Wednesday, September 30, 2009

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!

Tuesday, September 22, 2009

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.

Thursday, September 17, 2009

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.

Monday, September 14, 2009

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!


Sunday, September 6, 2009

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”.