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.

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