Sunday, April 25, 2010

"Time, time, on my side..."

I began my business career as a commercial mortgage lender.

Among the issues that had to be negotiated in every deal were the length of the period during which prepayment was not allowed and the size of the penalty that had to be paid when prepayment became possible.

In the mid-70’s we were not very sophisticated in our approach to these issues. We tended to just present a structure that might have been, for example: “closed for five years; open thereafter with a penalty beginning at 3% and decreasing at the rate of ½% each year thereafter”.

We would receive a memo from to time time from the corporate office telling us what the prepayment criteria needed to be and, without much thought, we’d usually just present that to the borrower as an edict from “on high” that was non-negotiable.

After a few years I moved into the equity side of the real estate business and I missed the evolution in thinking about prepayment that occurred in the ‘80s. I heard scraps of conversation in the hallways about the value of the “embedded put” that an open prepayment provision gave a borrower; but I didn’t pay a lot of attention to it.

I just knew that I was mightily annoyed when a lender refused to allow prepayment of a loan on a property purchase I was working on, for instance, or, in one case I remember well, quoted a 36% penalty for the right to prepay.

Why do I bring this up?

First: the more financially sophisticated analysis of the value of prepayment, which evolved during my absence from the lending business, was quite correct.

Second: the fundamental issue involved derives principally from the problem of asymmetrical commitments in the presence of prepayment options.

What’s asymmetrical about the commitments?

The lender might be agreeing to receive a fixed rate of return for 30 years but the prepayment option might allow the borrower to pay back the loan in 5 years. Because the duration of commitment is not symmetrical, neither is the risk.

If rates fall sharply from the level at which the loan is made, the right to prepay: a) allows the borrower to refinance into a lower-cost loan, arguably both decreasing his carrying costs and increasing his equity value, and b) puts the lender in the position of having to reinvest relatively high-yielding funds into instruments with lower returns for a potentially long period of time.

Running the numbers on an option of that sort is what produced the annoyingly high proposed prepayment penalty I quoted above.

The same mathematics apply in essentially all fixed income environments. We all know that time has value in financial terms.

But the ability to CONTROL time, compounds that value. The greater the control the greater the value.

The Receivables Exchange, being a marketplace for INVOICES rather than for receivables portfolios, is, by its nature, a very short-duration investing environment.

The weighted average life of the 91 TRE transactions that we have now closed-out has been about 35 days.

Granted, there’s not much we can do at this point to affect the speed of payment after we’ve bought an auction. But the period during which we are exposed to interest-rate risk is quite short. And the risk we are exposed to attaches only to those transactions that have been purchased and not yet repaid.

We have no obligation to buy or bid on the next auction that appears.

We have no obligation to offer the same terms on auctions after lunch as we did before lunch.

Our pricing can change from one moment to the next as can our willingness to participate either at the level of the Exchange or with respect to any particular Seller.

New information with respect to the economy, an industry or a Seller can be acted upon immediately.

Duration and pricing risks are symmetrical (rather than asymmetrical) as between Buyer and Seller.

In a period of rapidly rising interest rates, a TRE Buyer can respond very quickly; adjusting pricing on new transactions immediately and limiting exposure to potential increased cost of capital for a very short period.

It’s quite true that the knife cuts both ways and that, in a period of rapidly falling rates, the TRE Buyer might face a falling price environment more quickly than he would in some other markets.

But at this point I suspect we face another asymmetry.

What’s the risk of rapidly falling rates in the next couple of years versus rapidly rising rates?

In this environment my guess is that the greater value of the flexibility offered by TRE is on the side of the Buyer rather than the Seller.

There are plenty of points to make in the TRE value proposition for Sellers.

But I think the value of the options related to TIME is currently on the side of the Buyer.

Tuesday, April 20, 2010

The Luddite Trajectory

Lud•dite (lŭd'īt) n.

1. Any of a group of British workers who between 1811 and 1816 rioted and destroyed laborsaving textile machinery in the belief that such machinery would diminish employment.

2. One who opposes technical or technological change.
[After Ned Ludd, an English laborer who was supposed to have destroyed weaving machinery around 1779.]

I have to confess these things:

• I remember when the first ATM’s became available and I was unwilling to use them to make a deposit.

• I remember when electronic deposit of paychecks became available and I was unwilling to trust it; preferring to have a paper check in-hand on Friday afternoon.

• My first job was with a large financial institution in an investment department that routinely took weeks to process transactions because so much analysis was done via calculator. We had access to a leased-time mainframe computer which my boss never failed to term “the confuser”.

The Luddites could not change the course of the industrial revolution. My resistance to changes in banking technology was fear-driven and counterproductive. My first boss rendered himself obsolete (or “redundant” in the land of Ludd) in a few short years.

So, where is this going? Three data points:

The first:

I read a report from a British business newspaper this morning about the difficulty that smaller businesses are having collecting money owed them. The reporter made the point that a large percentage of the affected businesses had done nothing yet to change their processes to cope with the cash flow problems.

But, he reported, “9% have turned to invoice discounting and 8% have used factoring”! That was presented in a way that implied that the numbers seem small!

In the US market, achieving a 9% penetration in the invoice discounting business would translate to (at least) tens of billions of dollars of additional employed capital in the industry.

The second:

In this week’s edition of The Economist, also a British publication, an article on small business finance appeared, entitled “Markets for Minnows”. Among the points it makes are:

• Large businesses in developed economies can once again raise capital with ease, principally via the bond market.

• Spreads on loans to smaller businesses (however) are at their highest level in a decade.

• US banks holdings in commercial loans fell in the first quarter at an astonishing annual rate of 21% (this as we are supposed to be in recovery mode).

• Syndicated lending to medium-sized business is at less than half of peak levels.

• “Demand for factoring has fallen over the past year because businesses had fewer invoices to pledge, but is likely to rise sharply as small businesses struggle to finance an upturn in orders….”

• The head of Wells Fargo’s trade capital division sees the factoring market growing by 6-8% per year.

• “Another new form of invoice-based financing is The Receivables Exchange…..which helps users to overcome…the decline of traditional small-business finance and the stretching out of payment by their customers…”

The third:

• An article in last week’s Wall Street Journal (4/15 p B6) analyzed the extent to which small businesses, prior to the housing bust, depended on tapping real estate equity for working capital.

• In 2007 one survey showed that “30% of respondents tapped home loans for funding” their business working capital needs.

• In 2009 that figure had fallen to 7%.

• Based on that comparison, alone, 23% of small businesses have, in a very short time, lost access to one of their principal funding sources.

There is no question that small business MUST find alternate sources of working capital if they are to survive and prosper!

Last month we saw Morgan Stanley identifying TRE as a new and potentially important player on the invoice discounting landscape.

This month The Economist gives it prominent mention as an alternative.

Just last week I was shown promotional material of a company that appeared to be marketing a “copycat” program, which on further investigation actually offered nothing but some additional potential visibility for the Exchange, itself.

Here’s my take-away:

The British and the Europeans, in general, are far in front of the US in the adoption of invoice discounting in the SME community. We can and should learn from them (just this once).

Wells Fargo, now the largest player in the domestic factoring market, sees a 6-8% growth rate in the traditional-factoring sector of the business. That’s hardly a steep growth curve from present levels and hardly an answer for the smaller end of the market.

The SME market for invoice discounting in the US, while relatively immature and small, is one of the only avenues that will be available to meet the financing needs of the SME market going forward.

TRE, for all that it is neither perfect nor mature, offers a true alternative; efficient and scalable.

If it could provide the mechanism to take the US market just halfway from its current invoice-discounting penetration to the 9% level found in the British study quoted above, it would represent a significant avenue for employment of capital, a meaningful stimulus of economic growth and an important engine for job creation.

It took me a couple of years to trust ATM machines and electronic deposits. But thankfully both the world and I change faster now.

New questions are asked. New challenges posed. And in the great American tradition, new answers become available.

The job is to introduce the question to the answer.

Sunday, April 11, 2010

A Question of Morality

In prior posts (see "Caveat Emptor”, from November 2009 and “Blanket Security vs A Security Blanket” from June 2009) I’ve commented on The Receivables Exchange’s policies regarding both filing UCC Financing Statements to provide additional security for Buyers, and its practices regarding existing UCC Statements that have a position of priority with respect to the TRE filings.

First, as a reminder, the TRE filings encumber only those receivables that the Sellers sell on the Exchange. This is as opposed to the practice followed by many (I could probably say “most” without being inaccurate) in the industry to obtain a lien on ALL of the receivables of a factoring customer.

Second, early descriptions of the Exchange’s work on behalf of Buyers suggested that efforts would be made to obtain releases of or subordinations of liens held by others that have claims prior to those of TRE.

As one who considers this an important issue, I actually DO review the UCC filings of new TRE Sellers and, when it appears that there is a prior claim on receivables, I DO check for evidence of the lien holder’s release or subordination.

I must say that there are many instances where prior liens encumbering a Seller’s receivables do exist but that there are relatively few such instances where I also find a release or subordination.

It’s not fair to say, based on that evidence alone, that efforts to obtain releases are not made. I don’t know how hard the Exchange tries to get those releases. I do know that, in my own non-TRE business, it’s tough to get any bank or other entity that holds a security position today on ANYTHING, to release it!

But that’s only the lead-in to my real point today.

A couple of weeks ago I was in a conversation with a number of traditional factors and the issue of buying an invoice in the presence of a prior UCC filing came up. An opinion was voiced that not only was it a poor business practice to buy in such a situation but that it was actually IMMORAL! The theory was that someone else had a security interest in that receivable and purchasing it deprived that person of a portion of his rightful protection.

While I acknowledge that there are situations in which buying invoices in the presence of a prior lien might be poor business practice, I’ve thought about this question a good deal since then, and I cannot find any justification for an assertion that it is IMMORAL!

In my normal business I almost never buy when a prior lien exists but there have been two instances in which I have. In one case, every time I made a purchase from the client I withheld enough cash to make the payments to the prior lien holder for a certain period of time and I actually made those payments myself in order to assure that there would be no default during the period my funds were outstanding.

In the second case, the prior lien secured a loan whose balance was small, representing a de minimus percentage of the typical receivables balance and, to my mind, a de minimus risk of loss even in the event of default.

There are cases of TRE Sellers where it is clear that the obligations secured by the liens are very significant and, in the event of a default, could become really problematic for a Buyer.

There are also cases where the documentation of UCC filings is quite lengthy (there was a case not too long ago where the UCC file ran to 104 pages, for instance) and it’s a real job to try to figure out what’s still current and what is encumbered by whom).

Each Buyer will approach the question of assessing the risk posed in such cases differently. Some will just steer clear of auctions in which prior liens exist. Some will simply ignore them and hope for the best. Some will take the position that the filing is only problematic in case of a default by the Seller giving rise to action by the lien holder, and attempt to assess that risk.

One of the problems in assessing such a risk is that, often, it is unclear from the Seller’s financial statements, what the size of the secured obligation is. Another is that, often, the age of the financial statements makes the accuracy of the PRESENT liability structure uncertain.

Yet another is the uncertainty of a Seller’s disclosing the presence of any litigation that might have arisen potentially triggering the right to levy on receivables (although I would hope that the TRE fraud-protection group would devote a decent amount of time to this).

(Did anyone read this week-end about the apparent practice of many large banks of drastically reducing borrowing in the days immediately preceding financial-statement dates, only to dramatically increase borrowings during the middle of a quarter?)

So, my point is that the assessment of and response to the business risk of buying in the presence of prior liens, is obviously being approached differently by different Buyers.

But what about the MORALITY of the issue?

I have to say that, while I respect the individual whose position I quoted above, I just can’t see that this is a matter of morality.

At the most obvious level, an invoice-purchase transaction, of itself, takes nothing significant away from the security of the lien holder. A less-liquid asset, the invoice, is removed from the balance sheet. And a more-liquid asset, cash, replaces it (at least to the immediate extent of the advance amount).

Any well-written UCC filing will include in the description of security some language that extends the lien to the proceeds of the sale of any encumbered assets. So it could be argued that, as long as the proceeds of sale remain in some way in the business, the aggregate security of the lien holder is not damaged.

Conceptually, it can also be argued, I think, that to the extent that the assets encumbered exceed the value of the debt, restricting either the Seller or the TRE Buyer from converting the excess, less-liquid assets into more liquid assets, would be an unfair restriction of management. In such a case, it might be analogous to a first mortgage-holder prohibiting or preventing a property owner from using the proceeds of a second-mortgage to put a new roof on the house.

And from a purely practical point of view, except in the case of some kind of court-ordered immediate action to freeze (or seize) operations, it is highly unlikely that the ACTUAL invoices being bought by a factor would still be on the books of the seller by the time the holder of the first lien could get through the legal process required to levy on them.

Others might have different experience, but my own has been that the time required to get to the point of actually levying on receivables is so long that the AR Schedule at the time of levy bears little resemblance to the one at the time of default.

The issue of buying receivables in the presence of a prior lien raises all sorts of real and difficult business risk problems.

But I don’t find it to be a MORAL issue.

Do you?

Wednesday, April 7, 2010

Sizing It Up

In my March 21 post, “The Diet of 900 lb Gorillas”, I referred to the recently-published Morgan Stanley report on B2B Finance. That report raises a number of issues, only one of which was really addressed in that prior post, so I want to return to it again.

This time I want to point out a couple of statistics that are key to assessing the long-term potential of The Receivables Exchange.

The first of those statistics is the gross size of the SME (small to mid-sized enterprises) market. Morgan Stanley reports that the SME market accounts for about 45% of all business revenues in the US. Morgan defines the SME category as all businesses with annual revenues of less than $500 million.

Now for the purposes of discussing TRE’s near-to-intermediate term potential it’s unrealistic to assume that its addressable market includes businesses with $500 million in sales. So we have to adjust Morgan's 45% figure.

The smallest category Morgan uses comprises businesses with revenues of less than $25 million. That category accounts for 25% of total corporate revenues.

TRE requires Sellers to have annual revenues of about $1.5 million and, at present, a $25 million Seller would be at the upper end of the TRE size spectrum. So this is really the near-term target market-segment for TRE marketing efforts.

To eliminate those businesses that are too small to qualify for TRE Seller membership we have to reduce the 25% total. This is completely guesswork on my part but I suspect we wouldn’t be far off if we reduced the 25% figure to maybe 15-20% to eliminate the smallest businesses.

If we apply the 15-20% range to the estimate (based on the Fed’s flow-of-funds report) of the overall volume of annual B2B accounts receivable generation (about $18 Trillion), that suggests a potentially-addressable, near-term market size in the range of $2.7 to $3.6 Trillion.

That ignores the fact that some of those businesses, especially the smaller ones, probably do not extend trade credit, but it’s also the case that some large businesses extend very little trade credit. It’s hard to know how to adjust those volume figures with any confidence, so I’ll just let them stand with the caveat that there are potentials for error from a number of sources.

If we use the mid-point of that indicated range, or $3.15 Trillion, and we assume an average AR duration (days-to-pay) of 45; that suggests that the average outstanding AR balance on the books of that segment of the business community would be about $390 Billion.

That’s a big number!

The Morgan Stanley estimate of the total US factoring market is given at $136 Billion, suggesting that our estimate of the near-term, potential TRE-addressable market is three times the size of the entire current industry. But that's not really the appropriate comparison.

It is clear that the smallest businesses will account for no more than their relative percentage of the total factoring market and probably quite a bit less. How much less is a guess, but let’s just say for conversation that it’s overstated by 100%, or that the actual factoring activity in this smallest segment of the economy is half its representation in the total economy.

That would suggest that $10-$13 Billion is employed by the factoring community in the smallest segment of US business.

If that’s anywhere close to the mark, it implies a current market penetration of only 3% or so of indicated near-term potential.

If a realistic maximum penetration were, for argument's sake, to be measured at 25% of the currently-addressable market, the implied potential would be $390 Billion x .25 = $97.5 Billion, less (about) $12.5 billion (already served), or something in the range of $85 Billion in potential for capital employment.

That’s clearly a market worthwhile pursuing.

And that is without considering the potential ultimately afforded by businesses with revenues above $25 million, some of which, over time, should be attracted to the flexibility of an auction environment.

On the other hand, it has to be recognized that many smaller businesses are in no condition to be brought to TRE at this point.

TRE’s marketing effort has to include a long-range education program to bring potential Sellers to the realization that “clean” and accurate financial records and disciplined management of their billing and other AR functions are critical to positioning themselves for access to a market like TRE.

It’s easy to make the case that the market potential for TRE is substantial in the near-term and extremely substantial in the longer-term.

It’s not a stretch to view the TRE growth curve as exponential for some time to come.

But that doesn’t mean achieving that potential is a certainty.

There are difficult problems to be solved, not least of which is maintaining the discipline required to adequately vet potential Sellers and to strictly implement the safeguards in place to protect against abuses.

But it seems clear that the size of the opportunity makes tackling the problems well worth the effort.