Sunday, August 30, 2009

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.

Thursday, August 27, 2009

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.

Sunday, August 23, 2009

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.

Wednesday, August 19, 2009

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.

Sunday, August 16, 2009

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!

Friday, August 7, 2009

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!

Monday, August 3, 2009

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.