Sunday, February 27, 2011

Alignment of Interests

For nearly two years now I have spent a significant part of every working day (and of many non-working days, for that matter) somehow engaged in the activity of The Receivables Exchange.

Over the course of that time I have bought nearly 400 TRE auctions; analyzed the financial condition of hundreds of TRE Sellers and their customers; had some success; made some mistakes; and thought quite a bit about what makes TRE “tick”.

And over the course of that time I’ve seen TRE make many changes in its operating practices, responding to perceived opportunities to improve on its original business model. Most of those changes have been, I think, responsive to understandable issues or concerns, and most have been motivated by a quest to add value to the benefit of all involved in the Exchange.

Ultimately, for TRE to succeed, the interests of Seller Members, Buyer Members and the Exchange itself, must be served. All three business models have to work if the Exchange is to achieve its long-term goals.

It is with that in mind that I’d like to offer a suggestion, as one with a substantial interest in the success of the Exchange.

I believe that the fee structure of TRE could be modified, in two fairly straightforward ways, to better align the interests of the parties. And, at the same time, to provide an opportunity for both increased Seller volume and increased Buyer appetite.

The basis of my suggestion is:

FIRST: the fact that Buyer and Seller interests are (primarily) reflected in distinctly different Exchange functions.

1. The primary interest of the Seller is met at the time its auctions are sold and funded, but

2. The primary interest of the Buyer is met when an auction is repaid in accordance with auction terms, and

SECOND: the fact that all three parties have a common interest in the length of time between the sale and the repayment of an auction.

It is not necessary to this discussion that we refer to the actual LEVEL of fees charged to Buyers and Sellers by TRE. It is sufficient to discuss the STRUCTURE of the fees.

The fee charged a TRE Seller, with respect to a specific auction, is (with minor exception)a function of the size of the auction. And it is earned and payable when an auction is sold.

In principle, there is little to quarrel about there. If the Seller’s primary interest in selling an auction is met in the sale and funding process, then it makes sense that that process should provide both the nexus and the basis of fee payment.

The Buyer's fee structure, however, has two components:
a) a fixed charge payable at the time of purchase and based on auction size, and
b) a variable charge payable with each remittance received, based on the Buyer’s earnings.

It could be argued that the Buyer’s primary interest has two components: the opportunity to deploy funds and the opportunity to have its capital returned with agreed-upon earnings. Under that logic, the two-part fee structure might appear reasonable.

In fact, however, there would be no desire to deploy funds without the expectation of their return. The ESSENTIAL interest of the Buyer is not in buying: it is in earning. And that essential interest is not met until an auction is closed-out.

The current TRE fee structure aligns the interests of the Exchange with those of the Seller to a greater degree that it does to the interests of the Buyer.

An equally-aligned fee structure would eliminate the fixed, size-determined portion of the Buyer's fee and provide for fee payments to TRE as and when Buyers are paid. Such a fully-variable fee might well be at a higher rate than that of the current variable portion of the Buyers’ fee. My issue here is STRUCTURE, not rate.

I can well understand how the current Buyer fee structure was conceived but, at the same time, I think it’s hard to argue with the logic that the Seller’s basic need is met at the time of sale and the Buyer’s basic need is met when an auction is closed-out.

Aligning the fees to the time when those basic needs are met has a clarity and simplicity that I find compelling.

My second suggestion, which I believe would be in the interest of all parties, is also simple in concept if perhaps a little more difficult in implementation.

It arises from the issue of duration, which I’ve written about in several prior posts. In those prior posts my point has been that the fixed portion of the Buyer fee structure disadvantages short-duration auctions. Obviously, a fixed fee based on size will dilute the Buyer’s yield on an auction that is only open for 10 days to a much greater degree than it will on an auction open for 60 days.

If the fixed portion of the Buyer’s fee is eliminated, as I suggest, this problem goes away for the Buyer. However, since the fees to the Seller are payable without respect to duration, the actual cost of funds to the Seller rises as the duration decreases.

Currently, the return to the Buyer on short-duration auctions is squeezed by the fixed fee and the cost to the Seller in a short duration auction is substantially magnified.

As matters stand, I will almost never bid on an auction when the invoices included are due in 14 days or less. (That’s not iron-clad, of course. The LIKELY payment velocity is more important than the stated due date. But the principle is the same.)

If I won’t buy the short duration auctions, I suspect that there are others who act in the same way. The counter-argument will probably be: “But those auctions DO get sold!”

Agreed! There are clearly Buyers willing to pay up for paper that might roll over every 10 days.

But that’s not really the point!

All parties in this adventure need overall TRE volume to INCREASE.

The fact that there are a few Sellers that routinely succeed in selling short-term invoices and that find a way to rationalize the all-in cost of those funds, obscures the real question, which is: how many more Sellers, whose invoices are relatively short-term, might be attracted to TRE if the short-term nature of their invoices was reflected in the fee structure?

I don’t know the answer to that question. And I recognize that incorporating a variable element in the Seller fee structure would require solving a few complicating issues.

But consider the difference between the annualized fee costs of two Sellers, both of which pay the same size-based fee for selling an auction, one of which is selling invoices with an average life of 10 days and the other selling invoices with an average life of 60 days.

I cannot believe that more Sellers of short-term invoices would not be attracted to TRE if it made a fee accommodation for the shorter-term paper. Such an accommodation might be accomplished simply by providing a fee credit for payments received earlier than a specified number of days.

And I cannot believe that more Buyers would be not willing to consider shorter-term paper if the returns were not so diminished by the fixed fee element.

Fee structure is fundamental to the TRE business model and no consideration of a change so fundamental will be easy. But we’re in the third year of actual TRE operations and we’re in a rather prolonged period of flattish volume.

At this point I believe that all elements of the business model have to be open to further analysis.

The question of fee structure should not be ignored.

Wednesday, February 16, 2011

More Evidence of a Turn

In my last post I reported that there was evidence in the bidding dynamic that TRE auction pricing levels were stabilizing. An excess of liquidity in the market had helped push Buyers' yields down substantially and consistently since last September.

But there was evidence at the end of January that the deterioration in yields might be ending. At mid-February that evidence is stronger.

By our calculations the weighted average expected returns for all auctions sold in the first half of February was essentially the same as that for all auctions sold in January. The deterioration in yields, at least in the short term, had ended.

That doesn't mean things can't change rapidly; but to add a few data points to the conclusion suggested by market-wide averages, let me offer the following:

1. The stabilization in yields has occurred on LOWER volume. Now, nobody can be too pleased with lower volume, but if yields stabilize on lower volume it suggests that the demand has decreased at a rate greater than supply. So some of the enthusiasm of the new Buyers in December and January might have been dampened as they came to realize just how low they had pushed returns.

2. The velocity of closings has slowed substantially. Auctions are remaining on the screen for hours or days, in some cases, rather than seconds.

3. Bidding has returned to the auction dynamic. More and more auctions are starting at higher bids and attracting competing offers before closing.

4. Some auctions are again being sold to multiple Buyers, suggesting the deeper-pocket Buyers are not quite as driven to hit the buy-out button on larger transactions.

5. Asking prices are starting to creep back up from their rock-bottom levels of a few weeks ago. This is not a uniform phenomenon but we're seeing it from some of the Sellers that had really tested the lower-limits of pricing structure.

6. One Seller who sold at prices at the lowest end of the spectrum just a few weeks ago, sold three auctions today at projected yields more than double those of its average January transactions.

Let me stress again that all it would take for these initial indications of a firming, and perhaps a turning, in the market would be for money-flow to resume its rise at a rate greater than supply.

That could easily happen tomorrow.

But today, and for the first half of the month, it seems possible that the bottom in yields has been found, at least for the time being.

And that feels good.

Sunday, February 6, 2011

Push Back and Protest Bids

Before I get to the point of this post I’d like to introduce our new web site:

1150 Investments LLC was formed in 4Q 2010 to carry on and expand the TRE buying activity of The Interface Financial Group, LLC.

I invite any members of the TRE “family” to link to our site, which also contains a link to this blog.

Now to the point:

I’ve written several times since last September about the impact of increased liquidity on buy-side TRE auction yields. The trajectory of buy-side yields has been steeply negative since the last week of August 2010.

We’ve wondered when and at what level resistance might ultimately be encountered.

It appears that the answer to “When?” might now be developing.

Just as it took some time to confirm that the downward trajectory constituted a trend, it will take some time to confirm that the situation has changed again. But it IS beginning to look like we might have reached a point where stability is being sought.

That doesn’t say that returns to Buyers are rising but it MIGHT signal that they’ve stopped falling.

Over the past week or so we’ve begun to see some auctions stay on the screen for appreciably longer periods than has been the case for some time now. Many of those have ultimately sold at buy-out pricing but they haven’t sold as QUICKLY at that pricing as they might have a month ago.

Even some of the Sellers that have become accustomed to split-second sales at ever-decreasing cost have gotten some modestly chilly receptions recently.

Buyers of these auctions, while still willing to buy, have begun to place bids more often at levels higher than the buy-out prices. More often now we’re seeing several competing bidders “walking” the pricing down to the point of ultimate sale.

As to the questions of: “Where?” the trend might end, I can’t use absolute numbers under the confidentiality rules of the Exchange but I can say that our own calculations of dollar-weighted average returns for all TRE auctions have fallen by about 38% since September 2010. That’s a substantial reduction that cannot, in my opinion, be attributed (at least wholly) to decreased risk perception.

While there are quite a few Sellers that have proven themselves over that period and should reasonably command better pricing; when the entire auction portfolio is considered, a large part of the return decline, I believe, has to be attributed to increased market liquidity in the face of only modestly increasing supply.

If that is true, then there should be scope for a retracement of at least a portion of the yield declines of the past 5 months. IF and when, of course, supply begins to catch up with demand.

The type of bidding that I’ve described above, that requires a Seller to wait a while before closing a transaction and involves a process where actual BIDDING occurs, as opposed to immediate buy-outs, I call “push-back” bidding. Especially in the face of declining buy-out parameters.

The Buyers are not inclined to immediately accept whatever is offered at whatever price is asked.

But there’s another type of bidding that has also become evident in recent days. I call it “protest” bidding.

Protest bids have been showing up recently in cases where Sellers post auctions with pricing that is SO low that some Buyers express their annoyance by registering a bid SO far out of the money that it can only be interpreted as a message to the Seller.

The message is “WHAT are you thinking!” (Or, maybe “What are you smoking!”) And certainly conveys the message “Not ME, my friend!”

I must say that I find these protest bids refreshing. They are really the only way Buyers can communicate to Sellers, to other Buyers and to TRE that what they see on the screen is beyond what they consider rational.

SO……while it’s too early to call a trend change, there ARE some signs in the market that we might be nearing the end of the free-fall in yields that began last September.

From my point of view, that would be healthy for all concerned.