Tuesday, July 19, 2011

Appropriate Compensation #8: Once Removed

If I were forced to take a test that measured knowledge of genealogical matters I would fail abysmally!

I could get as far as defining a first cousin but I have no sense at all of what a second cousin might be and if that second cousin were twice removed I would have to assume it was for some sort of repetitive misbehavior.

In the case of my relationship with a TRE Seller, however, the idea of being “removed” is easily understood. In fact, it’s contractual.

I am prevented by agreement from having direct contact with a TRE Seller except under very narrowly-defined circumstances.

TRE provides Buyers a defined set of minimum due-diligence materials describing the Seller. That set of materials can be supplemented at the option of the Seller (and perhaps at the suggestion of TRE) to clarify or expand upon issues that the standard documents suggest need elaboration.

Public records and credit evaluation services can be utilized to augment the data available to assess the Seller’s business and financial condition, of course, and there are services that can be used to periodically scan media and public records to pick up items relating to specified companies.

So, what’s missing and how does the missing element contribute to the incremental risk of trading on TRE?

The short answer is that the TRE Sellers are “removed” from the Buyers. The Buyers’ relationship to the Sellers is intermediated via TRE.

It is a TRE person who sits across the table from a prospective Seller and talks about the Seller’s business. It is a TRE person who visits the Seller’s place of business and gets a sense of condition and activity. It is a TRE person who examines the prospective Seller’s financial records. It is a TRE person who gets a “feel” for the type of people who own and run the prospective Seller. It is a TRE person who determines that the prospective Seller appears to be credible and trustworthy.

TRE, of course, assumes no liability for its investigations or judgments but if it proves to be off-the-mark too frequently its business and reputation will certainly be damaged.

Once a Seller is approved and posting auctions for sale on the TRE platform, a Buyer may ask questions about the details of due diligence materials and about specific auctions. Those questions are asked of TRE, of course, and it is TRE that calls the Seller and relays back whatever information, if any, the Seller might provide.

I don’t agree with those who argue that the lack of liability will make TRE careless of its responsibilities to carry out its tasks prudently. But it does have to be acknowledged that, especially in the early growth phase of the business, TRE has a substantial incentive to approve Sellers. Sellers are harder to come by than Buyers (at least for the time being) and good Sellers are likely to be given the benefit of the doubt wherever reasonably possible.

But the fact is that the Buyers are limited in their decision making process to analysis of the available information, none of which will typically give them a sense of the PEOPLE on the other side of a transaction. The Buyers have no opportunity to form an opinion of the HONESTY of the Seller.

Why is that important?

As we’ve discussed, most financial statements provided by Sellers are internally generated. Anyone who has worked with Quickbooks or similar bookkeeping software packages will know just how easy it is to create a “second draft” of the statements. And, by the time the statements are posted, they are dated in any event.

As we’ve discussed, the invoice verification process used by TRE is not designed in a way that is likely to catch invoices that are actually fraudulent until damage has already been done.

And, as we’ve discussed, the owners and principals of the Sellers have no personal liability to TRE or its Buyers in the event of default.

Those issues and others make the assessment of a Seller’s character and honesty a critical part of the decision to buy. But the Buyer can’t make that assessment. The Buyer has to depend on TRE to be clear-eyed and unmoved by the incentive to attract Sellers.

A recent factoring industry survey quoted a contributor as saying “every factor experiences fraud every year”. The need for due diligence that extends beyond the four corners of a page of financial data is obvious.

The TRE Buyer is once-removed from one of the most important assessments in the decision to do business with a Seller.

I know that TRE takes the job of assessing Seller honesty seriously, even if it is not actually liable for the judgments made. I know that there have been situations in which prospective Sellers have been denied TRE membership because of uncertainty about character and veracity. And I know that TRE has to take the long view in balancing the desire for growth in the Seller base against the risk to which Buyers are subjected.

But I also know that face-to-face assessments of the counter-party in a transaction can have a big impact on decisions.

I know that having the ability to pick up the phone and ask a Seller direct questions about auctions, Debtors, invoices, changes in financial condition, and so forth, in real time, would have significant value. But the TRE Buyer can’t do that.

Being once-removed; being isolated from the Seller; unquestionably adds risk to the TRE Buyer's activity.

It is another risk element that deserves to be compensated.


  1. Nicholas E. RadiceJuly 20, 2011 at 12:38 AM

    Great thinking, Mr. Lightner. These are substantial risks, and possibly one way to frame the appropriate pricing is by comparing other potential investments, or essentially the opportunity cost.

    Are these risks greater than standard equity risk? I believe that most people would say "yes", and demand a higher risk premium to buy on TRE than to make a stock market investment.

    Are these risks greater than venture capital risk? In buying invoices both individually and collectively, I would probably argue "no". It is difficult to pinpoint an exact venture capital risk premium, but I would say something in excess of 25% annualized sounds reasonable.

    In other words, logical pricing would generally seem to be greater than a stock market return or earnings yield, and less than an expected return on high-risk investments such as venture capital.

  2. Thanks for your thoughts!

    Clearly a comparison to alternate investment opportunities is reasonable approach and a necessary part of a reality-check.

    The approach I've been taking has been to attempt to construct a likely loss estimate for TRE auction purchases and then build a top-line pricing range that accounts for TRE fees, credit losses, operating costs, cost of money and net return on invested funds.

    But testing both the top line and bottom line figures against expected performance of other asset classes makes a lot of sense. And I certainly wouldn't argue with the "bracketing" you suggest.