Congratulations to the TRE Team!

The Receivables Exchange announced this morning that it has received $17 million in additional funding from a group led by Bain Capital Ventures to continue to scale its operations and to substantially expand its reach into the B2B receivables financing space.

Funding of this magnitude from sources as respected as Bain, Redpoint Ventures and Prism Ventureworks is a major vote of confidence in the future of this platform and this marketplace.

TRE, its founders and its entire team are to be congratulated on this accomplishment.

For those of us who have already voted with our time, effort and capital on the TRE concept, this is also a significant day.

Only if the Exchange itself succeeds will our early efforts have laid the groundwork for the establishment of significant Exchange-based businesses.

If TRE ultimately fails it will not be because of a failure of vision. If it ultimately succeeds it will have been in spite of the opposition of much of the traditional factoring community.

I am among the first to criticize and to point out what I perceive as flaws in TRE practices.

But I can only be complimentary of the founders’ identification of a potentially huge under-served market and their vision of a solution to one of the most widespread and pressing needs in the business community.

Too many within the traditional industry have been, in my opinion, unable to conceive of a solution on anything approaching the true scale of the problem.

TRE might be criticized for hubris and for being insensitive to the influential players in the current market.

But the truth is that the current industry leaders haven’t produced a potential solution that even approaches the creativity and vision of the Exchange’s.

This is a day that the entire TRE team can celebrate and an accomplishment in which they can take well-deserved pride.

But tomorrow it’s back to work with an even steeper hill to climb!

The Punch Bowl

The teams that will meet in the Super Bowl will be decided this afternoon.

We’ve already seen the Rose Bowl and the Sugar Bowl, the Orange Bowl and the Hula Bowl. For many business owners those bowls only briefly take their minds off the most important bowl of them all…

Yes .... it’s the Punch Bowl.

Ever since someone described the essential job of the Federal Reserve Board as taking away the punch bowl just as the party is getting started, the term has been understood as describing the fuel that gets a party going.

In economic terms that’s understood to mean cheap money, or low interest rates; and more specifically, low interest rates in the commercial banking system. Because that’s what’s generally considered the necessary ingredient to get a stagnant economy moving.

But the Fed’s punch this time around doesn’t have the kick it used to. The central bank been keeping the cost of money at an all-time low level and the party, for many businesses has been all but canceled.

The punch in this year’s punch bowl is a punch in the stomach!

That’s what it feels like after a business owner, used to being able to access traditional credit markets at SOME cost, gets turned down flat again and again. There's no bank money for him at ANY cost.

It’s well documented that the Fed’s monetary stimulus is fueling a powerful carry-trade allowing banks to rebuild capital at the ultimate expense of the national debt we leave to our children.

The cheap money is being used, not to make loans to businesses, but to play the yield curve. It shouldn’t surprise anyone. It’s a perfectly natural and logical, low-risk way to repair some of the damage done when punch was really punch.

I was looking over the financial statements of a TRE Seller this morning. This particular Seller provided audited statements for the year 2007; before the current liquidity crisis began and during the period when low interest rates still fueled (arguably over-fueled) business expansion.

The Notes to the 2007 Statements described an accounts receivable financing facility provided by a commercial bank.

The borrower was not in great financial shape at that time. It recorded a substantial net loss for that year and had obviously been restructuring its equity financing to compensate for operating losses.

I was struck by the financing terms that this borrower had been able to secure from its bank. The rate was pegged at a fixed increment BELOW a widely-used benchmark. And the absolute level of interest cost produced by that formula was, to my mind, quite low in light of the quality of the credit.

The punch still had its kick!

It could be argued that this sort of lending was a symptom of the problem that would rock the financial system shortly thereafter and, therefore, the terms of that facility should not be considered a fair benchmark for comparison to a cost-of-funds today. And that’s a fair argument.

But it’s still useful for dramatic effect.

The pricing that the Seller has indicated as acceptable for current invoices to be sold on The Receivables Exchange is roughly TRIPLE the rate it was paying just over two years ago on its former bank facility!

Now it’s true that the former facility was probably under-priced. And the TRE pricing might well come down as the Seller becomes better-known. And the Seller HAS continued to lose money in the interim periods; so it’s appropriate that its cost of money should have risen. But the magnitude of the change in cost-of-funds is still dramatic.

Let’s say, for argument, that the appropriate measure of the increased cost represents a doubling rather than a tripling of rate. An increase in financing cost of that magnitude over a relatively short time period HAS to require compensating changes in business models.

But the biggest change required in business models is not actually compensating for COST of funds. It is compensating for AVAILABILITY of funds.

For a very large segment of small to medium sized-businesses, the traditional funding sources are just not available.

There are non-traditional sources for some of them, of course. But most of those non-traditional sources are relatively small when viewed in the context of the size of the current national problem.

The Receivables Exchange aims to provide an alternative financing platform on a major scale at prices that will be generally lower than, and with a process generally more flexible than, the existing non-traditional sources.

I suspect this Seller might still feel like he’s been punched in the gut at the prices he’ll have to pay to get his first few deals funded.

But I suspect that he’ll nonetheless be happy to just be able to play the game; that is, to keep his business going; even if it feels like he's playing in the punch bowl!

The Low-Risk Assertion

I’ve written in these posts about risk; about the assessment of it, the protection from it and the appropriate compensation for it; probably more than about any other topic.

It has been asserted that accounts receivable purchasing constitutes a low-risk asset class.

Let me share a little bit of a current story with you.

I settled a case of payment default in my traditional invoice purchase business last week. I have now recovered the funds originally advanced as well as a portion of my costs of litigation and collection and a portion of the modest post-judgment interest allowed in the state where the dispute occurred.

In the scheme of these things, that’s a “win”. But the financial result doesn’t capture the story.

I had done 76 transactions with this client over the course of nearly two years and so I had a degree of confidence in the process.

I had a first lien position via UCC filing on ALL of their receivables. I also had personal guarantees from two principals.

Then the default occurred. I’m not going to talk about either the identities of the parties or the details of the default; the PROCESS is the point of this story.

Following the default, the client and I met to discuss options and we agreed on a plan for payments to be made over the course of some months to clear up the problem. Given the transaction history, I thought then that it made sense to do that and I’d probably do it again today. And several payments WERE subsequently made; but not in the amounts or on the schedule agreed.

Then the payments stopped.

When it became clear that the co-operation of the client had ended I sued the client and both of the individual guarantors.

Ultimately I obtained judgments against all three parties. Meanwhile, however, the client corporation had merged with another entity, muddying the waters substantially on that claim. The two principals of the original client had parted ways. One had declared personal bankruptcy and the other had gone to work for another company in a different industry.

It takes only a few words to relate that outcome. Consider, though, that the definition of “ultimately” is two years of work and aggravation and the word “meanwhile” is its synonym.

From the time of default to the time of final settlement this issue will have consumed nearly four years, and hundreds of hours of my time and attention that could have been put to more productive use.

A lawyer who doesn’t specialize in collections work might be impressed with the idea that I was in the “right”; that I had a “solid claim”. But a lawyer whose job is to actually find and extract cash from uncooperative or desperate debtors will know better than to minimize the difficulty of actually getting paid even on an apparently clear claim.

In the end I will have gotten a portion of my money from a receivable that I had not actually purchased; a portion will have come from property seized on my behalf by the sheriff under court order; a portion will have come in the form of small monthly payments in lieu of a wage garnishment; and a portion will have been paid by one guarantor in exchange for an assignment of my rights against the other guarantor and the original client corporation.

If I had not had the personal guarantees, this outcome would not have been possible. If my UCC filing had encumbered only the receivable actually purchased, or if there had been a UCC filing senior to mine, I would have been out of luck.

This client had been in business for many years and was well-known in its industry. I had done dozens of transactions with the client before the default. But when the situation started to go bad it went very bad very quickly. And then it was a long, painful, expensive and maddening process to recover what I was owed.

My guess is that anyone who has been buying receivables for any length of time will have had similar experiences. And will know that the idea that this is a “low-risk” business reflects wishful thinking. It’s only low-risk until it’s not.

There HAS to be a risk premium built into the pricing of receivables purchases. That premium needs to accurately reflect the security of the buyer’s position and as each layer of potential security is stripped away; the price that the deal should command needs to be adjusted.

I began this year’s posts talking about the unusual nature of the TRE Buyer community and the impact of that on the auction process.

Those Buyers who are in the “short-term-parking” business will probably not have had the experience of having to pay a sheriffs department’s mileage costs to serve a writ of execution on a bank to try to seize a debtor’s funds. Or of having to wait a specified time period before the writ can be presented; allowing, of course, the funds in the account to be moved. Or of having to sit and watch as the myriad schemes of the professional judgment debtor are played out at his expense.

But those experiences do make a difference as one reaches to hit the “submit bid” button!

Restraint of Trade

In our post of January 4 entitled “Back to the Big Picture” we said that it would be up to the TRE Buyers to provide the counter-weight to the Exchange’s clear incentive to push for volume at the expense of quality. And in assessing the likelihood of that we said that the evidence at this point is mixed.

A number of instances of Buyer restraint can be pointed to in making the case on the positive side. I’d like to point out just one today, because I’ve been watching this situation and wondering how it would play out.

There is an active Seller that has been posting the invoices of a high-name-recognition Debtor since mid-October. The terms of the invoices call for payment in 60 days.

The Seller has been posting invoices of this Debtor at the rate of more than one per week and the auctions are of greater than average size, so a significant amount of money is involved.

I’ve been watching to see how the payment pattern would actually develop. After all, high name recognition doesn’t mean they pay well!

To date, there is no record on the TRE platform of a payment having been received from this Debtor, and the invoices included in the earlier auctions are now well beyond their 60 day terms.

It is important to note that none of the auctions has reached its re-purchase date. So I’m not suggesting that there is any default in the offing. I am using the situation only as a way to analyze and discuss the bidding pattern.

This Seller had sold invoices due from a number of other Debtors before the first auction of this Debtor’s invoices. So Buyers were used to seeing the Seller’s name. And the name of this new Debtor is a good one. So the auction was well-received. It sold right in the middle of the posted range.

Over the next ten, or so, transactions involving this Seller/Debtor pair, the pricing tended to decrease i.e. the discount demanded by the Buyers fell until it hit a low point about 48 days after the first auction. At that time, of course, no payment from the Debtor had been received.

Now, TRE management frequently points out a pattern of declining cost as auction history is amassed by a Seller.

I’ve never quite understood why the prices should get better for the Sellers until a pattern of actual payment has been established. From my point of view the greater the volume of unpaid invoices from a particular Debtor the higher (as opposed to lower) the discount should be on the next deal. But that’s just me, I guess.

But what has actually happened in this case does show some Buyer restraint.

Since that low-point in pricing was reached, half-a-dozen more auctions of this Seller/Debtor pair have been sold. There has been a clear movement toward higher discounts as those additional invoices have been brought to market while the lock-box has remained empty.

Buyers can argue about the attractiveness of this Seller and they can argue about the absolute level of pricing. They can even argue about the length of time it took for the pattern of pricing to change.

But, on a big-picture basis, the shift in pricing as more and more of the paper was sold without a history of payments being made, is rational.

The discount SHOULD go up under those circumstances. And maybe, when payments begin coming in, the pricing pattern will reverse.

But, in the meantime, a little restraint of trade is a positive sign.

Short Term Parking

In our post of September 17, 2009 entitled “The Company Capital Keeps” we commented on the fact that the TRE Buyer community is an unusual one.

In most, better-established financial markets, the professionals who provide capital have relatively similar motivations: they approach the markets in which they are active with similar analytical tools; they assess opportunities and risks relatively similarly; and their differences are usually apparent “at the margin”. Their assessment of appropriate pricing, for instance, will vary; but there is usually a fairly narrow range of central tendency.

In our last post we asked whether the TRE Buyers would provide the discipline required to act as an effective counter-weight to the Exchange’s understandable incentive to ramp up volume at the expense of quality.

These two issues are related.

The motivations of the TRE Buyers, as a group, are not as homogeneous as are typically found in more well-developed capital markets.

The TRE website, in its “Become a Buyer” section states: “Commercial banks, hedge funds and asset-based lenders are looking for new classes of high-yield investments to diversify their portfolios.”

Absent from this list (and from the “Become a Buyer” discussion generally) is any mention of the factoring community: the long and well-established industry of those whose business is buying accounts receivable.

TRE obviously seeks Buyer-members from the factoring community, but it is just as obvious that it has a strong emphasis on attracting capital from those NOT already in the business of buying accounts receivable.

In the list of benefits that TRE Buyers are provided by the Exchange, the short-term nature of the receivables purchase is specifically mentioned three times. References to the ability to “deploy more capital” or otherwise “access” a new market or “increase originations” are also a dominant theme of the advantages outlined in “Become a Buyer”.

The message sent to the reader, I believe, is that TRE provides a new place for investors whose business is NOT buying receivables to get some incremental yield on excess capital without committing money for a lengthy period.

So a hedge fund, for instance, that has cash sitting on the sidelines earning next-to-nothing, can pick up some extra income on that cash while retaining the ability to move the money fairly quickly into its more traditional business when opportunities arise.

This is the “TRE as short-term parking” model.

This model is likely to be employed by those committing only a small percentage of their capital to the receivables market. The combination of a relatively small commitment and a short duration provide two legs of a stool supporting the attractiveness of TRE to some of these potential Buyers. The third leg is the name-recognition factor of some Account Debtors.

TRE points out, quite accurately, that a significant percentage of the Account Debtors whose obligations are being offered on the Exchange are household names.

When the added yield and the lack of a significant time commitment is combined with the idea that the Debtor is a substantial, well-known, perhaps-public company, the decision process might seem quite simple i.e. “if I can pick up several hundred basis points of added yield on my cash position on a short-term instrument due from a AAA credit, why not?”

In the town where I live, the parking meters have a little button that you can push that gives you 10 minutes of free parking. So if you’re just going to run in to a store a pick up something quickly, it costs you nothing. But if you overstay the free period, the cost of a parking ticket will be the equivalent of your having put money in the meter 120 times! My guess is that the town makes a lot of money by giving away the first 10 minutes.

Those who employ the short-term parking model on TRE are not assessing risk in the same way that those whose principal business is buying receivables think about risk. They take comfort from the AAA Debtor name without, perhaps, fully realizing that it is the Seller, not the Account Debtor, that is really backing the obligation. And that many of the Sellers have much less than impressive financial capacity.

They take comfort in the notion that all invoices are verified by TRE when, in fact, that is no longer the case. They take comfort, perhaps, in the description of receivables as “attractive, low-risk investment opportunities”. Attractive? Yes. Low risk? Well, that depends.

The receivables-purchasing business has a very long history. There is much evidence to be used in assessing risk. That evidence should not be ignored.

The short-term parkers are providing buying power that TRE currently needs. But ultimately the short-term parkers are not the ones that, in my opinion, are going to prove the TRE concept.

Their money is “fast”, their interest is ultimately in other markets, and one deal gone bad may be all it takes to lose their participation.

Nor are they the Buyers that will provide an effective counter-weight to the risk of the Exchange’s clear growth-rate bias.

More to come on this subject.

Back to the Big Picture

My last post addressed one relatively small element of my own proof-of-concept question as a Buyer Member of The Receivables Exchange.

But this is the year in which the larger Exchange-level, proof-of-concept question will have to be answered: i.e. will TRE, in its current format, prove its economic viability?

The principals of TRE are actively seeking additional capital. This would be their third “round” of funding for the Exchange. This is not an unexpected development. Even at its own initial estimate of 2009 transaction volume the Exchange would not have reached break-even last year. So an additional round (at least one) of capital-raising was probably always in the cards.

I have no information on how the process is going but I would guess that they will succeed in raising enough funds to make it through 2010. At the end of this year, if the operation isn’t pretty close to breaking even, a fourth round of financing is likely to be a pretty hard sell. At that point the question of ownership structure and operating format would almost certainly come into play.

For those of us who have invested significant time, effort and money in the TRE concept there is an understandable desire to see the effort succeed; to see the concept proven; and to participate in the fruits of that success. And so I, for one, have to admit a bias on the positive side. The challenge is to avoid allowing that bias to affect either my analysis or my actions as a Buyer.

While my bias puts me on the same side of the larger conceptual issue as the Exchange itself, there is an important difference between the impact of the bias on an individual Buyer and the impact on the Exchange.

The essential trade-off in all financial markets is risk vs. reward.

In the context of the Exchange operations that trade-off is expressed in terms of volume vs. quality. We’ve commented before on the clear incentive the Exchange has to sacrifice quality for volume as it stretches to reach its proof-of-concept economic goal. There is an internal TRE counter-weight, however, provided by the very real need to control defaults and losses in this period. There’s only so far that TRE can afford to go in ramping up the aggressiveness of its Seller-marketing.

But the closer the time comes for clear proof-of-concept demonstration, the less effective a counter-weight that internal caution will provide.

The true counter-weight has to come from the Buyers.

If Buyers, who by definition have made a bet that the potential of the Exchange is worth their devoting time, effort and capital to it, hold a bias that is directionally similar to that of the Exchange, how can they be expected to provide an effective counter-weight?

The Buyers have to refuse to buy when the risk-reward proposition defies logic. If Buyers do not reject auctions that should be rejected, the message to the Seller-marketing group is “you haven’t yet found our pain threshold”. And the quality envelope will inevitably be pushed a bit farther.

There are those who would argue that rejection of auctions is not an appropriate response; that pricing should provide a clearing mechanism for any transaction. In theory, and on a large scale, that is true. But anyone who has had to try to enforce a judgment and collect funds from a defaulted receivables purchase will testify that there are some deals that just shouldn’t be done at any price. There just isn’t enough reward available to balance the risk. The cost in time and irritation exceeds any possible financial reward.

Will the Buyers provide the discipline to balance the Exchange’s clear incentive to push for growth?

There is mixed evidence at this point.

That question and its implications will be the subject of our next few posts.