchange and that of an individual Buyer.

TRE seems to want to analyze risk at the level of the entire portfolio of transactions that occur on the exchange. That, in my view, is not correct. TRE itself takes no transaction risk. There is no exchange-wide exposure from which a risk assessment at that level can validly be made.

Without the ability to buy what would amount to an “index” position in the entire TRE portfolio, a valid risk assessment can only be made from the point of view of the portfolio of an individual Buyer.

And Buyers will now only be sure that their invoices have been verified under certain defined conditions. Under any other conditions they cannot be certain.

To be sure, Buyers should be able to gain a sense of the probability that their invoices have been verified, but as long as the probability is less than 100%, the uncertainty should be reflected in higher required returns.

So the Sellers should ultimately wind up paying for their increased transaction velocity via higher returns to compensate the Buyers' increased risk.

And, in the end, only the exchange itself really appears to benefit.

That Made My Day!

I’ve been beating the table pretty strongly in this blog on the subject of short-duration transactions on The Receivables Exchange.

I’ve pointed out the fact that the shorter the duration of the transaction the more the Buyer’s return is diluted by the fixed portion of the TRE fees and transaction costs.

The same is true for the Seller. The shorter the duration of the transaction the higher the effective cost of the fixed portion of the fees charged.

The fact that Buyers have continued to pay higher prices (accept lower yields) on some short-duration transactions has been perplexing to me, and the longer the situation has persisted the more perplexed I have become.

Now, this might be an anomaly. I might be right back in my perplexed condition tomorrow. But as I sit here this afternoon I have to just take a moment and enjoy what seems to me to be a significant event.

A certain Seller regularly posts the invoices of a certain Account Debtor. The terms call for payment in 10 days. The actual average holding period following auction has been roughly 14 days. For the past three months or so these invoices have been bought essentially immediately at a price that, in my view, has not reflected the impact of the fixed fees and costs.

An auction by that Seller, of invoices of that Account Debtor, has just closed. This time it was different.

The offering was “live” for about 24 hours. Usually these auctions close within minutes.

No Buyer immediately hit the “buy out” button this time. A couple of bids were made but not until after some hours had passed and at yield levels significantly higher than had been seen for these invoices in quite some time.

You could almost feel the tension.

This Seller was used to immediate and very favorable responses and they were not forthcoming this time. The deal stayed live overnight and there was no further movement on the bid.

I found myself wondering whether the Seller was beginning to calculate the increase in its daily effective cost of money as the deal sat there without further action.Ultimately the Seller accepted the bid that had been “sitting there” for hours.

What was great about that?

It was the RIGHT THING to do!

The Buyers were right, in my view, by finally holding back and requiring higher compensation for the short term deal.

The Seller was right, in my view, by not allowing the deal to sit without further bids any longer, allowing its effective cost of money to rise.

The action was rational on both sides.

And that made my day!

Beware the Passage of Time

St. Augustine said: “Lord give me virtue -- but not yet.”

Augustine wasn’t talking about money, but the point is the same. Getting paid is a virtue. We want it-- but all in good time.

I’ve commented before on the perils of rapid repayment. I have to comment one more time. I just can’t help myself.

Included among the data provided by The Receivables Exchange on each Seller/Account Debtor relationship is a record of the Account Debtor’s payment velocity.

I personally think that TRE should report the figures on an “auction duration” basis; measured from the date of the sale of the Account Debtor’s invoice to the day that invoice is paid. That would tell the Buyers explicitly how long the funds used to buy the invoices were employed and it would tell the Seller's how much time they have "paid for".

But that is NOT what is provided and it is important to know that.

What IS provided is a record of the number of days from the DATE of the invoice to the date payment reaches the TRE lockbox. High, low and average figures are given.

So, in order to make an informed bid a Buyer needs to consider not just the payment history provided but also the age of the invoice at the time of purchase. Unless the payment history provided is analyzed in light of the current age of the invoice posted it can lead to unexpected results.

Let’s use an actual example:

A certain Account Debtor has a record of paying a certain Seller’s invoices in an average of 20 days. That is, 20 days from the date of the invoice.

That Seller posts a new auction. The invoice posted is 17 days old on the day of the posting. This invoice does not sell on the day of posting. In fact, three days later it still has not sold.

What is the position of a Buyer looking at that auction on the 20th day from the invoice date?

Based only on the history provided the answer is that he’s looking at a purchase with an expected duration of about ZERO days! The check could actually be hitting the lock box even as the payment for the invoice is being swept from the Buyer’s account.

In such a case what does the Buyer get?

He gets to pay the fixed exchange and transaction fees incurred in closing a purchase without earning anything at all. He gets to lose money on a deal that has been paid as agreed!

OK, so we have to be fair. The record shows that some payments have taken longer than 20 days to come in. So it’s possible that the Buyer will earn some revenue for his trouble. But, based on the record, it’s far from certain that he will earn enough to break even.

It’s also possible that the Seller knows something about the likely payment period of that specific invoice. Otherwise, why would he be willing to pay the Seller’s fees and transaction costs? He should hold that invoice and post a newer one for sale if he needs cash.

It’s also possible that the Seller has simply made an error and didn’t realize the implication of posting that particular invoice for sale. As a Buyer who has made errors while getting to know this new platform, I could both understand and sympathize.

It's also true that I don't know of an actual case in which the costs and fees of a transaction exceeded its revenue.

But the point still stands.

Taking the time to look at and understand the documentation supporting an auction is important and it’s clear that many auctions are completed without that being done.

As it happens, the auction described above sold on the 4th day after posting, or the 21st day after the date of the invoice. I considered making a bid calculated at the monthly discount rate necessary to break even on a one-day holding period but decided against it. Nobody likes a wiseguy!

The Price is Right??

This is going to be a little tricky -- to say enough to make the point but not so much as to cross the line of prohibited disclosure. But the situation is interesting enough to warrant the risk, I think, and if I cross the line you can find my lawyer’s phone number in my wallet.

Here’s the situation: on a single trading day recently four auctions involving the same Seller and four different Account Debtors were sold on The Receivables Exchange.

The Seller’s history on the exchange was short. It had only recently become a Seller and had sold only a couple of fairly small deals. No payments from any Account Debtors had yet been received.

According to standard “Z-Score” analysis, the Seller’s financial position is weak.

Each of the four auctions sold on that day involved rather modest dollar amounts and all were of invoices that were already 1-30 days past due.

Up to this point in the analysis there is little to differentiate the auctions.

But the effective monthly discount (nominal monthly discount divided by percentage of funds advanced) actually varied quite widely.

The range from the low cost to the high cost transaction was over 160 basis points per month; the equivalent of almost 20% per year on the cost of funds to the Seller. Logic suggests that there must be some significant differences among the auctions.

Between the lowest cost and the highest cost transaction, the pattern of price change showed an almost equal variation from deal to deal. And the sequence of deals closed does not help explain the pattern of variance.

Given that we have the same Seller, similar auction sizes, similar invoice ages and transactions all occurring on the same date, the obvious variable that we would look to for an explanation of the pricing differences is the quality of the Account Debtors.

We decided to test for differences in the strength/quality of the Account Debtors in these transactions using a credit-rating service that generates a two-part overall quality assessment: the first part is an alphabetical grade on a scale of A+ for the best and C for the worst. The second is a numeric rating on a scale of 100 for the best to 70 for the worst.

The following are the scores of the Account Debtors whose invoices were sold in the four auctions ordered from the lowest-cost transaction to the highest-cost:

Lowest Cost: A+ 100
1st Intermediate: A+ 95
2nd Intermediate A+ 100
Highest Cost A+ 98

Obviously, these credit scores do nothing to explain the wide variation in prices paid for the four auctions closed on that day.

If neither the Seller, nor the Account Debtor, nor the size of the auction, the general character of the invoices nor the sequence of the auction can explain any significant component of the pricing difference, what do we have left?

The Buyers!

We’ve written recently about the impact of varying Buyer motivations on auction activity. This is certainly an indicator that that dynamic is both real and important.

Under these circumstances, can we pick which auction represents the “market” return for the receivables of this Seller? I think not.

Under these circumstances, can we draw any conclusions about the “market” cost of funds for Sellers of invoices of this quality? I think not.

What CAN we say?

There were a number of Buyers obviously willing to bid on a relatively untested and weak Seller. Some were probably more influenced by the quality of the Account Debtor. Some were probably more influenced by the quality of the Seller.

None seems to have been willing to go after ALL of the auctions even though the aggregate size was well within the range of some Buyers.

I think what we’ve got here is an atmosphere of continuing experimentation. Buyers are willing to make small bets on even weak Sellers in order to gain experience and information. The absolute returns, for some, at this point might be less important than the experience.

So long as the actual returns are considered to be less important than gaining experience in operating in the exchange environment and the returns are at least high enough that they don’t represent a COST, compared to other ready short-term options, the value trade-off is acceptable.

If that is true, however, the current pricing statistics should not be given too much credence. We've got a ways to go in both time, volume, breadth of market and number of participants before conclusions of value can be drawn by either Buyers or Sellers.

The Company Capital Keeps

The essayist Fran Leibowitz wrote a piece that I’ve always been fond of entitled: “On the propensity of good weather to frequent the better neighborhoods”.

Her argument breaks down pretty quickly on closer examination but it’s quite true that we find concentrations of wealth in places like Palm Beach and Aspen. There is a natural matching of value and resources that we can find expressed throughout both our economy and our society.

For example: it’s undeniable that some diamonds should be sold by Cartier and some should be sold by Zale.

And some corporate credit should be served by those with the lowest cost of capital while others will be more naturally served by higher-cost providers.

The AmEx Black Card holder will not likely be applying for a “payday” loan. And the individual in need of a few hundred dollars to tide him over to the next paycheck is unlikely to go looking for it at a Swiss private bank. There is a natural matching of cost of capital to credit quality.

The Receivables Exchange is an unusual entity in that the strongest Sellers and the weakest will find their transactions offered at the same time to the same providers of funds without the sort of “natural selection” that would otherwise typically separate them.

In another era we might say that GM and ABC Dependable Plumbing Co. wouldn’t be shopping for financing at the same counter. Today we might need a different example but the idea is still the same.

What are the implications of this unusual juxtaposition of transactions?

It’s probably too early to tell. But it appears that, at least in the early days of the experiment, there is a tendency for the low-cost-of-capital players to compress the range of returns that would be otherwise required to clear transactions.

As much as we might read about the scarcity of capital today, the fact that the return on cash deposits is essentially zero is causing some investors to reach for yield into areas whose risk is hardly minimal.

The “natural” providers of funds in those higher-risk markets can find themselves crowded out because their higher cost of capital makes competition with the new entrants imprudent or uneconomic.

I’ve written in prior posts about the desirability of a quality-rating system for TRE auctions. The various quality ratings would, in effect, represent different “counters” for different customers. I continue to believe that such a system will be required to support the exchange’s desired growth.

In the long run, the exchange needs to attract as broad a range of Buyers as it does Sellers. Buyers representing low cost of capital have a low cost for a reason. And that reason should eventually cause them to generally match their lower cost of capital to higher quality, lower yield transactions. The same should occur at the other “counters” at which the needs of Buyers and Sellers are matched.

If the higher cost of capital Buyers are crowded out of the transaction flow in the short run, the growth of the exchange will be impeded.

I initially thought that the fact that TRE came online at a time of major credit market disruption was an advantage for it. I’m no longer sure that is the case.

I remain a firm believer in the TRE concept and in the ultimate value of TRE as a powerful agent of positive change in our market. I now think that it’s going to take longer to mature than I did six months ago.

The Perversity of Promptness

I’ve been buying receivables on The Receivable Exchange for several months now and I suspect that, in terms of the number of transactions, I’ve bought more than my fair share over that period.

A significant percentage of the auctions I’ve purchased have been closed-out: paid as agreed without problem. Those that remain open currently show no signs of problems: they appear to be running their natural course from purchase to close-out. And that’s, of course, a good thing.

During my time as an active Buyer I’ve learned a lot about the TRE Sellers and their Account Debtors, about the TRE platform and procedures and about the nuts-and-bolts mechanics of the buying, holding and close-out of transactions.

One of the things I had not anticipated is the promptness of some payments and the impact of that promptness on annualized transaction returns. The implications are significant and so I wanted to share the experience, at least in general terms (the TRE rules prevent my divulging actual transaction details).

However, since the result is a decision to refrain from bidding on some otherwise attractive receivables, I think the issue bears at least general discussion.

This issue arises because one of the fees charged to Buyers by TRE is a fixed percentage of the face amount of the receivables sold. The charge itself is a fraction of one percent and seems relatively insignificant; certainly not onerous. It’s impact becomes perverse only if payment is received very quickly.

For example: let’s consider the case of a single-invoice auction (or an auction of multiple invoices, all of which are paid at the same time). Let’s say that auction is paid off in 60 days. The impact of the up-front fixed fee is x times 360/60 in this case: or 6 times the fractional base. That will dilute the annualized return of the transaction, but not by an overly-significant amount.

On the other hand: let’s take a similar single-payment scenario when payment is received in 10 days. The initial fee impact in that case will be six times that of the case above. In other words the annualized return on the transaction will be diluted by 36 times the up-front fee, which now no longer looks so small!

What is the practical impact? Well, in my own case, I’m no longer willing to bid on the invoices of Account Debtors whose payments tend to come in very quickly. The dilution effect is just too substantial.

Now, it’s one thing to bid on an auction involving receivables due in 15 days, anticipating and aware of the likely dilution. It’s another to bid on an auction involving invoices payable in, say, sixty days and have them paid off in 10 days! That’s where the true perversity is felt!

Anomalies can always occur. Payments can be early or late for many reasons, some completely unpredictable.

But the TRE platform does provide Buyers the ability to research the past payment-velocity of each Account Debtor. Based on my own experience, Buyers should certainly take advantage of the opportunity to examine that history and take into account the probable velocity of payment receipt before bidding.

Bidding very aggressively on an auction that gets closed-out in just a few days is likely to lead to buyer’s remorse when the actual return on the closed deal is calculated!









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Rational Irrationality?

Ori and Rom Brafman, in their fascinating book: “Sway: The Irresistible Pull of Irrational Behavior” write about an experiment used by a business school professor on the first day of each new semester.

He auctions off a $20 bill to the students in his class.

Sound simple? At the time the book was written the highest price paid in those auctions had been $204!

Now there’s nothing special about the bills themselves; there’s no rarity value involved. So why would anyone be willing to pay any more than $20 for a $20 bill?

The answer lies in the motivation of the bidders, which reflects the rules of the auction.

In these auctions the winner gets the $20 bill BUT BOTH the winner and the runner-up have to pay what they’ve bid.

The bidder who comes in second has to make good on his bid, but he gets nothing in return; while the bidder who “wins” has to pay up, but at least he gets the $20.

So the motivation is not actually winning the auction, it’s avoiding the greater cost of losing the auction!

When I find myself unable to explain in any rational terms the actions of an auction participant I have to step back and remind myself that what appears to be irrational might be irrational only from my own frame of reference. The “winning” bidder might be operating under rules or influences, unknown to me, that explain his actions quite clearly.

At this stage in the life of The Receivables Exchange there are too few auctions involving too few Buyers to allow us to confidently equate value and price. And it is certainly too early to assert that price and risk are in any way firmly associated.

As we wrote in our post of August 19: “One Buyer with a perceived ‘need’ to put money to work in any significant quantity could easily … create a pricing environment that is not informed by any real risk assessment.”

The actions of such a Buyer might be primarily motivated by the desire to avoid the perceived “loss” incurred by not deploying allocated funds. In that case the loss avoidance behavior is captured in winning a certain quantity of auctions essentially regardless of price or quality. The perceived “loss” of failing to win is greater than the potential loss created by paying essentially whatever is asked or failing to assess the risk assumed.

In that type of environment, the price at which auctions are won is not a valid measure of value. Bidder behavior is driven by something other than the value of the item being auctioned.

The professor in the Brafmans’ book found that in almost every $20 bill auction, most participants realized when the bidding got to the $12 to $16 range that the correct decision, even at a level still below $20, was to withdraw from the auction.

While either unknown motivations or non-economic motivations control market action, the rational response is just to “hide and watch”.

A Key to Success: The Price of Failure

Those who have been in the commercial finance business for any length of time will have acquired the valuable experience of dealing with transactions gone bad.

Until you’ve had to litigate a failure-to-pay situation and pursue real-life collection efforts through local courts and sheriff’s offices it’s hard to understand just what an enormous drain on resources those activities can become. The issue of who has what “rights” in a case under the law is often far less the critical point than the calculation of how much it might actually cost to pursue those “rights”.

For a prospective Buyer on The Receivables Exchange, especially a prospect with knowledge of commercial finance and collections, the lack of experience in dealing with failed TRE transactions raises difficult questions. It’s all well and good to understand the theory but, perversely, a couple of failed transactions might be really helpful to TRE’s efforts in attracting more Buyers.

As we discussed in our post of June 11, one of the strengths of the TRE platform is its foundation on the Louisiana version of the provisions of UCC Article 9, which makes it clear that a sale of a receivable on TRE is a “True Sale” i.e. it’s not a financing. Check out that post for more detail.

But TRE also adds an element; potentially an added layer; in the process of dealing with a failed transaction that prospective Buyers might find troubling in the absence of actual experience. On the one hand it’s a good thing that there haven’t yet been failed transactions; on the other, we can’t really be sure how things are going to work when there are.

We can talk theory all day long; but until we see how it actually works; what role TRE actually plays; what the costs really are; how the Louisiana courts really work; what it really takes to enforce a Louisiana judgment when the Buyer, the Seller and the Account Debtor might all be based in different states; and so forth, we’re just not going to know.

I work with an attorney who specializes in commercial collections cases. His clients include banks, factors, asset-based lenders and other entities that routinely become involved in failed transactions. He has a “walk away” number: a potential claim amount below which he advises his clients to just “walk away” from the judicial process. That doesn’t mean he won’t use other efforts to try to get some satisfaction but it does recognize that the cost of litigation is a barrier to judicial pursuit in many smaller claims.

We don’t yet know what the “walk away” number is in a TRE transaction; but we have to acknowledge that there IS one.

Some prospective Buyers aren’t going to be drawn to the exchange until they have a good idea of what that number is. And some who are already Buyers but who are not experienced in the nitty-gritty of collecting on failed transactions may be overlooking that cost in their calculations of expected returns.

One of the unfortunate elements of the need for this experience is that the process of litigating and collecting on a failed transaction can be quite a long one. So we’re probably not going to have solid data on the real cost of failure for quite some time.

The TRE lawyers would probably strongly advise against this, but I suspect it would be really helpful to prepare a series of pro-forma failure scenarios; essentially stress-tests that use a few likely failure situations. In each situation a prospective analysis of the steps required to pursue and enforce collections efforts, and the time required and likely costs of those efforts, might be prepared.

If these analyses appear realistic to experienced prospective Buyers and demonstrate a clear-eyed understanding of the realities of the process; no matter what the conclusions might actually be, I think the effort of attracting Buyers will benefit.

Those prospects who might be frightened away by the stress tests probably shouldn't be Buyers in the first place. Those Buyers who might be moved to modify bidding strategies as a result should be grateful for the opportunity to reduce the potential of unanticipated future costs.

The Upside of Being Ignored

You might have noticed at the bottom of my blog page that I provide a link to the TRE website. On that website is TRE’s own Blog, which is well written, topical and interesting.

It is a “moderated” blog, meaning that someone reads all comments made to the TRE posts and vets them for appropriateness and quality before they are actually posted on the site. You can’t blame TRE for wanting to maintain a minimum level of professionalism on its own site!

I noticed the other day that the “comment” function seemed to have been removed from the TRE blog and I had a concern that the exchange might have decided to exercise more than just a prudent level of quality-control. I hoped that the decision did not reflect a lack of desire for conversation or an aversion to criticism. So I made inquiries.

I’m happy to report that, even though I’d really like to be able to respond to the TRE posts from time to time, and (selfishly, I admit) to use that medium for a little promotion of my own thoughts and this blog, the exchange’s reason for the decision is the best one possible, in my view.

It’s a matter of priorities. And the priority for TRE at this time has to be generating growth in the volume of quality receivables brought to the exchange for sale. On that issue there can be no argument.

So dedicating the time of someone qualified to review and make decisions on blog-post comments has got to be fairly far down the priority list.

I couldn’t agree more.

TRE announced a few days ago a program to recruit representatives in all 50 states whose function is to bring potential new Sellers to the exchange. That, for example, is a far more important activity at this point than providing for two-way blog communication.

I also understand that there is a series of webinars underway to introduce members of the Ariba Network to the benefits and mechanics of using the TRE platform to accelerate supplier receipts.

Many thanks to Drew Hofler of Arbia for taking the time to educate me a bit on the Ariba Network. For those buyers of receivables who are not aware of Ariba, some research might be profitable. Enough said…

TRE is in the 3rd quarter of its first full year of operation. It has ambitious goals whose achievement will depend on an unwavering focus on the issues that are critical to its success. Moderating a blog is not among those critical issues.

I’m happy to understand that the reason for putting that activity aside is to allow increased attention on what matters most: meeting the TRE growth objectives.

Meanwhile, let me suggest that if anyone does want to comment on a TRE Blog post, feel free to comment here. I'll be happy to provide a forum for conversation until TRE itself is able to return to that activity.

A Quality Opportunity?

In our post of June 23 we wrote about the differences among the principal types of financial statements that privately-owned companies produce.

The companies that sell receivables on The Receivables Exchange are privately-owned firms that usually do not have audited financial statements. Many, in fact, don’t provide even “reviewed” or “compiled” statements; the financial statements available to a TRE Buyer are most often those of the management only, without independent review.

In our June post we quoted a report of the American Institute of Certified Public Accountants that a “compiled” financial statement carries with it “no assurance” of reliability from the accounting firm that has prepared the statement. Clearly a report that is prepared and presented by management alone can be considered no more credible than one complied by an independent CPA.

It’s not that management-prepared statements are necessarily less accurate than those prepared by independent accountants but I think it’s fair to say that the odds of material error or misstatement are far greater in a management-prepared financial statement than in one audited by an independent accountant.

If TRE is to become a major force in the receivables-finance industry, as we certainly hope it will, it will have to attract thousands of Sellers and it will have to attract sufficient Buyer capital to meet the needs of those Sellers. It will ultimately need to provide Buyers with more and better tools to make decisions regarding the quality of Sellers and the risks involved in buying the receivables of those Sellers.

Just as we suggested that eventually TRE would do well to go back to the model of having an independent invoice-verification agent, it also would do well to actively promote the establishment of an independent Seller-quality rating system.

It is unrealistic to expect that each Buyer will be able to maintain appropriate due-diligence information on thousands of TRE Sellers. It is also unrealistic to expect that TRE growth targets will be met unless Buyers have some source of risk analysis independent of TRE itself.

Many of the Buyers that TRE will certainly want to attract will be capital sources with some (at least internal) quality-rating requirements on funding. Recent experience in the markets for "new" financial products also suggests that those with oversight responsibility for the investments of potential Buyers will find it prudent to have third-party quality opinions.

At some point, attracting capital is inevitably going to require greater perceived objectivity and independence in analysis of Seller risk.

My guess is that TRE understands this. My hope is that they are working on it.

There are several possible models for establishing rating mechanisms. There are qualified entities already in the business of analyzing the financial condition of private companies. If a convincing case can be made for the ultimate success of TRE, and I think one can, there should be someone interested in providing a rating system of some sort for its Sellers.

There are just as many potential difficulties and inconveniences for TRE in dealing with an independent quality-rating system as there are with an independent invoice-verification system. Dealing with those inconveniences and solving those problems is part of the price of success.

It’s one of those examples of the paradox of control: the more control, in this case over the analysis of risk, that TRE is ultimately willing to give up, the more likely it is to actually accomplish its objective.

It's a Balancing Act

In our last post we discounted to some degree the technical problems required to manage a significantly increased deal flow on The Receivables Exchange. There ARE technical issues to be addressed and they ARE important, but the fundamental requirement of attracting more Buyers and more Sellers to the exchange is the true challenge.

But numbers alone are not enough. Quality and balance are equally important in these early days of the exchange’s growth.

What do we mean by quality?

In terms of Sellers, we mean that TRE has to attract Sellers that have the capacity to make good on their commitments to re-purchase invoices if their Account Debtors do not pay.

We’ve pointed out in prior posts the fact that TRE obtains only limited acknowledgments from Debtors and that those do NOT include affirmation of the acceptability of the goods provided or services performed. We’ve pointed out also that there are no personal guarantees to back up the Seller’s own corporate capacity and that the UCC filings obtained by TRE encumber only the receivables actually traded on the exchange.

If there haven’t been situations yet in which the Account Debtor justifiably refuses payment; rest assured there will be. And if the Seller doesn’t have the money to make good, all parties will be damaged, including TRE.

In terms of Buyers, we mean that TRE has to attract prudent investors concerned about the quality of the obligations being purchased and the strength of the Sellers they buy from. Buyers have to understand the quality (or lack thereof) of the financial information made available and the risks involved in dealing with smaller and financially weaker companies than they might be used to.

TRE needs to seek an orderly and balanced increase in the relationship between deal flow and Buyer demand. That’s a tough job; especially with so much riding on rapid growth assumptions.

The current deal flow cannot yet absorb really substantial cash inflows. One Buyer with a perceived “need” to put money to work in any significant quantity could easily absorb the entire current deal flow and create a pricing environment that is not informed by any real risk assessment.

Can TRE be expected to counsel caution to Buyers willing to take any deal that comes along?

Can TRE be expected to turn away Sellers whose financial capacity and business characteristics do not meet its own stated requirements?

Not only CAN it be expected to do those things. If it doesn’t do those things; if it doesn’t work very hard to create an orderly and rational trajectory to its growth; it runs the risk of suffering the unhappy fate of other new markets which were overly focused on near-term growth objectives and into which undisciplined capital was allowed to move too quickly.

None of us needs that; least of all the exchange itself.

It's Trivial, Really!

My brother is a professor of computer science and electrical engineering. He has an annoying habit of conversation that I suspect is common among those who deal in theory more than practice.

We might be talking about an issue that seems to me to be quite complex and in need of clarification before moving forward in the conversation. And he, (seemingly) oblivious of my need to understand, will say “it’s trivial, really” and just move on to the next step, leaving me behind.

It still annoys me but now at least I understand.

He just means that all of the information or the tools necessary to move from that step in the analysis to the next one are already known or in hand.

No matter how complex the transition might be, if the necessary math is known or the process or engineering problems have already been solved, then it isn’t necessary for the academic to spend any time discussing them.

What is important is the next UNSOLVED problem; everything else from his point of view is “trivial”.

In our last post: “Sipping From a Fire Hose” we calculated that it would take about 27,500 transactions per day at the current average deal size to keep $50 billion employed in TRE transactions. I got an email from a reader expressing some skepticism that a deal flow of that magnitude could be managed.

I suggest that managing the deal flow is actually not the issue. In the words of my brother: It’s Trivial, Really!

Consider this: there is commercially available and affordable software that has the capacity to continuously screen the activity of tens of thousands of stocks, bonds, futures, and options positions, and to alert an investor to situations that meet highly complex predefined analysis criteria.

Screens that search for combinations of precisely-defined fundamental metrics in combination with selected technical analytics and real-time inter-market pricing anomalies can be run using these tools on a $1,000 laptop wirelessly connected to a data source at poolside.

There is nothing more theoretically complicated in providing TRE buyers the ability to precisely define the transactions they want to look at and to ignore all the rest.

Four things are needed to reach the calculated volume numbers we quoted in our last post:

1. More Buyers,

2. More Sellers,

3. An increase in the number of searchable criteria provided by TRE, and

4. Software upgrades sufficient to allow Buyers to search for the deals they are interested in and, potentially, to manage bidding strategies.

Managing the deal flow requires both the increase in searchable criteria and the software improvements.

The software part really IS trivial. Those problems have been solved. The adaptation by TRE is simply a matter of resource allocation.

The issue of establishing searchable criteria is more challenging.

The information currently provided on the TRE platform that the exchange actually COULD make searchable is not adequate to narrow down a very large deal flow. TRE could currently allow buyers to search by industry, by size, by transaction history, by number and character of Account Debtors, by a few of the most recent financial statement entries, etc.

A dozen meaningful criteria might be actually possible to search on now. (They aren’t searchable now, but they could be.) That’s too few to support the potential volume of transactions.

A screen that gives me a thousand options is of little help in a real-time auction situation unless I can also design automated bidding strategies. But actually the technology for that is also currently available! Adaptation to TRE needs in that regard would also be “trivial”.

In fact, when you really get down to it, if the estimates of potential market size are anything close to correct—all of the technological and information-management issues are actually trivial.

Not that they are easy. Not that solving them would be without complication or challenge. But the technical problems of managing the potential deal flow have already been solved.

It's not MANAGING the deal flow that we need to be concerned about--it's GETTING it!

Sipping From a Fire Hose

In our last post, on the subject of the size of the potential TRE opportunity, we concluded:

“TRE certainly won't reach its potential overnight. It will take some years. It will probably also take some changes in rules, format and process.”

As I re-read that statement it actually sounds a little weak. Let me make it a little stronger.

I truly believe the TRE concept to be brilliant. And no one I’ve spoken with about it disagrees, at least in principal. The question usually becomes: does the current implementation effort allow the potential to be achieved?

And the answer has to be: NO!

Of course it doesn’t. But, then again, how could it?

In the last post we worked backward from the national income accounts to the potential market size. The view was from 30,000 feet, or from the moon, depending on your level of skepticism.

Now, let’s look at it from a different vantage point.

TRE reports that its average auction size is currently about $65,000. The average number of auctions per day is a statistic that I don’t think I’m allowed to divulge. But let’s look at what is required to meet the market potential we discussed in the last post.

For TRE to achieve an annual gross volume of $450 billion, which would keep about $50 billion of capital employed, it would take nearly 7 million transactions per year at the current average size. That equals about 27,500 transactions per business day. The total number of auctions completed since TRE's inception is only a few percent of that required daily figure!

A buyer trying to deal with that kind of volume would be sipping from a fire hose! The velocity of offerings would quickly overwhelm him. But the current system would not allow that many transactions to even REACH him.

Let’s take a step back.

TRE estimates it will generate about $1 billion in gross volume next year. At the current average auction size that would suggest a total of about 15 thousand transactions for the year. That would equate to about 60 per business day.

That would probably require some re-working of the current platform, and it’s probably a stretch, but at this stage of the process the exchange HAS to stretch; certainly in setting goals for itself.

It’s easy to look at big numbers and decide that something can’t be done. It’s better, if you believe in an opportunity, to try to figure out how the problems can be solved.

There’s no question that huge changes would have to be made to the current system to accommodate anything like the volume we wrote about in the last post. But huge changes were required to go from the Sony Walkman to the Apple Ipod!

It wasn’t that long ago that we thought it was a marvel to be able to carry an entire hour of music on a device that clipped onto our belt. Now we can carry hundreds (maybe thousands) of hours of music on a device that is hardly noticeable in a shirt pocket!

The question is not whether we can sip from a fire hose.

The question is: how can we control the flow of water from the hose in such a way as to allow us to take a sip!

One mindset assumes failure; the other assumes success given a sufficiently powerful incentive.

Water is a powerful incentive to the thirsty!

Sizing Up the Opportunity

Recent economic headlines have desensitized us to very large numbers. “A billion here and a billion there” has become “a trillion here and a trillion there”.

Numbers that large tend to lose real meaning to us whether they represent government spending proposals or distances in interstellar space.

When I talk about The Receivables Exchange to people, eyes tend to glaze over at the TRE “headline” market size number of $17 trillion to $18 trillion. It’s just too big to get your arms around.

So I’d like to do a little rough reality check on the size of the TRE opportunity. These are my thoughts, not those of TRE, which might actually consider me a little conservative.

The Federal Reserve Board publishes a quarterly analysis of the constituent segments of the US economy. Table B-102 on page 103 of the Fed’s July 11 report contains its 1Q 2009 analysis of the “Nonfarm, Nonfinancial Corporate Business” segment of the US economy.

I’d reproduce the Table here for the readers’ convenience but I’ve already wasted hours unsuccessfully trying to format it in this blog software! So I’ll have to try to tell you what it says rather than show you.

At the end of Q1 2009 the total “Trade Receivables” of the nonfarm, nonfinancial corporate business segment of the US economy was $2,165.8 billion.

The average of the five prior year-end figures was $2,095.9 billion. (The range was from a low year-end figure of $1,831.3 billion in 2004 to a high of $2,263.1 billion in 2007.)

To convert a point-in-time balance to an annual volume we have to apply an estimate of receivables turnover i.e. how many cycles of payment are there in a year. Most estimates of payment velocity fall between 30 and 60 days with a central tendency in the 40 to 50 day range.

A 40-day turnover rate produces a multiplier of (365/40) 9.1 and a 50-day rate produces a multiplier of (365/50) of 7.3.

If we apply that range to the 5-year average of the Fed’s numbers we get an indicated total annual figure of $15.3 trillion to $19.1 trillion.

This shorthand calculation bears out the TRE estimates. The size of the aggregate corporate receivables market DOES actually appear to be in the vicinity of the $17 trillion annual figure the exchange uses in its materials.

But that’s just a starting point for estimating actual market potential.

There are many categories of receivables that are not eligible for posting on the exchange: a large volume of such ineligible receivables represent the progress payments typical in the construction industry, for example. Other significant excluded categories are related-party transactions and receivables of businesses too small to be TRE Sellers.

It’s tough to quantify the values of the various classes of receivables that are ineligible for TRE posting but, since we’ve managed to roughly verify their overall volume figures, it feels a bit safer to accept, for argument’s sake, their estimate of the actual addressable market i.e. what’s left after excluding all of the ineligible items.

A range of $2.5 trillion to $3.0 trillion is used in various TRE sources, which is about 15% of the total. Excluding 85% of the total market seems, on its face, to be conservative. But is there a way to get a quick confirmation of that?

Well, the government’s Bureau of Economic Analysis publishes a quarterly report on national income accounts that can give Ambien a run for its money.

It might be reasonable (or at least interesting) to compare the income attributable to “proprietors” as a proxy for the TRE-ineligible small, non-corporate sector of the economy, to that of the “corporate” sector.

The “proprietors” income, according to the BEA, represents about 41% of that total (see p15/D-16 Table 1.12 “National Income by Type of Income”)

If we accept that about 40% of the 85% might be represented by the small, non-corporate sector, it doesn’t seem unreasonable to attribute the balance to the other ineligible categories. Again, it seems OK on that basis to accept the TRE-estimate of the net addressable market. We’re just looking for broad-brush confirmation here, in any event.

Now, the next step.

If we assume that the average duration of TRE-eligible receivables roughly equals 45 days, the average outstanding eligible receivables balance at any point in time would be between:

$2.5 trillion / (365 days / 45 days) = $308 billion, and
$3.0 trillion / (365 days / 45 days) = $370 billion.

And, if we further assume that available capital can be actually employed about 85% of the time, the range of capital needed to serve that market would be between about $360 billion and $435 billion.

To pick a point in the middle, we can estimate that the market might have the potential to employ about $400 billion in capital on an ongoing basis. That assumes, of course, that the entire addressable market is captured, which is not reasonable.

So, one more step.

What level of potential TRE business opportunity does that really represent?

Let’s start with another report, this time from the Commercial Finance Association. The CFA reports that receivables factoring volume in 2007 amounted to $135 billion. And let’s convert that figure back to ongoing capital requirement using our same parameters i.e. a 45 day pay period and an 85% utilization rate. The total capital required to support the 2007 actual volume was roughly $20 billion, or just 5% of the indicated potential.

So the indicated potential market is 20 times the current volume of receivables factoring.

Now, some businesses obtain working capital financing using means other than factoring receivables. There are bank lines available to many businesses and various asset-based borrowing facilities. The CFA estimates 2007 asset based lending amounted to nearly $500 billion. If (and this is just a wild guess) about half of that figure is backed by receivables, and we apply the same parameters to calculating ongoing capital needs, the indicated ongoing capital requirement would be about $30 billion (rounded).

We’ve now accounted in a very rough way for about $50 billion of the estimated addressable market.

Many of the better-quality businesses that have wanted to use their receivables as a source of accelerated liquidity have had the opportunity to do so. But many businesses that have been able to liquify their receivables in the past have now lost their funding facilities. And some will undoubtedly find the TRE platform more convenient and attractive than the options they currently employ.

Just for fun, let’s say that 20% of the current factoring and receivables-based asset lending market can be enticed to TRE. That would generate an ongoing capital need of about $10 billion. (Some of the customers of those existing platforms will want to stay with them for a variety of reasons including the “full AR service” that traditional factors provide.)

And let’s say that 12.5%% of the currently un-served market can be enticed to the TRE platform. That would generate an ongoing capital need of about $45 billion (rounded).

So, based on the current volume of economic activity, the total capital deployment opportunity might be about $55 billion (rounded) and the total gross volume of transactions would be between $500 billion (40 day average turn) and about $400 billion (50 day average turn.)

Let’s, again, just pick a point in the middle and call that $450 billion.

If TRE could generate $450 billion in annual transaction activity that would represent a bit over 2.6% of the total volume of annual nonfarm, nonfinancial corporate receivables generated in the US.

A projected market penetration of less than 3% with a platform as unique as that of TRE does not seem to strain credulity.

A market with an ongoing capital need of over $50 billion demands the attention of anyone involved in the receivables-finance business.

It’s not only likely to entice customers away from traditional market participants but it’s likely to impact pricing, packaging and process throughout the market.

TRE certainly won't reach its potential overnight. It will take some years. It will probably also take some changes in rules, format and process. But the traditional players in the business need to be looking over their shoulders.

TRE cannot be ignored.