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.