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.

Wednesday, March 16, 2011

Further on Alignment of Interests

In my last post I suggested that TRE modify its fee structure to eliminate distortions caused by the fixed component of the Buy-side Exchange fees. Those distortions are magnified in auctions with relatively short durations.

One auction in this week’s market activity caused me to look back at the question of distortions from a different point of view.

On Monday afternoon, a fairly seasoned TRE Seller posted an auction with pricing parameters that set a new record. The buy-out advance requested was higher than any in my memory and the buy-out monthly fee offered was the lowest in my memory.

The Seller is solid, but not gold-plated. The Debtor has an unquestioned capacity to pay and its performance in prior auctions appears to have been fine. I have bought an auction from this Seller, involving invoices due from this Debtor, and was quite satisfied with the result.

So the deal deserved a good price.

But the pricing requested in this transaction would have returned to the Buyer something closer to a CD rate than a return typically associated with receivables financing.

My first reaction was: What are they thinking?

My second was: Let’s try to actually understand what they’re thinking.

I have to admit that I have a Buy-side bias when it comes to analyzing auctions. I spend a lot of time on the subject of return to the Buyers. I really haven’t spent much time working on the cost of funds from the Seller’s point of view.

But the only way to answer the question: “What are they thinking?” is to look at the transaction from the “other side”.

I’m not going to say much about the TRE sell-side fee structure except to say that the basis of the fee is essentially the size of the auction and that the rate charged is variable depending on certain Seller characteristics. For my purposes I’m going to assume that the Seller in this case enjoys a rate at the low end of the range.

The auction under study has a probable duration that can be readily estimated. There has been a reasonable amount of past activity and actual payment experience has been quite consistent.

If we know the auction size and its pricing parameters, the duration is really the only remaining variable in the return calculation. So this particular example is a good one to use from that perspective.

It really is quite surprising how the view of the transaction changes, depending on one’s perspective!

I looked at two cases:

1) the initial buy-out pricing parameters, and

2) the actual final sale pricing parameters.

And I looked at the projected return to the Buyer in both cases and then the projected cost of money to the Seller in both cases.

Case 1: Using the initial buy-out pricing parameters, the net annualized yield to the Buyer would have been in the very low single digit range. But the net annualized cost of funds to the Seller would have been about 5 times that level!

The cost of funds would still have presented an extraordinarily attractive deal for the Seller, however --in the mid single-digits on a net annualized basis -- so there’s no mystery why the Buyers weren’t willing to play.

The point is that the gap between the return to Buyer and the cost to Seller, which is clearly a function of the fees earned by the Exchange, is a hugely distorting factor when pricing is extremely aggressive and duration is relatively short.

Case #2: Using the actual sale parameters, the distortion is much lower but it is still substantial. The return to the Buyer is just into the double-digit range while the cost to the Seller is in the high teens.

Now I don’t know how many Sellers look at their cost of funds in the same way that I have looked at it. But in this instance, while I would have been unwilling as a Buyer to accept the return generated by the deal; if I were in the Seller’s shoes I would probably have thought I was paying a pretty fair price for the money.

There’s the rub.

At this stage in its life TRE has a fairly small transaction base on which to generate fees. It’s clear that fees alone can’t cover its current expenses. It will need to grow by a significant amount to reach that point, I suspect.

On the other hand, given the need to grow substantially, the question of the impact of fee structure on growth potential is a fair one to ask.

Having gone through this exercise I have a greater sensitivity to the position of the Seller.

But my sensitivity doesn’t change my estimation of appropriate return to Buyers’ capital one bit. And it won’t change my actions at all.

[Except that the language I use when I see what appears to be an irrational Seller pricing structure might be somewhat more moderate.]

Only TRE needs to be sensitive to BOTH sides of the auction transaction. Buyers are going to look to their own interests and Sellers to theirs. That's the nature of the market. But TRE has to understand and act to ensure that both sides find the net benefits fair.

Otherwise, the growth that we all need and want is at risk of failing to materialize.