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.

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