Wednesday, December 30, 2009

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.

Sunday, December 20, 2009

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!

Sunday, December 13, 2009

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!

Friday, December 11, 2009

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.

Sunday, December 6, 2009

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?

Tuesday, December 1, 2009

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.