Restraint of Trade -- Revisited

It’s the afternoon of the last day of the month and The Receivables Exchange has been well into record monthly-volume territory for a few days now. This is clearly going to be the best month in the Exchange’s history by a wide margin.

In addition, as I write, the currently-live auctions are of the largest average size that I can recall at any single time. These are clearly significant positives from the point of view of TRE.

There is also an issue that I think is both significant and positive for both the Exchange and the community of TRE Buyers.

On January 12, I wrote in a post entitled “Restraint of Trade” about a Seller that had been posting auctions of the invoices of a certain Account Debtor quite frequently and in substantial amounts. For a time those auctions had been very well accepted and the pricing demanded by Buyers continued to trend downward.

Then a point was reached at which a large amount of this paper had been sold but none had been paid, and pricing began to back up. I wrote at that time to make the point that this was rational behavior on the Buyers’ part and that it was good to see that sort of restraint.

Since that time, that Seller has continued to be quite active. There have been payments made by that Account Debtor and there has been no indication that any default has occurred. But the dollar-value of open auctions relative to the financial capacity of the Seller has continued to increase.

As that has occurred and as the Buyer-experience has matured with respect to this Seller, the pricing has continued (in general) to firm and the appetite for the Seller’s auctions has clearly diminished.

The message is being sent that there is a limited appetite for more of this Seller's auctions. It’s not that there is NO appetite. But there is a limit.

And that, I think, is a another positive message for Buyers to send.

The message was positive in January when the pricing began to firm and it is more positive now when even firmer pricing doesn’t necessarily attract interest.

In an open-outcry auction market, sentiment and motivation can both be pretty literally “in your face”. In an anonymous, on-line auction market, reading sentiment and motivation is a much less immediate process.

This particular case has been playing out over the course of many weeks and many transactions, but the evidence of market reaction continues to be rational and positive.

Congratulations to TRE on a big month!

The Diet of 900 lb Gorillas

In my post of March 11, “The Perversity of the Possible”, I wrote about large companies unilaterally changing payment terms for their obligations to suppliers.

My thanks to Dave Schmidt for his response to the post and confirmation of the problem!

Coincidentally, a report by Morgan Stanley was released at about the same time. It offers Morgan’s help to large firms in devising programs to leverage their cost-of-capital advantage to essentially squeeze discounts out of their suppliers.

This is presented as a win-win proposition, but that’s clearly just a smoke-screen.

Morgan Stanley’s suggestion is really that large firms with excess cash or credit capacity propose to pay suppliers early at a 4% discount. For those who chose not to participate, the unacknowledged flip-side would be a lengthening of payment terms.

Morgan uses relatively large print and bold typeface to trumpet its conclusions that these transactions increase profitability of BOTH the large companies that would be Morgan’s clients and their suppliers.

In the small-typeface, cramped-format analysis, however, we find that the assumption on which these conclusions are based is a 100-day acceleration of the supplier’s payment!

What is Morgan Stanley saying here?

It is saying that the large company, the 900-lb Gorilla, will force the supplier to either take a 4% discount or wait 100 days to get paid. This is very close to the situation I described in my March 11 post.

Let’s be clear, here. This is in no way an attempt to find a win-win solution. This is Morgan offering to coach large companies in the fine art of squeezing small ones. As if that were necessary!

To put an even finer point on it—this is Morgan Stanley offering to provide 3rd party justification for such squeezing so that the leaders of the large companies have the cover of expert advice as a defense for their actions.

Now, the Morgan report does introduce The Receivables Exchange as a potential alternative to using the large companies own excess working capital capacity. Its presentation of TRE and its process and benefits is flattering (if not completely accurate). And that is a good thing for TRE.

But the point of their bringing TRE into the report is as a thinly-veiled option for squeezing the suppliers WITHOUT using the large company’s own working capital.

They’re saying, even if you don’t HAVE the excess capacity yourself, you can STILL force extended payment terms on your suppliers by simultaneously suggesting that the suppliers utilize TRE to compensate for the extended payment terms.

Make no mistake. Morgan is not in this to help the supplier.

The Morgan report explicitly states that it is not a product of their research unit. This is a marketing initiative to help Morgan generate fee revenue by coaching large companies in the creation of accounts-payable strategies that increase their own profits at the expense of their smaller, weaker and less-well-capitalized suppliers.

I’m sure that Morgan publishes a list of its annual charitable initiatives. This isn’t one of them!

In individual or isolated instances, squeezing the suppliers as recommended by Morgan can work. It cannot work as a wide-spread, systematic shift in large-company AP strategies. At least, not without compensating pricing adjustments.

There might be room in the forest for one or two 900-lb Gorillas. But if all gorillas were that big there wouldn’t be enough food to sustain them, and some would have to die off or change their diet in order to restore balance.

Another Milestone!

On March 17, 2009; one year ago tomorrow; I read a comment about The Receivables Exchange in a message by Paul Ellis to the Factoring Professionals Group of the LinkedIn network.

That was the first time I had heard of TRE.

Today I bought my 100th TRE auction.

Of those 100 auctions, 76 have been closed-out so far: all paid-as-agreed.

I have bought invoices from 26 TRE Sellers representing 47 Account Debtors.

The average period of time from purchase to close-out has been about 45 days. The weighted average duration has been about 35 days (because many auctions include multiple invoices and some get paid more quickly than others.)

I don’t think the Exchange Rules allow me to cite the actual annualized returns generated from the 76 auctions that have been closed-out, but I think I can say this:

--The TRE web site gives a range of monthly discount fees at which auctions have been sold.

--Advances, on average, tend to fall in the 80% to 85% of face value range (sometimes more, sometimes less).

--My actual annualized returns have been consistent with auctions selling at slightly higher than the mid-point of the publicized discount fee range, adjusted for my actual duration experience, average advance rates and actual TRE fees charged.

I can say that I have been unwilling to compete at either extreme of the auction pricing spectrum and that my actual results have been consistent with my bias toward a conservative approach to "qualifying" Sellers and a moderate approach toward bidding.

I’ve gotten what I bargained for--what more could I ask?

The Perversity of the Possible

On Tuesday of this week a national association that tracks the conditions and sentiment of smaller businesses reported that the net percentage of small business owners whose outlook on the economy was positive had fallen from +2% in December, to +1% in January to a -9% in February.

An 11% net sentiment swing in three months is substantial.

On the other hand, this morning’s Wall Street Journal, on its front page, reported on the surprisingly strong rebound in the market for corporate debt. Large bond issues have been getting a surprisingly strong reception in the institutional market, reflecting an improvement in perceived business conditions and a corresponding reduction in risk.

So the small businesses are seeing increasingly cloudy skies while the big ones are enjoying more and more sunshine (pardon the imagery: I’m going to Miami for the week-end!).

Only a very few will have read a piece of news I found quite interesting on Wednesday; the day between these two much more widely-circulated reports.

On Wednesday a TRE Seller posted an auction of invoices that carried an unusually long days-to-pay number; almost triple the usual terms between that Seller and its Account Debtor.

Obviously anticipating Buyers’ questioning the terms, the Seller posted a letter explaining that its Account Debtor had, apparently unilaterally, notified its suppliers that it was only going to pay its bills once every three months. So the bills submitted early in it's 90-day cycle would take a long time to get paid.

That’s hardly the first time I’ve heard or read of such heavy-handed treatment of smaller businesses recently.

In two cases involving businesses that are among the largest in the nation I have recently heard of: a) a blanket imposition of 90 day terms, and b) a selective but significant imposition of 120 day terms.

I cannot say with certainty that there has been no opportunity for price adjustment in these cases but it is my understanding that there has not.

These larger companies are climbing out of the recession, in part, on the backs of their smaller suppliers. They are extending payment terms because they CAN.

So why do I use the term “perversity” in the title of this post?

Because squeezing the profit margins of the smaller businesses by forcing them to either reduce their production volume due to lack of working capital or to increase their costs in order to pay for financing, has a direct impact on their ability to grow and generate new jobs.

It is well documented that the bulk of job growth, particularly in the early stages of a recovery, comes from the small business sector. It is that job growth that generates the end-user demand for the goods and services of those large companies whose outlook is now relatively rosy. Without the job growth, their prospects dim.

So–perversely—the larger companies that are using their purchasing power to extend payment terms to UNUSUAL or UNANTICIPATED levels are, at least in aggregate, acting against their own long-run best interests. (Normal and expected payment durations are assumed to be built into the suppliers business models.)

I found myself wondering what this Seller would have done if it had received such a notice from a major customer and NOT been able to post the invoices for sale on TRE.

It will certainly cost more to preserve their cash flow velocity now, but if they had no way to compensate for the slower payments, their only option might have been to throttle back their production and reduce their staffing, taking more potential consumers out of the market for their Debtor’s product!

The possible CAN be perverse!

The Price of Perception

I’ve written in prior posts about Buyer-pricing that has seemed to me to ignore the risks that are inherent in the activity of invoice purchasing.

It is one thing to comment on the absolute level of return implied by a particular transaction. It is another to look at the range of returns implied by pricing within an array of transactions.

In the past few days of trading we’ve seen a very wide spread between the best terms offered to Sellers and the worst terms. Some of that spread is explained by the relative experience of the Sellers on the Exchange. Some of it is explained by the relative strength of both Sellers and Account Debtors. Some is explained by the pattern of transaction volume presented to Buyers recently.

But, whatever the explanation, I thought it would be interesting to just consider the size of the spread in pricing between the lowest implied cost of (return on) funds and the highest.

I’m not going to use absolute numbers at the risk of running afoul the Exchange’s rules on disclosure.

And the numbers that I’ll use are those I estimate to be the likely, annualized net return to a Buyer after all costs charged to the Buyer by TRE. The model I use to calculate expected net annualized return is sensitive to: transaction size, duration, advance percentage and monthly discount rate; and it incorporates all TRE-charged fees and costs including such incidental items as wire transfer fees.

I will not disclose the actual fee schedule charged to Buyers by TRE but, as I’ve written before, it acts to penalize returns when transactions are closed-out quickly. So a combination of small size, high advance, low discount rate and fast close-out produces the lowest net annualized return.

In order to avoid disclosing actual numbers, I am going to establish the lowest implied pricing of the last few days as the benchmark with an “index” value of 1.

That says nothing about the absolute return—it just means that it represents the lowest annualized return produced by putting the terms of the transaction into my little model.

If inputting the terms of another transaction into the model produced a value of 2, that would mean the expected net annualized return on that transaction is double that of the index transaction.

So, what was the range of implied return expectations on the deals done over the period examined?

Take a guess.

The answer is 5.6.

That is, the deal that generated the highest implied return expectation to the Buyer had an expectation 5.6 times that of the deal with the lowest implied return.

That’s quite a spread!

But, in my view, that is very good news. It means that the Buyers are recognizing and demanding compensation for differential quality and risk perception.

There are many days on which this kind of analysis would produce a much narrower differential. And, again, I’ve said nothing about the absolute level of return expectation.

But this particular period provided the data to make the point pretty dramatically.

TRE Buyers ARE currently discriminating on the basis of perceived quality differential and TRE Sellers, whether happy about it or not, ARE closing deals that recognize the difference in Buyers’ quality perceptions.

Those are both healthy signs!

It's a Bad Bet?

I was discussing my criteria for screening TRE Sellers with a friend the other day. This is a knowledgeable person who understands TRE quite well but is not a Member.

I told him what percentage of the TRE Sellers are on my “Do Not Bid” list. He asked how many losses had been incurred by Buyers who WERE willing to buy from those Sellers. I explained that, as far as I know, there hasn’t been an actual write-off at this point.

His reaction was “so you’ve bet wrong on X percent of the Sellers so far.”

NO! I don’t accept that analysis.

The fact that a loss has not yet occurred does not mean that buying would have been a “good bet”.

The fact that I might walk alone down a dangerous street late at night and not get mugged doesn’t mean it was wise to take the walk. And if I did it five times and didn’t get mugged, well, it was still unwise.

I was looking at the updated financial statements of one of the Sellers on my “Do Not Bid” list today.

A few data points:

 Accounts Payable = 4 times Accounts Receivable

 Current Liabilities = 10 times Current Assets

 Negative Retained Earnings; Negative Equity; Negative Net Income; Negative Cash Flow from Operations; Negative Cash on Hand.

Now, the Buyer’s recourse in the event of a problem with payment is to the Seller.

The notion that there are no circumstances under which an Account Debtor might justifiably refuse payment is a fiction.

In such a case the Buyer must look to the Seller: not to the Debtor, not to the Exchange, and not to the individual owners of the Seller. No---just to the corporate entity that is the Seller. (To be fair, there is a possibility that excess cash received by TRE on the Sellers account might be available to cure a default but that should hardly be counted on.)

There are those who might be willing to look at the financials I was looking at this afternoon and bid anyway. There are those who might bid without looking at the financials at all. And they might well avoid being mugged…once or twice or five times.

That doesn’t persuade me that buying would be a “good bet”.

Because, based on the Seller’s own, internally-prepared financial statements, it is unlikely to be able to cure a significant Account Debtor payment failure.

It’s a great thing to have really high quality Account Debtors. And I’ve commented recently and quite favorably on the success TRE has had in bringing a high percentage of good credit Debtors to the Exchange.

But at the end of the day, if the Seller can’t make good on an invoice gone bad, the Buyer is going to have a problem.

The Seller I described above is on my “Do Not Bid” list and it will stay there until its financial condition dramatically improves, no matter how many auctions it might successfully complete.