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.

Friday, May 7, 2010

Today I am 100

I began writing this post on Wednesday afternoon when there were 35 “live" auctions on the TRE platform.

The original subject was a revisiting of the topic addressed in my post of August 7, 2009: “Sipping from a Fire Hose”.

I wrote in that post about the inevitable need to manage the auction site differently as volume increases; to provide an efficient means to differentiate among classes of auctions.

I’ll pick up that topic and write the post I had planned on Sunday.

Today, however, I just want to report that we received payment this morning closing out our 100th auction!

We’ve now bought 125 auctions and 100 have been closed-out: all paid-as-agreed.

We’ve bought auctions from 33 Sellers including invoices of 64 Account Debtors.

The weighted average total days to close-out has been 43.

The weighted average actual duration (receiving multiple payments over the life of an auction decreases the average dollars-outstanding during the holding period) has been 35 days.

Weighted average net annualized return, after TRE fees and costs, has fallen slightly since last June, which was our first month as an active Buyer. But the decrease has been minimal: our monthly figures have varied within a range of only about 100 basis points.

That stability of return is more a reflection of our buying parameters than the overall Exchange activity, however.

We’ll address the increasingly-apparent “tiering” of the TRE pricing environment in another post.

But today—I just wanted to mark our 100th anniversary!

And, while I'm at it --- since the question recently came up in conversation --- over the course of closing-out 100 auctions there have been only two or three minor glitches in transaction reporting or the movement of funds. All of those were identified and corrected within one day by the TRE Member Services team, which does a great job.