Thursday, December 9, 2010

More Thoughts on Risk

In my last post I suggested that that the pricing of receivables purchases had to cover three things:

1) The Buyer’s cost of funds,

2) The Buyer’s operating costs, and

3) An appropriate return for the risk assumed.

The issue of appropriate pricing for risk assumed is also, in my opinion, a function of three principal elements. It’s been a while since I addressed that topic but current bidding dynamics make me think it’s time to at least remind MYSELF of those elements.

The CAPACITY of the Account Debtor to pay is one of the three elements of pricing risk. It is an important one; but it is only one.

It appears that some Buyers are being persuaded in their bidding and pricing decisions by this element only and that, I think, can be perilous.

The fact that an auction includes invoices presumably payable by a Debtor with an unquestioned CAPACITY to pay loses value if that Debtor either does not ACTUALLY have an obligation to pay or, almost as importantly, does not BELIEVE it has the obligation to pay.

The two additional elements critical to the pricing decision are:

a) The CAPACITY of the SELLER to pay if the Debtor does not, and

b) The character of the RELATIONSHIP between the Seller and the Debtor.

Under the terms of a Seller’s agreement with the Exchange, the Seller is obligated to pay if the Debtor does not. If it does not appear that the Seller has the capacity to make good on the obligation, it is clear that the level of risk is elevated. But the ability of a Buyer to assess the Seller’s capacity is impaired by the Buyer’s inability, under Exchange rules, to have direct contact with the Seller.

The Buyer, therefore, is limited in its assessment of the Seller’s capacity to an analysis of information available either via the Exchange or via publicly-available credit and other data.

TRE is doing a much better job these days at getting timely updates of financial statements from Sellers, but it remains the case that most Seller statements are internally-generated without any third-party review. They cannot be treated as if they were audited or even independently reviewed. And TRE itself makes no representations regarding the accuracy of the financial information provided.

Since 99% of TRE Sellers are privately-owned, the value of information available from credit rating/reporting agencies is also limited. Most often the data available from those sources relates to a Seller’s payments of typical operating expenses. Do they pay their utility, credit card and equipment leasing bills, for example?

That sort of information has SOME value but it does not really address the capacity of the Seller to make good on an unpaid invoice; especially if that invoice is very large in the context of the Seller’s resources.

Many Sellers are in businesses that require very little equity capital to either establish or operate. Many have little or no net working capital and little or even negative equity.

That doesn’t mean, necessarily, that they could not access the funds needed to make good on a re-purchase obligation. But where the Seller’s capacity to re-purchase is not beyond question (and certainly where that capacity is clearly questionable) there is an element of Seller risk that SHOULD be compensated regardless of the payment capacity of the Debtor.

Why is that?

Because there IS a risk, no matter who the Debtor is, that the Debtor is NOT actually liable to pay. And there is a risk that even if it IS liable to pay, it will ASSERT that it is not, in which case there might be a difficult and potentially expensive fight to prove liability and to collect.

That brings in the third issue that has to be considered in pricing transaction risk i.e. the relationship between the Seller and the Debtor.

The “relationship” issue I’m referring to here has two elements:

a) The contractual relationship regarding the obligation to pay a specified invoice, and

b) The history between the Seller and the Debtor specifically involving the provision of and payment for similar goods or services.

I’ve written in the past about the fact that the TRE model is not a “full notification” model. With few exceptions the Exchange does NOT receive assurance from the Debtor that the goods or services represented by the invoice have actually been provided in a manner that meets the contractual requirements for payment.

The Exchange DOES verify that an invoice exists in the Debtor’s AP system that matches the one posted for sale; however, after a pattern is established between Seller and Debtor, that verification process includes a statistical sampling element allowing for less than 100% of invoices to be verified.

There are reasons that the TRE process falls short of a “full notification” standard and those reasons are easily understood.

However, it’s just a fact that sometimes errors are made in billing or that goods are damaged in transit or that goods or services fail to meet specification.

Challenges to payment liability can arise for a variety of reasons that legitimately cause actual payments to differ from invoiced amounts. The “verification” process is not likely to bring these to the surface.

The full notification process is, itself, not without risk or flaw, but it does provide a significantly stronger assurance to a buyer of invoices than does the verification alternative.

That being said, it’s fair to acknowledge there are many Sellers with longstanding relationships with Debtors whose goods or services carry a relatively low risk of failing to meet specification.

For example: a staffing company that provides relatively unskilled personnel to a client. The question is: did employee Smith work 40 hours at a given hourly rate during a certain week?

If employee Smith is moving boxes from a truck to a warehouse the question of whether he properly performed his task will be an easy one to answer. And, if the documentation provided with that invoice includes a countersigned time card on which the Debtor verifies that Smith actually did work 40 hours moving boxes, there is relatively little risk that the Debtor will subsequently challenge the invoice.

But if a staffing firm provides a skilled technician in a research lab, or a computer programmer whose work has to properly interface with that of a dozen others, for instance, a failure to perform the tasks properly might not be immediately apparent.

So the character of the goods or services provided does (or should) affect the assessment of risk. It's part of the "relationship" question.

Now, if the Seller has posted and the Debtor has paid 25 similar invoices for similar services in the past, then the assessment of risk is further mitigated.

But the converse is also true: the more limited the experience and the more specialized the goods or services, the greater the likelihood of disputed invoices.

Why do I come back to some issues I’ve written about in the past?

Because it is my perception that there are Buyers who are pricing transactions today as if there is essentially neither Seller risk nor relationship risk. If the Debtor is a well-known and financially sound company it appears that some Buyers will pay nearly any price asked by a Seller.

And because it appears to me that some Buyers are not even looking at the back-up documentation made available by the Exchange either on the Sellers or their invoices. The auctions are selling too quickly in many cases for a Buyer to have even calculated the likely duration of the transaction.

I suspect that there will be those who will disagree with my suggestion that risk is being mispriced in some current and recent TRE auctions.

They might argue that the pricing does not reflect a lack of attention to risk but rather the ability to access extremely low-cost funds.

I actually wish that were true. But I don’t believe it is.

And the process of re-pricing to more rational levels can be difficult for all involved.

Sunday, November 28, 2010

A Comment on Risk

The downward pressure on auction pricing that began in late August has continued and intensified through November. I’ve suggested before that this might have more to do with excess liquidity than with either improved quality of Sellers or Debtors or with decreased transaction risk.

While auction volume has continued to increase it appears that liquidity has increased at a more rapid rate. One indicator of that is the percentage of auctions sold at their specified “buy-out” prices.

On one recent day, there was only one auction that DID NOT sell at its buy-out price.

I suspect that there is a substantial Buyer out there who has given instructions to a trader that he is not to BID on auctions; but rather only to BUY them.

So, no matter that an auction might be had on better terms, this Buyer pays the “ask” price. And that, of course, provides a powerful incentive for Sellers to drop their “buy-out” or “ask” pricing.

Now, I might very well be wrong about this and I have no knowledge of any other Buyer’s actual trading dynamics. I’m just speculating based on the activity as I see it.

Viewed from the perspective of both the Exchange and the Seller community, of course, the current dynamic is very attractive.

For the Exchange, it makes the job of attracting potential Sellers, and of retaining current ones, easier. Lower cost of funds and rapid auction closings provide the sales force with a strong "story" when marketing TRE to prospects.

For the Sellers, obviously, lower pricing is always desirable.

And Buyers could ultimately benefit as well to the extent that more Sellers might be attracted to the Exchange, although this benefit is a lagging function and is obviously offset by the lower yields available at least in the near term.

In the long run, the Exchange cannot thrive on the basis of a pricing level that does not, on average, compensate Buyers for: a) cost of funds, b) cost of operations, and c) risk assumed.

The TRE Buyer community is very diverse, not only in terms of the primary businesses they represent but also in terms of their motivation for participating in the Exchange. A Buyer that is not primarily in the receivables finance business; whose interest in TRE might principally be as a place to “park” cash balances in the short term; will have a very different view of acceptable pricing than will a Buyer whose principal business is buying accounts receivable.

It’s really impossible for anyone except the managers of the Exchange – who will know all of the Buyers and their reasons for participation -- to comment on the likely range of Buyers’ cost of funds, cost of operations or motives for participation.

But the risk involved in an Exchange transaction is the same regardless of the identity or motivation of the Buyer.

I’ve commented in previous posts about the differences between the typical business model of a company whose principal activity is the purchase of receivables and the model on which TRE is based.

In several respects the risks of buying invoices on TRE have to be acknowledged to be higher than is typically the case in the receivables finance business. Here I’m thinking of issues like the lack of personal guarantees and of blanket first liens on Sellers’ receivables.

On the other hand, there are offsetting advantages to the TRE model that are not inconsequential. The lock-box arrangement not typically available to a spot-factor, the advantageous nature of the Louisiana law and a generally higher-quality Debtor community, are examples.

Each Buyer, or potential Buyer, will make his own assessment of the balance between those advantages and disadvantages.

But today I want to revisit a risk-related topic that I’ve commented on before that has become a larger issue in the current pricing environment. It does not arise from the TRE operating model but is significantly affected by its pricing model: specifically the impact of its fee structure on auctions of very short duration.

Given the relatively brief history of TRE it’s very hard to devise a risk analysis that would result in a conclusion regarding the probability of loss in transactions with certain given characteristics.

We really can’t say, for example: “the probability of loss in a transaction in which Seller A is owed money by Debtor B for the provision of goods or services with characteristic C, under the terms of an agreement with characteristic D ---is in the range of X% to Y%”

We’re just not there yet.

But there is a way to make a STATEMENT regarding risk even without actually suggesting an actual evaluation of risk. The statement I’m referring to is grounded in the traditional payback-period calculation from Financial Analysis 101.

Applied to a TRE auction it would take the form of:

“It would take X successful transactions (with given characteristics) to offset 1 such transaction in which a total loss was suffered.”

That says nothing about the actual risk of loss, of course, but it can provide a useful means of:

a) conceptualizing the consequences of a default, and

b) providing a relative measure of loss consequence between and among transactions.

Looking to the actual auction activity from a recent day I can pull an example of a transaction made at the low end of the typical range of expected duration and discount rate; one at the high end; and one in the middle.

The analysis has two steps:

1) using the likely duration and actual transaction parameters, calculate the expected net dollars returned to the Buyer upon full payment of the invoices purchased, and

2) divide the total funds advanced, including transaction fees and costs, by the expected net dollars returned.

The low-return transaction example, because of its short duration and low discount rate, produces a small dollar-amount of expected return. If a Buyer were to suffer a total loss on an auction with these exact characteristics, it would take 489 successful transactions with the same characteristics to recapture the loss.

The high-return transaction example has a very long expected duration and an unusually high discount rate. It would take only 7 successful transactions with these characteristics to offset a total loss on one.

The mid-range example, which is more characteristic of the typical transaction, has a moderate expected duration and a discount rate somewhat higher than the current average (but closer to the historical average) than either of our “extreme” examples. In that case it would take 45 successful transactions to recapture one total loss.

To my knowledge there has been no default on auctions involving the Seller/Debtor pairings whose auctions I’ve used in these examples.

It SEEMS clear that the Buyer community assesses the relative risks among them quite differently. But I wonder…..

Let’s take the case of the low-end example above. I don’t know who is buying those auctions or others with similar characteristics. But I wonder if they actually consider the relative risk to be roughly 1/11 that of the mid-range example?

I don’t know.

But I do know that it’s wise to remember two things:

1) The typical receivables transaction is of very short duration when compared to most other fixed-income investments; meaning that the ratio of dollars earned to dollars risked in a single transaction is low, and,

2) The direction of errors in projecting (percentage)returns on an invoice-purchase transaction is almost always negative. Other than earning a slightly higher return than expected if durations extend, you can’t really get surprised on the upside.

As time passes and experience is accumulated we’ll be better able to quantify relative risk using appropriate statistical means. Until then we’ll have to do the best we can with what we’ve got.

But I think it pays to at least acknowledge the implicit judgments being made until we get to the point where explicit ones can be supported.

Thursday, November 4, 2010

Going Long(er)

I became a Buyer on TRE in April 2009 with the specific commitment to refrain from bidding for 60 days. I wanted to watch the activity and get comfortable with the process before actually participating in TRE auctions.

As readers of this blog will know, I did get comfortable with the process and, after my 60-day “hide and watch” period, I did become an active Buyer.

My bet was still almost fully hedged, though.

It was clear that becoming more seriously committed to the TRE process required a judgment that the Exchange was likely to capture sufficient transaction volume and process/product credibility to sustain itself as a going-concern.

Since I began buying in June of 2009, several things have happened:

1) My experience as a Buyer has been successful,

2) Exchange volume is running at roughly 7 times its pace of 18 months ago,

3) TRE has attracted significant and credible new financial banking, and

4) The Corporate auction program, which I wrote about in my last post, appears likely to provide an additional revenue stream, giving the Exchange another leg-up towards break-even.

On the basis of those developments it now seems that the odds favor the long-term survival and success of the Exchange.

On that basis my associates and I have just taken off a part of our hedge.

We have formed and funded a new company to pursue an expanded commitment to investment in TRE-posted auctions.

That’s a big step for us and a significant commitment to the notion that there IS a long-term and significant role for TRE in the receivables-finance market.

It’s not a complete lifting of the hedge, however.

The Exchange volume is still short of that required to support either itself or an infrastructure of fully-committed participants.

And the buy and sell interests are still not balanced enough to avoid periods when prices get pushed – in either direction -- beyond what I’d consider rational given the level of risk.

Over the summer we saw yields to Buyers spike for a couple of months. Since the end of August the pricing has moved decidedly in favor of Sellers. Neither extreme has been driven by quality, in my opinion. I think it’s much more likely that, in both cases, the driver has been a supply-demand imbalance.

Short term swings in pricing power are just a fact of life in a market with a growth curve like that of TRE. New money entering a market like TRE is “lumpy”. And the pace of new Seller adoption is unpredictable.

In the short term there will be days that are good for Buyers and days that are good for Sellers.

Our bet is that, over time, a reasonable balance will be found. That, on average, Buyers will be compensated reasonably and Sellers will find fair value in the price/service proposition offered by TRE.

Have we gone “all in”?

No. It’s still too soon for that, in my view.

But our bet is long(er) than it was last week. And we’re comfortable with that.

One step at a time.

Sunday, October 10, 2010

Expanding the Product Line

The Receivables Exchange announced a new initiative last week: a facility to be operated separate from but in tandem with its current on-line market for the receivables of small-to-medium sized businesses.

The new facility is called the “Corporate Auctions” program, as distinguished from the current “SMB” program. It targets Sellers in the Fortune 1000 category of size and quality.

This is yet another big step for TRE and has significant implications for both current and prospective TRE Members on both the Buy and Sell sides of the market.

At the time of its announcement TRE also announced that a Fortune 10 company has signed up as the first Seller in the Corporate Auction program.

The identity of that Seller was not made public but I can say that you can find multiple products of that company in every American household (and most households and businesses throughout the developed world, for that matter).

TRE Buyers on the SMB platform will have to be separately approved to buy on the Corporate platform; and the size, character, bidding methods and pricing parameters will certainly be different on the Corporate platform than on the SMB platform.

The average transaction size will certainly be significantly larger in the Corporate program. And the returns to the Buyers will be significantly lower; reflecting the credit quality and the reliability of the financial data available on the Sellers and Account Debtors in that program.

After all, the great majority of the SMB Sellers are private companies providing Buyers only internally generated, unaudited financial information.

In the Corporate program the Sellers will very likely be large public companies with complete, easily accessed, audited financial statements already studied and commented upon by professional financial analysts.

Clearly, these markets will appeal to different types of Buyers with different risk appetites, costs of capital and motivations for participating.

This is an unambiguously good thing for the Exchange. Especially with the announcement of a “whale” as an initial Corporate program Seller.

But it is also an unambiguously good thing for those Members of the Exchange that stick to the SMB program.

Why is that?

First, this is an additional revenue stream for TRE. Obviously TRE is still in the stage of its evolution when it is burning through venture capital cash as it aims for break-even operations. The added revenue stream of the new program presumably advances the date on which break-even can be projected and thus it reduces the risk of all current participants, whether owners, Buyers or Sellers.

Second, to the extent that some types of Buyers are unable, because of the character of the SMB receivables, to participate in that program, this new initiative provides the potential for those Buyers to enter the market. This will bring not only their cash and their names to the Exchange but it will broaden the universe of financial market participants with actual Exchange experience. The more broadly the Exchange is known and understood in the financial markets the better, in the long run, for us all.

Third, to the extent that there are Buyers now active on the SMB platform whose actual needs and motivations are more aligned with the Corporate-type risk/reward profile, those Buyers now have an option to get what they really want, leaving the SMB program to those whose appetite and objectives more closely match it.

Fourth, while this might be considered a “stretch”, I see no reason why TRE could not go searching down the Corporate program supply chain for additional SMB Sellers. If we know that there is funding moving down the supply chain from a Corporate program Seller, that knowledge affects the assessment of the risk of buying paper due from a third or fourth-tier supplier of labor or material in that chain.

Fifth, if TRE can cite the participation of some very high quality Corporate program Sellers, it will very likely help them to attract new SMB Sellers. Even though the programs are different, the impact of quality-by-association should not be ignored. The imprimatur of a Fortune 10 industrial conglomerate does mean something to the owner of a smaller, privately-owned business.

I am not sure when TRE will be able to make more information publically available about this new program. And until TRE makes it public, confidentiality agreements keep the rest of us from doing it.

But, from my point of view, this is as big a deal as the announcement of the Bain funding earlier this year.

Both events take TRE a big step closer to an assured future.

Both mean that evolution in the receivables finance market continues to advance.

Wednesday, September 29, 2010

Another Milestone

We received a payment from The Receivables Exchange this morning that closed out an auction we purchased on July 28.

It was a small auction; the first we had bought from that Seller. It contained invoices due from one regional firm based in California that I had never heard of before (but that turned out, on examination, to be quite solid) and one company known and respected world-wide.

The payment history was interestingly indicative of current patterns: the regional company paid in 14 days; the worldwide behemoth paid in 62 days.

We’ve written before about the move of larger, more credit-worthy companies to extend payment terms. One of the interesting consequences of this, for TRE and its Buyers, is that it tends to increase the working capital needs of companies that sell to those large credit-worthy firms.

The impact might be only marginal but it is to put generally upward pressure on the credit quality of the Account Debtors brought to auction by TRE Sellers.

The counter-point, obviously, is that it’s clearly NOT a good thing for the Sellers. While it’s great that TRE provides a ready market to liquefy the invoices of those Account Debtors, the net impact on the Sellers’ profitability is negative.

But that discussion is not the reason for this post.

I’m writing because the payment received this morning brought our total of closed-out auctions to the 200 figure!

That’s cool; at least it is to me.

Next stop = 500.

Monday, September 27, 2010

An Award & Bigfoot Lives

In the special Technology section of this morning’s Wall Street Journal ,The Receivables Exchange is named winner of the Journal’s 2010 Technology Innovation Award in the category of e-Commerce.

This is a well-deserved recognition of the TRE Platform, which is made even more impressive by the fact that there has not been a winner in this category since 2004.

Considering the e-commerce innovations that have come to market since 2004, that have NOT been considered worthy of an award, this is quite a compliment to the Exchange’s management and technology teams.

It’s one thing to have an important and innovative idea. It’s quite another to be able to actually make it work.

TRE has been able to do that both in terms of the basic concept of providing a liquid market for the receivables of small-mid-sized businesses and in terms of doing it in a real-time online environment that is so integrated from Seller through Exchange to Buyer, and back, that money flows, fully accounted-for, on the basis of a one-day turn-around.

A brilliant concept is of little value unless it can be made to work.

TRE makes it work and it’s making it work better all the time. Updates and upgrades to the platform are made on an essentially continuous basis. As the volume of TRE transactions continues to grow, significant additional platform development will be necessary. But history to-date provides a convincing case that the management of the Exchange and its tech people will more than keep up with the demand.

Another day of congratulations to TRE!

On another subject: to update my last post on the “reverse lurch” -- the shift of pricing power to the Sellers has continued throughout the month of September.

Bigfoot continues to make his presence felt as more and more auctions are closed by a leap to the buy-out pricing parameters. It’s difficult to tell if this is one new Buyer or a Buyer with a significant increase in allocated funds. But the tracks that Bigfoot leaves are pretty easy to follow.

When a price-insensitive Buyer is in action, fewer auctions are left for the rest of the players. That increases competition and depresses returns on the deals that Bigfoot does not buy.

To the extent that the new money is acting on the basis of lower cost, and the volume of auctions does not appreciably rise, pricing will likely remain at the lower levels. But, to the extent that some part of Bigfoot’s behavior might be modified over time as pricing lessons are learned, or the volume of product available increases sufficiently to offset his demand, pricing might well take another swing back toward the Buy-side.

That’s happened in several cycles over the relatively short life of the Exchange and I suspect it will happen again.

Ultimately, more liquidity will draw more product to the market just as more product (that the Buyers find attractive) ultimately draws more liquidity. This sort of cyclical pattern of pricing should be expected in a developing market.

Patience is a virtue, they say.

Monday, September 6, 2010

The Reverse Lurch

No, that’s not the patent-pending description of Tiger’s new putting stroke.

In my post of May 31, 2010: “A Lurch to the Left”, I commented on the fact that pricing of TRE auctions had taken a decided turn in favor of the Buyer-community.

Auction statistics over the six-week period prior to that post reflected a shift in pricing power away from the Sellers.

I also noted, though, that there had been periods when the balance of power had favored the Sellers and that it was reasonable to expect that TRE pricing dynamics would shift from time to time.

The shifts from Seller-power to Buyer-power and vice-versa can obviously reflect a variety of factors. New Buyers with a desire to put money to work quickly can push pricing down. A sudden increase in supply of auctions can have the reverse effect.

We’re also beginning to see some cyclical patterns reflecting the lumpy timing of invoice payments and the desire to quickly redeploy returned capital.

The” Reverse Lurch” I’m referring to now is a decided shift back toward the Sellers’ favor in auction pricing.

That’s been noticeable over the past few weeks but has been especially pronounced in just the past several trading sessions.

My guess is that one or more Buyers have either just begun to deploy capital on the Exchange or have significantly increased their allocations to Exchange activity.

Whatever the cause, the effect has been clear.

In the first three trading sessions in September I bid on a number of auctions at prices that would have had a high probability of acceptance a week or two ago. In several cases those auctions were bought by others very quickly at prices that reflected no desire to test the pricing possibilities.

By that I mean the Buyer accepted the “buy out” pricing parameters with no attempt to determine if a better deal might be available. In a number of cases there were other bids; some quite far away from the “buy out”; and the winning bidder jumped immediately to buy-out price level.

The character of the Exchange is such that none of us can really tell what motivations are at play in any given auction or at any given time. We can only observe what IS happening and speculate about patterns that emerge as we look back at what HAS happened.

Since the bidding of the first three days of September presented some unusual activity I decided to look back about six weeks to see what I might find.

I looked at four auctions that closed in the first three days of September. The Sellers were “regulars”. The Debtors had a good deal of payment history. So reasonable projections of duration could be made both for the new auctions and those that closed in late July. The sizes of the early September and the late July auctions were similar.

I plugged the parameters of the auctions into a model that estimates annualized net return.

The projected annualized net return from those four sample auctions averaged roughly HALF the levels those Sellers had to pay in the late July period for similar auctions of invoices due from the same Account Debtors.

That’s a MAJOR lurch!

Now, the AVERAGE auction has NOT fallen in yield in that way over the past six weeks. The pricing pressure is not indiscriminate. And it might well be that this shift is short-term and motivated by unusual Buyer dynamics.

The point of this post is to recall the reverse situation in late May and to point out that pricing DOES ebb and flow on TRE. My guess is that the magnitude of the swings will become less pronounced as the volume of Exchange transactions continues to increase.

One thing is clear: these “lurches” tend to be concentrated in auctions that might seem a bit “obvious”: meaning, for example, that the Debtor is a very well-known name.

There are still very good, if less-obvious, auctions to be had at better pricing levels.

And we should remember that it’s not clear that the “obvious” auctions necessarily deserve the pricing they receive.

There are three elements to analyze in any auction:

a) the capacity of the Seller to re-purchase if necessary,

b) the capacity of the Debtor to pay what it owes, and

c) the character and certainty of the rights and obligations connecting them.

A triple-A Debtor might appear to create an obvious “buy”.

But a triple-A Debtor that questions the obligation to pay can all of a sudden become the hardest collection case on the list.

Then it’s the Seller’s capacity to re-purchase that is the key issue in the analysis.

I'm not a golfer but I know enough to realize that a "lurch" is not a good thing in a putting stroke. But apparently it DOES happen from time to time; even to the best.

Tomorrow's another day!

Monday, August 30, 2010

In the Way of St. Augustine

St. Augustine of Hippo is famously known for pleading: “Lord, grant me chastity-- but not yet!”

Augustine clearly viewed chastity as a good thing but he wasn’t quite ready to enjoy its benefits.

In the receivables purchasing business, getting paid is a good thing. But getting paid much more quickly than expected – not so much.

The “good” in a payment pattern is more a function of predictability than absolute timing.

Regular readers might now anticipate my returning to a pet peeve. But hear me out.

An auction that I purchased recently was closed out last week: paid as agreed; which, in itself, is certainly a good thing.

But it wasn’t paid either “as expected”, or “as advertised”. And that’s not such a good thing.

When I first started buying receivables in my spot factoring business I made the mistake of telling a couple of prospective clients that I was looking for invoices that would pay in the range of 45 days, give or take. It’s been my good fortune to have gotten many of my clients via referral from other clients. And it’s amazing how often I’m told that a referred prospect’s payment expectation is about 45 days!

Word spread from those initial clients, of course, that that’s what I wanted to hear—so that’s what I’m invariably told. But those prospective sellers are most often saying “45 days” when the truth is that payments will take LONGER. They know it and I know it.

The phenomenon I’ve griped about in prior posts with respect to TRE auctions is having invoices presumably due in 45 or 60 days that get paid in 7 or 9 days.

Why do I gripe about that? Not because it happens once in a while -- that can be just the luck of the draw.

But recently the number of instances of significant disparity between the posted payment expectation and the actual payment experience has been increasing. This is the case both in auctions that I’ve bought and in those I’ve just been monitoring.

The trigger for this post is that the auction I referred to above, which was paid last week, was “due” to pay out in about 30 days. In fact, the actual weighted average duration was 3.7 days!

The result was that my actual net earnings on that auction were roughly zero. That was a “successful” but still unsatisfying transaction.

I had bought several auctions from that Seller prior to the one I’m describing and all had performed as expected. I have actually been quite happy with the experience.

And as annoyed as I was with the result of that one auction, I was prepared to assume it was just bad luck. That for some unknown and unusual reason the Account Debtor just paid very early.

And so I bought another auction from the same Seller even before this one had closed-out.

The first payment on the NEW auction was made ONE DAY after the auction closed. The invoices that were paid were not “due” until mid September.

With that additional experience, as much as I have been pleased with the initial auctions bought from this Seller, I’m now going to have to stay away from those auctions until there is evidence that these are anomalous situations and that a predictable relationship between the posted due dates and the actual payment expectations can be anticipated.

The reason, of course, is that acceptable pricing changes significantly as the duration of auctions changes. This is particularly true in cases of very rapid payment.

The marginal impact on return of payments expected in 45 days but received in 30 is actually pretty minimal. But the impact of a payment expected in 45 but received in 10 is quite significant.

I am not suggesting that the Seller in this case deliberately misstated the payment expectation. I don’t believe that is the case. Actually, I suspect that this transaction will have been as unsatisfactory for the Seller as for the Buyer.

Because of the TRE fee structure, the costs to the Seller on this auction will have been as high on a relative basis as the return to the Buyer was low.

But there is a small number of Sellers whose actual payment experience appears to be consistently more rapid than “expected”. That creates a credibility problem—-for me, at least. And I’m no longer willing to bid on those auctions.

Ultimately it is to everyone’s benefit for there to be a rational relationship between the posted “due date”, the Seller’s posted “expected payment date”, and the actual payment experience.

I’m not suggesting that there won’t always be outliers in payment patterns, in both directions. Of course there will.

But when the pattern itself is of “outlier” events – it has to be the posted due date or posted payment expectation that is called into question.

Wednesday, August 18, 2010

Bringing a Knife to a Gunfight

Last Friday I was listening to Bloomberg radio as I drove to a meeting.

Mohammed El-Erian, the brilliant CEO of PIMCO, was being interviewed on the question of European sovereign debt. Commenting on the assistance provided the Greek government he said that the program amounted to “applying a liquidity solution to an insolvency problem”. The implication was that, in his opinion, the weapon did not suit the battle.

As others might put it, the Euros were bringing a knife to a gunfight.

El-Erian’s words stuck with me, so I thought I ought to brush up on some definitions.

First, insolvency and bankruptcy are two different things. And Dr. El-Erian would know quite well, given his background at the IMF, that countries cannot technically become bankrupt. Bankruptcy is a legal concept that does not extend to sovereign entities.

Insolvency, on the other hand, is a financial condition. More accurately, there are two financial conditions associated with the term insolvency.

1. “Balance sheet insolvency” is the condition in which liabilities exceed assets, and

2. “Cash flow insolvency”, meaning that a company cannot meet its payment obligations on time.

The cure for balance sheet insolvency is a capital cure; increasing assets, decreasing liabilities, or some combination of the two that results in a positive capital account.

But, what is the cure for cash flow insolvency?

The condition has two elements: a) payment capacity, and b) time.

So the approach to a cure for cash flow insolvency (absent a reduction in the actual amounts due) will have to be a combination of increased payment capacity and extended payment terms. Both of which are liquidity solutions.

In fact, absent the steps noted above with respect to balance sheet insolvency, the only REAL solutions for cash flow insolvency are LIQUIDITY solutions.

Moving from a discussion of the rarified issue of sovereign debt to the arena in which Buyers and Sellers on The Receivables Exchange spend their time, the realities include:

1. A large percentage of private businesses in the small-mid-size space are “balance sheet insolvent”.

The liability protections and the tax treatment of the S-Corp and the LLC, which dominate private business ownership structure, create a bias in favor of minimizing assets left in the business. Especially in companies with high depreciation expenses; these structures tend to generate negative net worth over time.

2. The balance sheets of many businesses in the SMB space tend to reflect the personal finances of the owners as much as they do the financial results of the companies.

For instance; often the liabilities that make the business “balance sheet insolvent” are loans due to the business owners, which would likely be treated as capital contributions in other circumstances. The odds of a business owner forcing a solvency crisis by accelerating a loan due him are (usually) low.

3. Many businesses in the SMB space are not far from the start-up phase and the early-period losses still dominate the balance sheet.

4. It is the income statement, or more-accurately, the BANK statement, that commands the attention of most private business owners. A high percentage will know their cash position every day. A very low percentage will examine their balance sheet in detail even quarterly.

5. Cash flow is the lifeblood of these businesses. If the bills can be paid and the owners can draw enough cash to meet their personal needs, the fact that the balance sheet shows a negative net worth is not likely to affect management’s decision making, at least in the short term.

6. But, as we all know, it is cash flow that has suffered most during the recent financial contraction and de-levering of credit-granting institutions. And the relative complacency of owners whose businesses are balance sheet insolvent does NOT apply equally to the case of cash flow insolvency.

7. Cash flow insolvency threatens the going-concern viability of small businesses to a far greater degree than balance sheet insolvency.

Many recent studies and surveys have documented that access to cash is the number one problem in the SMB market today.

It is precisely a LIQUIDITY solution that is required for a problem of cash flow insolvency. It might not be a permanent one. It might well be that a capital structure solution is required in the longer term.

But in today’s financing environment the acceleration of cash flow via the sale of accounts receivable might provide the BEST solution for many smaller businesses.

In the world of global sovereign debt finance there might be room to question the KIND of solution used for a financing problem. To a small business owner, though, the existence of ANY solution is a big, and a welcome, thing.

Maybe a knife doesn’t win in a fight against a gun. But if I don’t have any bullets for my gun, the knife looks like a pretty good alternative!

Sunday, August 15, 2010

The "Two-Feet-Deep" Danger

We’ve all heard the one about a man (hopefully a statistician) drowning in a river that is, on average, only two feet deep.

It’s not that the information about average depth is either inaccurate or unimportant. It’s just that it’s not ENOUGH information if you happen to be crossing at the wrong point.

In my last post I said that I’d write next about the 2nd quarter figures in the “National Summary of Domestic Trade Receivables” published by the Credit Research Foundation. The CRF has published this survey quarterly for 50 years.

I’ll only make broad comments because the material is copyrighted. See for subscription information and other products and services offered.

The CRF has devised and publishes a “Collection Effectiveness Index”, which is a single-figure indicator of the general health of the domestic trade receivables market.

That measure showed a significant improvement in 2Q-2010 compared to 1Q and a small improvement over the year-ago period. Most other aggregate measures they report showed similar improvements:

a) decreasing days-sales-outstanding,

b) decreasing delinquencies,

c) increasing percentage of accounts current, and

d) decreasing percentage of accounts over 91 days past due.

These high-level, market-wide measures are useful indicators that nevertheless have to be understood in the context of potential lag-effect, bias from sample size and bias from self-reporting.

The breakdown provided by industry group can be more valuable since it reveals substantial variances from the reported medians.

For example, in the category of “% Current” the range among industries in 2Q-2010 was from 39.13% to 94.76%.

Of particular interest to me as I studied the results was the disconnect between the improving picture painted in the CRF report and the anecdotal information that I’ve been hearing recently from clients and others. The message I’m hearing is that there has been a continued deterioration in the ability to collect money owed to small and mid-sized businesses.

I’ve written in prior posts about an organized and concerted movement by Wall Street houses to educate large, credit-worthy businesses on the virtue of substantially lengthening payment terms to their suppliers and then offering to accelerate payments at a discount.

This “squeeze the little guy” campaign demonstrates a cynical disregard for the long-term damage to the SMB community, which is so important a source of job creation. Its openly-stated purpose is to leverage the large companies’ access to cheap capital as a tool to force suppliers to reduce effective prices.

Let me add a few, admittedly anecdotal, data points from conversations I’ve had in just the past week:

1. A colleague told me the other day that he had knowledge that a large, multi-national company had instituted a new, purposely-draconian, “reject the invoice” policy. The AP staff of this company will now reject any invoice for ANY deviance from its increasingly complex and difficult-to-understand invoicing policy; requiring a revision and re-submission. And, of course, stringing out the time to payment.

2. A client told me this week that one of their customers; an architectural firm that had done a substantial amount of work for a large public hospital; had had to fight for over 120 days to get a check, which then bounced.

3. A colleague reported that a large, national customer recently notified a certain class of supplier that it suspected that there had been fraud on the part of some of those suppliers and so had put a freeze on ALL payments to ALL suppliers in that category until an audit could be completed. Completion of the audit is not expected until YEAR-END!

4. A professional services firm that has been in business since 1914 has had to enter into a workout payment arrangement with a subcontractor on some UNDISPUTED bills to a large municipal school construction agency that have been unpaid for nearly a YEAR.

5. A painting contractor that has been doing a significant volume of work for one of the largest residential property management firms in the area for over 20 years now has about 75% of its receivables at over 90 days.

These are just a few items that have come up in the past week.

It’s certainly possible that my experience reflects a regional bias. It’s possible that the lag effect is a partial explanation. It’s also possible that it reflects a bias toward the kind of client I typically deal with in my spot-factoring business.

But the anecdotal reports that I’ve been getting certainly paint a picture that is at variance with that of the 2Q CRF report.

I do not question the CRF results. I think that the information they compile and analyze is valuable and important and I’d recommend it to anyone interested in top-line industry trends. It might well be that the next quarterly report will show the sort of softening that current anecdotal information hints at.

What I do suggest is that the need for liquidity in the SMB market and, specifically, for acceleration of receivable collections in that market, continues to be among the top two or three problems facing business owners.

And that’s good for prospecting by the TRE Seller-marketing group.

Friday, August 6, 2010

Misfiring Synapses

Some days the coherence of a rifle shot gives way to the less-organized pattern of a scatter-gun. This is such a day.

Rather than a single topic, I have a scatter-shot list of points to make and issues to address.

So, here goes…..

1. This week we’ve marked the close-out of our 150th TRE auction. (We’ve bought all or part of 189 auctions to-date.)

I can no longer say that we have encountered NO repayment problems but I CAN say that the issues that we have encountered have been handled professionally and successfully.

2. It has ALWAYS been unrealistic to suggest or to believe that everything would always work smoothly in the environment of SMB factoring. It doesn’t and it won’t. The challenge is to anticipate and avoid situations with a higher likelihood of problems, even if that means refraining from bidding on auctions that seem very tempting.

3. I was reminded this week that holding-period duration can be every bit as important as discount rate. I made an error and bid on an auction that could potentially have been repaid so soon that the TRE fee structure would generate a negative or negligible return to the Buyer. As I was berating myself for the bidding error and hoping that somehow I could be spared “success” on that auction, another Buyer placed a more aggressive bid that I’m convinced was also an error on his part. Give thanks for dodged bullets!

4. I continue to believe that the TRE fee structure should be re-considered. It provides a powerful disincentive for Buyers to bid on short-duration auctions and, therefore, acts to damage Sellers’ ability to maximize utilization of the platform.

5. In last Friday’s “Liquidity Weekly” email, Bill Siegel noted that July was another record month for exchange volume. The actual volume figures are TRE’s, not mine, to make public. But I think I can add a specific data point of interest without violating the Buyer confidentiality agreement.

By my reckoning, July 2010 represented the 12th consecutive month during which auctions were closed on EVERY trading day of the month. That’s pretty cool—a full year without a zero on the daily volume chart.

6. As I was considering the last twelve months activity, I looked back just out of curiosity, at the activity in the last week of July 2009 versus that of the last week of July 2010. What I found was interesting.

A high percentage of the Sellers active in the current period were also active in the year-ago period. Some of that seemed coincidental. Two Sellers, for instance, that were active in July 2009 have been largely absent from the exchange over the past several months but happened to pop up in the last week of July 2010. And their auctions were treated very well buy Buyers.

In a couple of cases, Sellers that were active in both year-apart periods found that their pricing in the 2010 week was much different than in the 2009 week.

My interpretation of that is that the Buyers are paying more attention to the updated financial statements, to the strength and payment records of the Account Debtors and to the likely duration of auctions; and they are adjusting their bids accordingly.

In other words, the analytic process is improving, at least among the Buyers that have been active for a while. That’s a good and healthy development.

7. While there was a surprising number of Sellers active in each of the two periods studied, there has also been an interesting pattern of rotation in the more-active Sellers over the intervening months. One Seller will be a major driver of volume for a few months and then go “quiet”, for instance. Some of these are seasonal issues. Some seem to reflect the Seller acquiring more traditional financing sources.

8. The positive aspect of the historical pattern is that when one major Seller goes quiet another tends to come along to replace it in fairly short order. The volume pattern of the last year should not be interpreted as continually building on a base of established and reliable Sellers (although there are certainly quite a few in that category).

Rather, the pattern is more like “rotation” in the equity markets. Leadership changes and Seller -participation changes for a variety of reasons, but the top-line trajectory remains strongly positive.

9. It is to the Exchange’s credit that, so far, there have been new leaders brought on to replace those who go quiet in a fairly seamless pattern.

10. The Credit Research Foundation has just published its newest quarterly “National Summary of Domestic Trade Receivables”, which is quite interesting. I’ll write about that in my next post.

In the meantime, pardon the misfiring synapses of an August Friday afternoon!

Wednesday, July 21, 2010

Remembering Jerry Maguire

There’s a great scene in the movie “Jerry Maguire” in which Tom Cruise is pleading with a prospective client. He says, again and again:

“Help me help you. Help ME help YOU!”

Without Cruise’s inflection it sounds a little flat but he was really PLEADING.

Suspend disbelief for a moment and let some of that pleading tone seep into your reading of this post!

In my June 30 post I complimented the TRE management on the job they’ve been doing at getting Sellers to post updated financial statements in a more timely manner (as required, by the way, in their program agreements). It’s an issue that I and others, I know, have been concerned about and things are moving in the right direction.

Now I’d like to make another suggestion. I can’t communicate directly with TRE Sellers. That’s not allowed. So I’ll make it in this forum and hope that it somehow gets transmitted through other channels.

Here’s the issue…..

As I sit here, there is a live auction on the platform that I might well be interested in, EXCEPT that the updated financial statements show what is to me a serious and inexplicable trend in the ratio of accounts receivable to gross sales. The number is so far out of the ordinary and the trend is so definite that, without some explanation, I just can’t bid.

The Seller MUST recognize that this is a red-flag item.

Absent some other explanation I have to assume that there is an unappealing reason why receivables are such an unusual percentage of sales. But maybe there IS another explanation. If the Seller were encouraged to post an explanatory note that solved the riddle, there might be a greater level of interest in its auction.

So.....“XYZ Corp, help US help YOU!”

Give the community of Buyers SOMETHING to explain the weird numbers!

I met the other day with a colleague and, among other things; we discussed some of the companies on my “bid vs. no-bid” list. In scanning my list he saw a name that I had categorized as “no bid”.

My colleague happens to know this company and its background. He told me that, while he is aware that they’ve had a history of very substantial losses and have a current a balance sheet that ”must look horrible”, he suspected the company’s backers were quite willing to continue funding it.

That’s information that is not available from the material provided on the TRE platform, from the credit information I had obtained on the company or from the data available from a quick online search. (I admit that, given the looks of the financial statements, I did not spend a great deal of time trying to find reasons to qualify the Seller.)

But in this case, too, some explanatory notes from management could be made available on the TRE platform to help Buyers understand in a more nuanced way the financial situation of the company.

And helping Buyers understand the Seller’s situation will ultimately help the Seller.

One more example and I’ll leave this alone.

There are several Sellers that have very substantial, unexplained, Intangible Asset entries on their balance sheets. In some cases the only net equity on the balance sheet results from these intangibles.

With no explanation of the nature of the intangible it’s hard to give its stated value any significant credence. A note of explanation COULD make the difference between having many interested Buyers vs. few and an attractive pricing vs. one less attractive.

The nature of the relationship between TRE Buyer and Seller is unusual. We can’t pick up the phone and ask the Seller questions. But the answers to some obvious questions could be of real benefit to all parties.

So, while I have no standing to make a request on behalf of all Buyers, I’ll say to both the Sellers and to TRE:

"Help us help you!”

Added clarity on financial statement items that are obvious red flags can only benefit the Sellers.

Tuesday, July 13, 2010

The Very Good Gets Much Better

One of the first items I discussed on this blog was the advantage of the Louisiana treatment of receivables transactions. The so-called “true sale” provision of the LA version of UCC Section 9 largely removes the potential that a purchase of receivables might be subsequently deemed a financing rather than an asset sale.

That’s a big deal and one of the reasons that TRE chose New Orleans as its headquarters.

Now that benefit has been significantly expanded and essentially “tailored” to specifically include transactions on the Exchange.

Governor Bobby Jindal took time out from his work on the BP oil spill to sign into law Louisiana Senate Bill No. 256 (Act 958) entitled the “Louisiana Exchange Sale of Receivables Act”.

The title of the law itself signals one of its principal benefits to TRE.

It does not apply to ALL transactions involving receivables sold in Louisiana. Rather, it deals only with those receivables transactions that take place “over electronic and other types of exchanges located in” Louisiana.

In other words: transactions that occur on TRE.

To make its aims quite clear, the stated legislative intent is specific i.e. “to encourage and promote businesses to offer sellers the ability to sell their receivables to qualified buyers over electronic and other types of exchanges in this state, thereby availing themselves of Louisiana civil law principles not found in common law jurisdictions…”

A few of the new advantages accorded exchange-based transactions are:

1. Clear and specific language affirming that exchange-based transactions are included under the very strong “true sale” protections already in the Louisiana law.

2. Clear and specific language affirming that exchange-based transactions will not be re-characterized as financing transactions even when seller-guarantees of repayment are provided and even when the seller might be entitled to subsequent additional payments for the receivables sold.

3. Clear and specific rejection of common law theories under which sale of receivables have been considered financing transactions in other jurisdictions.

4. Expansion of the definition of “receivable” to include other third-party domestic and international payment obligations that are not subject to the Uniform Commercial Code.

5. Provisions requiring anyone who attempts to re-characterize receivables transactions as financing transactions to pay the exchange-buyer’s costs to defend itself.

6. Clear, strong and specific language regarding the application of Louisiana law, and of these provisions particularly, regardless of the legal domicile of the seller, the buyer or the account debtor.

7. Provisions making clear the right of a buyer of exchange-traded receivables to resell the receivables purchased and to pledge or grant a security interest in the receivables purchased: in other words, facilitating a buyer’s securing financing to purchase exchange-traded receivables.

I again remind everyone that I’m not a lawyer, but as I see it there are some really big things in this bill, which should probably be titled the “Let’s Help TRE As Much As We Can ” Act.

Clarifying the “true sale” status of exchange-traded transactions is a very good thing. And this is the principal benefit discussed in the press release from TRE on this new legislation.

Specifically prohibiting re-characterization of exchange-based transactions is a good thing.

Providing for buyers’ entitlement to recover costs is a good thing.

But, from my point of view, the really BIG things in the bill are:

a) The expansion of the definition of “receivables”. This is not discussed in the TRE release but opens the door to new markets that could be of major benefit to the Exchange and its participants.

b) The specific provisions allowing exchange-traded receivables to be pledged as security. This will certainly aid those buyers looking to obtain leverage without pledging other assets as security.

c) The provisions that basically say “our law is THE law and the rest of you can go to hell”. The language of the Louisiana legislature is very strong on this point and while there has not been, to my knowledge, a test of the choice-of-law provisions in the TRE participant agreements, this language looks to have been crafted by a lawyer wanting to pre-empt any challenge of those provisions.

The “true sale” issue is obviously important but I think these three provisions might actually provide the more important springboard for TRE’s growth.

My guess is that we’ll see some creative use made of these new provisions sooner rather than later.

Congratulations, TRE! And congratulations Louisiana!

Well done.

Thursday, July 8, 2010

An Important Contingency

In the arcane world of receivables purchasing, there is a small corner of the industry that is even more arcane than the norm.

I’m referring to construction trades and to the various disciplines; such as architecture, engineering and other related fields that service or interact with the construction trades.

Often these professional services firms work for owners, including governmental entities, via subcontracts from firms that hold the primary contracts.

An example, for instance, is a client of mine: a cost-estimating firm that typically acts as a subcontractor to architecture or engineering firms. Sometimes the ultimate source of funds is the developer of a real estate project; sometimes it is a governmental or quasi-governmental entity contracting for public works projects.

I’m not going to attempt to describe the unusual problems raised in buying construction invoices. That is beyond the scope of a post like this. But suffice it to say that there are good reasons why construction invoice purchasing is a small and specialized sector of the factoring community.

The issue I want to address today is the frequently contingent nature of payment obligations in the construction or associated professional service businesses. Specifically, the impact of “pay when paid” or “pay if paid” clauses frequently found in contracts with those businesses.

These payment conditions are usually quite clearly stated and the substance of the language is enough to give any buyer pause.

In concept, they read, for example: “We’ll pay you WHEN we get paid” or “We’re only obligated to pay you IF we get paid.”

I am not an attorney and this is not to be understood in any way as legal advice, but those of us who do get involved in buying invoices from businesses like these are usually very quick to ask for a copy of the contract provisions dealing with payment, regardless of the apparent strength of either the Seller or the Account Debtor.

If either of these provisions is found in the contract, the first thing that a prospective Buyer can do is forget any stated due date on the invoices being reviewed for purchase. Those dates just don’t really matter.

The second thing that a Buyer might do is to request a full history of the invoices submitted and payments received under the contract in question.

The third thing might be to determine how the law in the applicable State treats “pay when paid” and “pay if paid” clauses. There has been a substantial amount of litigation on these clauses and there is not an answer that is universally applicable.

Some state courts; those of New York and California for instance; have ruled that a “pay IF paid” clause is against “public policy” and is unenforceable in those states. So a “pay IF paid” clause will be treated as a “pay WHEN paid” clause in those jurisdictions.

But what does that mean? In general, I understand that has been held to mean that payment will be made within some “reasonable” period. The effect of that, it seems to me, is to render the due date on an invoice essentially moot.

Other states have ruled that “pay IF paid” is an enforceable condition under certain circumstances. That’s scary.

When an invoice is posted by a TRE Seller whose business is like that of the client I mentioned above, for instance -- that might work for an architecture or engineering firm or for a construction manager – whose source of funds for the payment of subcontractors’ work is a third-party; it is very important to understand the payment provisions of the contract.

Currently, the Sellers on TRE do NOT post information that would allow a Buyer to determine whether the invoices being posted contain “pay when paid” or “pay if paid” provisions. If the Seller is in the type of business in which contracts often contain those clauses, the Buyer might be assuming an unknown and un-priced risk.

The point?

In some cases, regardless of the apparent strength of the Seller or the Account Debtor, or the validation of the invoice, or the satisfactory completion of the work required for payment, it is still possible to be exposed to either non-payment or very late payment.

Awareness of that possibility is the first line of defense.

Wednesday, June 30, 2010

A "Safe Haven"?

It’s been a busy month and I haven’t written as often as I usually do. I began thinking yesterday of what topics might be both timely and of interest for an end-of-month post.

There are many. It’s been a very active month for TRE.

LOTS of auctions; another volume record. Lots of new Sellers; some very interesting and some a little puzzling. Lots of established Sellers bringing new Account Debtors to the Exchange; again, some very interesting and some a little puzzling.

Those all suggest good topics.

TRE management has made significant and important efforts to enforce the requirement that Sellers update their financial statements on a more timely basis. Those new statements show that there have been some important swings in the condition of some Sellers: some in a positive direction and some negative.

It’s clear that 2009 was a tough year for many TRE Sellers. I’ve already commented on my own reactions to having to “let go of” some favorite Sellers and to become willing to buy from some Sellers that I’ve shunned in the past. There’s more than one good post in that topic.

And the bidding dynamics have continued to show changes in the relative strength of Buyers and Sellers and to provide some very interesting glimpses into the strategies and motivations of some market participants. Again, good topics to come back to.

But, as I sit here at the end of the day and the end of the month and the quarter, I have to pick a topic. And what strikes me as most important right now is “none of the above”.

I bought more auctions in June than in any of the 13 months that I’ve been an active Buyer. The average expected return on those auctions was higher than the average of any prior month.

I had more auctions close-out in June than in any prior month and none of those auctions was in any way problematic.

It wasn’t a month without some angst but most of that was self-inflicted and that goes with the territory in any investment medium.

And there’s the story…..

It was a month of increasing volume, increasing opportunity and increasing returns.

It was a month whose problems were the problems of managing opportunities.

Contrast that environment with the turmoil in stock market, the currency markets, the commodity markets or the sovereign debt markets. And then there were those who thought that bond yields couldn’t go any lower!

Who would have thought that buying receivables on an upstart electronic exchange would dampen portfolio volatility at the same time as providing incremental return!

Who would have considered this type of investment a “safe haven”.

Now, “safety” is relative and I am not going to downplay the potential risks involved in TRE transactions. I’ve taken pains to make some of those clear in prior posts. But I’m talking about the RELATIVE performance in an admittedly volatile period for other financial markets.

And, also admittedly, the volume of Exchange transactions is still too small to make a meaningful difference in the context of the portfolios of large investors.

But current experience has to be at least a LITTLE intriguing, even to the larger players, as we look forward to the day when TRE volume is a meaningful percentage of its potential.

Tuesday, June 22, 2010

Business As Usual

I started buying TRE auctions on June 1 of last year. The Exchange was still in its fairly early days of operation and each new auction posted seemed to represent something of an event.

There were two days in the first half of last June, in fact, on which no auctions closed. It certainly seemed at that time that there were more dollars seeking auctions than there were auctions to bid on. So “losing” an auction was, at least for me, kind of a big thing.

There have been many changes in TRE operations and dynamics since that time. By my count, over the same period in June of this year there have been five times as many auctions sold as last year and the average daily dollar volume has increased by a similar factor.

The number of Sellers has continued to increase and, while there are quite a few that don’t make it through our screen, there are quite a few that do. There is now a significant number of Sellers, in fact, that I’m quite pleased to buy from.

One of the happy consequences of the continued maturation of the Exchange is that it no longer feels like such a big deal when an auction is “lost”.

A year ago, the process of analyzing a Seller; analyzing it’s Debtor(s); reviewing the invoices posted; considering the past auction history; deciding to bid; and then actually placing a bid; represented not only a significant investment of time and energy but had an emotional component as well.

It represented a serious commitment. To fail to win an auction after all that actually felt something like a failure.

Well, times have changed. I “lost” two auctions yesterday that I bid on actively. I liked the Sellers. I liked the Debtors. I’d had good experience with each and I offered competitive pricing—actually a series of increasingly competitive bids.

And then those auctions, that I really assumed I was going to win, were just gone; snapped up at prices that I suspect pleased the Sellers quite a bit but left me empty-handed.

But here’s the point……

I didn’t get THOSE two auctions--but later in the day I got two others.

And I know that the Sellers of the auctions I lost are likely to be back very soon and I’ll have another opportunity to buy some of their invoices.

It’s no longer an “occasion” when a good auction is posted for sale. It’s business-as-usual. If I miss one today I’ll have another chance tomorrow.

On the other side of the coin, if a Seller has to pay a little more today because of the dynamics of this particular day’s activity, he can probably count on evening the score on a day when the Buyers are feeling the pressure to put money to work.

In short, what was a novelty a year ago is not a novelty today.

When I log onto the TRE platform tomorrow morning I will have every expectation that I’m going to have the chance to do some business.

Some days will be better than others. You win some and you lose some.

But that’s what a market is about, right.

And that’s what the Exchange has now really become.

Thursday, June 10, 2010

When the Evidence Changes

The last decade or so of stock market experience testifies to the truth of the admonition: “never fall in love with a stock”. I confess that I have done that to my ultimate disadvantage more than once.

In essence, the rule tells us that it is perilous to ignore changed conditions; to hold fast to prior decisions when the premises of those decisions change.

Roughly a year and a half into the active life of The Receivables Exchange we’re now getting some information on some longer-term Sellers that allows us to chart the trajectory of their operations and financial condition over a few comparable periods.

(As an aside: I wrote last year suggesting that TRE make an arrangement with a credible academic institution to try to isolate and study the impact of the TRE facility on the financial health of its Sellers and I still think that would be a very useful long-term project!)

My point today, though, is to suggest a TRE analog to the stock market maxim. That is: “never fall in love with a Seller”. And to suggest the inverse, of course: “never hold to a negative conclusion when the evidence turns positive.”

As easy as it might sound, it’s still hard to do!

After analyzing a Seller. And concluding that buying from that Seller is a sound decision. And then actually buying a number of auctions from that Seller. And after getting paid properly for those auctions. It is difficult to look at new information that shows a deterioration in that Seller’s financial condition and conclude that the buy-decision needs to change!

In fact, for me, it is more difficult to “let go” of a deteriorating Seller than it is to re-evaluate one that I’ve previously found too weak. It feels a little disloyal. After all, everything’s gone well… far!

But one of the advantages that I’ve suggested the TRE model provides is that new information can be acted on immediately. I CAN stop buying from a Seller just as soon as new information suggests that’s the right course. And I CAN recognize positive changes in the condition of a Seller and immediately move them onto the “buy list”.

I just have to be willing to act dispassionately based on all of the information in hand.

I have “let go” of a couple of Sellers recently: reluctantly, I’ll admit.

And I have recently bought from a couple of Sellers that were previously on my “don’t buy” list.

So far, I haven’t seen any pattern in the follow-on financial statements of longer-term TRE Sellers. The business of some active Sellers has gotten better over the past year or so and that of others has deteriorated. But it’s far too early in the life of the Exchange, and the economic environment of the past 18 months has been far too tumultuous, to draw any BROAD conclusions at this point.

But the evidence does suggest that consistent re-evaluation is necessary as new information becomes available.

And that we can't assume that today's evidence will necessarily support the same conclusion as yesterday’s.

Monday, May 31, 2010

A Lurch to the Left

No, this is not a political comment.

At the end of each day I print out a nicely-formatted spreadsheet provided on the TRE trading platform that displays certain data regarding the auctions closed that day. Before entering the data in my records I manually note on the spreadsheet the actual terms of each sale.

The format of the spreadsheet includes columns for “Minimum Advance %” and “Maximum 30-day Fee”. This represents the highest price the Seller is willing to pay for the funds it seeks.

To the right of those two columns are two additional columns representing the “Buyout Advance %” and the Buyout 30-day Fee%”. These are the pricing parameters that a Buyer has to meet in order to close out the bidding and be assured that he will be awarded the auction.

If an auction sells at or near the highest cost of money the Seller is willing to pay, the pricing will be at or near the figures found in the columns to the left. This suggests the Buyer has the greater power in the auction.

If the Seller has the greater power, the pricing will be at or near the figures in the right-hand columns.

A very low-tech way to get a sense of the relative power of the parties is to just mark the cells of the spreadsheet that come closest to representing the actual terms of sale.

If the Sellers were “in charge” that day, the marks will cluster in the right-hand columns. If the Buyers were “in charge”, however, the marks will cluster in the left-hand columns.You get a very quick visual picture of current market dynamics.

Then, borrowing the equally low-tech methods of early cartoonists, you can pick up a stack of these marked-up daily spreadsheets and just riffle through the stack. You’ll see a representation of the shifts in power over time.

If you were to do that for the past six weeks or so you’d see that the pricing of TRE auctions has taken a decided “lurch to the left” during that period.

Pricing power has shifted to the Buyers.

There HAVE been periods previously when the power has been decidedly on the side of the Sellers. And it’s reasonable to expect that market dynamics will change from time to time. But this period really HAS been a lurch as opposed to a gentle shift and it’s interesting to speculate about the reasons.

First, there have been many new Sellers brought to the market over the last 4 to 6 weeks and newer Sellers tend to command less attractive terms.

Second, volume has increased significantly and so, all else equal, it should be expected that increasing the supply of auctions should result in somewhat higher cost of funds.

Third, (and some might disagree here) I think there has been a decrease in average quality. A number of high quality Sellers have been relatively inactive and a number of lower-quality Sellers have increased their activity.

Fourth, the average terms of sale have shifted. There have been more and more auctions of invoices due in 45 days or 60 days, and some even in 90 days, than has been the case previously. Holding constant, just for argument, the supply of Buyers’ funds, a lengthening of the average auction duration will reduce the Buyers’ capacity to absorb supply.

Combining increased volume and increased duration compounds the pressure on funding required and, presumably, the pressure on pricing.

Now, I’m not suggesting that there is a shortage of Buyers’ funds. While volume has increased substantially, it still hasn’t reached a level that would come close to taxing the ACTUAL resources of the community of Buyers. It might, however, be a factor when measured against the ALLOCATED resources of some Buyers.

At the margin; increased volume, increased duration, decreased quality and a higher proportion of new Sellers should be expected to put upward pressure on cost of funds.

And that’s what we’ve seen.

If the brief history of the Exchange is a guide; as the new Sellers prove themselves over time the pricing for their auctions will improve. As some of the higher-quality Sellers that have had seasonal reductions in activity come back to the market, their renewed demand should reduce average pricing levels (but perhaps put even more upward pressure on the lower quality Sellers).

The macro issue that I wonder about is the impact on Buyers’ funds of the increased volatility in other financial markets.

May was obviously a month of increased volatility in both equity and fixed-income markets. TRE is still too small and too new to provide any real alternative to those major asset classes. But, over time, assuming its success, the month of May might have been a period when some marginal liquidity might have found its way from those other markets to an alternative destination like the Exchange.

That would likely cause a “lurch to the right”, which is precisely what we did NOT see this time. So I think it’s fair to assume that the aggregate allocated funding of TRE Buyers still represents a fairly small and “closed” system, responding more to internal trading dynamics than to either macroeconomic forces or the dynamics of more traditional financial markets.

So we lurch into the Exchange’s second summer still gathering experience, information and, hopefully, momentum.

Friday, May 28, 2010

The Year-on Perspective

This is the first anniversary of The TRE Observer!

Sixty-seven blog posts later; one hundred and thirty-nine transactions later; several TRE platform upgrades later; TRE volume growth of several hundred percent later; several significant operating and marketing changes later; one major TRE funding round later; I re-read my initial post of 5/28/09 this morning.

And I think there is some value in just re-posting it today. It doesn't hurt to look back on the thoughts of the past.

As I do I find that I could say almost exactly the same things today. So, without apology for lack of new material, here again is the first TRE Observer post, one-year on.


"On November 17, 2008 the first transaction on The Receivables Exchange (TRE) was completed. I think we will look back on that day and that transaction as the start of a new era in the financing of small business.

TRE is a real-time, on-line auction market for accounts receivable. Some call it, I think derisively, “an EBay” for invoices. Those who would minimize the importance of providing a means to efficiently and economically liquefy one of the largest balance-sheet items of the most liquidity-starved segment of the business community are simply missing the elephant in the room.

TRE is new and it is far from perfect. It will inevitably be required to make adjustments as experience teaches its operators and its users some valuable (and some potentially expensive) lessons. All beginnings are hard.

But TRE is a game-changer. It is disruptive.

Those whose businesses face disruption will scoff at first and then resist but they will ultimately adjust to the new reality because they will have no choice.

I first learned of TRE in early March 2009. By April 1, 2009 I had signed up as a Buyer.

I told the TRE staff at that time that I would not trade on the exchange until I had observed it for a reasonable period and felt that I understood it. So I have been lurking for nearly two months: watching and taking notes, compiling a database and asking questions about technical details. TRE personnel have been very forthcoming in addressing my questions and concerns. They have been open to my suggestions and understanding of my criticisms.

I have reached a number of conclusions about both the current TRE operation and what I would change if it were up to me. I have also determined with some specificity what criteria I would use to participate in the TRE activity. And I have decided to not only begin to trade but also to write about the exchange, its operations, its strengths and its weaknesses.

It is not often that a truly new market is created. When one is created, though, it inevitably spawns an infrastructure of support facilities and activities, among them comment and analysis by third-party observers.That is the purpose of this blog…to observe and comment on both the good and the bad of TRE.

I look forward to this. It is a journey and an experience that I invite you to share."

Friday, May 21, 2010

The Quality Issue -- Again

In my post of May 14 entitled “The Wheat From the Chaff” I said I’d write next about the recent comments from Bill Gross of PIMCO and the new work of Edward Altman of NYU on the issue of quality/credit ratings.

I got sidetracked a bit but now I want to return to that topic.

I’ve argued previously that, if TRE is to realize its growth aspirations, it will eventually have to provide SOME means for Buyers to more conveniently differentiate Seller financial strength and transaction quality.

The Exchange doesn’t have to actually DO that itself; it can outsource the function. Or it can co-operate with a 3rd party service provider who might see an opportunity to create a new business line or to leverage an existing one.

But the current system, which requires that each Buyer analyze the financial data made available by each Seller, and keep checking for and analyzing updates, is not going to work when there are actually hundreds or even thousands of Sellers.

In his May “Investment Outlook” piece, Bill Gross essentially dismisses the three big bond-rating agencies: Moody’s, S&P and Fitch, as purveyors of Kool-Aid to an “unsuspecting (and ignorant) investment public”. The solution for PIMCO is to have its own large credit staff that can “bypass, anticipate and front-run all three, benefiting from their timidity and lack of common sense”.

Now, when someone as smart as Gross can have so little respect for the analysis of a Moody’s or an S&P, even given the level of their experience and the quality of the information they have to work with, you have to ask whose analysis CAN be trusted.

I’ve written before about the condition of TRE Seller financial statements: not only about their quality but also their timeliness. The information that S&P has to work with in analyzing a bond issuer is, I suspect, much more likely to be accurate and timely than the financials provided by the majority of TRE Sellers.

Most TRE Buyers will not be able to follow the PIMCO lead and have large in-house credit analysis departments. They’re going to have to make do with less. They’re also not going to have the same quality of information. But that doesn’t mean that NOTHING can or should be done.

Edward Altman, developer of the well-known “Z-Score” Analysis has shown that near-term insolvency of businesses can be predicted with a high degree of accuracy based on metrics that are readily calculated from financial statements.

Altman and his associates have just published (March 2010) an updated version of their analytical tools, which appear to further improve their predictive power.

It’s true that these newer Altman metrics are more applicable to larger businesses than are currently found on the Exchange, but the notion that there are relatively easily-applied tests with strong predictive powers is still important.

There are three basic elements of risk assessment that are important to a TRE auction:

a) As to the Seller: the ability to make good on a defaulted invoice and the likelihood of its solvency in the near term,

b) As to the Account Debtor: the ability to pay its obligations and the likelihood of its solvency in the near term, and

c) As to the receivable purchased: the level of certainty that the obligation represents actual sums owing for work done or services properly provided under binding agreement between the parties. And the extent to which there are other claims that might be superior to that of the Buyer.

These are all issues that can be addressed, admittedly with varying levels of confidence. But SOME level of confidence, based on a reasonable attempt at analysis, is better than either guesswork, hope or blind faith.

I can understand that TRE might not want to present any analysis of its own, fearing liability in the event of loss. But that doesn’t mean it could not contract with a third-party provider to look at these three basic elements of risk analysis and assign a quality rating that reflects the three areas of fundamental risk listed above.

Such an analysis would be less robust than most in the financial world because of the quality of the data available, but it would have to add value when compared to the currently available information.

If the Exchange can convince its backers that there is a large enough potential volume of business to warrant their equity investments, I suspect it is persuasive enough to convince a 3rd-party analytical group to take on this quality-rating task!

Such an effort would benefit all who hope for Exchange success.

Friday, May 14, 2010

Fear of Commitment

In a former life I was a lender, as I’ve mentioned before in these posts. One of the realities of the business was that when we issued a loan commitment we got a commitment fee.

The prospective borrower could walk away from the deal but if he did he’d forfeit the fee. That would at least partially compensate us for “reserving” the funds committed and for doing the work necessary to underwrite the loan.

I’ve been thinking about the value of “reserving” funds in light of the recent activity on The Receivables Exchange and that’s led me to post this unscheduled comment on a Friday afternoon.

We’re in a period of rapidly rising auction volume, which is great. Predictably, though, with a rapid increase in the demand for funds, the price of funds has also firmed a bit. The presence of a substantial number of new Sellers, whose auctions have not yet “proven” themselves, also tends to lift overall pricing levels.

While the pricing of auctions at the time of sale has firmed, the initial asking prices have remained pretty much constant. So the percentage of auctions sold at “buy-out” pricing has fallen. One consequence of this is that auction duration has lengthened.

So, what’s the issue to write about on a Friday afternoon?

It’s this—any bid except a buy-out bid is a commitment of funds without any corresponding compensation. And the longer the auction period, the longer the potential uncompensated commitment.

Let’s say there’s an auction posted with a stated duration of 5 days and a buy-out price of 85% advance and 1.5% per month discount. Let’s say, further, that recent experience suggests that auction should actually sell at 80% x 2.0%.

If I bid 80% x 2.0% as soon as the auction appears, I am agreeing to hold the funds at that price for up to 5 days, giving the Seller the option to take the deal at any time but being unable to re-allocate the funds until the Seller acts.

My incentive in such a situation is to avoid bidding early; to hold back, assuming the auction will sit on the shelf for a while, and react to others’ bids rather than take the initiative myself.

In that way I can maintain the flexibility to bid on something else that comes up in the interim.

In that way I avoid giving the Seller a free 5-day put option; a fee-free commitment of funds.

That situation is not really good for anyone.

All parties: the Seller, the Buyer and the Exchange, benefit from auctions that sell quickly. But if both price and time are barriers to bidding, what’s to be done?

I suspect that few Sellers are going to adjust their asking prices in a meaningful way except to reflect changed invoice payment terms or Account Debtor quality. (We HAVE seen pricing change in some cases to reflect short payment terms, which is rational and positive.)

My suggestion in this situation would be to shorten the auction duration.

We’ve seen some auctions come to the board with terms as long as 14 days! The idea of getting stuck allocating funds for that long is really unattractive. But even the more typical 5 day auction period causes problems.

If the Seller doesn’t want to adjust pricing to the level of the current market, why not counsel that Seller to post auctions with single-day durations?

Absent a buy-out bid, real price discovery frequently happens shortly before (sometimes VERY shortly before) expiration.

So accelerate the expiration!

Post an auction at 9:30 am expiring at 3:00 pm and find out what the pricing really is on that day.

If it doesn’t sell, post it again the next day. But then the previous day’s unsuccessful bidders are released to re-think the situation and the Seller can re-think the pricing if that seems appropriate.

When the shoe is on the other foot, and there is more demand than supply, the Buyers jump at good product. They pay up, and quickly, to make sure that they get the product they’re looking for.

The Sellers need to adjust in the same way when the cycle happens to be going in the Buyers’ favor. It won’t last forever!

Wednesday, May 12, 2010

The Wheat from the Chaff

I’ve written before about the need for TRE to provide Buyers with the means to discriminate among auctions offered: a screening capacity based on a range of filtering criteria.

Some of those filters would be relatively easy and probably inexpensive. Those would include such straightforward criteria as: size of auction, auction experience of Seller, auction experience of Account Debtor, Seller industry, etc.

There should also be a Buyer-defined screening capacity that would eliminate from the displayed auctions any Sellers, Account Debtors (or classes of either) that a Buyer might choose to ignore.

When there were only a handful of auctions live at any one time it was possible, after some experience, to just “know” who was who and what was what. But now there are frequently 30 or more live auctions at any one time.

The day will soon come, I suspect, when that number will be 100.

And, if the Exchange were to grow to the size of 10% of the current factoring market in the US, it is likely that there would be an average of about 1,000 auctions per day.

So TRE needs to be working on adding those relatively simple screening functions. Hopefully they are.

The other screening metric I’ve argued for in the past is a Seller-quality rating system. I’ve suggested that an affiliation with a third-party credit rating agency might provide an arm’s-length approach to both analyze differential risk and support better informed pricing.

Since I last wrote on that subject TRE has brought on many new Sellers and both they and we and, presumably, the rest of the Buyer community have gotten more experience in analyzing the financial information made available on TRE Sellers.

Tuesday afternoon, in our shop, is the time when we look at the financial information on all new Sellers brought to the Exchange in the prior week and the financial statement updates posted by existing Sellers.

We then decide whether the new Sellers go on the “OK to Bid” list (which would still be conditional, requiring a certain level of experience) or the “No Bid” list.

And we decide whether new financial information posted by existing Sellers changes our prior decisions about Seller acceptability, for better or worse. (And that subsequent information HAS caused us to move Sellers from OK to Not OK, and vice versa.)

There have been several Tuesdays recently when the quality of the information available has caused more Sellers to end up on the “No Bid” list than I’d like and maybe more than actually SHOULD be on that list.

Unfortunately, we sometimes just can't really TELL whether a Seller is of lesser financial strength than we’d like. It’s too often the case that the numbers just look so odd that we can’t be comfortable that we really understand them. And if we can’t understand them they go on the ‘No Bid” list.

That might be fair or unfair in terms of the actual financial health of the Seller but if the Seller can’t present its financial statements in way that makes a believable case for its health, it’s got only itself to blame.

The books of privately-owned businesses often reflect idiosyncratic practices and motivations – to state the case kindly.

But, since the TRE Buyer has to look to the Seller for ultimate recourse, TRE Sellers are going to have to be led to adopt financial statement presentation methods that are more accurate, understandable and generally accepted.

But that would just get us to the point where we could apply whatever analysis tools we think appropriate in decision-making. Until the data available appears to be reliable enough to analyze credibly, the selection of analysis tools and methods is a moot point as to that Seller.

Coincidentally, both Bill Gross of PIMCO and Professor Roger Altman of “Z-Score” fame, have written recently about rating tools, agencies and analysis methods.

In our next post we’ll comment on their recent work as it might apply to the analysis of TRE Sellers.

Bottom-line here, though: while TRE can't be responsible for the Seller's financial statements, it CAN and SHOULD advise both existing and prospective Sellers about the parameters of acceptable statement preparation and perhaps provide referrals to accounting professionals who could help clean up the Seller's numbers.