Appropriate Compensation #10 : The View from Below

In this series of posts we’ve identified a number of risks assumed by Buyers of TRE auctions that we’ve suggested deserve incremental compensation beyond that provided for the risk in typical factoring transactions.

From the start we’ve acknowledged that quantifying an appropriate level of incremental compensation is going to be difficult.

There is no evidence (that I am aware of) to support a rigorous quantitative analysis of the incremental risk associated with reliance on unaudited financial statements as opposed to audited ones. There is no evidence (that I am aware of) to support a rigorous quantitative analysis of having a limited lien position versus an “all asset” lien, or a junior lien as opposed to a first lien. And so on.

We all know that the additional risks assumed in TRE transactions DO exist and that they are real and that they are not trivial.

But how can we approach assigning a value to them?

In our post of May 11, 2011 I wrote, having provided some supporting data and analysis:

“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.”

My expectation at that time was that, after examining the major factors that add risk to TRE transactions, I’d arrive at a suggested analogous number that might be used in analyzing TRE transactions.

The more I’ve thought about it, though, the more I’m drawn to a different approach.

Here’s why.

When we look at the factoring industry as a whole we’re looking at a highly competitive environment in which competition constrains the participants’ pricing power.

Average gross revenue is largely a market-determined number and the participants are challenged to operate their businesses within that revenue environment in a way that generates an adequate profit after costs.

A market-wide average credit loss experience will affect top-line, market-wide pricing only over the longer term. That is, increasing (or decreasing) credit losses will tend to affect FUTURE pricing to the extent that they appear to be a reflection of a structural change in overall risk. They are analyzed, calculated and reported in terms of their relationship to the market-driven gross fee environment.

They occupy one line in a top-down analysis of profitability.

The question we’re really asking in THIS analysis, it seems to me, is NOT one of the relative size of a number in a top-down profitability analysis but rather one of the ABSOLUTE size of a number in a bottom-up pricing structure.

The ultimate question is NOT how much of a relatively fixed top line should be reserved for losses but rather what level of loss expectation does the top line need to INCLUDE, as a compensation for risk, in the unique environment that TRE represents. The top line, rather than being relatively fixed, has to be flexible enough to expand to accommodate the risk assumed.

So, rather than stating the conclusion in terms of a percentage of income to be subtracted from the top line, we would state the conclusion in terms of a percentage of capital that must be included in the pricing of auctions to compensate for losses.

This is an approach that implicitly assumes that much more of the TRE Buyer’s risk is Seller-based than Debtor-based.

The question becomes not how many Account Debtors fail to pay invoices posted for sale but rather how many Sellers, for whatever reason, default on THEIR obligations.

That would include simple inability to make good on invoices not paid by their Debtors as well as Seller insolvency or default arising from one of the various forms of potential Seller fraud.

So we would ask:

a) What is the percentage of the total TRE Seller universe that is likely to default in any given period of time?

b) What is the percentage of total TRE auction volume that is likely to be represented by those Seller defaults?

c) What is the likely NET recovery rate (gross recoveries less costs of recovery) in cases of Seller default?

The answer to those questions gets us to a projected loss-of-capital allowance for the Exchange as a whole. Each Buyer is, of course, able to construct diversification and Seller-qualification strategies that he believes would mitigate either the absolute or risk-adjusted loss potential.

In the next post I’ll explore the impacts on pricing of a range of assumptions on these issues.

I invite anyone interested to share their own views of this approach and their thoughts about reasonable values to assign to the variables.