Friday, October 19, 2012

Swans Do Not Sing Sweetly

The term “swan song” has come to mean “a final gesture, effort or performance given just before death or retirement”. Early in its history the term became associated with the myth that such a final song was expected to be soaringly beautiful and moving.

In fact, the noise that a swan makes both during and at the end of its life is not sweet at all but rather a kind of “honking, grunting and hissing.”

The swan song of the TRE Observer is neither the sweet and beautiful finale of the myth nor (I hope) an unlovely grunting and hissing.

It’s more a weary sigh.

In a few days TRE will mark the 4th anniversary of its first auction.

It’s been a long 4 years!

A lot has happened: some of it good, some not. A lot has been learned: some lessons have been expensive, some maddening and some just disconcerting; but all have been instructive.

Our interest in TRE, aside from the purely intellectual, has been in its potential to support an asset management business whose revenues would be generated from investing in TRE auctions on behalf of those who would pay a fee for the service.

Four years on, we are not close to the point where that is a feasible proposition. Maybe four years from now it will be, but we don’t have another four years to invest in the experiment.

So we are bowing out.

There is a lot that can be said about the reasons that TRE volume has disappointed. (It now looks like the exchange might achieve in 4Q 2012 the annualized volume projected for 4Q 2009.) And it’s hard, having spent so much time and effort on this project, to see a recent uptick in new Seller acquisition and in total auction volume and say it’s just “too little too late” for our purposes.

Bu it is, in fact, too little and too late for us.

Current returns from TRE auctions are roughly half the level we saw in the first few quarters of our experience with the platform. All else equal, that doubles the size of funds-under-management required to generate a minimal level of gross income to the asset management function.

That compounds the problem created by the much slower than expected volume ramp.

It might be argued that, after a summer of very low returns caused by excess liquidity, the current volume increases; coming as they do with concurrent yield increases; ought to make us willing to wait a bit longer. After all, we’ve lived through the lean times: why sit out the fat ones?

Well, as Aunt Bertha said, fat is relative.

It’s true that increased returns do compensate for some increased risk but, as I’ve written to my partners, we’ve just moved back from the ridiculous to the marginal.

But auction risk is not the only one faced by the TRE Buyer. While increased return might better compensate for some of the auction risk, it does not compensate for increased organizational and management risk.

TRE management changes have inserted a critical unknown into the risk equation.

It is quite possible that the future direction of the enterprise will be constructive for both its owners and its participants. We sincerely hope that it will. But it’s also possible that it won’t.

New leadership will take time to grapple with the issues that have hindered the healthy growth of the business. It will take time to decide how to move forward and even more time to determine whether those decisions have been correct.

If all goes well and those decisions are correct and their execution is disciplined and effective, then maybe a volume level sufficient to support an asset management business might be reached in a few more years.

But there’s also a chance that all will not go well -- and if it does not, the next move of the owners is unpredictable.

I began my investment career in a very bad real estate market. It became a commonplace during those years to observe that it might be the second or third or even fourth owner of a project who would ultimately make money from it.

The same is true, I believe, in the case of TRE. I continue to believe that the TRE concept was brilliantly insightful. But management did not execute as brilliantly as it dreamed.

Maybe the next generation will -- or the one after that. But, like a number of the very talented people brought together in the initial TRE team, who just couldn’t wait any longer, neither can we.

So, with all best wishes to TRE, to its owners and managers and to the communities of Buyers and Sellers with whom we’ve had the pleasure of exchanging ideas and support, the TRE Observer now signs off with a swan song that is neither soaring and lovely nor a grunt and a groan; but just with a bit of a weary and hopefully wiser sigh.

Good luck, and be careful out there.

Sunday, July 8, 2012

(In)appropriate Compensation

In a series of 12 previous posts I wrote about the issues that seemed to me to affect the level of compensation a TRE Buyer should receive (or require) in exchange for taking the risk of supplying liquidity to TRE Sellers via the Exchange platform.

That series of posts ended on a rather inconclusive note because experience did not, at that time, allow an estimate of risk that seemed clearly well-supported.

There is no difficulty IDENTIFYING risks that face the TRE Buyer.

There are a number of quite significant risks the Buyer assumes and there is little argument that can be offered about their existence.

The issue is QUANTIFYING those risks, at this point in TRE history, either individually or in aggregate.

We know without question, for example, that unaudited, management-generated financial statements are more likely to contain errors or misstatements than are audited financials.

What level of incremental return should be required of a Buyer to compensate for that risk -- well, that’s the more difficult question.

The last of the series of "appropriate compensation" posts was written in September, 2011. At that time it seemed to me that we were still in an auction environment that justified serious examination of questions such as the incremental risk posed by different invoice verification methods and the presence or absence of Seller personal guarantees, for example.

The implicit assumption was that we were working within a pricing environment in which “appropriate” compensation was actually in view and that the adjustments required for the incremental risk issues were within the realm of reasonable discussion and expectation.

We are no longer in that environment.

Returns on TRE auctions have not just continued to trend lower. They have plummeted.

The average implied return to the Buyer from auctions sold in June fell by nearly one-third from their year-earlier levels and by roughly one-half from their level of 18 months earlier.

I have commented on more than one previous occasion that the risk management functions of TRE have been strengthened significantly over the past couple of years but, in my view, those improvements resulted in a movement to a level of risk that had already discounted their presence.

That is – risk was being previously underestimated and underpriced, in my opinion, and the improvements made by TRE management, significant though they have been, have just brought reality closer to prior expectation.

The compensation being accepted by TRE Buyers in today’s auction environment does not adequately compensate for the risk being assumed.

And as much as the June numbers were inadequate, a plot of initial July results looks like the trajectory of an egg rolling off a kitchen table.

That’s a trajectory that ends badly.

Wednesday, May 30, 2012

Thoughts at Three

This week marks the 3rd anniversary of this Blog. The pace of new posts has slowed in recent months for two reasons:

1) the structure and mechanics of TRE have already been discussed and there’s no value in repetition for its own sake, and

2) much of what I have not discussed I can’t discuss because of the confidentiality provisions of the TRE Member documents.

But I can’t let the anniversary pass without comment so I’ll share today (in my 118th post)as much of what’s on my mind as I am allowed.

I began observing TRE as a lurking Buyer in April 2009 and I began to actively bid on auctions as of June 1, 2009. Since that time I have bought all or part of 836 auctions of which 780 have been closed-out.

Those auctions have been purchased from 120 Sellers and included invoices due from 346 Debtors.

Total TRE auction volume over that period (in dollar terms) has increased ten-fold.

During that period, pricing parameters have changed significantly. The average implied net return to TRE Buyers today is roughly half what it was 3 years ago.

A ten-fold volume increase over 3 years is substantial but still it falls short of initial expectations.

I suspect that the ramp of volume is about 2 years behind initial projections. And, since a portion of TRE revenue is dependent on returns; as returns have fallen, the break-even TRE volume requirement has risen.

TRE has learned a LOT over the past three years. I’ve been quick to compliment its management in the past when I thought that was due.

The positive point that I would make today is that I think TRE is light-years ahead of where they were three years ago in the assessment and management of risk in the transactions that are sold on the Exchange. There is still plenty of room for improvement but I don’t think it can be denied that much progress has been made.

I think the Buyers who have stuck with TRE over the past three years would agree with me and I suspect that the drop in yields reflects, in part, an assessment by the Buyer community that transaction risk has fallen.

Unfortunately, though, I think that change in risk assessment only partially explains the drop in returns.

I’ve written previously about periods in which excess liquidity has been the principal driver of TRE pricing. We’ve been in such a period, in my opinion, for the past several months.

Watching the auction activity day after day for a long period is an instructive (if sometimes frustrating) exercise. But it does allow buying and pricing patterns to be observed. And the recent patterns are pretty clear.

There are active Buyers with substantial appetites whose motivations are clearly volume-driven rather than return-driven.

When “buy out” pricing is hit on multiple auctions nearly simultaneously the odds are that it is the activity of a single Buyer with a desire to deploy a certain level of funds right away.

So, what’s wrong with that?

There’s nothing wrong with the activity itself. It does give Sellers the "all clear" to continue to reduce pricing and it does make it hard for them to return to reality when the dynamic changes. But that’s ultimately what an auction market is about.

There is something “wrong” with what the pricing dynamic implies for the exchange, though.

Today’s auction activity does not suggest that TRE is becoming the “disruptive” force in the receivables market that I suggested it would be in my first post three years ago.

Even at current volume levels; even though they are 10 times what they were; TRE has captured only a very small percentage of the receivables market and only a small part of that has come by way of attracting Sellers from the more conventional factoring market.

While some investment vehicles have been formed for the sole purpose of trading receivables on TRE, the current volume and pricing levels do not make a stand-alone TRE investment vehicle an attractive proposition. It’s just not big enough and does not generate enough Buyer-revenue to support such entities.

So why is there excess liquidity? Doesn’t that suggest attractive economics?

The key to that question is: “attractive for whom?”

For Buyers whose principal business is not receivables financing; that have excess cash earning nearly nothing; putting some money to work in short-term, TRE-traded paper might look like an attractive proposition. They might be able to get several hundred basis points of “excess” return on cash balances. When the alternative opportunity is a zero return, the bar is not set very high.

But that is not the kind of healthy buying that will support the long term growth and success of TRE. It’s just “getting by”.

In the scheme of things, the amounts being invested in TRE don’t yet represent rounding error in the financial markets. Volume needs to grow by another ten-fold and pricing needs to make sense in the context of the risks and costs of receivables financing, rather than as an alternative to “zero”, if TRE is to realize its potential.

So why is TRE in the position it is in today i.e. a great idea that hasn’t yet been realized?

I think it’s because of two major, and maybe fatal, strategic errors:

1. The founders chose to alienate the traditional receivables-finance industry rather than to become a part of it and seek to change it from within, and

2. The founders adopted a “Henry Ford” mentality. (Ford famously said his customers could have any color car they wanted as long as it was black.)

Both errors represent a product vs service mentality.

Facilitating a transaction is fundamentally a service function.

The TRE platform and process is not a market: it is a means of facilitating a market. The difference is critical.

The seller of a service approaches its customers with an attitude of: “we can help you accomplish something that is important to you”.

Henry Ford had the attitude that he knew best and the customer could take it or leave it. That only works if the customer has no choice.

If TRE had approached the receivables-finance market as a service provider rather than with the attitude of a product monopolist, things might well be different today.

I know that others who are planning receivables exchanges in other countries have observed the TRE approach and are consciously choosing to position themselves differently. It will be interesting to see how those ventures fare.

I will say that there is an interesting indicator of a change in “substance over form” to be found on the TRE trading platform. The last press release posted on the trading platform is dated February 27.

What’s significant about the fact that the TRE PR machine seems to have gone quiet?

It might indicate that the resources have been redirected to more productive purposes.

Three years into this experiment I continue to believe that the fundamental concept of TRE is sound. I continue to believe that it can be disruptive. I continue to believe that the receivables-finance market can be, and ultimately will be, revolutionized.

Whether TRE as it is currently constituted will bring about that revolution is an open question.

Without a fundamental change in philosophy and approach I think the headwind is awfully strong.

Thursday, March 15, 2012

The REST of the story...

REVISED 3/25/2012 CRL

I got a note after my last post from a regular reader who is smart and knowledgeable and very much a part of the supply-chain finance industry. He’s not directly involved with TRE but is quite familiar with the sell-side mechanics of the process.

I referred only briefly in that post to potential market reactions to recently-instituted fee changes. He wrote that he was unaware of any changes in the fee structure. But his comment was specific to the sell-side and was made in a way that suggested he might not be aware that Buyers also pay fees.

From a subsequent exchange of notes I learned that, in fact, he was NOT aware of the existence of Buyer fees. His assumption seemed to have been that the costs of TRE transactions were borne by Sellers only.

I asked myself: if this bright and well-informed person is unaware of the existence of fees charged by TRE to Buyers, who else might be trying to understand TRE auction dynamics knowing only a part of the story?

I’ve been curious about some Sellers who devise odd-looking pricing parameters that produce round numbers when the monthly discount is divided by the advance rate and the result is multiplied by 12. I ask myself: is it possible that this Seller really believes that such a fee structure is an appropriate way to think about either his cost of funds or the the return to the Buyer?

For example: does the Seller who prices an auction at 1.05% per month with an 90% advance rate really believe that he is “offering” the Buyer a 14% annualized return (.0105/.9 x 12 = .14)?

If so, that would actually explain a lot of Seller pricing and behavior that seems odd from the buy-side.

Those whose experience listening to radio news broadcasts goes back far enough will remember one of the most distinctive of radio personalities of the 20th century: Paul Harvey. Harvey ended his newscasts with a distinctively-delivered summary line:

“And now you know the REST of the story!”

So, for the benefit of those who might not be familiar with the existence of Buyer fees let me first assure you that TRE Buyers DO pay fees. I can’t actually tell you what the fees ARE but I can offer some general comments about them.

To the Seller (above) who might have thought he was “offering” the Buyer a 14% annualized return, I'd say that the ACTUAL annualized return to the Buyer will certainly be meaningfully lower than that and, in fact, depending on the auction size, duration and terms, it could be could be far lower. If the auction were paid back TOO quickly, the fees charged to the Buyer could actually exceed those earned on the auction!

TRE Buyers are charged fees that are based on the size of the auction and on the gross discount earned. The fees based on the size of the auction are paid when the auction is purchased and will vary depending on whether or not the auction is subject to risk-mitigation program charges.

I've written before about the importance of auction duration to the Buyer's return from a TRE auction. Because there is a fee component that is based on auction size, regardless of earnings, the shorter the duration of the auction (all else equal) the greater the portion of total earnings that are consumed by fees.

I can offer a current example...

I purchased an auction on March 16. The invoice in that auction had a due date of April 11 and prior history suggested that a payment date close to the due date could be reasonably expected. With an expected duration of about 26 days the anticipated return seemed fair to me.

But in fact, the invoice was paid quite early and the auction was closed out on March 23, producing an actual auction duration of only 7 days.

The impact of the very short duration was to magnify the effect of the fixed transaction fees, substantially increasing the proportion of the gross discount that was absorbed by fees. That, of course, substantially diluted my actual annualized return.

In fact, the only reason my actual return was positive, given such a short duration, was because the auction was not a part of the risk mitigation program. If it had been part of that program the total of all fees payable would have exceed the total gross earnings.

That sort of situation has happened before but, in fairness, it hasn't happened to me very often.

But because the calculation of a Buyer's total fees and costs has a number of variables, there is no simple way to describe the relationship between the "apparent return" that might be suggested by the basic auction pricing and either the actual expected return or the actual realized return to the Buyer on that auction.

The following statements are true, however:

--in any TRE auction, the Buyer will pay a meaningful percentage of the gross discount to TRE for the various Buyer fees charged,

--certain fairly common circumstances can produce auction economics in which the fees payable by the Buyer are equal to or greater than the income actually retained by the Buyer from an auction, and

--it is possible that, depending on actual circumstances, the "successful" Buyer of an auction can close out a deal at a loss even if all invoices purchased are paid in full.

None of this will come as any surprise to the experienced Buyer or to the Exchange. But I don't know how many TRE Sellers are actually aware of these circumstances.

It is unfortunate, in my view, that TRE chooses to maintain that all such matters must be kept confidential. Its competitors, while admittedly a long way behind TRE in market development, make their fee structures public. In such circumstances Sellers can tell quite easily what the actual returns to Buyers of their auctions will be.

Ultimately the Seller pays. The question is: "Who does the Seller pay?"

If the Seller thinks it is paying the Buyer compensation that is actually going to TRE, via the Buyer fees, that misconception can potentially distort market dynamics.

And that’s at least PART of the rest of the story!

Wednesday, February 29, 2012

A Little Off Balance

It’s been another month of half-written, then discarded posts. That might reflect, in part, my own uncertainties about TRE but I think it’s actually more a matter of the transitional nature of the times. My sense is that things are just a little off balance.

What’s transitional in TRE-land? A number of things:

--The increased volume that we saw last December, which represented a significant break-out after a plateau of many months duration, has thankfully persisted. It appears we have a new baseline volume that is about 50% higher than the former baseline. (As I write this I think it’s already fair to say that February will have set a new monthly volume record.)

--Average auction size, which also spiked last December, has also maintained its new level. In fact, the increased volume is almost solely attributable to increased average auction size, not to an increase in the number of auctions sold.

--The increased average auction size reflects the activity of a number of new Sellers whose businesses are much larger and whose auction appetite is much larger than the previous average Seller. Volume is more highly concentrated as a result, however, which has its own issues.

--Increased average auction size has meaningful implications for a Buyer's ability to construct a diversified portfolio. The opportunities and constraints are different for those who can buy 100% of the average auction versus those who cannot.

--We are still digesting the impact of the risk mitigation measures that went live last November. And by "we" I mean both Buyers and Sellers.

--We are still digesting the impact of the fee changes that took effect on January 1. (Same "we".)

--We have just begun to see the first of the new Sellers that would not have previously met the TRE registration criteria but do meet the new “smaller Seller” criteria.

For those who have watched the daily auction activity for any significant length of time, I think some changes will have been noticed during the first two months of 2012. It appears that an intra-month cycle of sorts might be developing, partially as a result of the structure of the risk mitigation program, for instance.

Whether those changes will persist is open question.

Whether the experience of this past 60 days will lead Buyers to react somewhat differently over the next 60 days is also an open question.

But things have been changing and I have a sense that many of us are feeling our way through those changes at this point. Which is the real cause of my relative silence – I’ve just not been sure what I’ve wanted to actually put in writing!

But there are some just straightforward factual issues that can be noted:

1. Weighted average returns to Buyers have been falling even as the spike in volume has persisted.

2. Pricing parameters have been migrating toward a band that shows much less recognition of Seller-quality differential.

3. (Some) Sellers have apparently not yet fully grasped the impact of the risk mitigation program.

4. New SMB Sellers have been appearing at a consistently more rapid pace than was the case at this time a year ago.

5. Corporate auction activity has increased in a meaningful way.

6. Organizational and operational changes continue to be made that seem to me to reflect a commitment to long-run business-building. TRE appears to me to continue to invest in its future even at the apparent expense of the near-term cash burn-rate.

7. According to my records, in February, TRE marked its 10,000th auction sold. (My records are missing a small bit of early data but not enough to shift the date of that milestone into January.) That’s a piece of data that I haven’t yet seen in a press release.

The issue of Appropriate Compensation is still very much on my mind and the question of the true value of (versus the cost of) the risk mitigation program is also very much still open.

Unfortunately, answering those questions remains very difficult because the answers are necessarily dependent on volume and actual measured risk.

Solutions to some problems come only at certain not-yet-attained volume levels. Projecting when those levels will be reached is an uncertain enterprise.

Solutions to other problems will come only with certain not-yet-available risk measurements. In that case only time will really tell.

So, we wait and watch. And some of us continue to buy. [We recorded our 750th purchase a couple of days ago!]

It’s interesting to note that the concept of an auction market for receivables is one that continues to attract attention and investment both in the US and abroad.

--The Market Invoice platform in the UK is the only such effort that I'm aware of that has actually generated a meaningful operating history. It has been active for over a year. While volume is not large, it is growing and participants with whom I’ve spoken have been pleased with initial results.

--The Receivables Market platform here in the US has been in development for some time but does not yet appear to be operational. An attempted launch over a year ago seemed to be stillborn but RMC has recently begun to reach out for participants and a good deal of work has been done on their website. From what I can see, though, it cannot be called a “trading platform” at this point.

--The EuroTRX platform in the UK is targeting a late-2Q launch and appears to be the most TRE-like of the new market entrants. EuroTRX appears to have studied the TRE model closely and to have identified several significant differentiation elements that they will attempt to exploit. My sense is that EuroTRX will have the edge over other new entrants if they are able to translate their concepts of process and structure into reality.

I continue to believe that that the concept of TRE was, and is, an excellent one.

First movers have to solve all the problems of a new business. Those who come later get to leverage the experience of the first movers.

One of the most important qualities of the first mover who wants to survive is flexibility; principally the flexibility to recognize when an initial idea is not working and needs to be changed.

I think it can be said that TRE’s initial concept and vision is essentially unchanged and is being validated; perhaps more slowly than initially hoped but nonetheless…..

It’s also fair to say that there have been a number of areas of implementation that have tested the flexibility of TRE’s management.

In many cases the need to change has been recognized quickly and responded to promptly.

In other areas, both recognition and response have taken longer; sometimes too long.

In still others, recognition might not yet have occurred.

Tuesday, January 17, 2012

Fishing in a Stocked Pond

Two press releases caught my eye on January 5, 2012.

The first was TRE’s announcement that it had reached the $1 billion mark in "funding" on the SMB platform. It caught my eye because it was from TRE and I’m always interested in TRE news. But it also caught my eye because I couldn’t understand how the number could be correct.

As far as I can tell, the only way for that release to be accurate is to change the language to say that $1 billion in transaction ACTIVITY has been completed. That’s different from saying $1 billion has been FUNDED. But I guess we can blame the PR folks. After all, PR folks are notoriously unconcerned with numbers, right?

The second press release that came out on the 5th was issued by the Ariba Network. Unlike TRE, Ariba buried its numbers in the middle of the release.

Quoting from the fifth paragraph, referring to Ariba, it reads in part: “Used by more than 730,000 companies around the world to transact more than $202 billion on an annual basis….”

How do you bury a sentence like that?

It’s huge!

The fact that those releases came out on the same day is not the only thing that connects them, of course.

The Ariba Network’s software has, as I understand it, a specially-constructed module that will allow an Ariba vendor to quickly and easily post its invoices for sale on the TRE platform.

Ariba and TRE have been working together virtually since TRE began operations to bring Ariba vendors onto the TRE platform and to make it as easy as possible for them to sell to TRE Buyers.

Let’s move past the obvious for a moment and ignore the 730,000 companies with $202 billion in annual transactions and consider the fact that transactions done via the Ariba Network provide a solution to the single most significant weakness in the TRE system i.e. the invoice verification process.

Prior to an Ariba Network invoice being posted for sale on TRE, the Account Debtor must acknowledge that the goods or services have been provided appropriately, that the invoice properly reflects the amount due, that the payment terms are accurate and that payment will be made in accordance with the terms.

That is the strongest affirmation of invoice validity available to a TRE Buyer.

Buying an Ariba Network invoice has obvious advantages for TRE Buyers, which means that it has obvious advantages for TRE. But the volume of Ariba invoices being sold on TRE has been decreasing rather than increasing.

Some time ago I heard that TRE was going to assign a dedicated marketing person to the Ariba relationship; specifically to try to move more Ariba volume onto the platform. If that was done it has not generated perceptible results.

To the TRE marketing people I would ask: What other pool of prospects is unified by a common operational and financial system; can be reached through a single communication channel; have available to them a ready-made auction posting tool; and bring with them a significant invoice verification advantage? And, to get back to the numbers, what other single pool of prospects is as large?

For TRE marketers, selling to Ariba is like fishing in a stocked pond. There’s never a guarantee of success but the odds are certainly skewed in your favor. And that’s worth a lot.

I’ve heard a number of explanations of why the Ariba volume on TRE has been anemic. Some of them sound reasonable, at least to a degree. But none of them would convince me that TRE shouldn’t be going after Ariba Sellers with every tool they have.

One tool that TRE might not have used, but that I suspect might be helpful, is price.

Sourcing Sellers from an identified pool, via an established communication network, with a built-in reference from Ariba, just has to be more efficient and less costly than prospecting elsewhere. And being relieved of the bulk of the cost of verification and, I would guess, having a lower cost of dealing with problem cases, also should afford TRE a meaningful advantage.

If TRE has had trouble attracting Ariba Sellers, why not offer them a better price by discounting the fees the Exchange charges to Ariba Sellers? Establishing a special class of Sellers for fee purposes has to be justifiable given the affinity-group efficiencies.

Now, let’s go back to the numbers. I know much more about the actual TRE volume numbers than I do about the Ariba numbers. For all I know, Ariba might count transaction volume like a VAT collector would count it: at each step along the way. But in the scheme of things, it doesn’t really matter. If the relevant comparison is to $101 billion in Ariba transactions rather than $202 billion, the argument still holds.

Not only is Ariba a pond stocked with the kind of fish TRE wants but it’s a very deep pond and TRE already has a license to fish there.

Several generations of marketing folks at TRE have been, for whatever reason, unsuccessful in marketing to Ariba members.

Maybe it’s time to try a different approach. Maybe it's the bait.