Friday, December 30, 2011

Musings at Year-End

Here we are at the end of December and I haven’t written anything since late November.

Actually, that’s not quite true… I’ve begun several posts in the past six weeks but I haven’t finished (or posted) any of them.

In a couple of those cases I didn’t finish because I realized I was writing in a state of frustration and confusion and that nothing written under those conditions ought to actually be shared.

In others cases I just decided I wasn’t sure that what I had to say was either correct or of any value.

And that kind of sums up the 4th quarter activity for me: It’s been a time of frustration, uncertainty and doubt about the future.

But I can’t let the year end without a few comments. So.....

Thankfully, the flood of liquidity that played havoc with pricing early in the quarter began to recede in November and by the second half of December it appeared that a reasonable balance had again been found.

That reasonable balance wasn’t necessarily reflected in pricing, though, because in early November the Exchange’s new risk mitigation program went live. And the initial reactions to that program had a significant impact on prices.

There’s not a lot that can be said about that program at this point except that I think it is both more and less than meets the eye.

It will take quite a while before anyone will be able to say what its real value is or what an appropriate pricing response actually should be. Meanwhile we’ll just have to muddle through making decisions on the basis of largely unproven assumptions.

TRE deserves much credit, I think, for a number of things as this 3rd full year of operation ends:

1. There are still a few hours left in the trading day as I write this but it is quite clear that December 2011 will set, by a very substantial margin, a new high water mark for SMB auction volume.

2. December has also seen the first new activity in the Corporate auction market since the NYSE relationship was completed in September. The new auctions were received positively and I suspect that all parties must be pleased.

3. The pace of new SMB Seller acquisition has clearly accelerated in the 2nd half of the year and some of the new Sellers have been unusual in both size and expected volume of activity. The Seller marketing team appears to have shifted its targeting in a way that might be really meaningful.

4. The roll-out of the new risk-mitigation program appeared to go quite smoothly. While it was delayed a bit in an effort to get it right before roll-out, that decision seems to have been a good one. Implementing that sort of program in a relatively seamless manner is tough. Both the tech people and the business people involved in the implementation appear to have done a very good job.

5. TRE’s administrative people have continued to tighten up their processes. The job of obtaining and posting updated financial data from Sellers has become much more disciplined, with more Sellers finding their postings delayed until the required data is provided. For a volume-dependent organization, it’s tough to exercise that sort of discipline.

6. The Member Services department which, among other things, handles the transaction reporting and cash management functions deserves a lot of credit. It's one of those functions that only gets noticed when there's a mistake. But, at least in my case, I can't think of a single error that has occurred this year in those functions. That's actually remarkable.

7. The risk management and loss control functions have been significantly strengthened, both in terms of people and processes.

8. The operation of the trading desk has been strengthened and communication between the desk and the Buyers has clearly been an operational focus.

9. TRE management has to be acutely aware that volume growth has been much slower than initially hoped. Many would be tempted, in such a situation, to scrimp on investment in the “nuts and bolts” improvements in systems, personnel and processes: especially in those functions that few people actually see. To their credit, TRE’s management did not take the short view. They have continued to invest in the platform and the processes even though it must hurt to do so.

10. And, of course, you’ve got to give TRE management full marks for PR! They DO get noticed and their name IS out there all the time.

On the other hand...

In order for any of us involved in the TRE enterprise to prosper, the business has to achieve substantial scale, and we’re a long way from any level that might be called “substantial” in the context of the market size.

A year ago the volume pattern could appropriately be called “encouraging”. But for most of 2011 we couldn’t really say that the pattern was encouraging.

After three full years of operation we have to look at things as they are, not just as they might be. And the way things ARE falls short.

There are two issues that are really cultural, as opposed to technical or strategic, that I frankly think TRE has gotten wrong and should reconsider in 2012.

The logical approach for those wanting to bring a new process to an existing industry is to attempt to align themselves with the opinion leaders in that industry or to at least create some strategic relationships within the industry. There will be differences of opinion as to why TRE has not done, or has not been able to do, that. But the fact is that TRE continues to be an outsider with respect to the established factoring community.

I happen to believe that the TRE model has much to recommend it as a way to substantially increase the penetration of the factoring function in our economy. And I think that there are ways for TRE and the established community to work together for common benefit. That is not happening. And I believe that at least some of the failure to achieve TRE volume goals can be attributed to a failure to capitalize on the opportunities that working with the established community might present.

Responsibility for that situation has to be shared. Finger pointing helps neither side. It’s time to mend the rift and move forward.

The second cultural issue manifests in a number of ways that I think hinder the growth and threaten the success of the TRE enterprise.

It is the implicit stance taken by TRE that it should be in complete control but at the same time be relieved of all liability. That approach, I believe, might prove to be the largest barrier to actually achieving scale. Because a lot of potential participants will “just say no”.

Shakespeare got it right when he wrote: "First we'll kill all the lawyers..."

There is only one way that I can conceive of a total-control strategy working; but that also goes against the TRE cultural grain. And it will certainly be rejected by its lawyers.

That approach is ... complete transparency.

The culture of control includes a total control of information about Exchange operations, participants, finances, defaults, etc.

The TRE PR machine cranks out positive releases on a seemingly round-the-clock basis.

But information about the real operation of the Exchange is held very tightly to the corporate vest.

Ultimately, an approach that is intended to protect the Exchange actually, in my view, makes TRE more vulnerable. It becomes the subject of unfounded rumors, inaccurate analysis and ill-informed attacks. It makes it appear that there is something to hide. And that’s counter-productive.

I have made this point to TRE in private communication, so this will come as no surprise, but I would strongly advise the Exchange and its management to adopt a policy of complete transparency and to foster, rather than hinder, a full range of communications among all market participants.

TRE should start acting like a public company.

It should make public a full range of operational and financial information just as if it were public.

It should support, rather than hinder, productive and even organized communications and associations among Buyers and Sellers and analysts.

It should stand ready to explain what has worked well and what has not and what has been done in response to the problems that it has faced.

No business, and certainly no new business, is going to escape problems and errors. The good ones acknowledge those problems and errors and respond to them openly and constructively. That stuff always comes out eventually, anyway, so why not take control of THAT and use it to advantage?

Finally, Happy New Year to all! And may 2012 be a year of growth, learning and prosperity for the entire community of TRE participants.

Tuesday, November 22, 2011

The Implicit Assumption

The issue of risk measurement and the relationship of perceived risk to expected return has been a principal occupation of finance theorists for the past several decades. It is received wisdom that as risk rises, return must also rise, and vice versa (perhaps with a lag).

That admittedly simplistic formulation suggests that when a risk-reducing element is added to an investment opportunity, the rationally expected return should fall.

We’ve all witnessed repeated failures of the rational-investor hypothesis, the efficient market hypothesis and of modern portfolio theory over the past decade.

We’ve witnessed the well documented flame-outs of risk pricing models demonstrating that the “greek” factors of financial math, when stressed, can be as reliable as Greek bond ratings.

So the question of the day is: when is it NOT rational for expected returns to fall when new risk-reducing conditions are introduced?

The answer… (drum roll, please)…is: when risk wasn’t being rationally priced PRIOR to the application of the new measures.

When returns fall in the face of new risk-mitigation measures, the implicit assumption is that pricing prior to the introduction of the new measure already correctly reflected risk.

The extent of the decline should rationally be a function of the gross risk reduction less the cost of the risk reduction, modified by the confidence that can be placed in the “before and after” risk measurements.

New risk-mitigation measures have been applied to some TRE transactions in recent days.

It is too early to draw conclusions about their long-term impact.

In the short term, though, the reaction has been clear. Returns have fallen sharply.

If the reduction in returns was observed only in the cases where risk mitigation measures have been introduced, the problem of analysis would be made more straightforward. But that has not been the case.

The deterioration in expected yields that we commented on in our last post has persisted. So returns had already begun to fall; apparently as a result of excess liquidity; before the reaction to the risk-mitigation measures began.

And there is not yet enough data to support an analysis allocating the overall decline between the two apparent sources.

On a preliminary basis, though, it does not appear to me that the extent of the initial price reaction can be rationally supported as a reflection of the net value of the risk mitigation measures.

And it is far from clear to me that risk was being appropriately compensated BEFORE this latest development.

Having written a rather lengthy series of posts on the subject of Appropriate Compensation, which is really all about risk; and having not yet proposed a definitive conclusion on that question; I can understand that Buyers of TRE auctions will and do analyze appropriate pricing differently.

But all Buyers and, indeed, all observers of TRE, suffer from a similar impediment in their assessments of risk i.e. lack of disclosure of actual TRE experience in sufficient detail to make reasonably informed risk assessments.

I have previously stated that the actual early experience of TRE might not be an appropriate basis on which to analyze current or forward-looking risk. And I continue to believe that.

Because TRE has responded in meaningful ways to its early experience I believe that risk today is lower than it was 2 years ago.

But a RELATIVE shift in risk says nothing particularly useful about the ABSOLUTE level of return necessary to compensate for that risk. And the absolute level of average expected return to Buyers has fallen far more over the last 2 years than warranted, in my opinion, by the change in auction risk profile.

It might be that the current price action is a temporary condition and that we’ll see an adjustment of the sort that occurred earlier this year. In that case we might look back on the current period as a temporary overreaction.

If that does not occur, and the current conditions persist, my guess is that we’ll see reactions within the Buyer community that will drain some of the current liquidity from the market.

Friday, November 11, 2011

Absolutely Relative vs Relatively Absolute

In September 2011 TRE announced its new affiliation with the New York Stock Exchange. I wrote in my post of September 13 that “the benefits to those whose involvement is limited to the SMB market (would be) pretty obvious and (would) become clear over time.”

The operative phrase there was “over time”.

It might have been coincidence; but I doubt it; that new Buyer money clearly came into the market as the “bell rang” on October 1. And since that time the pricing of SMB auctions has reflected the enthusiasm of increased demand relative to supply.

That also happened in 1Q 2011, when we saw a significant drop in average returns that lasted for about 90 days.

It appears that the combination of October’s influx of new money and structural issues arising from process changes recently instituted by TRE might now push returns even below the levels of 1Q 2011. Whether that will be a short-duration phenomenon, as was the dip in 1Q, or will have more lasting impact cannot yet be known.

But it does raise a question that I think is critical, more for those who look to the possibility of trading on TRE as a stand-alone business than for others, perhaps; but to TRE as well, in my view.

I’ve written previously about the difference between Buyers whose activities on TRE are ancillary to their principal business; who might be looking for short term, opportunistic means to improve returns on excess cash balances; as opposed to those whose business is actually investing in accounts receivable and are looking to make investing in TRE auctions a viable business on its own.

In the case of the short-term “money parkers”, the TRE market is probably viewed in an absolutely relative light.

If a Buyer, whose business is actually investing in other asset types, has excess cash balances from time to time on which very little can be earned, the prospect of picking up a few hundred basis points over Libor, for example, might look very attractive.

Such a Buyer might well have minimal marginal costs involved in its TRE activities and, unless (or until) it is faced with defaults, might be quite pleased with the incremental returns received.

But the nature of that Buyer’s activity is that it is driven by lack of sufficient opportunity in its primary business or in its usual short-term investment options. And as those opportunities and options improve it will likely move its cash back to its normal operations and withdraw liquidity from TRE.

The supply/demand balance in TRE trading is still delicate. Volume of auction activity has certainly grown over time but relative to other financial markets, TRE volume is still within rounding error. What might seem to some investors to be relatively small increases in funds allocated to TRE purchases can have a meaningful impact on the market.

In the short run, TRE probably has little control over Buyer allocations of funds or the impact of meaningful changes in market dynamics caused by shifts in those allocations.

In the longer run, however, I believe TRE should strive for the relative stability that would more likely come from a Buyer community largely composed of those who are approaching the Exchange as a part of their primary business activity.

It is that class of Buyer that can be expected to be consistently participating in the market and seeking to match growth in the market with growth in their own level of commitment.

But it should be recognized that the return requirement of that class of Buyer is not absolutely relative; rather, it is relatively absolute.

Those Buyers whose business is investing in accounts receivable will know that the TRE transaction structure has certain risks that are not typical in their normal activities and that those risks will have to be adequately compensated if the TRE activity is to be supported in the long run.

The cost of money might be similar when the absolutely relative Buyers are compared to the relatively absolute Buyers. But it’s likely that there will be meaningful differences between the two classes of Buyers in the areas of:

1. Operating costs
2. Credit loss assumptions, and
3. Net return requirement

The short term parkers of excess funds will probably attribute little, if any, marginal operating cost to their TRE trading activity.

Until they actually experience the potential risks involved in buying invoices in the TRE structure, it is likely that the credit loss assumptions of the absolutely relative Buyers will be minimal.

And the net return requirement of the absolutely relative Buyer will also likely be minimal. The Exchange activity of that Buyer is a footnote to its business plan. For the relatively absolute Buyer, its Exchange activity is the BASIS of its business plan!

The long term growth and prosperity of TRE, in my view, depends on attracting, retaining and supporting the activity of the relatively absolute Buyers.

To the extent that the absolutely relative Buyers threaten the ability of the relatively absolute Buyers to price transactions sensibly in light of the actual risks being assumed, they also threaten the long term success of TRE.

Monday, October 24, 2011

A Comment on Seller Marketing

I've been waiting for several weeks for the conditions to materialize that will allow me to comment on a new TRE risk-mitigation program. We're not there yet, so I still can't write about that initiative.

But, as I wait, the issues of risk and appropriate pricing are still at the top of my list and there was a trigger for comment on those topics last week.

An article, written by a senior officer of TRE, appeared in an industrial trade magazine published last week. The article was a marketing piece setting out a variety of reasons why owners of manufacturing concerns should consider an alternative financing facility like TRE.

The points made in favor of an alternative working capital facility were familiar and predictable to anyone with involvement in or knowledge of TRE. One of them, however, seemed to me to be overemphasized and not completely accurate.

The point was discussed under the heading: "Avoid Personal Guarantees". The discussion began with a comment on the typical working capital provider's requirement of a personal guarantee and of the potential impact on a business owner in the event of a default if a personal guarantee has been provided.

A fair enough comment.

But then the point is made that TRE does not require personal guarantees "because investors who are bidding for your receivables assess their risk based primarily on the credit rating of your customers, not your rating."

The author appropriately points out the obligation of the business to repurchase defaulted invoices but closes with the statement: "Most owners would rather assume this obligation than risk losing their house or savings because of a personal guarantee."

This emphasis is troubling in several respects:

1. In a post entitled "Pardon the Interruption" published June 28, 2011, I argued for the adoption of at least a contingent personal guarantee. At that time I suggested that it be contingent on the posting of non-conforming invoices for sale. That's not the only approach, of course. Such a contingent guarantee could also be triggered by a fraud test. But nothing has happened since June 28 that changes my opinion on that issue. If anything, I am more convinced than ever that TRE will eventually HAVE to move in that direction.

2. Speaking only as one Buyer I can say without hesitation that our buying decisions are not "based primarily on the credit rating of your (the Seller's) customers". The invoice verification process used by TRE does not allow that level of confidence. The uncertainty caused by that process is not an issue of Debtor strength but of confidence in the validity of the invoice. It does not matter if the Debtor is the most creditworthy company on earth. If the invoice is defective it won't get paid. So, the most important question to be asked is NOT whether the Debtor can pay the invoice, it is whether the Seller can pay it if the Debtor does not.

3. Selling the TRE facility on the basis of limited Seller risk is like throwing blood in a shark tank. It's an irresistible attraction to the Sellers that are most likely to become problems. Obviously those business owners; and they are out there; who are just crooks, will find the situation tempting. They don't even have to negotiate to get a personal guarantee requirement waived. It's not even a point of discussion. But even owners who are generally trustworthy can be tempted to act badly when the pressure gets strong enough. And in this economic environment, a lot of them are under pressure.

4. The tension between the sales and risk control functions that is felt in all credit-market institutions is heightened when so much is riding on volume growth. In the case of most banks, for example, there is a counter-force to be found in the requirements for public disclosure. If the credit metrics begin to move in the wrong direction, that will become apparent relatively quickly. That is not the case with TRE. Little data about auction performance is made available publicly and so the pressure on the sales and marketing functions from that source is largely absent. We have to rely on senior management to appropriately balance the growth objectives with a robust risk control environment.

The success of the TRE sales and marketing functions is in the best interest of all of us who are involved in the TRE enterprise. But it is only in our best interest to the extent that it is achieved in the context of effective control of risk and appropriate pricing of risk.

Emphasizing the limitation of owner liability in marketing efforts is, in my view, a dangerous approach to business building that is clearly tempting in the short term but is likely to be counter-productive in the long term.

Monday, September 19, 2011

Appropriate Compensation # 12: Another Tack

In our last post in this series we discussed the idea of risk analysis at the level of the Seller, on the assumption that a probability of default might be usefully considered in terms of a Seller-based metric.

That actually brings up an interesting distinction between the TRE model and that of traditional factoring relationships.

In the traditional full-line factoring relationship the factor will have funded a significant portion of the total receivables portfolio of the client. Not necessarily the entire portfolio, but perhaps all of the invoices due from specified debtors or all invoices due from specified debtors within a specified age limit, or something of the sort. And the factor will have a buffer against loss equal to the aggregate dollars held-back from all invoices funded plus (in many cases) additional value from invoices not actually funded.

In such a case, a debtor’s default on one invoice, or the default by one debtor among many, will not necessarily put the factor's advance position at risk; there might be enough value in the unfunded positions to cover the defaults.

In the spot-factoring model, particularly in the case where the lien is specific to the invoices purchased and there is no other security provided, the buyer of the invoice has fewer options to effect a cure of any default.

That is typically the case in a TRE transaction.

So, some might argue that the risk of loss might be better viewed at the level of the individual transaction rather than at the level of the Seller. I don’t necessarily agree but it does provide another interesting approach to risk analysis.

Let's say that we’re looking at a $50,000 single-invoice auction and that the terms of sale are: an 85% advance; a monthly discount fee of 1.5%; and, an expected duration of 30 days. The net earnings on an auction with those parameters will be approximately 1/79th of the initial advance.

In that case, just for illustration, if the buyer thought there was 1 chance in 79 of suffering a complete loss on an auction with similar characteristics, the net expected return after credit losses would be zero.

Inverting the analysis, if the buyer thought that a credit loss equal to 10% of the expected earnings was acceptable (just to keep the numbers round), he would have to attach a 1 in 790 probability of a total loss to this auction in order for it to meet his loss tolerance.

Using that approach a Buyer can fairly easily construct a loss tolerance distribution using variables for size, duration, rate and targeted loss levels. This won’t answer the question of what the probability of loss might actually be. But it will provide a measure against which the Buyer can test the reasonableness of various assumptions.

Let’s keep size, rate and targeted loss levels constant and test for the effects of duration change. If the duration were 15 days instead of 30 days, the net earnings expectation would be about 1/212th of the initial advance and, in order to hold losses to a 10% level, it would take about 2,120 successful auctions for each 1 that was a total loss.

If the duration were to be double the initial case i.e. 60 days, the expected earnings would be 1/35th of the advance amount and 1 auction in 350 could be allowed as a total loss while maintaining a 10% loss ratio.

We’ve noted that there is not enough data yet to reliably attach probabilities of loss to TRE auctions. And the variations among Seller and Debtor strength, experience, and other metrics are so wide that any analysis of the TRE market as a whole is perilous.

However, a Buyer CAN approach a single auction armed with the calculation of implied loss tolerance given the auction parameters and his own appetite for risk.

Loss tolerance calculation is not loss probability calculation. But it’s something.

It seems that we’ll soon be able to discuss a significant new risk-mitigation step being taken by TRE. When we CAN discuss it we will.

But the fact that mitigation actions are taken doesn’t relieve us of the need to assess the risk itself. It just imposes the additional requirement of analyzing the extent to which the mitigation measures actually affect the net loss probability.

Tuesday, September 13, 2011

Credit Where It's Due

This morning's announcement that NYSE Euronext has taken an equity position in TRE and is partnering with TRE to offer the TRE Corporate Receivables Program to NYSE-listed companies is a significant vote of confidence in the concept, the technology and the management of TRE.

This development is unambiguously good for all participants in the TRE enterprise including those of us who are Buyers and Sellers, regardless of whether we participate in the Corporate Receivables Program or not.

The benefits to those whose involvement is limited to the SMB market are, I think, pretty obvious and will, I suspect, become clear over time.

Those who were not yet convinced that TRE had proven itself as a going concern should take comfort in today's announcement.

In my first post on this blog I noted that just as "all beginnings are hard", so too the road toward success for TRE would be bumpy and difficult: mistakes would be made and changes in direction would be required.

It is clearly to the credit of TRE and its management that regardless of the difficulties faced and the course corrections required, the focus on moving forward, on facing up to problems, on seeking solutions and on pursuing opportunities has been maintained.

Today's announcement is a big thing for TRE and credit is due to its founders, its management, and to all who have been a part of sustaining it to this day.

Wednesday, August 31, 2011

Appropriate Compensation #11: Keep it Simple(r)

Here in post-Irene New Jersey many of us still have some recovery to attend to but, as the month ends, I want to quickly clarify the idea put forward in our last post.

This is what I mean by a Seller-based approach to an allowance for credit losses:

1. Let’s say that all active Sellers on TRE represent the same share of total auction activity. (Clearly, that’s unrealistic, but it’s just for illustration.) And let’s say that our analysis suggests that 3% of active Sellers will default in any given year. If we assume that every default results in a total loss, we might say that overall TRE pricing has to provide for an annual loss of 3% of capital (before recovery expenses).

That 3% loss provision is not based on the gross income of auctions purchased. It’s not a top-down calculation. It is an absolute loss provision that has to be included in auction pricing to compensate for perceived Seller-default risk.

That’s an extremely simplified example of a platform-level approach but, hopefully, it conveys the idea.

It’s not possible at this point, for a Buyer to “buy the Exchange” i.e. there is no single transaction that will expose the Buyer to a pro-rata position in the entire TRE portfolio. So an Exchange-level analysis, even if it were really possible in a statistically meaningful way, wouldn’t go far enough for the individual Buyer.

The individual Buyer will have to account for his own strategic portfolio and auction purchase decisions in creating an allowance.

2. Let’s say that a given Buyer has a portfolio diversification rule that limits his exposure to any one Seller to an amount equal to 10% of the Buyer’s capital. And let’s say that the Buyer believes that his Seller-qualification criteria allow an annual probability of default of 1 in 20. If a total loss on default were assumed, and the Buyer’s investment at the time of default were at its 10% maximum, the simplistic loss allowance should be about 5% of capital per year.

3. Let’s take the same situation as in #2 and assume that the Buyer actually expects a net loss recovery of 50% of defaulted amounts. In that case a net loss allowance of 2.5% of capital per year would be indicated.

Obviously, a Buyer projecting a loss of 2.5% of capital per year will think and act differently than one projecting a 5% loss. (And those making no conscious allowance for loss will be unpleasantly surprised sooner or later!)

There is not yet enough history of TRE operations to reasonably estimate the probability of a “typical” Seller defaulting. Nor is the information about actual default experience publicly available.

What we ARE able to say is that the experience of TRE to-date has caused it to make a number of meaningful changes to procedures, staffing and operations that affect both risk of default and likelihood of recovery post-default. And that those changes have been constructive.

However, it remains true that:

• There is a wide range of (reported) financial capacity among TRE Sellers.

• There is a wide range of financial capacity among TRE Account Debtors.

• There is a wide range of past experience among TRE Seller/Debtor pairings.

• There is a wide range of documentation strength provided in TRE transactions.

• There is a wide range of actual pricing in TRE transactions.

Because each Buyer’s actual and perceived risk/return profile is dependent on many individual portfolio construction and auction purchase decisions; and many assessments of risk are still largely subjective in the context of limited TRE history; the question of an appropriate loss reserve will also necessarily be both individual and largely subjective.

I might think, based on my own portfolio construction and auction purchase criteria, that an annual Seller default probability of 1 in 20 is reasonable. Another Buyer might find some other number to be more reasonable.

I might think that a net recovery expectation of 25% is reasonable. Another Buyer might think differently.

I’ll develop this idea further in subsequent posts but I hope this clarifies the distinction between a Seller-based analytical process and one that is Debtor-based.

I should note that I’m not ignoring the differential strength of Account Debtors. Regardless of Debtor capacity, it is the Seller that is ultimately responsible to make good on invoices sold. And, in the context of TRE notification/verification procedures, I think that the quality of the Debtor is best considered as one element in the assessment of Seller risk.

Thursday, August 18, 2011

Appropriate Compensation #10 : The View from Below

In this series of posts we’ve identified a number of risks assumed by Buyers of TRE auctions that we’ve suggested deserve incremental compensation beyond that provided for the risk in typical factoring transactions.

From the start we’ve acknowledged that quantifying an appropriate level of incremental compensation is going to be difficult.

There is no evidence (that I am aware of) to support a rigorous quantitative analysis of the incremental risk associated with reliance on unaudited financial statements as opposed to audited ones. There is no evidence (that I am aware of) to support a rigorous quantitative analysis of having a limited lien position versus an “all asset” lien, or a junior lien as opposed to a first lien. And so on.

We all know that the additional risks assumed in TRE transactions DO exist and that they are real and that they are not trivial.

But how can we approach assigning a value to them?

In our post of May 11, 2011 I wrote, having provided some supporting data and analysis:

“It seems to me that an average credit loss allowance in the range of 10% to 12.5% of gross income in typical factoring transactions, over the course of a credit cycle, is not unreasonable.”

My expectation at that time was that, after examining the major factors that add risk to TRE transactions, I’d arrive at a suggested analogous number that might be used in analyzing TRE transactions.

The more I’ve thought about it, though, the more I’m drawn to a different approach.

Here’s why.

When we look at the factoring industry as a whole we’re looking at a highly competitive environment in which competition constrains the participants’ pricing power.

Average gross revenue is largely a market-determined number and the participants are challenged to operate their businesses within that revenue environment in a way that generates an adequate profit after costs.

A market-wide average credit loss experience will affect top-line, market-wide pricing only over the longer term. That is, increasing (or decreasing) credit losses will tend to affect FUTURE pricing to the extent that they appear to be a reflection of a structural change in overall risk. They are analyzed, calculated and reported in terms of their relationship to the market-driven gross fee environment.

They occupy one line in a top-down analysis of profitability.

The question we’re really asking in THIS analysis, it seems to me, is NOT one of the relative size of a number in a top-down profitability analysis but rather one of the ABSOLUTE size of a number in a bottom-up pricing structure.

The ultimate question is NOT how much of a relatively fixed top line should be reserved for losses but rather what level of loss expectation does the top line need to INCLUDE, as a compensation for risk, in the unique environment that TRE represents. The top line, rather than being relatively fixed, has to be flexible enough to expand to accommodate the risk assumed.

So, rather than stating the conclusion in terms of a percentage of income to be subtracted from the top line, we would state the conclusion in terms of a percentage of capital that must be included in the pricing of auctions to compensate for losses.

This is an approach that implicitly assumes that much more of the TRE Buyer’s risk is Seller-based than Debtor-based.

The question becomes not how many Account Debtors fail to pay invoices posted for sale but rather how many Sellers, for whatever reason, default on THEIR obligations.

That would include simple inability to make good on invoices not paid by their Debtors as well as Seller insolvency or default arising from one of the various forms of potential Seller fraud.

So we would ask:

a) What is the percentage of the total TRE Seller universe that is likely to default in any given period of time?

b) What is the percentage of total TRE auction volume that is likely to be represented by those Seller defaults?

c) What is the likely NET recovery rate (gross recoveries less costs of recovery) in cases of Seller default?

The answer to those questions gets us to a projected loss-of-capital allowance for the Exchange as a whole. Each Buyer is, of course, able to construct diversification and Seller-qualification strategies that he believes would mitigate either the absolute or risk-adjusted loss potential.

In the next post I’ll explore the impacts on pricing of a range of assumptions on these issues.

I invite anyone interested to share their own views of this approach and their thoughts about reasonable values to assign to the variables.

Monday, August 8, 2011

Appropriate Compensation #9: Upon Mature Reflection

I worked with a guy once who had a wonderful way of reversing his expressed opinion on a matter, which was particularly useful when he found that it conflicted with the boss’s opinion.

When it was clear that he’d dug himself into a hole, he’d invariably preface his remarks with: “Upon more MATURE reflection….”

We’ve identified a number of significant issues that we believe add risk to TRE transactions when compared to the typical factoring transaction. The financial statement issue; the personal guarantee issue; the lien priority issue; for example, are all significant and all clearly differentiate the TRE transaction.

Before moving to the question of what kind of pricing response might be appropriate I want to bring up another element that is perhaps the most difficult to analyze and probably impossible to quantify. It is, nevertheless, quite real.

It is the fact that a real-time, competitive auction environment creates a unique potential for self-defeating behavior: behavior that is influenced by the trading environment in a way that does not affect the typical factoring transaction.

There is a great deal of literature about the impact of bidder motivation and psychology on behavior in various auction environments.

The TRE auction environment is one in which, unlike some others, the Buyer does not have the practical option to exit the trade to correct a buying or bidding error. There is no opportunity to say: “Upon more MATURE reflection…..get me out of this thing!” And then to sell what might have been purchased in error, or in haste, or under pressure to put money to work or even just in a momentary fit of pique at having lost a number of auctions that day.

All of these things, and more, can be the cause of a Buyer looking up from an Awarded Auction Report and saying “I can’t believe I really did that.” The only thing to be done at that point is own up to the lapse and hope the thing actually gets paid.

That is not to say that the decisions of the typical factoring company are not subject to the motivations of competitive pressure and internal goal setting. Of course they are.

But they are not subject to the pressures of a real-time auction environment, which requires that decisions be made very quickly, usually without prior warning, frequently in the face of new information that has not been previously analyzed, often in an environment of excess market liquidity, and often in competition with others with differing motivations for participation.

One of the dynamics proven true in competitive auctions is the increase in the perceived “need” to win as the number of “lost” auctions increases. That is, a buyer’s propensity to act against his own bidding rules will tend to increase with the number of unsuccessful bids made. That’s a dangerous but very real temptation when being the successful bidder is defined in terms of “winning” the auction.

In fact, the successful bidder is the one who only bids according to his pre-established bidding rules.

And it might be that a consistently successful bidder is NOT particularly successful at keeping funds deployed in some market environments. But that’s a different question.

I can tell you that, based on my own experience, there is a dynamic in the competitive, real-time auction environment that has clear error-making potential. Some Buyers will be more susceptible to it and some less. So the actual level of incremental risk is as much Buyer-driven as process-driven.

Whatever the actual MEASURE of incremental risk, the fact of incremental risk in real-time, competitive auctions is well documented in academic literature and clearly felt in practice.

I confess that I have found myself (and I will bet that many other Buyers have as well), after placing a bid or winning an auction, wishing that “upon more mature reflection” there was an un-do function on the TRE platform!

It is no coincidence that the competitive nature of the TRE buying environment is stressed in TRE's marketing to SELLERS rather than to Buyers!

Tuesday, July 19, 2011

Appropriate Compensation #8: Once Removed

If I were forced to take a test that measured knowledge of genealogical matters I would fail abysmally!

I could get as far as defining a first cousin but I have no sense at all of what a second cousin might be and if that second cousin were twice removed I would have to assume it was for some sort of repetitive misbehavior.

In the case of my relationship with a TRE Seller, however, the idea of being “removed” is easily understood. In fact, it’s contractual.

I am prevented by agreement from having direct contact with a TRE Seller except under very narrowly-defined circumstances.

TRE provides Buyers a defined set of minimum due-diligence materials describing the Seller. That set of materials can be supplemented at the option of the Seller (and perhaps at the suggestion of TRE) to clarify or expand upon issues that the standard documents suggest need elaboration.

Public records and credit evaluation services can be utilized to augment the data available to assess the Seller’s business and financial condition, of course, and there are services that can be used to periodically scan media and public records to pick up items relating to specified companies.

So, what’s missing and how does the missing element contribute to the incremental risk of trading on TRE?

The short answer is that the TRE Sellers are “removed” from the Buyers. The Buyers’ relationship to the Sellers is intermediated via TRE.

It is a TRE person who sits across the table from a prospective Seller and talks about the Seller’s business. It is a TRE person who visits the Seller’s place of business and gets a sense of condition and activity. It is a TRE person who examines the prospective Seller’s financial records. It is a TRE person who gets a “feel” for the type of people who own and run the prospective Seller. It is a TRE person who determines that the prospective Seller appears to be credible and trustworthy.

TRE, of course, assumes no liability for its investigations or judgments but if it proves to be off-the-mark too frequently its business and reputation will certainly be damaged.

Once a Seller is approved and posting auctions for sale on the TRE platform, a Buyer may ask questions about the details of due diligence materials and about specific auctions. Those questions are asked of TRE, of course, and it is TRE that calls the Seller and relays back whatever information, if any, the Seller might provide.

I don’t agree with those who argue that the lack of liability will make TRE careless of its responsibilities to carry out its tasks prudently. But it does have to be acknowledged that, especially in the early growth phase of the business, TRE has a substantial incentive to approve Sellers. Sellers are harder to come by than Buyers (at least for the time being) and good Sellers are likely to be given the benefit of the doubt wherever reasonably possible.

But the fact is that the Buyers are limited in their decision making process to analysis of the available information, none of which will typically give them a sense of the PEOPLE on the other side of a transaction. The Buyers have no opportunity to form an opinion of the HONESTY of the Seller.

Why is that important?

As we’ve discussed, most financial statements provided by Sellers are internally generated. Anyone who has worked with Quickbooks or similar bookkeeping software packages will know just how easy it is to create a “second draft” of the statements. And, by the time the statements are posted, they are dated in any event.

As we’ve discussed, the invoice verification process used by TRE is not designed in a way that is likely to catch invoices that are actually fraudulent until damage has already been done.

And, as we’ve discussed, the owners and principals of the Sellers have no personal liability to TRE or its Buyers in the event of default.

Those issues and others make the assessment of a Seller’s character and honesty a critical part of the decision to buy. But the Buyer can’t make that assessment. The Buyer has to depend on TRE to be clear-eyed and unmoved by the incentive to attract Sellers.

A recent factoring industry survey quoted a contributor as saying “every factor experiences fraud every year”. The need for due diligence that extends beyond the four corners of a page of financial data is obvious.

The TRE Buyer is once-removed from one of the most important assessments in the decision to do business with a Seller.

I know that TRE takes the job of assessing Seller honesty seriously, even if it is not actually liable for the judgments made. I know that there have been situations in which prospective Sellers have been denied TRE membership because of uncertainty about character and veracity. And I know that TRE has to take the long view in balancing the desire for growth in the Seller base against the risk to which Buyers are subjected.

But I also know that face-to-face assessments of the counter-party in a transaction can have a big impact on decisions.

I know that having the ability to pick up the phone and ask a Seller direct questions about auctions, Debtors, invoices, changes in financial condition, and so forth, in real time, would have significant value. But the TRE Buyer can’t do that.

Being once-removed; being isolated from the Seller; unquestionably adds risk to the TRE Buyer's activity.

It is another risk element that deserves to be compensated.

Thursday, July 14, 2011

Appropriate Compensation #7: The Lien Position

In this series of posts we've identified a number of ways in which the TRE Buyer is assuming incremental risk when compared to typical factoring transactions. The goal is to ultimately draw a conclusion regarding the appropriate level of incremental return necessary to compensate for that additional risk.

Today I want to return to the issue of the lien position that the TRE Buyer acquires in the assets of the TRE Seller. We’ve addressed this issue before.

Please see:

• Caveat Emptor #2: December 15,2009, and
• Blanket Security vs. a Security Blanket: June 29, 2009

There are two principal conditions in the Buyer’s lien position that give rise to risk in TRE transactions that would not normally be accepted in typical factoring transactions:

1) The TRE Buyer obtains a lien ONLY on the invoices purchased from the TRE Seller, and

2) It is often the case that other parties already hold prior liens on the receivables of a TRE Seller, so the TRE Buyer might hold a second or even more-junior lien position on the receivables it purchases.

The fact that the Buyer’s lien attaches only to the receivables purchased is made more problematic by the lack of a full notification process that we’ve recently discussed. If the invoice purchased is defective and the Buyer’s lien attaches only to that invoice, the value of the lien is questionable.

And the fact that other parties might have superior lien positions with respect to the assets of the TRE Seller, puts the TRE Buyer at risk that the rights and actions of others, which neither TRE nor the Buyer can control, can substantially reduce the value of the Buyer’s lien.

Compounding that problem is the fact that I know of no truly reliable warning system to alert the TRE Buyer to the existence of action or threatened action by a 3rd party in time for protective measures to be taken by either TRE or the Buyer.

In typical factoring relationships there is an opportunity for ongoing dialog and business-condition assessment. That is not the case in the TRE environment.

In the TRE environment the Buyer is almost always going to be behind the curve, learning of problems after the fact. Even if a Buyer is an astute analyst of financial data, able to tease out indicators of developing problems, the information available on the TRE platform is always dated. And, as we’ve discussed, the quality of the information contained in internally-generated financial statements – always less-assured than audited data – is far more likely to be inaccurate in conditions where Sellers are in trouble or heading in that direction.

Becoming aware of a threat to one’s position via notice of a superior lien-holder’s action is unpleasant.

On the subject of the breadth of the Buyer’s lien position I’d like to add a point to the prior conversation that I haven’t brought up before. The UCC filings in typical factoring relationships very often extend beyond creating a security interest in all accounts receivable. Often they are either “all-asset” liens; or extend to all of the personal property of the Seller in addition to its accounts; or specifically include other named property.

More and more often, especially in the cases of companies that are in the various “tech” sectors, the critical assets of the TRE Sellers are intangible. A Seller that is a software development firm, for instance, might have a copyright, trademark, patent or other intangible as its primary revenue-producing asset. Without some means to control or, at least, threaten that asset, the leverage of a creditor is substantially diminished.

This limited security position in the assets of the Seller is obviously quite attractive to the Seller. It is used to attract Sellers to the TRE platform in the same way the lack of a personal guarantee requirement is used. It has a flavor of the “you can’t get this anywhere else” to it.

Of course, there’s a reason it’s not generally available and that reason is that it increases the risk to the provider of funds.

It increases risk not only because the security might be defective or a because a superior lien position might be asserted but also because any action to cure a default that depends on attaching assets that have limited lives (i.e. the receivables portfolio of a Seller might be liquidated and its proceeds “evaporated” before any substantive court action can be commenced) carries the incremental risk of dependence on a wasting asset.

There is no question that the TRE Buyer should demand incremental compensation for the incremental risk assumed because of the limited security provided by its lien position.

[Note: To be fair, there is a potentially mitigating factor in the form of the right of TRE and its Buyers to attach Seller cash balances in the TRE lock-box. Mitigating factors will be discussed as a part of the wrap-up of this series of posts.]

Tuesday, June 28, 2011

Pardon the Interruption

I intended to complete the list of posts identifying sources of incremental risk assumed in trading on the TRE platform before either attempting to quantify a risk premium or suggesting risk-mitigating changes in practice.

So, pardon the interruption, but I want to pause here for just one post to make a suggestion. It’s one that I think would help mitigate risk from two sources: the lack of a personal guarantee and the lack of a full notification procedure.

First, let me acknowledge that I understand the reasons why TRE has adopted the policies in place.

As we’ve pointed out, almost all TRE Sellers would be asked to provide personal guarantees by other funding sources. The lack of that requirement by TRE is thought to be of significant help in attracting Sellers. On the notification issue, I understand that a true full-notification policy would require a very substantial commitment of additional time and manpower AND it would substantially slow down the process of bringing auctions to market.

I do get it.

But the fact is that the combination of these two issues produces a potentially tempting opportunity for Sellers who either fall on hard times , or who are simply dishonest, to post invoices for sale that do not meet the criteria set forth in the Master Program Agreement.

The lack of a full notification criterion undoubtedly increases the risk that invoices will be improperly posted for sale. And the lack of a personal guarantee reduces the risk to the Seller of doing so.

There is, I think, a fairly straight-forward way to mitigate (if not eliminate) this risk.

The principals of TRE Sellers could be required to execute a CONTINGENT personal guarantee agreement that would have no effect EXCEPT in the event that invoices not meeting the criteria of the Master Program Agreement were posted for sale on the TRE platform.

So long as invoices, even those that might become problematic, actually meet the specified criteria, the obligations to cure defaulted payments would remain corporate only. However, if the invoices were improperly posted, which is a condition under the control of management, TRE and the Buyers could look beyond the corporate assets of the Seller to the personal assets of the owners.

Obviously, such a change in policy would meet with Seller resistance and would likely cause some potential Sellers to fall by the wayside.

However, if the principals of a Seller are not willing to guarantee their own adherence to the invoice posting requirements; essentially assuring TRE and the Buyers of their own honesty; they might be Sellers we could all do without in the long run anyway.

Thursday, June 23, 2011

Appropriate Compensation #6: The Notification Issue

No single issue has been discussed in as many of our posts as the issue of invoice notification versus verification.

See the following for prior comments:

 An Inconvenient Truth Part One: July 6, 2009
 An Inconvenient Truth Part Two: July 8, 2009
 Whose Ox is Gored? : October 19, 2009
 Half a Bubble Off Plumb: November 30, 2009

Why has this issue been given such attention?

Because, in my view, it represents the single largest potential threat to TRE Buyers. And, as such, the compensation it deserves is meaningful.

That compensation should be considered both at the level of the entire TRE platform as compared to systems that DO include full notification and among TRE auctions and Sellers, where differential risks can often be identified.

Let’s review the general issue.

In a “full notification” invoice purchase the Account Debtor will be asked to confirm that:

1) It has a contractual relationship with the Seller,

2) The invoice presented has been generated under the terms of that contract,

3) The work done by the Seller has been completed AND meets the terms of the contract,

4) The amount of the invoice is correct,

5) The payment terms are correct, and

6) Payment will be made as instructed in the notification document.

Problems might (and do) still arise, of course, even given all of the assurances listed above, but the general approach should go a long way to minimize surprises.

TRE does not use a “full notification” system. Instead, it uses an invoice “verification” system.

Under the TRE verification system the Account Debtor is asked to verify that an invoice matching the one posted by the Seller for sale DOES exist in its Accounts Payable system. That is: there is an invoice from the Seller in the Debtor’s AP system that has matching identification and amount details.

Essentially this tells us that the Debtor has SUBMITTED an invoice. It does not necessarily tell us that the invoice is valid, that the goods or services meet contract requirements or that the Debtor actually acknowledges the obligation.

TRE is understandably reluctant to make public in any detail the exact mechanics of the verification system it uses. Too much transparency would risk allowing Sellers to “game” the system.

However, it did notify Buyers in 2009 that it would not verify 100% of the invoices posted for sale on the TRE platform. Instead, after gaining a certain (unspecified) amount of experience with a Seller/Debtor pair, it would employ a statistical sampling process that it said would at least match the best practices of the factoring industry in terms of the percentage of invoices verified in given Seller/Debtor relationships.

There are Sellers whose auctions routinely consist of dozens of individual invoices and some of those Sellers post auctions of invoices due from the same Debtors quite frequently. It is understandable that asking the AP department of a Debtor to frequently verify dozens, or even hundreds of individual invoices might generate a little “push back” from the Debtor after a while.

While I have no knowledge of the actual sampling system employed by TRE, I’m willing to accept the idea that sampling can be an appropriate practice IF, of course, you’ve already accepted the verification versus notification alternative.

But that’s not really the issue here. The issue is: “what level of additional income should a TRE Buyer receive to compensate for the added risk inherent in accepting the verification versus notification alternative?”

There are two points that can be made immediately:

1. As we've said on other points of risk assessment, we just don’t have the data to measure this risk factor with any meaningful level of statistical reliability; any "answer" will be a judgment call; and

2. The answer is not “zero”. There IS an incremental risk to the TRE Buyers that should be compensated and that, over time, MUST be compensated if the exchange is to thrive.

So, how can we approach the problem?

Is the experience of TRE, itself, a useful guide?

In terms of quantifying the appropriate risk premium I don’t actually think the experience of TRE to date would be particularly meaningful even if complete data were available.

First, the level of transaction volume is still in its early growth phase and too small to provide a reasonable denominator against which to measure default/loss experience.

Second, the public default information involves ongoing litigation whose outcome continues to be uncertain. So the numerator is also problematic.

Third, while the details are not public, it is certain that TRE has made changes to its practices on the basis of what it’s learned in the early cases of default.

That being said, however, we CAN identify the kinds of things that cause a verification process to carry with it a higher level of risk than a notification process.

These tend to fall into two categories:

1. Falsification of, or fraudulent offering of, invoices: by completely fabricating the invoice or by materially misstating its amount or payment terms or by selling invoices that have already been sold to others or that are subject to the specific claims of others.

2. Diversion of payments either by actively causing payments to be made to an incorrect party or passively by accepting and retaining payments mistakenly received.

There are a lot of variations on these themes, of course, but most situations will fall into one of these two broad categories.

I think it is unquestionably easier to sell false or fraudulent invoices in a factoring system that is based on verification than it is in one based on full notification.

The case of diversion is not as straightforward. Diversion certainly occurs in both its active and passive forms in notification systems as well as in verification systems.

It can be argued that active diversion is easier in a verification system because the only point of contact between the factor and the debtor is at the level of an AP person who might have no knowledge of the substance of the relationship between the Seller and the Debtor.

I suspect that the chances of a payment being sent improperly to an invoice seller are probably just as high in either system. On balance, given the level of uncertainties in trying to analyze any of these issues, I’d probably call the diversion risk a “wash” for our purposes.

But the falsification or fraudulent offering issue (including the various forms involving collusion) is, I would argue, a significant differential risk factor. Buyers deserve to be compensated for assuming that risk.

What would represent adequate compensation?

In this case, as in the case of personal guarantees, we have no evidence to offer in support of a specific incremental return requirement.

In this case, as in that one, however, both the incremental risk and the appropriate return premium are “significant”.

There ARE auction situations on TRE in which this risk factor is significantly mitigated; such as in the case of Ariba Network invoices. There are also cases where the Seller documentation provided with an auctioned invoice gives the Buyer substantial comfort that the invoice is valid.

We'll discuss ways in which TRE and its Sellers might provide risk-mitigating information with auctions in a later post.

But, in general, our view is that an invoice verification process carries significantly higher risk to the Buyer than would a notification process and its pricing should reflect that reality.

Friday, June 10, 2011

Appropriate Compensation # 5: It's Still Not Personal

In our post of June 22, 2009, entitled “Liability: It’s Not Personal” we discussed the fact that TRE Sellers are not required to provide the personal guarantee of their owner(s) as additional security for the performance of their responsibilities to TRE and its Buyers.

In that post we made a general statement:

Most firms that buy individual invoices routinely obtain a personal guarantee of the seller’s obligations from one or more individuals associated with the seller.”

As we revisit that topic in this series on the issue of appropriate pricing of risk I think it’s time to firm up that earlier generality.

I’ll draw on two current sources for data relating to the prevalence of personal guarantee requirements:

1) the semi-annual report of the “Pepperdine Private Capital Markets Project” for summer 2011 by Dr. John Paglia of Pepperdine University (PPCM), and

2) the “Annual Asset-Based Lending and Factoring Survey Highlights, 2010” (April 27, 2011) of The Commercial Finance Association, (CFA).

The PPCM data is collected from a broader cross-section of the market that the CFA data and the CFA data is published publicly in “highlight” rather than detailed form but, for our purposes, those differences are not really critical. In fact the results of the two fit together quite reasonably.

According to PPCM data, the requirement for a personal guarantee in asset-based lending transactions varies substantially and as a function of the size of the loan. The smaller the loan the more likely is the requirement for a personal guarantee.

For loans under $1 million the median response revealed a 100% requirement for a guarantee. That figure falls to 90% as loan size increases to $5 million and 80% as it increases to $10 million. At a $50 million loan size, no personal guarantee requirements are reported.

PPCM survey responses from those in the factoring business are not given in such detail. PPCM reports that 87.5% of factoring industry respondents require personal guarantees while 12.5% do not. I think it’s reasonable to assume that the size of transactions and relationships is also a substantial variable in this sample and that the 12.5% of the deals done without personal guarantees would be found at the larger end of the size distribution.

So, as a general conclusion, PPCM suggests that the smaller transactions; presumably involving the smaller businesses; have a very high incidence of personal guarantee requirement; whether the transaction is an asset-based loan or a factoring arrangement.

The CFA survey draws data from a smaller, more-targeted sample of firms. In its own words it “decided to base the industry surveys on data reported by almost 40 of the largest asset-based lenders and factors…”

The “highlights” version of the CFA report does not provide data on the requirement of personal guarantees by asset-based lenders but it does provide that data for the respondents in the factoring survey.

In the CFA sample only 31% of respondents reported requiring full or partial “recourse”: a portion of which presumably includes personal guarantee requirements. While this might seem at odds with the PPCM data, it is not necessarily.

The CFA data is drawn specifically from the largest providers of funds. Presumably the largest transactions would be heavily represented among the largest funding providers. And, as we saw in the PPCM data, as deal size increases the requirement for personal guarantees decreases.

These two current reflections of the market for both asset-based and factoring transactions strongly suggest that personal guarantees are required as a matter of course in at least most of the smaller transactions in both the asset-based lending and factoring markets.

The issue of what is “small” is not as clear in the CFA data as it is in PPCM, but I think we would be justified in concluding that most, if not all, of the transactions that trade on TRE would; if they were made in the conventional marketplace; be subject to personal guarantee requirements.

One of the marketing points that TRE makes to prospective Sellers is that personal guarantees are NOT required, which is itself a statement about the otherwise general prevalence of the guarantees.

The “value” of those guarantees is not readily calculated – at least not with data that I have available. My own experience dealing principally with small sellers is that personal guarantees are of greater value in curing defaults than are “all asset liens” and certainly more valuable than “specific asset liens”.

In fact, given the length of time required to litigate a claim, obtain a judgment and then actually execute on a judgment it’s often the case that there’s nothing to be gotten from what remains of a business by the time a judgment creditor can actually try to seize anything.

On the other hand, the owners of businesses against which judgments have been secured, often have personal assets that really CAN satisfy claims. But if they haven’t provided a guarantee, the creditor has little effective means of reaching those assets.

This is another one of those cases where quantifying the value of a risk parameter is a difficult task if we’re looking for real analytical rigor. But I suspect we’d find broad agreement in the industry with the assertion that the premium required to compensate for the lack of guarantees should be “significant”.

What “significant” means, I think, has to be considered as a part of an overall evaluation of a transaction or relationship and I suspect that it changes with respect to a client over time and with experience.

But this is certainly an important item on our list of issues deserving a pricing increment in (at least) most TRE transactions.

Tuesday, May 31, 2011

Planetary Alignment

There was a story on the news the other night about a rare occurrence that has allowed astronomers during parts of May to see 6 planets all lined up in a row in the morning sky.

Compared to that, my topic today is just coincidence.

But it IS the case that we “went live” as TRE Buyers on June 1, 2009. We had been lurking and studying for a couple of months before that, but today is the end of our second year of active trading on TRE.

As it happens, we bought our 500th auction today, which is a significant milestone for us.

And to continue the coincidence theme, this is our 100th TRE Observer post.

Two years is not a long time, really. But it’s a big part of the life of the Exchange.

The first auction we bought was #255, which will mean something to those who follow TRE activity.

And, as I write this (at 4:00 pm) we have bought as many auctions so far TODAY as we did in our first MONTH as an active Buyer.

In fact, one of the auctions we’ve bought today was bought from the Seller of our second auction. And today’s auction included one of the same Account Debtors as did that June 2009 auction.

This blog is in the process of analyzing various risks that deserve to be compensated in buying auctions on TRE and, as such, the current conversation inevitably tends toward the negative: concentrating on problems and difficulties. I don’t apologize for that: it’s reasonable and necessary.

But neither would I modify the words of the first TRE Observer post written on May 28, 2009:

“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.”

Many would have bet at that time that TRE wouldn’t still be around today. They would have been wrong.

Not only is TRE still around but there is another online invoice trading platform about to go live in the US; there is one that is live and growing in the UK; there is one just getting started in Sweden; and, there is one that is live in Germany.

What's that about the highest form of flattery?

Some of these markets might thrive. Some might fail. But my bet is that the idea is here to stay. And that the industry will ultimately adjust to it.

Next stop 1,000!

Wednesday, May 25, 2011

Appropriate Compensation # 4: Financial Statement Risk

The issue of the reliability of TRE Seller financial statements was brought up very early in the history of this blog.

Our post of June 23, 2009 concluded:

“All else equal, the lower the level of assurance that the Seller’s financial data is reliable, the higher the appropriate Buyer’s risk premium.”

In our discussion at that time we pointed out that the Reliability Task Force of the American Institute of CPAs, under the criteria of its March 2008 paper on the subject, would include unaudited, unreviewed, management-generated statements in the category of having “no assurance” of reliability.

On the other hand, we noted that “the fact that an accountant has not certified the accuracy of the data presented in a financial statement doesn’t mean that the data is not accurate”.

There’s nothing in that June 2009 post that, nearly two years later, I would change.

But we do now have two more years of actual experience analyzing the financial statements submitted by TRE Sellers. And that additional experience does allow us to make some more observations.

One interesting phenomenon is that the percentage of TRE Sellers providing audited financial statements has actually fallen over time. The percentage was not high in earlier days but today it is almost zero. In fact, very few Sellers now provide even reviewed statements.

One reason, I suspect, is that TRE doesn’t REQUIRE audited, reviewed or compiled statements. And if a Seller does not HAVE to spend the money on such statements, its cost of obtaining financing is reduced, perhaps significantly, by eliminating that expense.

That’s only true, of course, if the Buyers don’t require a higher risk premium to compensate for the lack of assurance that a third-party review would provide.

Having had feedback from some Buyers on this subject I think I can say that there is a segment of the Buyer population that is looking quite closely at the Seller financials and using that information as a key element in the decision to buy or not to buy.

On the other hand I think it is clear that there are many Buyers who do not spend any significant time analyzing Seller financials, presumably on the assumption that the Account Debtor is the more important element in the decision process.

[One clear indicator of that is the speed with which the auctions of some first-time Sellers are bought. It has been clear in many instances that the Buyer had no time between posting and purchase to examine the due diligence materials available.]

That is perilous not only for the Buyer but also, ultimately, for TRE.

If any element of risk is materially mispriced, sooner or later it will generate losses that have not been adequately anticipated. Those financial losses will generate loss of confidence, which might actually prove the bigger long-term threat.

Since there is a Buyer for nearly every TRE auction, including those offered by Sellers whose financials some would find unacceptable or lacking in credibility, we have to conclude that Buyers who are NOT guided by the analysis of Seller financial capacity are probably setting the marginal pricing levels.

If there are Buyers willing to bid without giving effect to the financials then the Buyers who DO take the financials into account are faced with a binary decision.

They are either willing to buy or are not willing to buy based on their view of Seller capacity.

It is not yet possible, in my opinion, to implement an incremental pricing strategy that might, for instance, require an additional 50 basis points of monthly discount to compensate for a relative lack of confidence in one Seller’s financial statements versus those of another Seller.

Anyone who has analyzed the financial statements of TRE Sellers, which are largely privately-owned small to mid-sized firms, will have encountered some systemic issues that arise from the nature of that business structure. The accounting for owners’ contributions and distributions, for example will tend to penalize liquidity ratios and distort equity accounts. The desire to minimize taxable income, sometimes at the expense of a true picture of profitability, is also frequently apparent.

And management-generated statements for companies whose management doesn’t devote much attention to such matters can produce results that might charitably be termed idiosyncratic.

One of the most interesting phenomena is the change in statements over time by Sellers who are forced to actually produce and provide statements on a quarterly basis in order to remain in compliance with their agreements with TRE. I’ve noticed a number of cases in which it’s clear that increased attention produces improved product over time. Messy “legacy” issues on the books are cleaned up. Items are reclassified to more appropriately reflect the character of insider obligations. And so forth.

But the overall conclusion remains the same, in my opinion. There is meaningful, if not directly measurable, risk that the financial statements of the TRE Seller community, as a whole, would be found wanting if audited.

Given the obligation of Sellers to repurchase invoices not paid by Account Debtors that financial statement risk should command a pricing response.

Wednesday, May 18, 2011

Appropriate Compensation #3

In our last post we suggested, with a number of caveats, that a reasonable full-cycle credit loss assumption for the traditional factoring business might average something in the range of 10% to 12.5% of gross revenues.

Two of the critical caveats were that :

1) actual experience would vary substantially over the course of the credit cycle, and

2) different customer segments of the factoring industry faced widely varying levels of probable loss: for instance, loss experience in staffing and transportation might differ significantly from loss expectation in manufacturing and construction-related industries.

It’s been interesting that my invitation for comments or differing opinions on a baseline loss level has elicited little response. Readers of this blog have become more and more willing to venture opinions, especially contrary opinions, over the course of its history. No response received proposed a specific adjustment to the suggested range.

I don’t know whether to interpret the relative silence as tacit agreement that it’s just a tough subject to document; or that the conclusion seems to be about right; or that it’s just not worth a response.

But I’m going to assume for the moment that it strikes readers as at least in the ballpark. And I’ll go on with the exercise.

Having ventured an opinion on a baseline, it is now time to move to discussion of issues specific to TRE that would cause a loss estimate specific to TRE to vary from the baseline. There are a number of these but we have to acknowledge that it is going to be impossible to attach an incremental risk measure to individual issues.

The best we are going to be able to do is to lay out the issues, consider the risk implications of each independently, and then try to assess and quantify the risk impact of all the issues as a single adjustment.

Neither our individual assessments nor any overall suggestion of differential risk is going to be defensible on the basis of hard data.

I cannot propose any way to reliably quantify the incremental risk of assessing Seller suitability on the basis of management-generated financial statements vs independently reviewed statements or audited statements, for example. But I doubt that anyone would argue that unaudited statements should be given the same level of credence as audited ones. There is SOME incremental risk, no matter how difficult it might be to quantify.

With all that said, it is still appropriate for each Buyer to CONSIDER both the baseline level of risk in the business of purchasing receivables AND the incremental risks attributable to the TRE process.

It’s also only fair to add that there are some elements of the TRE process that might act to REDUCE risk, at least as compared to certain invoice purchasing models, and that those need to be considered and provided for as well.

So this process will involve identifying and discussing a number of individual issues over a series of posts and then a discussion of and suggestion for quantifying an adjustment factor for application to TRE transactions.

Since I’ve used the financial statement issue as an example I'll address that one in the first post of the series.

I invite any reader with either information or thoughts on the relative risks of relying on management-generated financial statements versus compiled, reviewed or audited statements, to share that information either publicly or privately with the understanding that I will respect all requests for confidentiality.

Wednesday, May 11, 2011

Appropriate Compensation # 2

It has been about six weeks since I wrote the first post in what is intended to be a series on the issue of “appropriate compensation” for the risk of loss faced by TRE Buyers.

I acknowledged at the time that this would not be an easy or straightforward task. And that has proven to be an understatement.

In attempting to establish a credit loss benchmark for the factoring business as a whole there are a number of difficulties that have to be acknowledged. Among them are:

 The industry is highly fragmented and relatively few of its participants are public companies with public reporting requirements.

 For most of the public companies that do engage in factoring activities, those activities are a relatively minor part of their overall business and their financial statements do not disaggregate results in a way that allows the isolation of factoring income and expenses. [Note: New FASB reporting standards will apparently allow factoring results to remain unclear due to the exclusion related to carrying values and the duration exemption.]

 The information that IS available on an industry-wide basis does not allow the isolation of credit loss figures that are mitigated by the employment of credit insurance.

 Disaggregated loss experience that IS available makes it clear that there are some segments of the factoring market that tend to generate much higher losses than average and some that generate much lower losses than average. This is the case both in terms of size of business and industry segment.

 Available information supports the intuitively reasonable notion that losses are cyclical with the change in overall economic conditions. So the most recent periods provide loss experience that is probably at the top end of a reasonable longer-term benchmark.

 Available information is not reported in a uniform manner: some reports measure losses as a percentage of income; some measure them as a percentage of average receivables owned; some report as a percentage of total receivables purchased; and some report as a percentage of average net funds employed.

Presentation of a full analysis of the data I’ve gathered and studied is beyond the scope of this post. And I could not present it here in a way that is fully documented in any case.

What I CAN do is to say that I’ve spent a reasonable amount of time on this question and gathered and analyzed what information I have been able to find in a pretty diligent search.

I can also say that, no matter what difficulties there might be in quantifying the risk numbers, it is appropriate to actively ATTEMPT to quantify them and to consciously incorporate a risk premium into the pricing of all factoring transactions, including those that occur via TRE.

So I’ll share with you what I think is reasonable, without suggesting that the research and analysis is actually robust enough to withstand a rigorous technical challenge.

There are undoubtedly others whose databases are better than mine. And there are certainly others whose primary activity is analyzing such data, while mine is not. And I invite anyone to provide alternate or additional information, either publicly or privately.

And finally, these figures are not those that I would suggest are appropriate for TRE transactions. These are meant as a starting point; a baseline for the typical factoring business BEFORE adjusting for the specific TRE approach to the business.

So, with all of that as preface, these are my suggestions at this point:

1. The nature of the TRE transaction requires that whatever adjustment for risk is chosen, it needs to be applied in the pricing of each transaction. There isn’t really a portfolio-level adjustment mechanism when you’re operating in a spot-factoring auction market.

2. I think the most useful way to state and to adjust for loss expectation for our purposes is on the basis of a percentage of gross revenue. I think that allows the most straightforward means of adjusting pricing parameters at the level of an individual transaction.

3. It is necessary to decide whether to choose a single loss expectation figure based on an assumption about a full credit cycle and a typical transaction. This would be in the nature of a fixed reserve allowance against which actual losses would be charged as incurred. It would presumably be higher than actual losses during relatively good times and lower during relatively bad times.

4. If the single reserve figure does not appear appropriate, then a range of loss expectations over the course of a credit cycle might be established, and at any point in time the actual allowance assumed would reflect the current state of the credit markets.

5. It is also necessary to decide whether to choose a single loss expectation figure for all transactions or to vary the allowance based on the character of the transaction. One level of adjustment might, for instance, be based on industry e.g. adopting a different allowance for staffing industry transactions vs manufacturing industry transactions or transportation industry transactions.

6. These are relatively “high level” adjustments, of course. Specific underwriting criteria and other matters affecting risk would also obviously need to be reflected in the pricing.

7. Based on the data I’ve seen it appears to me that a baseline risk adjustment that reflects the “typical” factoring transaction would range over the course of a credit cycle from somewhere in the mid single digits; say 5% of gross income; to a level much higher than that when we’re in the worst phase of a contraction; say 25% of gross income (or even more in some recent cases).

8. It appears that, over the course of a cycle, there are generally more years with experience towards the lower end of the range than at the peak of contraction. So, if we were to pick an average to use over the cycle, it would probably fall below the mid-point of the range.

9. It seems to me that an average credit loss allowance in the range of 10% to 12.5% of gross income in typical factoring transactions, over the course of a credit cycle, is not unreasonable.

This series of posts will continue with discussions of the differences between the “typical” factoring transactions and TRE transactions, focusing on the distinctions between the two that affect risk and loss expectations.

To make the point again: I welcome any comments on this issue and especially any data that might help make the analysis more robust.

Sunday, April 24, 2011

A Brief Digression

I had intended by now to post at least two additional pieces on the issue of appropriate compensation for risk in TRE transactions. But it’s been a busy month and I’m still in the process of gathering data and thinking through the analysis. I’ll get back to that important topic soon.

However, I had a conversation a couple of weeks ago that brings up an unrelated but, I think, interesting subject. So if you’ll permit me a brief digression…..

The conversation was with a prominent member of the traditional factoring community. He said that it was his opinion that a company whose only business was buying receivables via TRE was not in the factoring business. Rather, in his view, it was in the investment business.

Now, as I’ve written, my associates and I formed a new company last year whose sole occupation is buying receivables via TRE. So this is an issue of more than a little interest to me.

Having spent my entire business career in various investment businesses I could hardly take offense at being termed an investor. On the other hand, the implication in this case was negative: that there is something important lacking in the TRE Buyer that excludes him from being recognized as a part of the factoring community.

Putting aside for the moment the question of what that says about the relationship between the traditional factoring community and TRE, the topic is, in itself, an interesting one to consider.

Is a TRE Buyer in the factoring business?

A standard dictionary of business law provides the following definition of factoring (with a useful reference to a ‘factor company’):

“Factoring is a form of financing in which a business sells its receivables to a third party or ‘factor company’ at a discounted price. Under this arrangement, a factor company agrees to provide financing and other services to the selling business in return for interest and fees on the money that they advanced against the seller's accounts receivables.”

It is clear that a TRE Buyer DOES: a) buy the receivables of a business, b) at a discounted price, c) in return for fees on the money advanced.

That much of the definition cannot be argued. What, then, is lacking or could be said to be lacking?

The only thing that appears to me to be open to question is PROCESS.

The standard definition cites “other services” and it is (at least arguably) implied that the connection between the selling business and the ‘factor company’ is direct.

In the case of the TRE Buyer the provision of “other services”, such as collection of payments, accounting for and distribution of funds etc. is performed by a paid intermediary i.e. the Exchange.

It is also true that the Exchange, not the Buyer, establishes and maintains the direct relationship with the Seller and that it provides the Buyer with certain due diligence materials that the Buyer may use in its decision making.

I think that it is beyond question that a factoring transaction occurs when a business that is a TRE Seller sells invoices via the Exchange to a TRE Buyer. (Certainly the law of the State of Louisiana recognizes such a transaction as factoring.) It is the structure and process of the TRE factoring transaction that is unique.

But the uniqueness of the structure doesn’t, in my view, change the character of the transaction.

The person with whom I spoke on this subject actually argued that neither TRE nor the TRE Buyer was in the factoring business. But if a factoring transaction is taking place, surely SOMEONE has to be playing the role of “factor”.

Now, it might be argued that the sum of the parts equals “factoring” but none of the parts equals “factor”. I think that argument is hard to support.

Let’s walk through the functions and responsibilities.

TRE does the marketing. It finds the Sellers. TRE qualifies the Sellers in accordance with criteria agreed upon with the Buyers and it provides the Buyers a set of due diligence materials that the Buyers can analyze in their decision making.

TRE manages the process of packaging the Sellers’ invoices for sale, offering the packages to the Buyers, determining when sale criteria have been met, “closing” and funding the sale. It provides the accounting of the sale to both parties. It receives payments from account debtors, accounts for them and distributes them. It is responsible for the process of verifying invoices, for following up on payments and for certain defined matters in the event of payment defaults.

All of these are clearly important parts of the process.

What does the Buyer do?

First, the Buyer must decide to invest money in the purchase of accounts receivable. I don’t hesitate to use the term “invest”. Every factoring company is investing in the purchase of accounts receivable regardless of any fine distinction of language one might desire to make.

Having made the decision to invest in purchasing accounts receivable it is the Buyer’s responsibility to decide on certain portfolio-level matters, for instance: how much to invest, what concentration and diversification rules should be used, how will the due diligence materials provided by TRE be analyzed and evaluated, what due diligence activities and materials should be considered in addition to those provided by TRE, what Seller-experience criteria must be met prior to considering a purchase from that Seller and what account debtor experience criteria must be met before considering a purchase of that debtor’s invoices.

On the basis of those considerations, the Buyer must decide which Sellers to buy from, which account debtors’ invoices to buy and what pricing level is acceptable.

The unique additional responsibility of the TRE Buyer is that it must act in the arena of real-time competitive auction, which requires a discipline, an approach to decision making and a flexibility and sensitivity to changing real-time conditions that are not required of the traditional factoring company.

So, given that factoring transactions ARE unquestionably taking place, what can we say about the separation of functions in the TRE process: the division of responsibilities between the Exchange and the Buyers?

Well, I’ll tell you what I’d say.

In a nutshell, the TRE Buyer exercises the executive functions in the process while the Exchange is responsible for the technical functions.

Portfolio-level decisions are the Buyer’s. Risk management decisions are the Buyer’s. Seller acceptance and account debtor acceptance decisions are the Buyer’s. Pricing decisions are the Buyer’s.

If we were looking at a hypothetical factoring company office, the Buyer would occupy the CEO’s office on the top floor. The Buyer performs the CEO function.

The marketing, research, accounting and treasury offices are all down further in the building. They support and report to the CEO and any one of them can be outsourced and purchased on a pay-for-service basis.

And that’s precisely what TRE is: a multi-function, outsourced back-office combined with a unique transaction facilitation process.

Where is the ‘factoring company'?

I’d suggest that both the Buyer and TRE are in the factoring business but if I had to identify one ‘factoring company’ I think the typical analysis of a business structure suggests that the executive function, the locus of ultimate decision making, defines the business.

I spent many years in the real estate investment business. It frequently happened that a deal was brought to us by a broker. The broker typically provided a substantial amount of analytic material, had the direct relationship with the seller and acted as intermediary in the negotiation. After a property was purchased, its day-to-day operations were outsourced to independent property management and leasing companies.

Was I in the “real estate business”? None would argue.

With respect to those holding differing opinions in this case I would say: OF COURSE a company that buys receivables via TRE is in the factoring business. It’s disingenuous to argue otherwise.

That doesn’t mean that all TRE Buyers are GOOD at it. And it doesn’t mean that they actually DO perform all of the functions I’ve cited above.

I didn’t say that every TRE Buyer actually DOES all of those things. I said they were RESPONSIBLE for them.

If they avoid their responsibilities, make bad decisions, lose money, get mad, take their marbles and go home…..well they will have done what many in the traditional factoring business have done.

They will have failed.

But neither their failure nor their success will change the character of the business they were in.

Monday, March 28, 2011

Appropriate Compensation #1

For a few weeks in February and early March there was just a hint of a Buyers’ strike in the TRE auction dynamic. Many more auctions stayed open for hours or even days. Fewer buy-out bids were made. More Sellers adjusted pricing upward to close deals.

That hasn’t completely ended. We’re still seeing some egregious over-reaching by some Sellers and some push-back against that by Buyers.

One relatively new Seller this past week wound up agreeing to terms roughly double its initially-posted buy-out level. That says more about the unrealistic ask-price than the final auction terms, though.

The average returns to Buyers during March have fallen back from their brief February rise and it’s possible that we’ll close the month with new lows in average market-wide returns.

It’s not fair to say that TRE auctions are “priced for perfection”. They’re not.

But it IS fair, I think, to ask whether they are priced appropriately in light of the risk assumed by the Buyers.

So this is the first in a series of posts examining the question of what might be an appropriate level of compensation for risk in TRE auctions.

I think it’s useful at the start of this conversation to acknowledge that it can be perilous to try to analyze ANYTHING at the level of an entire market or to use market-wide averages as benchmarks. Compensation for risk is only one component of the total return required by investors, whether they are Buyers on TRE or involved in any other investment activity.

Cost of money, cost of operations, applicable taxation levels and an appropriate net profit also have to be considered.

If we were to look at the traditional factoring community we’d find that these individual variables tend towards a common level reflecting the similarities among the participants in a well-established industry. That would be true in any mature segment of the investment community. The economics of participants in a mature market tend to be shaped by the market over time and to converge around parameters that reflect the investment characteristics of that market.

That is not currently the case when we look at the TRE Buyer community. It is nowhere near as homogeneous a group as is the traditional factoring community or the community of firms that specialize in any other mature investment market.

In fact, the TRE Buyer community is an extremely diverse group. My guess is that there are substantial differences within the group in very basic characteristics like cost of funds and cost of operations.

And the motivations of the TRE Buyer community, as reflected in the determination of what might be an “appropriate” level of profit, are just as diverse.

Some might be simply looking for a place to “park” short-term funds at an expected rate better than the near-zero current money market returns. Their TRE activity is a side-line, at best; maybe even a short term experiment.

There are other Buyers, though, that are looking at TRE as potentially a primary business; one that has to both cover reasonable costs and generate reasonable profits.

So the total returns considered adequate by TRE Buyers will probably fall in a wider range than would the returns of either a fairly homogeneous industry or of a well-established asset class. TRE really represents neither of those at this point.

On the other hand, TRE DOES represent a closed system when the question of assessment of investment risk is concerned. All who choose to participate in the TRE market assume the risk that the market presents. They will react to that risk in different ways: i.e. via diversification rules, Seller-quality rules, auction-characteristic rules, etc. But they are nevertheless participating in a market that has some common risk parameters.

Our ability to define those parameters is limited by experience. TRE presents a new approach to its market and its history is short.

But some experiences external to TRE can be used with value to analyze risks that are specific to TRE. Because of the relative lack of experience with and information about TRE-specific risks I think we actually HAVE TO look outside of the limited experience of TRE itself if we are to have a meaningful discussion.

In some cases we’ll be able to offer quantitative data drawn from other sources and markets. In many we’ll only be able to suggest relative measures: e.g. that a certain TRE-specific risk is likely more than or less than that of an alternative.

But even if we can’t offer actual quantitative measures, it is still useful to consider a particular source of risk and to ask in some disciplined way whether the risk facing a TRE Buyer is likely to be greater than or less than that faced by participants in other markets that present similar challenges.

I don’t know yet how many posts this subject will occupy but I suspect it will be several; maybe half a dozen. So there’s plenty of opportunity for readers to help shape the conversation.

I welcome any suggestions of issues that should be examined in this conversation. And I’d be delighted to receive any information, especially good data, that anyone might be willing to share.

One of the things we’ll need to address, for instance, in establishing a relative benchmark, is the loss experience of the traditional factoring and receivables-finance markets. Some data on that is public, of course, but any good information that might be shared on that or any other relevant issue would be much appreciated.

We have to acknowledge at the beginning of this exercise that its primary value might be in the exercise itself as opposed to the conclusions. But that’s OK, too.

We’ll take value where we can find it.