Friday, June 10, 2011

Appropriate Compensation # 5: It's Still Not Personal

In our post of June 22, 2009, entitled “Liability: It’s Not Personal” we discussed the fact that TRE Sellers are not required to provide the personal guarantee of their owner(s) as additional security for the performance of their responsibilities to TRE and its Buyers.

In that post we made a general statement:

Most firms that buy individual invoices routinely obtain a personal guarantee of the seller’s obligations from one or more individuals associated with the seller.”

As we revisit that topic in this series on the issue of appropriate pricing of risk I think it’s time to firm up that earlier generality.

I’ll draw on two current sources for data relating to the prevalence of personal guarantee requirements:

1) the semi-annual report of the “Pepperdine Private Capital Markets Project” for summer 2011 by Dr. John Paglia of Pepperdine University (PPCM), and

2) the “Annual Asset-Based Lending and Factoring Survey Highlights, 2010” (April 27, 2011) of The Commercial Finance Association, (CFA).

The PPCM data is collected from a broader cross-section of the market that the CFA data and the CFA data is published publicly in “highlight” rather than detailed form but, for our purposes, those differences are not really critical. In fact the results of the two fit together quite reasonably.

According to PPCM data, the requirement for a personal guarantee in asset-based lending transactions varies substantially and as a function of the size of the loan. The smaller the loan the more likely is the requirement for a personal guarantee.

For loans under $1 million the median response revealed a 100% requirement for a guarantee. That figure falls to 90% as loan size increases to $5 million and 80% as it increases to $10 million. At a $50 million loan size, no personal guarantee requirements are reported.

PPCM survey responses from those in the factoring business are not given in such detail. PPCM reports that 87.5% of factoring industry respondents require personal guarantees while 12.5% do not. I think it’s reasonable to assume that the size of transactions and relationships is also a substantial variable in this sample and that the 12.5% of the deals done without personal guarantees would be found at the larger end of the size distribution.

So, as a general conclusion, PPCM suggests that the smaller transactions; presumably involving the smaller businesses; have a very high incidence of personal guarantee requirement; whether the transaction is an asset-based loan or a factoring arrangement.

The CFA survey draws data from a smaller, more-targeted sample of firms. In its own words it “decided to base the industry surveys on data reported by almost 40 of the largest asset-based lenders and factors…”

The “highlights” version of the CFA report does not provide data on the requirement of personal guarantees by asset-based lenders but it does provide that data for the respondents in the factoring survey.

In the CFA sample only 31% of respondents reported requiring full or partial “recourse”: a portion of which presumably includes personal guarantee requirements. While this might seem at odds with the PPCM data, it is not necessarily.

The CFA data is drawn specifically from the largest providers of funds. Presumably the largest transactions would be heavily represented among the largest funding providers. And, as we saw in the PPCM data, as deal size increases the requirement for personal guarantees decreases.

These two current reflections of the market for both asset-based and factoring transactions strongly suggest that personal guarantees are required as a matter of course in at least most of the smaller transactions in both the asset-based lending and factoring markets.

The issue of what is “small” is not as clear in the CFA data as it is in PPCM, but I think we would be justified in concluding that most, if not all, of the transactions that trade on TRE would; if they were made in the conventional marketplace; be subject to personal guarantee requirements.

One of the marketing points that TRE makes to prospective Sellers is that personal guarantees are NOT required, which is itself a statement about the otherwise general prevalence of the guarantees.

The “value” of those guarantees is not readily calculated – at least not with data that I have available. My own experience dealing principally with small sellers is that personal guarantees are of greater value in curing defaults than are “all asset liens” and certainly more valuable than “specific asset liens”.

In fact, given the length of time required to litigate a claim, obtain a judgment and then actually execute on a judgment it’s often the case that there’s nothing to be gotten from what remains of a business by the time a judgment creditor can actually try to seize anything.

On the other hand, the owners of businesses against which judgments have been secured, often have personal assets that really CAN satisfy claims. But if they haven’t provided a guarantee, the creditor has little effective means of reaching those assets.

This is another one of those cases where quantifying the value of a risk parameter is a difficult task if we’re looking for real analytical rigor. But I suspect we’d find broad agreement in the industry with the assertion that the premium required to compensate for the lack of guarantees should be “significant”.

What “significant” means, I think, has to be considered as a part of an overall evaluation of a transaction or relationship and I suspect that it changes with respect to a client over time and with experience.

But this is certainly an important item on our list of issues deserving a pricing increment in (at least) most TRE transactions.

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