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.

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