Sunday, February 28, 2010

The Lost Decade

Today marks the 10th anniversary of the date of my best-ever brokerage account statement. The NASDAQ peaked on March 10, 2000. According to the February, 2000 statement I was a bloody genius!

In fact, they could have just addressed the statement to “Resident Genius” at my street address and I wouldn’t have had any trouble knowing who it was for.

It’s been a long ten years!

The pundits are calling it “the lost decade”, at least for stock investors. According to a report in this week’s Economist, Treasury Bills have outperformed the S&P over the past 10 years.

But some people made a lot of money over the past decade. They weren’t the buy-and-hold stock investors. They weren’t the buy-and-hold bond or currency or real estate investors either.

For the most part, the people who made a lot of money over the past 10 years have been those who have taken simple financial ideas and products and created highly complex financial products and markets from them. Particularly those who were able to do so utilizing massive amounts of leverage.

The idea of a sub-prime mortgage is simple. Creating a market based on the theory that a whole lot of sub-prime paper, carved up and leveraged smartly would produce AAA securities, was brilliant. Getting the government to essentially REQUIRE that these deals be done was genius—until it wasn’t, which didn't take long.

The ideas behind credit default swaps and collateralized debt obligations are not terribly complex but when the pricing of risk is based on horribly flawed measurements of it and, again, there is strong incentive to massively over-produce these instruments, the risk to the financial system is understated on an equally massive basis.

It’s perilous enough that market participants were given the incentive to produce huge quantities of complex and relatively illiquid assets. But when the government, in its dubious wisdom and false caution, mandated mark-to-market rules for major players in these illiquid assets, they nearly guaranteed that a meltdown would occur at SOME point.

When the markets for relatively illiquid assets freeze-up, as they all do from time to time, the issue of valuation becomes a very difficult one. When the small, or off-market, or marginal, or forced transaction becomes the only benchmark for assigning value to huge pools of assets, the result is a price graph that looks like the side of a cliff. And when other assets are derivatives of the one whose graph looks like that, the dominoes really start to fall.

What’s my point?

As has been well demonstrated by a number of analysts over the past year or so, the mathematics of risk measurement on which the last ten years of financial engineering has been based, was flawed. The fact that the occurrence of a particular event is highly improbable does not mean that it is impossible. And it does not mean that its risk can be ignored. People win the lottery every day. The highly improbable happens all the time.

Some people (relatively few) made a whole lot of money over the past 10 years on the theory that financial instrument risks were being appropriately measured. When it turned out that they were not, the economy as a whole very nearly imploded and we and our children will be paying the price for that for many years to come.

Here’s my point.

It has been shown that it is extremely difficult to accurately assess the risk of the sort of highly complex financial structures and instruments that have proliferated in the past decade. In fact, some say that it is impossible to foresee all of the ways in which some of these structures can go bad. And if we can’t foresee a risk it’s awfully hard to protect against it.

The creation of an invoice is a simple financial transaction. The structure of the obligation is straightforward. The mechanics of its fulfillment are straightforward.

The purchase of an invoice is a little trickier but still, in the scheme of financial transactions, pretty simple. The risks involved can be itemized with some assurance and the assessment of those risks does not require rocket science or rooms-full of PhDs with access to supercomputers.

Buying an invoice is essentially a low-tech financial transaction. But the pool of invoices created each year is enormous.

The traditional participants in the market have managed only minimal penetration.

But there is now a means of participating in that market in a way that is simple, efficient and scalable: courtesy of The Receivables Exchange.

TRE is not where it needs to be yet to absorb a great deal of capital. It has a lot to do before it becomes a real player in the big-money financial markets. But it’s still early days.

All things being equal, TRE offers the potential of size and simplicity as opposed to the sort of size and complexity that have caused such problems recently. After the past 10 years, SIMPLE sounds pretty good to me.

But, then, I’m not the genius I was 10 years ago!

Tuesday, February 23, 2010

Whiskey on a Troop Train

An early mentor of mine, when unimpressed with someone’s ability or job performance, used to quip: “He couldn’t sell whiskey on a troop train!”

There are (at least) two things in the current economy that are widely assumed to be as easy as selling whiskey on a troop train:

1) buying distressed real estate in markets like Las Vegas when you’ve got the cash to close immediately, and

2) putting money to work in the SMB (small-to-medium sized business) market.

In the first case there has been such carnage and the outlook remains so glum that the idea that you’d have a hard time BUYING rather than selling just doesn’t seem credible.

In the second, the news has been so full of stories about the lack of financing for small businesses that it is assumed that anyone willing to provide financing to that market should have no trouble.

I thought of my old friend this morning when I read the article in the Wall Street Journal (p A3) headlined “National Housing Bargains Drying Up”. The article chronicles the difficulties that prospective buyers of foreclosed houses are facing today.

If you’re willing to look for bargains in inner-city Detroit, they can be found (depending on your definition of “bargain”). But in places where you might really want to live, the supply is “dwindling” and “bidding wars are the norm on foreclosed homes”.

In the SMB space, the bankers who have been pilloried for dramatic reductions in business loans have argued that:

1) part of the reduction in lending reflects reduced demand. Business is slow and so business spending is down and loan demand is down, and

2) the portion of reduced lending that reflects tightened standards is justified by the increased risk that weaker loan applicants pose.

I confess that a year ago, when the banks were pulling back as quickly as they could, I thought that ramping up volume in the receivables finance business was a pretty sure bet. But I have to admit that the bankers’ arguments are more valid than not.

I’d state it this way: while lending has become more restrictive and the SMB market is suffering from a lack of liquidity, risk-adjusted financing demand IS actually down.

That doesn’t mean that total demand is down. I don’t know that to be the case. But I think it IS true that the overall quality level of the business that is available is lower than it was, say, two years ago.

When I talk to people about TRE the common reaction reminds me of my old friend. In effect, they say: how hard can it be to put money to work when there’s no one else out there willing to provide capital?

Well, I wouldn’t have thought it would be hard to buy a foreclosed house in Las Vegas, either.

Anybody can put money out. The trick is getting it back!

The growth of TRE, I suspect, has NOT been helped by the financial crisis, as counter-intuitive as that might seem. Because the TRE Buyers DO want their money back and WILL (generally) exercise a reasonable degree of prudence in determining what to bid on and how to price their bids.

I think the crisis has actually acted as a pretty strong headwind for TRE in its first 15 months of operation.

Finding QUALIFIED sellers is a tough job in this market. It is NOT like selling whiskey on a troop train.

It’s probably as hard, in fact, as it would be to keep whiskey OFF a troop train!

Sunday, February 21, 2010

Selling the Counter-intuitive

In my traditional invoice-purchase business, one of the most difficult points to make to a new seller is that their interests are NOT best served by trying to sell the invoices of their WORST paying customers.

It is most often the case that they are best served by offering for sale the invoices of their most RELIABLE customers. In this case I look at reliability in terms of both credit strength and predictability of payment.

The first impulse of the seller is often to try to find a buyer for their problematic invoices; on the theory that they then become the buyer’s problem. But because we require both personal guaranties and first liens on all receivables, that logic is flawed. In fact, an Account Debtor that is predictably problematic might well become even more so when they become aware that their obligations have been sold.

Most often the best solution is for the seller to offer for sale the invoices that present the LEAST UNCERTAINTY to the buyer. That doesn’t mean that they’ll necessarily be paid the quickest; there are a lot of very good customers that pay reliably in 45 or 50 or even 60 days.

But a customer with good credit that pays reliably in 50 days might be a much better solution to the seller’s cash needs than either: 1) a customer that pays reliably in ten days, or 2) one whose credit history is either poor or whose payment timing is erratic.

The customer that pays very quickly is probably not the source of the seller’s cash flow need in any event; and the buyer then faces the need to rapidly re-deploy the funds returned, having earned a relatively small fee for its efforts.

On the other hand, the reliable customer whose obligations are outstanding for a reasonable and predictable period presents not only a lower overall risk profile but also requires lower re-investment velocity and the likelihood of maintaining a higher percentage of funds employed.

Over time, that sort of Account Debtor should command the lowest fees from the buyers and provide the sellers with the least expensive solution to their cash needs.

In the specific case of The Receivables Exchange, this issue of least uncertainty is even more important.

Because the Buyers on TRE do not have the protection of personal guaranties or first liens on all receivables; and the TRE notification and verification processes are not as strong as is usually the case in single invoice purchases; there is limited scope for managing transaction risk.

Essentially, the TRE formula presents the Buyer a “barbell” shaped risk analysis problem.

The Buyer can make a decision regarding the Seller and one regarding the Account Debtor. But some important elements that constitute the relationship between the two are unavailable to, and not under the control of, the TRE Buyer.

As we’ve written a number of times before, the TRE Seller-marketing team has an inherent incentive to “reach” deeply into the pool of possible Sellers to ramp up volume. And we’ve seen some Sellers that clearly appear to have questionable financial capacity.

Often transactions involving Sellers of questionable financial capacity, even Sellers that have not yet completed a single TRE round-trip transaction, are priced quite favorably by TRE Buyers. And the reason for that is usually quite clear: the other end of the barbell, the Seller, is a well-known and established firm.

The current statistics on the TRE website show that 81% of the Account Debtors whose invoices are offered for sale on the Exchange are “Investment Grade”. Debtors whose stock is publicly traded represent 58% of the transactions. And those whose stock is among the S&P 500 represent 50% of the transactions.

While the strength of the Account Debtor might make little ACTUAL difference in many conceivable instances in which a transaction might become problematic, it is certain that a strong Debtor reduces at least the APPARENT risk in a transaction.

I have heard the TRE Seller-marketing argument on this point. They stress quite effectively the point that Sellers are best served by offering the invoices of their BEST customers for sale. Offering the least apparent risk attracts the broadest interest, the best pricing and ultimately the lowest-cost solution to the Seller’s cash flow problem.

A Seller with marginal credit credentials can get a lot of attention by offering the invoices of an S&P 500 Debtor, even though it is ultimately the Seller’s financial capacity that the Buyer must depend upon.

The statistics above make it clear that the TRE Seller-marketing team is doing a very good job at convincing Sellers to offer the most attractive invoices they have, rather than trying to unload their problems. Such an attempt would ultimately fail in any event, damaging both the reputations of the Exchange and the Seller.

The argument is still, at least initially, counter-intuitive. It’s not an easy sell. And TRE should be complimented for making it well and successfully.

Monday, February 1, 2010

To Discriminate: v. di-skrim-uh-neyt

The Bain announcement is now old news. It’s still good news...very good news, in fact.

But a new day and month are upon us.

The problem of FUNDING continued growth and development of The Receivables Exchange has been solved for the time being.

Now there are other problems to solve.

I heard it said last week that perhaps Bain could help to bring in new Buyers. And that might well be so. But if that is their principle follow-on benefit, the TRE proposition might still fail.

The TRE challenge is not availability of Buyer funds. Any one of a number of current Buyers could probably absorb the entire current deal flow without any great problem.

On the Buyer side the best possible solution would be for a steady addition of Buyers who commit NOT to flood the market with liquidity, but rather to limit their activity to provide a balance between supply of and demand for funds.

The challenge for TRE, without any doubt, is attracting qualified Sellers.

A friend who knows her way around QuickBooks told me the other day that she had been asked by a relative to help him organize the financial data of his business. The business has been in operation for quite some time. Until the current downturn in its industry it had grossed nearly $20 million per year. And it is of a type that might qualify for Seller-membership in TRE.

She told me that she found that her relative had no real idea of the financial condition of the business; that he could not even tell her how much cash was in the bank; that essentially all of his family’s personal expenses had been run through the company, making analysis of the profitability of the business itself very difficult; and, that the only real “control” mechanism exercised was at the level of pricing bids for new work.

This might be a good business; it probably is; but no one can really tell because of the way that it’s being managed. And I would bet that there are hundreds and thousands of businesses all over the country that fit this same description. Over time, with some outside help and some discipline, this business owner might be able to change his practices and create a financial track-record that would support an application to sell invoices on the Exchange. But that won’t happen in one year.

Penetrating this segment of the potential TRE Seller market is a long-term project. But TRE needs to ramp volume in a serious way in the short-term. How might it do that?

Remember when “to discriminate” simply meant “to distinguish by discerning or exposing differences; especially: to distinguish from another like object”?

I've argued in more than one prior post for the establishment of a quality rating system to distinguish among Sellers so that Buyers might be better able to support risk analysis and pricing differences. That idea, like the education of the class of business owners discussed above, is a longer-term project.

But there is a variation on that idea that would NOT take substantial time.

There is a class of business that finances its receivables through factoring companies or divisions that require audited financial statements. The rates that these companies have come to expect are at the lowest-end of the range that TRE Sellers currently command.

Those companies have not become TRE Sellers and the financing firms that currently serve them have not become TRE Buyers.

But these are the big fish on both sides of the transaction equation!

There is no question that TRE needs to continue to work very hard on expanding its book of smaller, higher-rate-paying Sellers. But in the near term it also needs to go after some of the bigger fish.

What’s the bait for that enterprise?

Why not create a separate class, or designation, of Seller? Why not discriminate? Not in function; just in terms of designation.

Given that the guarantee of the TRE Seller to re-purchase invoices not paid by Account Debtors is the principle security of a TRE Buyer (whether recognized or not). And given that almost no current Seller financial statements are actually audited. Why not create a class of Seller distinguished simply by their ability to provide audited financial statements? And add some sort of designation to the description of that Seller to distinguish it from the others. Or collect the auctions of those Sellers on separate "page". get the idea.

This would assure the potential Sellers that they will be presented to the Buyer community in a way that recognizes that they are qualitatively distinguished from companies like that of my friend’s relative; presenting greater assurance and, therefore, less risk.

This would allow potential Buyers whose internal controls require audited financials to at least consider TRE membership.

This would provide a simple, logical and supportable means of differential risk assessment and transaction pricing.

And, it could be implemented immediately and without cost.

It is, at best, a proxy for a real system of quality discrimination.

But even a proxy has value!