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.

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