The TRE Observer

Fishing in a Stocked Pond

2012-01-17T16:01:00.000-05:00

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.

Musings at Year-End

2011-12-30T12:30:00.000-05:00

Here we are at the end of December and I haven’t written anything since late November.

Actually, that’s not quite true… I’ve begun several posts in the past six weeks but I haven’t finished (or posted) any of them.

In a couple of those cases I didn’t finish because I realized I was writing in a state of frustration and confusion and that nothing written under those conditions ought to actually be shared.

In others cases I just decided I wasn’t sure that what I had to say was either correct or of any value.

And that kind of sums up the 4th quarter activity for me: It’s been a time of frustration, uncertainty and doubt about the future.

But I can’t let the year end without a few comments. So.....

Thankfully, the flood of liquidity that played havoc with pricing early in the quarter began to recede in November and by the second half of December it appeared that a reasonable balance had again been found.

That reasonable balance wasn’t necessarily reflected in pricing, though, because in early November the Exchange’s new risk mitigation program went live. And the initial reactions to that program had a significant impact on prices.

There’s not a lot that can be said about that program at this point except that I think it is both more and less than meets the eye.

It will take quite a while before anyone will be able to say what its real value is or what an appropriate pricing response actually should be. Meanwhile we’ll just have to muddle through making decisions on the basis of largely unproven assumptions.

TRE deserves much credit, I think, for a number of things as this 3rd full year of operation ends:

1. There are still a few hours left in the trading day as I write this but it is quite clear that December 2011 will set, by a very substantial margin, a new high water mark for SMB auction volume.

2. December has also seen the first new activity in the Corporate auction market since the NYSE relationship was completed in September. The new auctions were received positively and I suspect that all parties must be pleased.

3. The pace of new SMB Seller acquisition has clearly accelerated in the 2nd half of the year and some of the new Sellers have been unusual in both size and expected volume of activity. The Seller marketing team appears to have shifted its targeting in a way that might be really meaningful.

4. The roll-out of the new risk-mitigation program appeared to go quite smoothly. While it was delayed a bit in an effort to get it right before roll-out, that decision seems to have been a good one. Implementing that sort of program in a relatively seamless manner is tough. Both the tech people and the business people involved in the implementation appear to have done a very good job.

5. TRE’s administrative people have continued to tighten up their processes. The job of obtaining and posting updated financial data from Sellers has become much more disciplined, with more Sellers finding their postings delayed until the required data is provided. For a volume-dependent organization, it’s tough to exercise that sort of discipline.

6. The Member Services department which, among other things, handles the transaction reporting and cash management functions deserves a lot of credit. It's one of those functions that only gets noticed when there's a mistake. But, at least in my case, I can't think of a single error that has occurred this year in those functions. That's actually remarkable.

7. The risk management and loss control functions have been significantly strengthened, both in terms of people and processes.

8. The operation of the trading desk has been strengthened and communication between the desk and the Buyers has clearly been an operational focus.

9. TRE management has to be acutely aware that volume growth has been much slower than initially hoped. Many would be tempted, in such a situation, to scrimp on investment in the “nuts and bolts” improvements in systems, personnel and processes: especially in those functions that few people actually see. To their credit, TRE’s management did not take the short view. They have continued to invest in the platform and the processes even though it must hurt to do so.

10. And, of course, you’ve got to give TRE management full marks for PR! They DO get noticed and their name IS out there all the time.

On the other hand...

In order for any of us involved in the TRE enterprise to prosper, the business has to achieve substantial scale, and we’re a long way from any level that might be called “substantial” in the context of the market size.

A year ago the volume pattern could appropriately be called “encouraging”. But for most of 2011 we couldn’t really say that the pattern was encouraging.

After three full years of operation we have to look at things as they are, not just as they might be. And the way things ARE falls short.

There are two issues that are really cultural, as opposed to technical or strategic, that I frankly think TRE has gotten wrong and should reconsider in 2012.

The logical approach for those wanting to bring a new process to an existing industry is to attempt to align themselves with the opinion leaders in that industry or to at least create some strategic relationships within the industry. There will be differences of opinion as to why TRE has not done, or has not been able to do, that. But the fact is that TRE continues to be an outsider with respect to the established factoring community.

I happen to believe that the TRE model has much to recommend it as a way to substantially increase the penetration of the factoring function in our economy. And I think that there are ways for TRE and the established community to work together for common benefit. That is not happening. And I believe that at least some of the failure to achieve TRE volume goals can be attributed to a failure to capitalize on the opportunities that working with the established community might present.

Responsibility for that situation has to be shared. Finger pointing helps neither side. It’s time to mend the rift and move forward.

The second cultural issue manifests in a number of ways that I think hinder the growth and threaten the success of the TRE enterprise.

It is the implicit stance taken by TRE that it should be in complete control but at the same time be relieved of all liability. That approach, I believe, might prove to be the largest barrier to actually achieving scale. Because a lot of potential participants will “just say no”.

Shakespeare got it right when he wrote: "First we'll kill all the lawyers..."

There is only one way that I can conceive of a total-control strategy working; but that also goes against the TRE cultural grain. And it will certainly be rejected by its lawyers.

That approach is ... complete transparency.

The culture of control includes a total control of information about Exchange operations, participants, finances, defaults, etc.

The TRE PR machine cranks out positive releases on a seemingly round-the-clock basis.

But information about the real operation of the Exchange is held very tightly to the corporate vest.

Ultimately, an approach that is intended to protect the Exchange actually, in my view, makes TRE more vulnerable. It becomes the subject of unfounded rumors, inaccurate analysis and ill-informed attacks. It makes it appear that there is something to hide. And that’s counter-productive.

I have made this point to TRE in private communication, so this will come as no surprise, but I would strongly advise the Exchange and its management to adopt a policy of complete transparency and to foster, rather than hinder, a full range of communications among all market participants.

TRE should start acting like a public company.

It should make public a full range of operational and financial information just as if it were public.

It should support, rather than hinder, productive and even organized communications and associations among Buyers and Sellers and analysts.

It should stand ready to explain what has worked well and what has not and what has been done in response to the problems that it has faced.

No business, and certainly no new business, is going to escape problems and errors. The good ones acknowledge those problems and errors and respond to them openly and constructively. That stuff always comes out eventually, anyway, so why not take control of THAT and use it to advantage?

Finally, Happy New Year to all! And may 2012 be a year of growth, learning and prosperity for the entire community of TRE participants.

The Implicit Assumption

2011-11-22T10:30:00.000-05:00

The issue of risk measurement and the relationship of perceived risk to expected return has been a principal occupation of finance theorists for the past several decades. It is received wisdom that as risk rises, return must also rise, and vice versa (perhaps with a lag).

That admittedly simplistic formulation suggests that when a risk-reducing element is added to an investment opportunity, the rationally expected return should fall.

We’ve all witnessed repeated failures of the rational-investor hypothesis, the efficient market hypothesis and of modern portfolio theory over the past decade.

We’ve witnessed the well documented flame-outs of risk pricing models demonstrating that the “greek” factors of financial math, when stressed, can be as reliable as Greek bond ratings.

So the question of the day is: when is it NOT rational for expected returns to fall when new risk-reducing conditions are introduced?

The answer… (drum roll, please)…is: when risk wasn’t being rationally priced PRIOR to the application of the new measures.

When returns fall in the face of new risk-mitigation measures, the implicit assumption is that pricing prior to the introduction of the new measure already correctly reflected risk.

The extent of the decline should rationally be a function of the gross risk reduction less the cost of the risk reduction, modified by the confidence that can be placed in the “before and after” risk measurements.

New risk-mitigation measures have been applied to some TRE transactions in recent days.

It is too early to draw conclusions about their long-term impact.

In the short term, though, the reaction has been clear. Returns have fallen sharply.

If the reduction in returns was observed only in the cases where risk mitigation measures have been introduced, the problem of analysis would be made more straightforward. But that has not been the case.

The deterioration in expected yields that we commented on in our last post has persisted. So returns had already begun to fall; apparently as a result of excess liquidity; before the reaction to the risk-mitigation measures began.

And there is not yet enough data to support an analysis allocating the overall decline between the two apparent sources.

On a preliminary basis, though, it does not appear to me that the extent of the initial price reaction can be rationally supported as a reflection of the net value of the risk mitigation measures.

And it is far from clear to me that risk was being appropriately compensated BEFORE this latest development.

Having written a rather lengthy series of posts on the subject of Appropriate Compensation, which is really all about risk; and having not yet proposed a definitive conclusion on that question; I can understand that Buyers of TRE auctions will and do analyze appropriate pricing differently.

But all Buyers and, indeed, all observers of TRE, suffer from a similar impediment in their assessments of risk i.e. lack of disclosure of actual TRE experience in sufficient detail to make reasonably informed risk assessments.

I have previously stated that the actual early experience of TRE might not be an appropriate basis on which to analyze current or forward-looking risk. And I continue to believe that.

Because TRE has responded in meaningful ways to its early experience I believe that risk today is lower than it was 2 years ago.

But a RELATIVE shift in risk says nothing particularly useful about the ABSOLUTE level of return necessary to compensate for that risk. And the absolute level of average expected return to Buyers has fallen far more over the last 2 years than warranted, in my opinion, by the change in auction risk profile.

It might be that the current price action is a temporary condition and that we’ll see an adjustment of the sort that occurred earlier this year. In that case we might look back on the current period as a temporary overreaction.

If that does not occur, and the current conditions persist, my guess is that we’ll see reactions within the Buyer community that will drain some of the current liquidity from the market.

Absolutely Relative vs Relatively Absolute

2011-11-11T13:25:00.001-05:00

In September 2011 TRE announced its new affiliation with the New York Stock Exchange. I wrote in my post of September 13 that “the benefits to those whose involvement is limited to the SMB market (would be) pretty obvious and (would) become clear over time.”

The operative phrase there was “over time”.

It might have been coincidence; but I doubt it; that new Buyer money clearly came into the market as the “bell rang” on October 1. And since that time the pricing of SMB auctions has reflected the enthusiasm of increased demand relative to supply.

That also happened in 1Q 2011, when we saw a significant drop in average returns that lasted for about 90 days.

It appears that the combination of October’s influx of new money and structural issues arising from process changes recently instituted by TRE might now push returns even below the levels of 1Q 2011. Whether that will be a short-duration phenomenon, as was the dip in 1Q, or will have more lasting impact cannot yet be known.

But it does raise a question that I think is critical, more for those who look to the possibility of trading on TRE as a stand-alone business than for others, perhaps; but to TRE as well, in my view.

I’ve written previously about the difference between Buyers whose activities on TRE are ancillary to their principal business; who might be looking for short term, opportunistic means to improve returns on excess cash balances; as opposed to those whose business is actually investing in accounts receivable and are looking to make investing in TRE auctions a viable business on its own.

In the case of the short-term “money parkers”, the TRE market is probably viewed in an absolutely relative light.

If a Buyer, whose business is actually investing in other asset types, has excess cash balances from time to time on which very little can be earned, the prospect of picking up a few hundred basis points over Libor, for example, might look very attractive.

Such a Buyer might well have minimal marginal costs involved in its TRE activities and, unless (or until) it is faced with defaults, might be quite pleased with the incremental returns received.

But the nature of that Buyer’s activity is that it is driven by lack of sufficient opportunity in its primary business or in its usual short-term investment options. And as those opportunities and options improve it will likely move its cash back to its normal operations and withdraw liquidity from TRE.

The supply/demand balance in TRE trading is still delicate. Volume of auction activity has certainly grown over time but relative to other financial markets, TRE volume is still within rounding error. What might seem to some investors to be relatively small increases in funds allocated to TRE purchases can have a meaningful impact on the market.

In the short run, TRE probably has little control over Buyer allocations of funds or the impact of meaningful changes in market dynamics caused by shifts in those allocations.

In the longer run, however, I believe TRE should strive for the relative stability that would more likely come from a Buyer community largely composed of those who are approaching the Exchange as a part of their primary business activity.

It is that class of Buyer that can be expected to be consistently participating in the market and seeking to match growth in the market with growth in their own level of commitment.

But it should be recognized that the return requirement of that class of Buyer is not absolutely relative; rather, it is relatively absolute.

Those Buyers whose business is investing in accounts receivable will know that the TRE transaction structure has certain risks that are not typical in their normal activities and that those risks will have to be adequately compensated if the TRE activity is to be supported in the long run.

The cost of money might be similar when the absolutely relative Buyers are compared to the relatively absolute Buyers. But it’s likely that there will be meaningful differences between the two classes of Buyers in the areas of:

1. Operating costs
2. Credit loss assumptions, and
3. Net return requirement

The short term parkers of excess funds will probably attribute little, if any, marginal operating cost to their TRE trading activity.

Until they actually experience the potential risks involved in buying invoices in the TRE structure, it is likely that the credit loss assumptions of the absolutely relative Buyers will be minimal.

And the net return requirement of the absolutely relative Buyer will also likely be minimal. The Exchange activity of that Buyer is a footnote to its business plan. For the relatively absolute Buyer, its Exchange activity is the BASIS of its business plan!

The long term growth and prosperity of TRE, in my view, depends on attracting, retaining and supporting the activity of the relatively absolute Buyers.

To the extent that the absolutely relative Buyers threaten the ability of the relatively absolute Buyers to price transactions sensibly in light of the actual risks being assumed, they also threaten the long term success of TRE.

A Comment on Seller Marketing

2011-10-24T10:37:00.000-04:00

I've been waiting for several weeks for the conditions to materialize that will allow me to comment on a new TRE risk-mitigation program. We're not there yet, so I still can't write about that initiative.

But, as I wait, the issues of risk and appropriate pricing are still at the top of my list and there was a trigger for comment on those topics last week.

An article, written by a senior officer of TRE, appeared in an industrial trade magazine published last week. The article was a marketing piece setting out a variety of reasons why owners of manufacturing concerns should consider an alternative financing facility like TRE.

The points made in favor of an alternative working capital facility were familiar and predictable to anyone with involvement in or knowledge of TRE. One of them, however, seemed to me to be overemphasized and not completely accurate.

The point was discussed under the heading: "Avoid Personal Guarantees". The discussion began with a comment on the typical working capital provider's requirement of a personal guarantee and of the potential impact on a business owner in the event of a default if a personal guarantee has been provided.

A fair enough comment.

But then the point is made that TRE does not require personal guarantees "because investors who are bidding for your receivables assess their risk based primarily on the credit rating of your customers, not your rating."

The author appropriately points out the obligation of the business to repurchase defaulted invoices but closes with the statement: "Most owners would rather assume this obligation than risk losing their house or savings because of a personal guarantee."

This emphasis is troubling in several respects:

1. In a post entitled "Pardon the Interruption" published June 28, 2011, I argued for the adoption of at least a contingent personal guarantee. At that time I suggested that it be contingent on the posting of non-conforming invoices for sale. That's not the only approach, of course. Such a contingent guarantee could also be triggered by a fraud test. But nothing has happened since June 28 that changes my opinion on that issue. If anything, I am more convinced than ever that TRE will eventually HAVE to move in that direction.

2. Speaking only as one Buyer I can say without hesitation that our buying decisions are not "based primarily on the credit rating of your (the Seller's) customers". The invoice verification process used by TRE does not allow that level of confidence. The uncertainty caused by that process is not an issue of Debtor strength but of confidence in the validity of the invoice. It does not matter if the Debtor is the most creditworthy company on earth. If the invoice is defective it won't get paid. So, the most important question to be asked is NOT whether the Debtor can pay the invoice, it is whether the Seller can pay it if the Debtor does not.

3. Selling the TRE facility on the basis of limited Seller risk is like throwing blood in a shark tank. It's an irresistible attraction to the Sellers that are most likely to become problems. Obviously those business owners; and they are out there; who are just crooks, will find the situation tempting. They don't even have to negotiate to get a personal guarantee requirement waived. It's not even a point of discussion. But even owners who are generally trustworthy can be tempted to act badly when the pressure gets strong enough. And in this economic environment, a lot of them are under pressure.

4. The tension between the sales and risk control functions that is felt in all credit-market institutions is heightened when so much is riding on volume growth. In the case of most banks, for example, there is a counter-force to be found in the requirements for public disclosure. If the credit metrics begin to move in the wrong direction, that will become apparent relatively quickly. That is not the case with TRE. Little data about auction performance is made available publicly and so the pressure on the sales and marketing functions from that source is largely absent. We have to rely on senior management to appropriately balance the growth objectives with a robust risk control environment.

The success of the TRE sales and marketing functions is in the best interest of all of us who are involved in the TRE enterprise. But it is only in our best interest to the extent that it is achieved in the context of effective control of risk and appropriate pricing of risk.

Emphasizing the limitation of owner liability in marketing efforts is, in my view, a dangerous approach to business building that is clearly tempting in the short term but is likely to be counter-productive in the long term.

Appropriate Compensation # 12: Another Tack

2011-09-19T13:31:00.000-04:00

In our last post in this series we discussed the idea of risk analysis at the level of the Seller, on the assumption that a probability of default might be usefully considered in terms of a Seller-based metric.

That actually brings up an interesting distinction between the TRE model and that of traditional factoring relationships.

In the traditional full-line factoring relationship the factor will have funded a significant portion of the total receivables portfolio of the client. Not necessarily the entire portfolio, but perhaps all of the invoices due from specified debtors or all invoices due from specified debtors within a specified age limit, or something of the sort. And the factor will have a buffer against loss equal to the aggregate dollars held-back from all invoices funded plus (in many cases) additional value from invoices not actually funded.

In such a case, a debtor’s default on one invoice, or the default by one debtor among many, will not necessarily put the factor's advance position at risk; there might be enough value in the unfunded positions to cover the defaults.

In the spot-factoring model, particularly in the case where the lien is specific to the invoices purchased and there is no other security provided, the buyer of the invoice has fewer options to effect a cure of any default.

That is typically the case in a TRE transaction.

So, some might argue that the risk of loss might be better viewed at the level of the individual transaction rather than at the level of the Seller. I don’t necessarily agree but it does provide another interesting approach to risk analysis.

Let's say that we’re looking at a $50,000 single-invoice auction and that the terms of sale are: an 85% advance; a monthly discount fee of 1.5%; and, an expected duration of 30 days. The net earnings on an auction with those parameters will be approximately 1/79th of the initial advance.

In that case, just for illustration, if the buyer thought there was 1 chance in 79 of suffering a complete loss on an auction with similar characteristics, the net expected return after credit losses would be zero.

Inverting the analysis, if the buyer thought that a credit loss equal to 10% of the expected earnings was acceptable (just to keep the numbers round), he would have to attach a 1 in 790 probability of a total loss to this auction in order for it to meet his loss tolerance.

Using that approach a Buyer can fairly easily construct a loss tolerance distribution using variables for size, duration, rate and targeted loss levels. This won’t answer the question of what the probability of loss might actually be. But it will provide a measure against which the Buyer can test the reasonableness of various assumptions.

Let’s keep size, rate and targeted loss levels constant and test for the effects of duration change. If the duration were 15 days instead of 30 days, the net earnings expectation would be about 1/212th of the initial advance and, in order to hold losses to a 10% level, it would take about 2,120 successful auctions for each 1 that was a total loss.

If the duration were to be double the initial case i.e. 60 days, the expected earnings would be 1/35th of the advance amount and 1 auction in 350 could be allowed as a total loss while maintaining a 10% loss ratio.

We’ve noted that there is not enough data yet to reliably attach probabilities of loss to TRE auctions. And the variations among Seller and Debtor strength, experience, and other metrics are so wide that any analysis of the TRE market as a whole is perilous.

However, a Buyer CAN approach a single auction armed with the calculation of implied loss tolerance given the auction parameters and his own appetite for risk.

Loss tolerance calculation is not loss probability calculation. But it’s something.

It seems that we’ll soon be able to discuss a significant new risk-mitigation step being taken by TRE. When we CAN discuss it we will.

But the fact that mitigation actions are taken doesn’t relieve us of the need to assess the risk itself. It just imposes the additional requirement of analyzing the extent to which the mitigation measures actually affect the net loss probability.

Credit Where It's Due

2011-09-13T10:35:00.000-04:00

This morning's announcement that NYSE Euronext has taken an equity position in TRE and is partnering with TRE to offer the TRE Corporate Receivables Program to NYSE-listed companies is a significant vote of confidence in the concept, the technology and the management of TRE.

This development is unambiguously good for all participants in the TRE enterprise including those of us who are Buyers and Sellers, regardless of whether we participate in the Corporate Receivables Program or not.

The benefits to those whose involvement is limited to the SMB market are, I think, pretty obvious and will, I suspect, become clear over time.

Those who were not yet convinced that TRE had proven itself as a going concern should take comfort in today's announcement.

In my first post on this blog I noted that just as "all beginnings are hard", so too the road toward success for TRE would be bumpy and difficult: mistakes would be made and changes in direction would be required.

It is clearly to the credit of TRE and its management that regardless of the difficulties faced and the course corrections required, the focus on moving forward, on facing up to problems, on seeking solutions and on pursuing opportunities has been maintained.

Today's announcement is a big thing for TRE and credit is due to its founders, its management, and to all who have been a part of sustaining it to this day.

Appropriate Compensation #11: Keep it Simple(r)

2011-08-31T10:57:00.000-04:00

Here in post-Irene New Jersey many of us still have some recovery to attend to but, as the month ends, I want to quickly clarify the idea put forward in our last post.

This is what I mean by a Seller-based approach to an allowance for credit losses:

1. Let’s say that all active Sellers on TRE represent the same share of total auction activity. (Clearly, that’s unrealistic, but it’s just for illustration.) And let’s say that our analysis suggests that 3% of active Sellers will default in any given year. If we assume that every default results in a total loss, we might say that overall TRE pricing has to provide for an annual loss of 3% of capital (before recovery expenses).

That 3% loss provision is not based on the gross income of auctions purchased. It’s not a top-down calculation. It is an absolute loss provision that has to be included in auction pricing to compensate for perceived Seller-default risk.

That’s an extremely simplified example of a platform-level approach but, hopefully, it conveys the idea.

It’s not possible at this point, for a Buyer to “buy the Exchange” i.e. there is no single transaction that will expose the Buyer to a pro-rata position in the entire TRE portfolio. So an Exchange-level analysis, even if it were really possible in a statistically meaningful way, wouldn’t go far enough for the individual Buyer.

The individual Buyer will have to account for his own strategic portfolio and auction purchase decisions in creating an allowance.

2. Let’s say that a given Buyer has a portfolio diversification rule that limits his exposure to any one Seller to an amount equal to 10% of the Buyer’s capital. And let’s say that the Buyer believes that his Seller-qualification criteria allow an annual probability of default of 1 in 20. If a total loss on default were assumed, and the Buyer’s investment at the time of default were at its 10% maximum, the simplistic loss allowance should be about 5% of capital per year.

3. Let’s take the same situation as in #2 and assume that the Buyer actually expects a net loss recovery of 50% of defaulted amounts. In that case a net loss allowance of 2.5% of capital per year would be indicated.

Obviously, a Buyer projecting a loss of 2.5% of capital per year will think and act differently than one projecting a 5% loss. (And those making no conscious allowance for loss will be unpleasantly surprised sooner or later!)

There is not yet enough history of TRE operations to reasonably estimate the probability of a “typical” Seller defaulting. Nor is the information about actual default experience publicly available.

What we ARE able to say is that the experience of TRE to-date has caused it to make a number of meaningful changes to procedures, staffing and operations that affect both risk of default and likelihood of recovery post-default. And that those changes have been constructive.

However, it remains true that:

• There is a wide range of (reported) financial capacity among TRE Sellers.

• There is a wide range of financial capacity among TRE Account Debtors.

• There is a wide range of past experience among TRE Seller/Debtor pairings.

• There is a wide range of documentation strength provided in TRE transactions.

• There is a wide range of actual pricing in TRE transactions.

Because each Buyer’s actual and perceived risk/return profile is dependent on many individual portfolio construction and auction purchase decisions; and many assessments of risk are still largely subjective in the context of limited TRE history; the question of an appropriate loss reserve will also necessarily be both individual and largely subjective.

I might think, based on my own portfolio construction and auction purchase criteria, that an annual Seller default probability of 1 in 20 is reasonable. Another Buyer might find some other number to be more reasonable.

I might think that a net recovery expectation of 25% is reasonable. Another Buyer might think differently.

I’ll develop this idea further in subsequent posts but I hope this clarifies the distinction between a Seller-based analytical process and one that is Debtor-based.

I should note that I’m not ignoring the differential strength of Account Debtors. Regardless of Debtor capacity, it is the Seller that is ultimately responsible to make good on invoices sold. And, in the context of TRE notification/verification procedures, I think that the quality of the Debtor is best considered as one element in the assessment of Seller risk.

Appropriate Compensation #10 : The View from Below

2011-08-18T14:16:00.000-04:00

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.

Appropriate Compensation #9: Upon Mature Reflection

2011-08-08T09:16:00.000-04:00

I worked with a guy once who had a wonderful way of reversing his expressed opinion on a matter, which was particularly useful when he found that it conflicted with the boss’s opinion.

When it was clear that he’d dug himself into a hole, he’d invariably preface his remarks with: “Upon more MATURE reflection….”

We’ve identified a number of significant issues that we believe add risk to TRE transactions when compared to the typical factoring transaction. The financial statement issue; the personal guarantee issue; the lien priority issue; for example, are all significant and all clearly differentiate the TRE transaction.

Before moving to the question of what kind of pricing response might be appropriate I want to bring up another element that is perhaps the most difficult to analyze and probably impossible to quantify. It is, nevertheless, quite real.

It is the fact that a real-time, competitive auction environment creates a unique potential for self-defeating behavior: behavior that is influenced by the trading environment in a way that does not affect the typical factoring transaction.

There is a great deal of literature about the impact of bidder motivation and psychology on behavior in various auction environments.

The TRE auction environment is one in which, unlike some others, the Buyer does not have the practical option to exit the trade to correct a buying or bidding error. There is no opportunity to say: “Upon more MATURE reflection…..get me out of this thing!” And then to sell what might have been purchased in error, or in haste, or under pressure to put money to work or even just in a momentary fit of pique at having lost a number of auctions that day.

All of these things, and more, can be the cause of a Buyer looking up from an Awarded Auction Report and saying “I can’t believe I really did that.” The only thing to be done at that point is own up to the lapse and hope the thing actually gets paid.

That is not to say that the decisions of the typical factoring company are not subject to the motivations of competitive pressure and internal goal setting. Of course they are.

But they are not subject to the pressures of a real-time auction environment, which requires that decisions be made very quickly, usually without prior warning, frequently in the face of new information that has not been previously analyzed, often in an environment of excess market liquidity, and often in competition with others with differing motivations for participation.

One of the dynamics proven true in competitive auctions is the increase in the perceived “need” to win as the number of “lost” auctions increases. That is, a buyer’s propensity to act against his own bidding rules will tend to increase with the number of unsuccessful bids made. That’s a dangerous but very real temptation when being the successful bidder is defined in terms of “winning” the auction.

In fact, the successful bidder is the one who only bids according to his pre-established bidding rules.

And it might be that a consistently successful bidder is NOT particularly successful at keeping funds deployed in some market environments. But that’s a different question.

I can tell you that, based on my own experience, there is a dynamic in the competitive, real-time auction environment that has clear error-making potential. Some Buyers will be more susceptible to it and some less. So the actual level of incremental risk is as much Buyer-driven as process-driven.

Whatever the actual MEASURE of incremental risk, the fact of incremental risk in real-time, competitive auctions is well documented in academic literature and clearly felt in practice.

I confess that I have found myself (and I will bet that many other Buyers have as well), after placing a bid or winning an auction, wishing that “upon more mature reflection” there was an un-do function on the TRE platform!

It is no coincidence that the competitive nature of the TRE buying environment is stressed in TRE's marketing to SELLERS rather than to Buyers!

Appropriate Compensation #8: Once Removed

2011-07-19T13:30:00.000-04:00

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.

Appropriate Compensation #7: The Lien Position

2011-07-14T11:18:00.000-04:00

In this series of posts we've identified a number of ways in which the TRE Buyer is assuming incremental risk when compared to typical factoring transactions. The goal is to ultimately draw a conclusion regarding the appropriate level of incremental return necessary to compensate for that additional risk.

Today I want to return to the issue of the lien position that the TRE Buyer acquires in the assets of the TRE Seller. We’ve addressed this issue before.

Please see:

• Caveat Emptor #2: December 15,2009, and
• Blanket Security vs. a Security Blanket: June 29, 2009

There are two principal conditions in the Buyer’s lien position that give rise to risk in TRE transactions that would not normally be accepted in typical factoring transactions:

1) The TRE Buyer obtains a lien ONLY on the invoices purchased from the TRE Seller, and

2) It is often the case that other parties already hold prior liens on the receivables of a TRE Seller, so the TRE Buyer might hold a second or even more-junior lien position on the receivables it purchases.

The fact that the Buyer’s lien attaches only to the receivables purchased is made more problematic by the lack of a full notification process that we’ve recently discussed. If the invoice purchased is defective and the Buyer’s lien attaches only to that invoice, the value of the lien is questionable.

And the fact that other parties might have superior lien positions with respect to the assets of the TRE Seller, puts the TRE Buyer at risk that the rights and actions of others, which neither TRE nor the Buyer can control, can substantially reduce the value of the Buyer’s lien.

Compounding that problem is the fact that I know of no truly reliable warning system to alert the TRE Buyer to the existence of action or threatened action by a 3rd party in time for protective measures to be taken by either TRE or the Buyer.

In typical factoring relationships there is an opportunity for ongoing dialog and business-condition assessment. That is not the case in the TRE environment.

In the TRE environment the Buyer is almost always going to be behind the curve, learning of problems after the fact. Even if a Buyer is an astute analyst of financial data, able to tease out indicators of developing problems, the information available on the TRE platform is always dated. And, as we’ve discussed, the quality of the information contained in internally-generated financial statements – always less-assured than audited data – is far more likely to be inaccurate in conditions where Sellers are in trouble or heading in that direction.

Becoming aware of a threat to one’s position via notice of a superior lien-holder’s action is unpleasant.

On the subject of the breadth of the Buyer’s lien position I’d like to add a point to the prior conversation that I haven’t brought up before. The UCC filings in typical factoring relationships very often extend beyond creating a security interest in all accounts receivable. Often they are either “all-asset” liens; or extend to all of the personal property of the Seller in addition to its accounts; or specifically include other named property.

More and more often, especially in the cases of companies that are in the various “tech” sectors, the critical assets of the TRE Sellers are intangible. A Seller that is a software development firm, for instance, might have a copyright, trademark, patent or other intangible as its primary revenue-producing asset. Without some means to control or, at least, threaten that asset, the leverage of a creditor is substantially diminished.

This limited security position in the assets of the Seller is obviously quite attractive to the Seller. It is used to attract Sellers to the TRE platform in the same way the lack of a personal guarantee requirement is used. It has a flavor of the “you can’t get this anywhere else” to it.

Of course, there’s a reason it’s not generally available and that reason is that it increases the risk to the provider of funds.

It increases risk not only because the security might be defective or a because a superior lien position might be asserted but also because any action to cure a default that depends on attaching assets that have limited lives (i.e. the receivables portfolio of a Seller might be liquidated and its proceeds “evaporated” before any substantive court action can be commenced) carries the incremental risk of dependence on a wasting asset.

There is no question that the TRE Buyer should demand incremental compensation for the incremental risk assumed because of the limited security provided by its lien position.

[Note: To be fair, there is a potentially mitigating factor in the form of the right of TRE and its Buyers to attach Seller cash balances in the TRE lock-box. Mitigating factors will be discussed as a part of the wrap-up of this series of posts.]

Pardon the Interruption

2011-06-28T16:34:00.000-04:00

I intended to complete the list of posts identifying sources of incremental risk assumed in trading on the TRE platform before either attempting to quantify a risk premium or suggesting risk-mitigating changes in practice.

So, pardon the interruption, but I want to pause here for just one post to make a suggestion. It’s one that I think would help mitigate risk from two sources: the lack of a personal guarantee and the lack of a full notification procedure.

First, let me acknowledge that I understand the reasons why TRE has adopted the policies in place.

As we’ve pointed out, almost all TRE Sellers would be asked to provide personal guarantees by other funding sources. The lack of that requirement by TRE is thought to be of significant help in attracting Sellers. On the notification issue, I understand that a true full-notification policy would require a very substantial commitment of additional time and manpower AND it would substantially slow down the process of bringing auctions to market.

I do get it.

But the fact is that the combination of these two issues produces a potentially tempting opportunity for Sellers who either fall on hard times , or who are simply dishonest, to post invoices for sale that do not meet the criteria set forth in the Master Program Agreement.

The lack of a full notification criterion undoubtedly increases the risk that invoices will be improperly posted for sale. And the lack of a personal guarantee reduces the risk to the Seller of doing so.

There is, I think, a fairly straight-forward way to mitigate (if not eliminate) this risk.

The principals of TRE Sellers could be required to execute a CONTINGENT personal guarantee agreement that would have no effect EXCEPT in the event that invoices not meeting the criteria of the Master Program Agreement were posted for sale on the TRE platform.

So long as invoices, even those that might become problematic, actually meet the specified criteria, the obligations to cure defaulted payments would remain corporate only. However, if the invoices were improperly posted, which is a condition under the control of management, TRE and the Buyers could look beyond the corporate assets of the Seller to the personal assets of the owners.

Obviously, such a change in policy would meet with Seller resistance and would likely cause some potential Sellers to fall by the wayside.

However, if the principals of a Seller are not willing to guarantee their own adherence to the invoice posting requirements; essentially assuring TRE and the Buyers of their own honesty; they might be Sellers we could all do without in the long run anyway.

Appropriate Compensation #6: The Notification Issue

2011-06-23T15:30:00.000-04:00

No single issue has been discussed in as many of our posts as the issue of invoice notification versus verification.

See the following for prior comments:

 An Inconvenient Truth Part One: July 6, 2009
 An Inconvenient Truth Part Two: July 8, 2009
 Whose Ox is Gored? : October 19, 2009
 Half a Bubble Off Plumb: November 30, 2009

Why has this issue been given such attention?

Because, in my view, it represents the single largest potential threat to TRE Buyers. And, as such, the compensation it deserves is meaningful.

That compensation should be considered both at the level of the entire TRE platform as compared to systems that DO include full notification and among TRE auctions and Sellers, where differential risks can often be identified.

Let’s review the general issue.

In a “full notification” invoice purchase the Account Debtor will be asked to confirm that:

1) It has a contractual relationship with the Seller,

2) The invoice presented has been generated under the terms of that contract,

3) The work done by the Seller has been completed AND meets the terms of the contract,

4) The amount of the invoice is correct,

5) The payment terms are correct, and

6) Payment will be made as instructed in the notification document.

Problems might (and do) still arise, of course, even given all of the assurances listed above, but the general approach should go a long way to minimize surprises.

TRE does not use a “full notification” system. Instead, it uses an invoice “verification” system.

Under the TRE verification system the Account Debtor is asked to verify that an invoice matching the one posted by the Seller for sale DOES exist in its Accounts Payable system. That is: there is an invoice from the Seller in the Debtor’s AP system that has matching identification and amount details.

Essentially this tells us that the Debtor has SUBMITTED an invoice. It does not necessarily tell us that the invoice is valid, that the goods or services meet contract requirements or that the Debtor actually acknowledges the obligation.

TRE is understandably reluctant to make public in any detail the exact mechanics of the verification system it uses. Too much transparency would risk allowing Sellers to “game” the system.

However, it did notify Buyers in 2009 that it would not verify 100% of the invoices posted for sale on the TRE platform. Instead, after gaining a certain (unspecified) amount of experience with a Seller/Debtor pair, it would employ a statistical sampling process that it said would at least match the best practices of the factoring industry in terms of the percentage of invoices verified in given Seller/Debtor relationships.

There are Sellers whose auctions routinely consist of dozens of individual invoices and some of those Sellers post auctions of invoices due from the same Debtors quite frequently. It is understandable that asking the AP department of a Debtor to frequently verify dozens, or even hundreds of individual invoices might generate a little “push back” from the Debtor after a while.

While I have no knowledge of the actual sampling system employed by TRE, I’m willing to accept the idea that sampling can be an appropriate practice IF, of course, you’ve already accepted the verification versus notification alternative.

But that’s not really the issue here. The issue is: “what level of additional income should a TRE Buyer receive to compensate for the added risk inherent in accepting the verification versus notification alternative?”

There are two points that can be made immediately:

1. As we've said on other points of risk assessment, we just don’t have the data to measure this risk factor with any meaningful level of statistical reliability; any "answer" will be a judgment call; and

2. The answer is not “zero”. There IS an incremental risk to the TRE Buyers that should be compensated and that, over time, MUST be compensated if the exchange is to thrive.

So, how can we approach the problem?

Is the experience of TRE, itself, a useful guide?

In terms of quantifying the appropriate risk premium I don’t actually think the experience of TRE to date would be particularly meaningful even if complete data were available.

First, the level of transaction volume is still in its early growth phase and too small to provide a reasonable denominator against which to measure default/loss experience.

Second, the public default information involves ongoing litigation whose outcome continues to be uncertain. So the numerator is also problematic.

Third, while the details are not public, it is certain that TRE has made changes to its practices on the basis of what it’s learned in the early cases of default.

That being said, however, we CAN identify the kinds of things that cause a verification process to carry with it a higher level of risk than a notification process.

These tend to fall into two categories:

1. Falsification of, or fraudulent offering of, invoices: by completely fabricating the invoice or by materially misstating its amount or payment terms or by selling invoices that have already been sold to others or that are subject to the specific claims of others.

2. Diversion of payments either by actively causing payments to be made to an incorrect party or passively by accepting and retaining payments mistakenly received.

There are a lot of variations on these themes, of course, but most situations will fall into one of these two broad categories.

I think it is unquestionably easier to sell false or fraudulent invoices in a factoring system that is based on verification than it is in one based on full notification.

The case of diversion is not as straightforward. Diversion certainly occurs in both its active and passive forms in notification systems as well as in verification systems.

It can be argued that active diversion is easier in a verification system because the only point of contact between the factor and the debtor is at the level of an AP person who might have no knowledge of the substance of the relationship between the Seller and the Debtor.

I suspect that the chances of a payment being sent improperly to an invoice seller are probably just as high in either system. On balance, given the level of uncertainties in trying to analyze any of these issues, I’d probably call the diversion risk a “wash” for our purposes.

But the falsification or fraudulent offering issue (including the various forms involving collusion) is, I would argue, a significant differential risk factor. Buyers deserve to be compensated for assuming that risk.

What would represent adequate compensation?

In this case, as in the case of personal guarantees, we have no evidence to offer in support of a specific incremental return requirement.

In this case, as in that one, however, both the incremental risk and the appropriate return premium are “significant”.

There ARE auction situations on TRE in which this risk factor is significantly mitigated; such as in the case of Ariba Network invoices. There are also cases where the Seller documentation provided with an auctioned invoice gives the Buyer substantial comfort that the invoice is valid.

We'll discuss ways in which TRE and its Sellers might provide risk-mitigating information with auctions in a later post.

But, in general, our view is that an invoice verification process carries significantly higher risk to the Buyer than would a notification process and its pricing should reflect that reality.

Appropriate Compensation # 5: It's Still Not Personal

2011-06-10T15:39:00.000-04:00

In our post of June 22, 2009, entitled “Liability: It’s Not Personal” we discussed the fact that TRE Sellers are not required to provide the personal guarantee of their owner(s) as additional security for the performance of their responsibilities to TRE and its Buyers.

In that post we made a general statement:

“Most firms that buy individual invoices routinely obtain a personal guarantee of the seller’s obligations from one or more individuals associated with the seller.”

As we revisit that topic in this series on the issue of appropriate pricing of risk I think it’s time to firm up that earlier generality.

I’ll draw on two current sources for data relating to the prevalence of personal guarantee requirements:

1) the semi-annual report of the “Pepperdine Private Capital Markets Project” for summer 2011 by Dr. John Paglia of Pepperdine University (PPCM), and

2) the “Annual Asset-Based Lending and Factoring Survey Highlights, 2010” (April 27, 2011) of The Commercial Finance Association, (CFA).

The PPCM data is collected from a broader cross-section of the market that the CFA data and the CFA data is published publicly in “highlight” rather than detailed form but, for our purposes, those differences are not really critical. In fact the results of the two fit together quite reasonably.

According to PPCM data, the requirement for a personal guarantee in asset-based lending transactions varies substantially and as a function of the size of the loan. The smaller the loan the more likely is the requirement for a personal guarantee.

For loans under $1 million the median response revealed a 100% requirement for a guarantee. That figure falls to 90% as loan size increases to $5 million and 80% as it increases to $10 million. At a $50 million loan size, no personal guarantee requirements are reported.

PPCM survey responses from those in the factoring business are not given in such detail. PPCM reports that 87.5% of factoring industry respondents require personal guarantees while 12.5% do not. I think it’s reasonable to assume that the size of transactions and relationships is also a substantial variable in this sample and that the 12.5% of the deals done without personal guarantees would be found at the larger end of the size distribution.

So, as a general conclusion, PPCM suggests that the smaller transactions; presumably involving the smaller businesses; have a very high incidence of personal guarantee requirement; whether the transaction is an asset-based loan or a factoring arrangement.

The CFA survey draws data from a smaller, more-targeted sample of firms. In its own words it “decided to base the industry surveys on data reported by almost 40 of the largest asset-based lenders and factors…”

The “highlights” version of the CFA report does not provide data on the requirement of personal guarantees by asset-based lenders but it does provide that data for the respondents in the factoring survey.

In the CFA sample only 31% of respondents reported requiring full or partial “recourse”: a portion of which presumably includes personal guarantee requirements. While this might seem at odds with the PPCM data, it is not necessarily.

The CFA data is drawn specifically from the largest providers of funds. Presumably the largest transactions would be heavily represented among the largest funding providers. And, as we saw in the PPCM data, as deal size increases the requirement for personal guarantees decreases.

These two current reflections of the market for both asset-based and factoring transactions strongly suggest that personal guarantees are required as a matter of course in at least most of the smaller transactions in both the asset-based lending and factoring markets.

The issue of what is “small” is not as clear in the CFA data as it is in PPCM, but I think we would be justified in concluding that most, if not all, of the transactions that trade on TRE would; if they were made in the conventional marketplace; be subject to personal guarantee requirements.

One of the marketing points that TRE makes to prospective Sellers is that personal guarantees are NOT required, which is itself a statement about the otherwise general prevalence of the guarantees.

The “value” of those guarantees is not readily calculated – at least not with data that I have available. My own experience dealing principally with small sellers is that personal guarantees are of greater value in curing defaults than are “all asset liens” and certainly more valuable than “specific asset liens”.

In fact, given the length of time required to litigate a claim, obtain a judgment and then actually execute on a judgment it’s often the case that there’s nothing to be gotten from what remains of a business by the time a judgment creditor can actually try to seize anything.

On the other hand, the owners of businesses against which judgments have been secured, often have personal assets that really CAN satisfy claims. But if they haven’t provided a guarantee, the creditor has little effective means of reaching those assets.

This is another one of those cases where quantifying the value of a risk parameter is a difficult task if we’re looking for real analytical rigor. But I suspect we’d find broad agreement in the industry with the assertion that the premium required to compensate for the lack of guarantees should be “significant”.

What “significant” means, I think, has to be considered as a part of an overall evaluation of a transaction or relationship and I suspect that it changes with respect to a client over time and with experience.

But this is certainly an important item on our list of issues deserving a pricing increment in (at least) most TRE transactions.

Planetary Alignment

2011-05-31T17:07:00.000-04:00

There was a story on the news the other night about a rare occurrence that has allowed astronomers during parts of May to see 6 planets all lined up in a row in the morning sky.

Compared to that, my topic today is just coincidence.

But it IS the case that we “went live” as TRE Buyers on June 1, 2009. We had been lurking and studying for a couple of months before that, but today is the end of our second year of active trading on TRE.

As it happens, we bought our 500th auction today, which is a significant milestone for us.

And to continue the coincidence theme, this is our 100th TRE Observer post.

Two years is not a long time, really. But it’s a big part of the life of the Exchange.

The first auction we bought was #255, which will mean something to those who follow TRE activity.

And, as I write this (at 4:00 pm) we have bought as many auctions so far TODAY as we did in our first MONTH as an active Buyer.

In fact, one of the auctions we’ve bought today was bought from the Seller of our second auction. And today’s auction included one of the same Account Debtors as did that June 2009 auction.

This blog is in the process of analyzing various risks that deserve to be compensated in buying auctions on TRE and, as such, the current conversation inevitably tends toward the negative: concentrating on problems and difficulties. I don’t apologize for that: it’s reasonable and necessary.

But neither would I modify the words of the first TRE Observer post written on May 28, 2009:

“TRE is new and it is far from perfect. It will inevitably be required to make adjustments as experience teaches its operators and its users some valuable (and some potentially expensive) lessons.

All beginnings are hard.

But TRE is a game-changer. It is disruptive.

Those whose businesses face disruption will scoff at first and then resist but they will ultimately adjust to the new reality because they will have no choice.”

Many would have bet at that time that TRE wouldn’t still be around today. They would have been wrong.

Not only is TRE still around but there is another online invoice trading platform about to go live in the US; there is one that is live and growing in the UK; there is one just getting started in Sweden; and, there is one that is live in Germany.

What's that about the highest form of flattery?

Some of these markets might thrive. Some might fail. But my bet is that the idea is here to stay. And that the industry will ultimately adjust to it.

Next stop 1,000!

Appropriate Compensation # 4: Financial Statement Risk

2011-05-25T09:46:00.000-04:00

The issue of the reliability of TRE Seller financial statements was brought up very early in the history of this blog.

Our post of June 23, 2009 concluded:

“All else equal, the lower the level of assurance that the Seller’s financial data is reliable, the higher the appropriate Buyer’s risk premium.”

In our discussion at that time we pointed out that the Reliability Task Force of the American Institute of CPAs, under the criteria of its March 2008 paper on the subject, would include unaudited, unreviewed, management-generated statements in the category of having “no assurance” of reliability.

On the other hand, we noted that “the fact that an accountant has not certified the accuracy of the data presented in a financial statement doesn’t mean that the data is not accurate”.

There’s nothing in that June 2009 post that, nearly two years later, I would change.

But we do now have two more years of actual experience analyzing the financial statements submitted by TRE Sellers. And that additional experience does allow us to make some more observations.

One interesting phenomenon is that the percentage of TRE Sellers providing audited financial statements has actually fallen over time. The percentage was not high in earlier days but today it is almost zero. In fact, very few Sellers now provide even reviewed statements.

One reason, I suspect, is that TRE doesn’t REQUIRE audited, reviewed or compiled statements. And if a Seller does not HAVE to spend the money on such statements, its cost of obtaining financing is reduced, perhaps significantly, by eliminating that expense.

That’s only true, of course, if the Buyers don’t require a higher risk premium to compensate for the lack of assurance that a third-party review would provide.

Having had feedback from some Buyers on this subject I think I can say that there is a segment of the Buyer population that is looking quite closely at the Seller financials and using that information as a key element in the decision to buy or not to buy.

On the other hand I think it is clear that there are many Buyers who do not spend any significant time analyzing Seller financials, presumably on the assumption that the Account Debtor is the more important element in the decision process.

[One clear indicator of that is the speed with which the auctions of some first-time Sellers are bought. It has been clear in many instances that the Buyer had no time between posting and purchase to examine the due diligence materials available.]

That is perilous not only for the Buyer but also, ultimately, for TRE.

If any element of risk is materially mispriced, sooner or later it will generate losses that have not been adequately anticipated. Those financial losses will generate loss of confidence, which might actually prove the bigger long-term threat.

Since there is a Buyer for nearly every TRE auction, including those offered by Sellers whose financials some would find unacceptable or lacking in credibility, we have to conclude that Buyers who are NOT guided by the analysis of Seller financial capacity are probably setting the marginal pricing levels.

If there are Buyers willing to bid without giving effect to the financials then the Buyers who DO take the financials into account are faced with a binary decision.

They are either willing to buy or are not willing to buy based on their view of Seller capacity.

It is not yet possible, in my opinion, to implement an incremental pricing strategy that might, for instance, require an additional 50 basis points of monthly discount to compensate for a relative lack of confidence in one Seller’s financial statements versus those of another Seller.

Anyone who has analyzed the financial statements of TRE Sellers, which are largely privately-owned small to mid-sized firms, will have encountered some systemic issues that arise from the nature of that business structure. The accounting for owners’ contributions and distributions, for example will tend to penalize liquidity ratios and distort equity accounts. The desire to minimize taxable income, sometimes at the expense of a true picture of profitability, is also frequently apparent.

And management-generated statements for companies whose management doesn’t devote much attention to such matters can produce results that might charitably be termed idiosyncratic.

One of the most interesting phenomena is the change in statements over time by Sellers who are forced to actually produce and provide statements on a quarterly basis in order to remain in compliance with their agreements with TRE. I’ve noticed a number of cases in which it’s clear that increased attention produces improved product over time. Messy “legacy” issues on the books are cleaned up. Items are reclassified to more appropriately reflect the character of insider obligations. And so forth.

But the overall conclusion remains the same, in my opinion. There is meaningful, if not directly measurable, risk that the financial statements of the TRE Seller community, as a whole, would be found wanting if audited.

Given the obligation of Sellers to repurchase invoices not paid by Account Debtors that financial statement risk should command a pricing response.

Appropriate Compensation #3

2011-05-18T12:00:00.000-04:00

In our last post we suggested, with a number of caveats, that a reasonable full-cycle credit loss assumption for the traditional factoring business might average something in the range of 10% to 12.5% of gross revenues.

Two of the critical caveats were that :

1) actual experience would vary substantially over the course of the credit cycle, and

2) different customer segments of the factoring industry faced widely varying levels of probable loss: for instance, loss experience in staffing and transportation might differ significantly from loss expectation in manufacturing and construction-related industries.

It’s been interesting that my invitation for comments or differing opinions on a baseline loss level has elicited little response. Readers of this blog have become more and more willing to venture opinions, especially contrary opinions, over the course of its history. No response received proposed a specific adjustment to the suggested range.

I don’t know whether to interpret the relative silence as tacit agreement that it’s just a tough subject to document; or that the conclusion seems to be about right; or that it’s just not worth a response.

But I’m going to assume for the moment that it strikes readers as at least in the ballpark. And I’ll go on with the exercise.

Having ventured an opinion on a baseline, it is now time to move to discussion of issues specific to TRE that would cause a loss estimate specific to TRE to vary from the baseline. There are a number of these but we have to acknowledge that it is going to be impossible to attach an incremental risk measure to individual issues.

The best we are going to be able to do is to lay out the issues, consider the risk implications of each independently, and then try to assess and quantify the risk impact of all the issues as a single adjustment.

Neither our individual assessments nor any overall suggestion of differential risk is going to be defensible on the basis of hard data.

I cannot propose any way to reliably quantify the incremental risk of assessing Seller suitability on the basis of management-generated financial statements vs independently reviewed statements or audited statements, for example. But I doubt that anyone would argue that unaudited statements should be given the same level of credence as audited ones. There is SOME incremental risk, no matter how difficult it might be to quantify.

With all that said, it is still appropriate for each Buyer to CONSIDER both the baseline level of risk in the business of purchasing receivables AND the incremental risks attributable to the TRE process.

It’s also only fair to add that there are some elements of the TRE process that might act to REDUCE risk, at least as compared to certain invoice purchasing models, and that those need to be considered and provided for as well.

So this process will involve identifying and discussing a number of individual issues over a series of posts and then a discussion of and suggestion for quantifying an adjustment factor for application to TRE transactions.

Since I’ve used the financial statement issue as an example I'll address that one in the first post of the series.

I invite any reader with either information or thoughts on the relative risks of relying on management-generated financial statements versus compiled, reviewed or audited statements, to share that information either publicly or privately with the understanding that I will respect all requests for confidentiality.

Appropriate Compensation # 2

2011-05-11T16:49:00.000-04:00

It has been about six weeks since I wrote the first post in what is intended to be a series on the issue of “appropriate compensation” for the risk of loss faced by TRE Buyers.

I acknowledged at the time that this would not be an easy or straightforward task. And that has proven to be an understatement.

In attempting to establish a credit loss benchmark for the factoring business as a whole there are a number of difficulties that have to be acknowledged. Among them are:

 The industry is highly fragmented and relatively few of its participants are public companies with public reporting requirements.

 For most of the public companies that do engage in factoring activities, those activities are a relatively minor part of their overall business and their financial statements do not disaggregate results in a way that allows the isolation of factoring income and expenses. [Note: New FASB reporting standards will apparently allow factoring results to remain unclear due to the exclusion related to carrying values and the duration exemption.]

 The information that IS available on an industry-wide basis does not allow the isolation of credit loss figures that are mitigated by the employment of credit insurance.

 Disaggregated loss experience that IS available makes it clear that there are some segments of the factoring market that tend to generate much higher losses than average and some that generate much lower losses than average. This is the case both in terms of size of business and industry segment.

 Available information supports the intuitively reasonable notion that losses are cyclical with the change in overall economic conditions. So the most recent periods provide loss experience that is probably at the top end of a reasonable longer-term benchmark.

 Available information is not reported in a uniform manner: some reports measure losses as a percentage of income; some measure them as a percentage of average receivables owned; some report as a percentage of total receivables purchased; and some report as a percentage of average net funds employed.

Presentation of a full analysis of the data I’ve gathered and studied is beyond the scope of this post. And I could not present it here in a way that is fully documented in any case.

What I CAN do is to say that I’ve spent a reasonable amount of time on this question and gathered and analyzed what information I have been able to find in a pretty diligent search.

I can also say that, no matter what difficulties there might be in quantifying the risk numbers, it is appropriate to actively ATTEMPT to quantify them and to consciously incorporate a risk premium into the pricing of all factoring transactions, including those that occur via TRE.

So I’ll share with you what I think is reasonable, without suggesting that the research and analysis is actually robust enough to withstand a rigorous technical challenge.

There are undoubtedly others whose databases are better than mine. And there are certainly others whose primary activity is analyzing such data, while mine is not. And I invite anyone to provide alternate or additional information, either publicly or privately.

And finally, these figures are not those that I would suggest are appropriate for TRE transactions. These are meant as a starting point; a baseline for the typical factoring business BEFORE adjusting for the specific TRE approach to the business.

So, with all of that as preface, these are my suggestions at this point:

1. The nature of the TRE transaction requires that whatever adjustment for risk is chosen, it needs to be applied in the pricing of each transaction. There isn’t really a portfolio-level adjustment mechanism when you’re operating in a spot-factoring auction market.

2. I think the most useful way to state and to adjust for loss expectation for our purposes is on the basis of a percentage of gross revenue. I think that allows the most straightforward means of adjusting pricing parameters at the level of an individual transaction.

3. It is necessary to decide whether to choose a single loss expectation figure based on an assumption about a full credit cycle and a typical transaction. This would be in the nature of a fixed reserve allowance against which actual losses would be charged as incurred. It would presumably be higher than actual losses during relatively good times and lower during relatively bad times.

4. If the single reserve figure does not appear appropriate, then a range of loss expectations over the course of a credit cycle might be established, and at any point in time the actual allowance assumed would reflect the current state of the credit markets.

5. It is also necessary to decide whether to choose a single loss expectation figure for all transactions or to vary the allowance based on the character of the transaction. One level of adjustment might, for instance, be based on industry e.g. adopting a different allowance for staffing industry transactions vs manufacturing industry transactions or transportation industry transactions.

6. These are relatively “high level” adjustments, of course. Specific underwriting criteria and other matters affecting risk would also obviously need to be reflected in the pricing.

7. Based on the data I’ve seen it appears to me that a baseline risk adjustment that reflects the “typical” factoring transaction would range over the course of a credit cycle from somewhere in the mid single digits; say 5% of gross income; to a level much higher than that when we’re in the worst phase of a contraction; say 25% of gross income (or even more in some recent cases).

8. It appears that, over the course of a cycle, there are generally more years with experience towards the lower end of the range than at the peak of contraction. So, if we were to pick an average to use over the cycle, it would probably fall below the mid-point of the range.

9. 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.

This series of posts will continue with discussions of the differences between the “typical” factoring transactions and TRE transactions, focusing on the distinctions between the two that affect risk and loss expectations.

To make the point again: I welcome any comments on this issue and especially any data that might help make the analysis more robust.

A Brief Digression

2011-04-24T10:42:00.001-04:00

I had intended by now to post at least two additional pieces on the issue of appropriate compensation for risk in TRE transactions. But it’s been a busy month and I’m still in the process of gathering data and thinking through the analysis. I’ll get back to that important topic soon.

However, I had a conversation a couple of weeks ago that brings up an unrelated but, I think, interesting subject. So if you’ll permit me a brief digression…..

The conversation was with a prominent member of the traditional factoring community. He said that it was his opinion that a company whose only business was buying receivables via TRE was not in the factoring business. Rather, in his view, it was in the investment business.

Now, as I’ve written, my associates and I formed a new company last year whose sole occupation is buying receivables via TRE. So this is an issue of more than a little interest to me.

Having spent my entire business career in various investment businesses I could hardly take offense at being termed an investor. On the other hand, the implication in this case was negative: that there is something important lacking in the TRE Buyer that excludes him from being recognized as a part of the factoring community.

Putting aside for the moment the question of what that says about the relationship between the traditional factoring community and TRE, the topic is, in itself, an interesting one to consider.

Is a TRE Buyer in the factoring business?

A standard dictionary of business law provides the following definition of factoring (with a useful reference to a ‘factor company’):

“Factoring is a form of financing in which a business sells its receivables to a third party or ‘factor company’ at a discounted price. Under this arrangement, a factor company agrees to provide financing and other services to the selling business in return for interest and fees on the money that they advanced against the seller's accounts receivables.”

It is clear that a TRE Buyer DOES: a) buy the receivables of a business, b) at a discounted price, c) in return for fees on the money advanced.

That much of the definition cannot be argued. What, then, is lacking or could be said to be lacking?

The only thing that appears to me to be open to question is PROCESS.

The standard definition cites “other services” and it is (at least arguably) implied that the connection between the selling business and the ‘factor company’ is direct.

In the case of the TRE Buyer the provision of “other services”, such as collection of payments, accounting for and distribution of funds etc. is performed by a paid intermediary i.e. the Exchange.

It is also true that the Exchange, not the Buyer, establishes and maintains the direct relationship with the Seller and that it provides the Buyer with certain due diligence materials that the Buyer may use in its decision making.

I think that it is beyond question that a factoring transaction occurs when a business that is a TRE Seller sells invoices via the Exchange to a TRE Buyer. (Certainly the law of the State of Louisiana recognizes such a transaction as factoring.) It is the structure and process of the TRE factoring transaction that is unique.

But the uniqueness of the structure doesn’t, in my view, change the character of the transaction.

The person with whom I spoke on this subject actually argued that neither TRE nor the TRE Buyer was in the factoring business. But if a factoring transaction is taking place, surely SOMEONE has to be playing the role of “factor”.

Now, it might be argued that the sum of the parts equals “factoring” but none of the parts equals “factor”. I think that argument is hard to support.

Let’s walk through the functions and responsibilities.

TRE does the marketing. It finds the Sellers. TRE qualifies the Sellers in accordance with criteria agreed upon with the Buyers and it provides the Buyers a set of due diligence materials that the Buyers can analyze in their decision making.

TRE manages the process of packaging the Sellers’ invoices for sale, offering the packages to the Buyers, determining when sale criteria have been met, “closing” and funding the sale. It provides the accounting of the sale to both parties. It receives payments from account debtors, accounts for them and distributes them. It is responsible for the process of verifying invoices, for following up on payments and for certain defined matters in the event of payment defaults.

All of these are clearly important parts of the process.

What does the Buyer do?

First, the Buyer must decide to invest money in the purchase of accounts receivable. I don’t hesitate to use the term “invest”. Every factoring company is investing in the purchase of accounts receivable regardless of any fine distinction of language one might desire to make.

Having made the decision to invest in purchasing accounts receivable it is the Buyer’s responsibility to decide on certain portfolio-level matters, for instance: how much to invest, what concentration and diversification rules should be used, how will the due diligence materials provided by TRE be analyzed and evaluated, what due diligence activities and materials should be considered in addition to those provided by TRE, what Seller-experience criteria must be met prior to considering a purchase from that Seller and what account debtor experience criteria must be met before considering a purchase of that debtor’s invoices.

On the basis of those considerations, the Buyer must decide which Sellers to buy from, which account debtors’ invoices to buy and what pricing level is acceptable.

The unique additional responsibility of the TRE Buyer is that it must act in the arena of real-time competitive auction, which requires a discipline, an approach to decision making and a flexibility and sensitivity to changing real-time conditions that are not required of the traditional factoring company.

So, given that factoring transactions ARE unquestionably taking place, what can we say about the separation of functions in the TRE process: the division of responsibilities between the Exchange and the Buyers?

Well, I’ll tell you what I’d say.

In a nutshell, the TRE Buyer exercises the executive functions in the process while the Exchange is responsible for the technical functions.

Portfolio-level decisions are the Buyer’s. Risk management decisions are the Buyer’s. Seller acceptance and account debtor acceptance decisions are the Buyer’s. Pricing decisions are the Buyer’s.

If we were looking at a hypothetical factoring company office, the Buyer would occupy the CEO’s office on the top floor. The Buyer performs the CEO function.

The marketing, research, accounting and treasury offices are all down further in the building. They support and report to the CEO and any one of them can be outsourced and purchased on a pay-for-service basis.

And that’s precisely what TRE is: a multi-function, outsourced back-office combined with a unique transaction facilitation process.

Where is the ‘factoring company'?

I’d suggest that both the Buyer and TRE are in the factoring business but if I had to identify one ‘factoring company’ I think the typical analysis of a business structure suggests that the executive function, the locus of ultimate decision making, defines the business.

I spent many years in the real estate investment business. It frequently happened that a deal was brought to us by a broker. The broker typically provided a substantial amount of analytic material, had the direct relationship with the seller and acted as intermediary in the negotiation. After a property was purchased, its day-to-day operations were outsourced to independent property management and leasing companies.

Was I in the “real estate business”? None would argue.

With respect to those holding differing opinions in this case I would say: OF COURSE a company that buys receivables via TRE is in the factoring business. It’s disingenuous to argue otherwise.

That doesn’t mean that all TRE Buyers are GOOD at it. And it doesn’t mean that they actually DO perform all of the functions I’ve cited above.

I didn’t say that every TRE Buyer actually DOES all of those things. I said they were RESPONSIBLE for them.

If they avoid their responsibilities, make bad decisions, lose money, get mad, take their marbles and go home…..well they will have done what many in the traditional factoring business have done.

They will have failed.

But neither their failure nor their success will change the character of the business they were in.

Appropriate Compensation #1

2011-03-28T09:13:00.000-04:00

For a few weeks in February and early March there was just a hint of a Buyers’ strike in the TRE auction dynamic. Many more auctions stayed open for hours or even days. Fewer buy-out bids were made. More Sellers adjusted pricing upward to close deals.

That hasn’t completely ended. We’re still seeing some egregious over-reaching by some Sellers and some push-back against that by Buyers.

One relatively new Seller this past week wound up agreeing to terms roughly double its initially-posted buy-out level. That says more about the unrealistic ask-price than the final auction terms, though.

The average returns to Buyers during March have fallen back from their brief February rise and it’s possible that we’ll close the month with new lows in average market-wide returns.

It’s not fair to say that TRE auctions are “priced for perfection”. They’re not.

But it IS fair, I think, to ask whether they are priced appropriately in light of the risk assumed by the Buyers.

So this is the first in a series of posts examining the question of what might be an appropriate level of compensation for risk in TRE auctions.

I think it’s useful at the start of this conversation to acknowledge that it can be perilous to try to analyze ANYTHING at the level of an entire market or to use market-wide averages as benchmarks. Compensation for risk is only one component of the total return required by investors, whether they are Buyers on TRE or involved in any other investment activity.

Cost of money, cost of operations, applicable taxation levels and an appropriate net profit also have to be considered.

If we were to look at the traditional factoring community we’d find that these individual variables tend towards a common level reflecting the similarities among the participants in a well-established industry. That would be true in any mature segment of the investment community. The economics of participants in a mature market tend to be shaped by the market over time and to converge around parameters that reflect the investment characteristics of that market.

That is not currently the case when we look at the TRE Buyer community. It is nowhere near as homogeneous a group as is the traditional factoring community or the community of firms that specialize in any other mature investment market.

In fact, the TRE Buyer community is an extremely diverse group. My guess is that there are substantial differences within the group in very basic characteristics like cost of funds and cost of operations.

And the motivations of the TRE Buyer community, as reflected in the determination of what might be an “appropriate” level of profit, are just as diverse.

Some might be simply looking for a place to “park” short-term funds at an expected rate better than the near-zero current money market returns. Their TRE activity is a side-line, at best; maybe even a short term experiment.

There are other Buyers, though, that are looking at TRE as potentially a primary business; one that has to both cover reasonable costs and generate reasonable profits.

So the total returns considered adequate by TRE Buyers will probably fall in a wider range than would the returns of either a fairly homogeneous industry or of a well-established asset class. TRE really represents neither of those at this point.

On the other hand, TRE DOES represent a closed system when the question of assessment of investment risk is concerned. All who choose to participate in the TRE market assume the risk that the market presents. They will react to that risk in different ways: i.e. via diversification rules, Seller-quality rules, auction-characteristic rules, etc. But they are nevertheless participating in a market that has some common risk parameters.

Our ability to define those parameters is limited by experience. TRE presents a new approach to its market and its history is short.

But some experiences external to TRE can be used with value to analyze risks that are specific to TRE. Because of the relative lack of experience with and information about TRE-specific risks I think we actually HAVE TO look outside of the limited experience of TRE itself if we are to have a meaningful discussion.

In some cases we’ll be able to offer quantitative data drawn from other sources and markets. In many we’ll only be able to suggest relative measures: e.g. that a certain TRE-specific risk is likely more than or less than that of an alternative.

But even if we can’t offer actual quantitative measures, it is still useful to consider a particular source of risk and to ask in some disciplined way whether the risk facing a TRE Buyer is likely to be greater than or less than that faced by participants in other markets that present similar challenges.

I don’t know yet how many posts this subject will occupy but I suspect it will be several; maybe half a dozen. So there’s plenty of opportunity for readers to help shape the conversation.

I welcome any suggestions of issues that should be examined in this conversation. And I’d be delighted to receive any information, especially good data, that anyone might be willing to share.

One of the things we’ll need to address, for instance, in establishing a relative benchmark, is the loss experience of the traditional factoring and receivables-finance markets. Some data on that is public, of course, but any good information that might be shared on that or any other relevant issue would be much appreciated.

We have to acknowledge at the beginning of this exercise that its primary value might be in the exercise itself as opposed to the conclusions. But that’s OK, too.

We’ll take value where we can find it.

Further on Alignment of Interests

2011-03-16T11:53:00.001-04:00

In my last post I suggested that TRE modify its fee structure to eliminate distortions caused by the fixed component of the Buy-side Exchange fees. Those distortions are magnified in auctions with relatively short durations.

One auction in this week’s market activity caused me to look back at the question of distortions from a different point of view.

On Monday afternoon, a fairly seasoned TRE Seller posted an auction with pricing parameters that set a new record. The buy-out advance requested was higher than any in my memory and the buy-out monthly fee offered was the lowest in my memory.

The Seller is solid, but not gold-plated. The Debtor has an unquestioned capacity to pay and its performance in prior auctions appears to have been fine. I have bought an auction from this Seller, involving invoices due from this Debtor, and was quite satisfied with the result.

So the deal deserved a good price.

But the pricing requested in this transaction would have returned to the Buyer something closer to a CD rate than a return typically associated with receivables financing.

My first reaction was: What are they thinking?

My second was: Let’s try to actually understand what they’re thinking.

I have to admit that I have a Buy-side bias when it comes to analyzing auctions. I spend a lot of time on the subject of return to the Buyers. I really haven’t spent much time working on the cost of funds from the Seller’s point of view.

But the only way to answer the question: “What are they thinking?” is to look at the transaction from the “other side”.

I’m not going to say much about the TRE sell-side fee structure except to say that the basis of the fee is essentially the size of the auction and that the rate charged is variable depending on certain Seller characteristics. For my purposes I’m going to assume that the Seller in this case enjoys a rate at the low end of the range.

The auction under study has a probable duration that can be readily estimated. There has been a reasonable amount of past activity and actual payment experience has been quite consistent.

If we know the auction size and its pricing parameters, the duration is really the only remaining variable in the return calculation. So this particular example is a good one to use from that perspective.

It really is quite surprising how the view of the transaction changes, depending on one’s perspective!

I looked at two cases:

1) the initial buy-out pricing parameters, and

2) the actual final sale pricing parameters.

And I looked at the projected return to the Buyer in both cases and then the projected cost of money to the Seller in both cases.

Case 1: Using the initial buy-out pricing parameters, the net annualized yield to the Buyer would have been in the very low single digit range. But the net annualized cost of funds to the Seller would have been about 5 times that level!

The cost of funds would still have presented an extraordinarily attractive deal for the Seller, however --in the mid single-digits on a net annualized basis -- so there’s no mystery why the Buyers weren’t willing to play.

The point is that the gap between the return to Buyer and the cost to Seller, which is clearly a function of the fees earned by the Exchange, is a hugely distorting factor when pricing is extremely aggressive and duration is relatively short.

Case #2: Using the actual sale parameters, the distortion is much lower but it is still substantial. The return to the Buyer is just into the double-digit range while the cost to the Seller is in the high teens.

Now I don’t know how many Sellers look at their cost of funds in the same way that I have looked at it. But in this instance, while I would have been unwilling as a Buyer to accept the return generated by the deal; if I were in the Seller’s shoes I would probably have thought I was paying a pretty fair price for the money.

There’s the rub.

At this stage in its life TRE has a fairly small transaction base on which to generate fees. It’s clear that fees alone can’t cover its current expenses. It will need to grow by a significant amount to reach that point, I suspect.

On the other hand, given the need to grow substantially, the question of the impact of fee structure on growth potential is a fair one to ask.

Having gone through this exercise I have a greater sensitivity to the position of the Seller.

But my sensitivity doesn’t change my estimation of appropriate return to Buyers’ capital one bit. And it won’t change my actions at all.

[Except that the language I use when I see what appears to be an irrational Seller pricing structure might be somewhat more moderate.]

Only TRE needs to be sensitive to BOTH sides of the auction transaction. Buyers are going to look to their own interests and Sellers to theirs. That's the nature of the market. But TRE has to understand and act to ensure that both sides find the net benefits fair.

Otherwise, the growth that we all need and want is at risk of failing to materialize.

Alignment of Interests

2011-02-27T12:02:00.001-05:00

For nearly two years now I have spent a significant part of every working day (and of many non-working days, for that matter) somehow engaged in the activity of The Receivables Exchange.

Over the course of that time I have bought nearly 400 TRE auctions; analyzed the financial condition of hundreds of TRE Sellers and their customers; had some success; made some mistakes; and thought quite a bit about what makes TRE “tick”.

And over the course of that time I’ve seen TRE make many changes in its operating practices, responding to perceived opportunities to improve on its original business model. Most of those changes have been, I think, responsive to understandable issues or concerns, and most have been motivated by a quest to add value to the benefit of all involved in the Exchange.

Ultimately, for TRE to succeed, the interests of Seller Members, Buyer Members and the Exchange itself, must be served. All three business models have to work if the Exchange is to achieve its long-term goals.

It is with that in mind that I’d like to offer a suggestion, as one with a substantial interest in the success of the Exchange.

I believe that the fee structure of TRE could be modified, in two fairly straightforward ways, to better align the interests of the parties. And, at the same time, to provide an opportunity for both increased Seller volume and increased Buyer appetite.

The basis of my suggestion is:

FIRST: the fact that Buyer and Seller interests are (primarily) reflected in distinctly different Exchange functions.

1. The primary interest of the Seller is met at the time its auctions are sold and funded, but

2. The primary interest of the Buyer is met when an auction is repaid in accordance with auction terms, and

SECOND: the fact that all three parties have a common interest in the length of time between the sale and the repayment of an auction.

It is not necessary to this discussion that we refer to the actual LEVEL of fees charged to Buyers and Sellers by TRE. It is sufficient to discuss the STRUCTURE of the fees.

The fee charged a TRE Seller, with respect to a specific auction, is (with minor exception)a function of the size of the auction. And it is earned and payable when an auction is sold.

In principle, there is little to quarrel about there. If the Seller’s primary interest in selling an auction is met in the sale and funding process, then it makes sense that that process should provide both the nexus and the basis of fee payment.

The Buyer's fee structure, however, has two components:
a) a fixed charge payable at the time of purchase and based on auction size, and
b) a variable charge payable with each remittance received, based on the Buyer’s earnings.

It could be argued that the Buyer’s primary interest has two components: the opportunity to deploy funds and the opportunity to have its capital returned with agreed-upon earnings. Under that logic, the two-part fee structure might appear reasonable.

In fact, however, there would be no desire to deploy funds without the expectation of their return. The ESSENTIAL interest of the Buyer is not in buying: it is in earning. And that essential interest is not met until an auction is closed-out.

The current TRE fee structure aligns the interests of the Exchange with those of the Seller to a greater degree that it does to the interests of the Buyer.

An equally-aligned fee structure would eliminate the fixed, size-determined portion of the Buyer's fee and provide for fee payments to TRE as and when Buyers are paid. Such a fully-variable fee might well be at a higher rate than that of the current variable portion of the Buyers’ fee. My issue here is STRUCTURE, not rate.

I can well understand how the current Buyer fee structure was conceived but, at the same time, I think it’s hard to argue with the logic that the Seller’s basic need is met at the time of sale and the Buyer’s basic need is met when an auction is closed-out.

Aligning the fees to the time when those basic needs are met has a clarity and simplicity that I find compelling.

My second suggestion, which I believe would be in the interest of all parties, is also simple in concept if perhaps a little more difficult in implementation.

It arises from the issue of duration, which I’ve written about in several prior posts. In those prior posts my point has been that the fixed portion of the Buyer fee structure disadvantages short-duration auctions. Obviously, a fixed fee based on size will dilute the Buyer’s yield on an auction that is only open for 10 days to a much greater degree than it will on an auction open for 60 days.

If the fixed portion of the Buyer’s fee is eliminated, as I suggest, this problem goes away for the Buyer. However, since the fees to the Seller are payable without respect to duration, the actual cost of funds to the Seller rises as the duration decreases.

Currently, the return to the Buyer on short-duration auctions is squeezed by the fixed fee and the cost to the Seller in a short duration auction is substantially magnified.

As matters stand, I will almost never bid on an auction when the invoices included are due in 14 days or less. (That’s not iron-clad, of course. The LIKELY payment velocity is more important than the stated due date. But the principle is the same.)

If I won’t buy the short duration auctions, I suspect that there are others who act in the same way. The counter-argument will probably be: “But those auctions DO get sold!”

Agreed! There are clearly Buyers willing to pay up for paper that might roll over every 10 days.

But that’s not really the point!

All parties in this adventure need overall TRE volume to INCREASE.

The fact that there are a few Sellers that routinely succeed in selling short-term invoices and that find a way to rationalize the all-in cost of those funds, obscures the real question, which is: how many more Sellers, whose invoices are relatively short-term, might be attracted to TRE if the short-term nature of their invoices was reflected in the fee structure?

I don’t know the answer to that question. And I recognize that incorporating a variable element in the Seller fee structure would require solving a few complicating issues.

But consider the difference between the annualized fee costs of two Sellers, both of which pay the same size-based fee for selling an auction, one of which is selling invoices with an average life of 10 days and the other selling invoices with an average life of 60 days.

I cannot believe that more Sellers of short-term invoices would not be attracted to TRE if it made a fee accommodation for the shorter-term paper. Such an accommodation might be accomplished simply by providing a fee credit for payments received earlier than a specified number of days.

And I cannot believe that more Buyers would be not willing to consider shorter-term paper if the returns were not so diminished by the fixed fee element.

Fee structure is fundamental to the TRE business model and no consideration of a change so fundamental will be easy. But we’re in the third year of actual TRE operations and we’re in a rather prolonged period of flattish volume.

At this point I believe that all elements of the business model have to be open to further analysis.

The question of fee structure should not be ignored.

More Evidence of a Turn

2011-02-16T18:05:00.000-05:00

In my last post I reported that there was evidence in the bidding dynamic that TRE auction pricing levels were stabilizing. An excess of liquidity in the market had helped push Buyers' yields down substantially and consistently since last September.

But there was evidence at the end of January that the deterioration in yields might be ending. At mid-February that evidence is stronger.

By our calculations the weighted average expected returns for all auctions sold in the first half of February was essentially the same as that for all auctions sold in January. The deterioration in yields, at least in the short term, had ended.

That doesn't mean things can't change rapidly; but to add a few data points to the conclusion suggested by market-wide averages, let me offer the following:

1. The stabilization in yields has occurred on LOWER volume. Now, nobody can be too pleased with lower volume, but if yields stabilize on lower volume it suggests that the demand has decreased at a rate greater than supply. So some of the enthusiasm of the new Buyers in December and January might have been dampened as they came to realize just how low they had pushed returns.

2. The velocity of closings has slowed substantially. Auctions are remaining on the screen for hours or days, in some cases, rather than seconds.

3. Bidding has returned to the auction dynamic. More and more auctions are starting at higher bids and attracting competing offers before closing.

4. Some auctions are again being sold to multiple Buyers, suggesting the deeper-pocket Buyers are not quite as driven to hit the buy-out button on larger transactions.

5. Asking prices are starting to creep back up from their rock-bottom levels of a few weeks ago. This is not a uniform phenomenon but we're seeing it from some of the Sellers that had really tested the lower-limits of pricing structure.

6. One Seller who sold at prices at the lowest end of the spectrum just a few weeks ago, sold three auctions today at projected yields more than double those of its average January transactions.

Let me stress again that all it would take for these initial indications of a firming, and perhaps a turning, in the market would be for money-flow to resume its rise at a rate greater than supply.

That could easily happen tomorrow.

But today, and for the first half of the month, it seems possible that the bottom in yields has been found, at least for the time being.

And that feels good.

Push Back and Protest Bids

2011-02-06T11:46:00.001-05:00

Before I get to the point of this post I’d like to introduce our new web site:

www.1150Investments.com

1150 Investments LLC was formed in 4Q 2010 to carry on and expand the TRE buying activity of The Interface Financial Group, LLC.

I invite any members of the TRE “family” to link to our site, which also contains a link to this blog.

Now to the point:

I’ve written several times since last September about the impact of increased liquidity on buy-side TRE auction yields. The trajectory of buy-side yields has been steeply negative since the last week of August 2010.

We’ve wondered when and at what level resistance might ultimately be encountered.

It appears that the answer to “When?” might now be developing.

Just as it took some time to confirm that the downward trajectory constituted a trend, it will take some time to confirm that the situation has changed again. But it IS beginning to look like we might have reached a point where stability is being sought.

That doesn’t say that returns to Buyers are rising but it MIGHT signal that they’ve stopped falling.

Over the past week or so we’ve begun to see some auctions stay on the screen for appreciably longer periods than has been the case for some time now. Many of those have ultimately sold at buy-out pricing but they haven’t sold as QUICKLY at that pricing as they might have a month ago.

Even some of the Sellers that have become accustomed to split-second sales at ever-decreasing cost have gotten some modestly chilly receptions recently.

Buyers of these auctions, while still willing to buy, have begun to place bids more often at levels higher than the buy-out prices. More often now we’re seeing several competing bidders “walking” the pricing down to the point of ultimate sale.

As to the questions of: “Where?” the trend might end, I can’t use absolute numbers under the confidentiality rules of the Exchange but I can say that our own calculations of dollar-weighted average returns for all TRE auctions have fallen by about 38% since September 2010. That’s a substantial reduction that cannot, in my opinion, be attributed (at least wholly) to decreased risk perception.

While there are quite a few Sellers that have proven themselves over that period and should reasonably command better pricing; when the entire auction portfolio is considered, a large part of the return decline, I believe, has to be attributed to increased market liquidity in the face of only modestly increasing supply.

If that is true, then there should be scope for a retracement of at least a portion of the yield declines of the past 5 months. IF and when, of course, supply begins to catch up with demand.

The type of bidding that I’ve described above, that requires a Seller to wait a while before closing a transaction and involves a process where actual BIDDING occurs, as opposed to immediate buy-outs, I call “push-back” bidding. Especially in the face of declining buy-out parameters.

The Buyers are not inclined to immediately accept whatever is offered at whatever price is asked.

But there’s another type of bidding that has also become evident in recent days. I call it “protest” bidding.

Protest bids have been showing up recently in cases where Sellers post auctions with pricing that is SO low that some Buyers express their annoyance by registering a bid SO far out of the money that it can only be interpreted as a message to the Seller.

The message is “WHAT are you thinking!” (Or, maybe “What are you smoking!”) And certainly conveys the message “Not ME, my friend!”

I must say that I find these protest bids refreshing. They are really the only way Buyers can communicate to Sellers, to other Buyers and to TRE that what they see on the screen is beyond what they consider rational.

SO……while it’s too early to call a trend change, there ARE some signs in the market that we might be nearing the end of the free-fall in yields that began last September.

From my point of view, that would be healthy for all concerned.

#350 and Whac-a-Mole

2011-01-26T14:34:00.000-05:00

We bought our 350th TRE auction this morning. Of that number, 293 have been re-paid to date.

We have now bought auctions offered by 71 Sellers including invoices due from 162 Account Debtors.

The Sellers break down as follows, by type of business:

Service 39%
Manufacturing 32%
Staffing 13%
Technology 10%
Trade 6%

The Account Debtors break down as follows, by ownership structure:

Public Companies 37% (including subsidiaries and divisions)
Privately-Owned Companies 63%

Two auctions were sold this morning before we bought #350 that we WOULD have bought based on our view of the Seller, the Account Debtor(s), the transaction history and the pricing available. Neither of those became #350 because they were bought before we could see them.

I mean that literally.

I was at my desk, watching the activity, ready to bid. As soon as these auctions appeared I moved to pull up the bidding screen. Before the screen loaded, buy-out bids had been recorded.

For the past several weeks it’s become a “Whac-a-Mole” market.

The Buyer with the fastest internet connection and processor gets first chance at the auction.

That’s troublesome on many levels.

First, I’ve got to upgrade my tech capacity. But that’s just a symptom, really.

The real problem continues to be excess liquidity in the market. And that excess liquidity does not just drive down pricing. It also alters both Buyer and Seller behavior.

As I write, there are more live auctions on the TRE screen than there have been at this time of day for quite a while. But that’s the exception.

The rule has been that Buyers have been so motivated to deploy funds that they’ve been willing to accept ever lower returns with less and less evidence of deal quality.

A couple of days ago a deal offered by a first-time Seller, involving an invoice from a first-time Debtor, sold very quickly at a pricing level that would normally reflect a well-known Seller with a substantial amount of transaction experience with the Debtor.

That deal might well work out just fine. But sooner or later the odds favor disappointment from that sort of bidding.

And now it’s confession time:

I bought deal #348 yesterday morning. It was only the third time in 350 purchases when I said immediately afterward: “Damn, that was a mistake!”

It wasn’t a mistake because of the Seller. I’d actually been waiting for that Seller to post an auction for some time. I’ve bought quite a few of their auctions, I like them and they hadn’t posted an auction for sale in over a month.

It wasn’t a mistake because of the Debtors. I have had good experience with all of them.

And it wasn’t even a mistake because of the terms of sale. The price represented a much lower return than that Seller had offered in the past, but in the current climate I was prepared for that.

It was a mistake because I acted too quickly. I got into the Whac-a-Mole game.

I saw the Seller that I’d been looking for. I saw Debtors that I knew. I saw pricing that was marginal but at least it was marginal. And I acted.

Only after I “won” the auction and looked more closely at the invoice terms did I realize that the likely duration was too short to reasonably support the pricing parameters. The TRE fees were going to eat up much more of the gross return than was acceptable.

I had succumbed to the Whac-a-Mole motivation and in doing so I missed the duration issue that I’ve written about on a number of occasions.

To make matters worse, as I was berating myself for being so dumb, the same Seller posted another auction at the same pricing but with a likely duration that WAS reasonable and I couldn’t get to it fast enough to try to mitigate my error. It was gone before I could load the page.

In the end, I have every expectation that the auction will be paid properly. And it was small. I’ll make a little money and that one auction does no significant or lasting damage. Unless I don’t learn from it.

So, I acknowledge this dumb mistake publicly because the motivation to avoid another such public confession is stronger than the motivation to win at Whac-a-Mole!

Dear Anonymous

2011-01-14T10:25:00.000-05:00

I appreciate your most recent comment and, as has been the case with some other comments, I think you make some points that add to the conversation and should be given an airing. However, you bury those points in what I consider clearly expressions of unsupported hostile opinion.

I'm not against the expression of opinion, even anonymous opinion, even negative opinion; but when you include unsupported assertions that are hostile and serious, without identifying yourself, you force me to block the entire comment.

Unfortunately, in doing that, we lose the opportunity to hear and consider the fact-based issues that you quite reasonably raise.

Because I cannot respond to you privately, since you've given me no means to do so, I am writing to you publicly to suggest: a) that you give me some way to respond to you so that I can tell you more specifically what I find inappropriate for general posting (I'm not going to make your points public for you by identifying them), b) to assure you that I will honor your anonymity if you choose to identify yourself privately, and c) to invite you to re-post if you'd like on the specific issue of advertising content that you raise.

Thanks. I do appreciate the time and effort evident in your comments.

Chuck

An Interesting Snapshot

2011-01-12T09:45:00.000-05:00

I was doing a little long-overdue organizing yesterday and one of the stacks of paper that I happened upon contained the printout of daily TRE auction results from this time last year. In fact, it contained the record of auctions closed on 1/11/10.

Since I came across it on 1/11/11 I thought I’d look at the two days, exactly one year apart, and see what I might find. The comparison was quite interesting.

Here are some highlights of the “snapshot” look at history:

1. There were 3.5 times as many auctions closed on 1/11/11 as on 1/11/10.

2. The value of the auctions closed yesterday was 2.6 times that of the closed auctions a year ago.

3. The average auction size yesterday was 75% of that in the 1/11/10 list. (From day to day, though, that number can bounce around quite a bit. The actual average auction size increased by about 50% over the course of 2010.)

4. Fully half of the Sellers that closed auctions on 1/10/10 are no longer active on TRE, which says something about the difficulty of the sell-side job for TRE. Churn is a real issue and net gains in volume mask the actual efforts required of the Seller-attraction team.

5. Interestingly, for our purposes, there was one Seller common to both days. That is, this Seller closed an auction on both 1/11/10 and 1/11/11.

Analyzing the year-apart auctions of that one common Seller we find:

• In both auctions, the Account Debtors were of good quality and had established payment records on TRE,

• The auction that closed yesterday was larger than the one that closed in 2010 but both were very close to the average auction size for the period in which they were closed,

• Both would be expected to have a duration somewhat longer than average.

• Our calculations of the likely returns to the Buyer of these two auctions suggests that the auction that closed yesterday would yield the Buyer a net annualized return of just over half (actually about 55%) of that expected of the year-ago auction.

Now, as we’ve written, we’re in a period of excess liquidity in the TRE market and a portion of the decrease in return to the Buyer can be attributed to that excess liquidity.

A portion of the decrease in return can be attributed to the fact that the Seller has continued, over the course of the past year, to sell auctions that have performed well.

And a portion of the decrease might be attributable to the maturation of the Exchange itself and a reduction in perceived platform-level risk.

But a (roughly) 50% drop in yield is a lot!

As one who believes that average yields are too low currently I’m quite interested to see how Sellers and auction pricing respond if and when we begin to move back toward a more balanced market liquidity position.

The Moderator Moderates

2011-01-05T08:21:00.000-05:00

I’ve been quiet lately. Mostly that’s because I haven’t had much to say that I thought would be of value.

Volume growth on TRE has been sluggish.

Buy-side liquidity growth has not been.

I’ve been commenting since last September on the erosion in average yields. That trend accelerated into year end.

I’ve also commented on the increasing percentage of auctions being sold at buy-out pricing and at the speed of auction closings. Those trends also accelerated into year-end.

One has to ask if we truly have an “auction” market if the principal competitive issue seems to be who can hit the “Buy-out” button most quickly.

But there’s no mystery here.

The supply of Buyer money has increased more quickly than the supply of Seller auctions.

The cause of that can be debated. It’s clear that TRE is well aware of the issue. It’s clear, to me in any case, that TRE is taking steps to address the issue.

Time will tell if those steps are adequate to resolve the problem.

It’s also clear, though, that the situation is causing concern and consternation among the Buyers. My guess is that the earlier Buyers will be the most affected, having seen dramatic changes in both the pricing and the dynamic of auction activity.

Which brings me to the real point of this post.

As owner and moderator of this blog I have the option to screen responses to my posts before allowing them to become public and a part of the permanent record of the discussion.

I’ve gotten a few responses recently from anonymous readers that reflect frustration with the changed character of the auction dynamic.

I have no issue with the expression of such frustration: I share it.

But comments have been made and opinions offered that I am not willing to allow to be posted here without the writer identifying him or herself.

It’s not for me to provide a forum for anonymous TRE-bashing.

So here’s the deal.

I’m not going to allow egregious bashing to be posted—full stop.

I have no problem with reasonably-supported and civilly-voiced opinion, whether that’s positive or negative.

I have no problem with criticism, suggestion for improvement, the pointing out of weaknesses, etc.

But as moderator I reserve the right to set a price for a seat at the table. And that price, at my option, can be the waiver of anonymity.

I have no problem with anonymous responses, per se.

But if you want to “sound off” you’ve got to be willing to identify yourself.

We’re all professionals here and ought to be willing to own the opinions we voice.

So if you’ve sent in a reply to one of my posts recently and you don’t see it on the blog, I invite you to write or call me to discuss the reason why I haven’t allowed your reply to be posted.

More Thoughts on Risk

2010-12-09T12:03:00.000-05:00

In my last post I suggested that that the pricing of receivables purchases had to cover three things:

1) The Buyer’s cost of funds,

2) The Buyer’s operating costs, and

3) An appropriate return for the risk assumed.

The issue of appropriate pricing for risk assumed is also, in my opinion, a function of three principal elements. It’s been a while since I addressed that topic but current bidding dynamics make me think it’s time to at least remind MYSELF of those elements.

The CAPACITY of the Account Debtor to pay is one of the three elements of pricing risk. It is an important one; but it is only one.

It appears that some Buyers are being persuaded in their bidding and pricing decisions by this element only and that, I think, can be perilous.

The fact that an auction includes invoices presumably payable by a Debtor with an unquestioned CAPACITY to pay loses value if that Debtor either does not ACTUALLY have an obligation to pay or, almost as importantly, does not BELIEVE it has the obligation to pay.

The two additional elements critical to the pricing decision are:

a) The CAPACITY of the SELLER to pay if the Debtor does not, and

b) The character of the RELATIONSHIP between the Seller and the Debtor.

Under the terms of a Seller’s agreement with the Exchange, the Seller is obligated to pay if the Debtor does not. If it does not appear that the Seller has the capacity to make good on the obligation, it is clear that the level of risk is elevated. But the ability of a Buyer to assess the Seller’s capacity is impaired by the Buyer’s inability, under Exchange rules, to have direct contact with the Seller.

The Buyer, therefore, is limited in its assessment of the Seller’s capacity to an analysis of information available either via the Exchange or via publicly-available credit and other data.

TRE is doing a much better job these days at getting timely updates of financial statements from Sellers, but it remains the case that most Seller statements are internally-generated without any third-party review. They cannot be treated as if they were audited or even independently reviewed. And TRE itself makes no representations regarding the accuracy of the financial information provided.

Since 99% of TRE Sellers are privately-owned, the value of information available from credit rating/reporting agencies is also limited. Most often the data available from those sources relates to a Seller’s payments of typical operating expenses. Do they pay their utility, credit card and equipment leasing bills, for example?

That sort of information has SOME value but it does not really address the capacity of the Seller to make good on an unpaid invoice; especially if that invoice is very large in the context of the Seller’s resources.

Many Sellers are in businesses that require very little equity capital to either establish or operate. Many have little or no net working capital and little or even negative equity.

That doesn’t mean, necessarily, that they could not access the funds needed to make good on a re-purchase obligation. But where the Seller’s capacity to re-purchase is not beyond question (and certainly where that capacity is clearly questionable) there is an element of Seller risk that SHOULD be compensated regardless of the payment capacity of the Debtor.

Why is that?

Because there IS a risk, no matter who the Debtor is, that the Debtor is NOT actually liable to pay. And there is a risk that even if it IS liable to pay, it will ASSERT that it is not, in which case there might be a difficult and potentially expensive fight to prove liability and to collect.

That brings in the third issue that has to be considered in pricing transaction risk i.e. the relationship between the Seller and the Debtor.

The “relationship” issue I’m referring to here has two elements:

a) The contractual relationship regarding the obligation to pay a specified invoice, and

b) The history between the Seller and the Debtor specifically involving the provision of and payment for similar goods or services.

I’ve written in the past about the fact that the TRE model is not a “full notification” model. With few exceptions the Exchange does NOT receive assurance from the Debtor that the goods or services represented by the invoice have actually been provided in a manner that meets the contractual requirements for payment.

The Exchange DOES verify that an invoice exists in the Debtor’s AP system that matches the one posted for sale; however, after a pattern is established between Seller and Debtor, that verification process includes a statistical sampling element allowing for less than 100% of invoices to be verified.

There are reasons that the TRE process falls short of a “full notification” standard and those reasons are easily understood.

However, it’s just a fact that sometimes errors are made in billing or that goods are damaged in transit or that goods or services fail to meet specification.

Challenges to payment liability can arise for a variety of reasons that legitimately cause actual payments to differ from invoiced amounts. The “verification” process is not likely to bring these to the surface.

The full notification process is, itself, not without risk or flaw, but it does provide a significantly stronger assurance to a buyer of invoices than does the verification alternative.

That being said, it’s fair to acknowledge there are many Sellers with longstanding relationships with Debtors whose goods or services carry a relatively low risk of failing to meet specification.

For example: a staffing company that provides relatively unskilled personnel to a client. The question is: did employee Smith work 40 hours at a given hourly rate during a certain week?

If employee Smith is moving boxes from a truck to a warehouse the question of whether he properly performed his task will be an easy one to answer. And, if the documentation provided with that invoice includes a countersigned time card on which the Debtor verifies that Smith actually did work 40 hours moving boxes, there is relatively little risk that the Debtor will subsequently challenge the invoice.

But if a staffing firm provides a skilled technician in a research lab, or a computer programmer whose work has to properly interface with that of a dozen others, for instance, a failure to perform the tasks properly might not be immediately apparent.

So the character of the goods or services provided does (or should) affect the assessment of risk. It's part of the "relationship" question.

Now, if the Seller has posted and the Debtor has paid 25 similar invoices for similar services in the past, then the assessment of risk is further mitigated.

But the converse is also true: the more limited the experience and the more specialized the goods or services, the greater the likelihood of disputed invoices.

Why do I come back to some issues I’ve written about in the past?

Because it is my perception that there are Buyers who are pricing transactions today as if there is essentially neither Seller risk nor relationship risk. If the Debtor is a well-known and financially sound company it appears that some Buyers will pay nearly any price asked by a Seller.

And because it appears to me that some Buyers are not even looking at the back-up documentation made available by the Exchange either on the Sellers or their invoices. The auctions are selling too quickly in many cases for a Buyer to have even calculated the likely duration of the transaction.

I suspect that there will be those who will disagree with my suggestion that risk is being mispriced in some current and recent TRE auctions.

They might argue that the pricing does not reflect a lack of attention to risk but rather the ability to access extremely low-cost funds.

I actually wish that were true. But I don’t believe it is.

And the process of re-pricing to more rational levels can be difficult for all involved.

A Comment on Risk

2010-11-28T12:28:00.000-05:00

The downward pressure on auction pricing that began in late August has continued and intensified through November. I’ve suggested before that this might have more to do with excess liquidity than with either improved quality of Sellers or Debtors or with decreased transaction risk.

While auction volume has continued to increase it appears that liquidity has increased at a more rapid rate. One indicator of that is the percentage of auctions sold at their specified “buy-out” prices.

On one recent day, there was only one auction that DID NOT sell at its buy-out price.

I suspect that there is a substantial Buyer out there who has given instructions to a trader that he is not to BID on auctions; but rather only to BUY them.

So, no matter that an auction might be had on better terms, this Buyer pays the “ask” price. And that, of course, provides a powerful incentive for Sellers to drop their “buy-out” or “ask” pricing.

Now, I might very well be wrong about this and I have no knowledge of any other Buyer’s actual trading dynamics. I’m just speculating based on the activity as I see it.

Viewed from the perspective of both the Exchange and the Seller community, of course, the current dynamic is very attractive.

For the Exchange, it makes the job of attracting potential Sellers, and of retaining current ones, easier. Lower cost of funds and rapid auction closings provide the sales force with a strong "story" when marketing TRE to prospects.

For the Sellers, obviously, lower pricing is always desirable.

And Buyers could ultimately benefit as well to the extent that more Sellers might be attracted to the Exchange, although this benefit is a lagging function and is obviously offset by the lower yields available at least in the near term.

In the long run, the Exchange cannot thrive on the basis of a pricing level that does not, on average, compensate Buyers for: a) cost of funds, b) cost of operations, and c) risk assumed.

The TRE Buyer community is very diverse, not only in terms of the primary businesses they represent but also in terms of their motivation for participating in the Exchange. A Buyer that is not primarily in the receivables finance business; whose interest in TRE might principally be as a place to “park” cash balances in the short term; will have a very different view of acceptable pricing than will a Buyer whose principal business is buying accounts receivable.

It’s really impossible for anyone except the managers of the Exchange – who will know all of the Buyers and their reasons for participation -- to comment on the likely range of Buyers’ cost of funds, cost of operations or motives for participation.

But the risk involved in an Exchange transaction is the same regardless of the identity or motivation of the Buyer.

I’ve commented in previous posts about the differences between the typical business model of a company whose principal activity is the purchase of receivables and the model on which TRE is based.

In several respects the risks of buying invoices on TRE have to be acknowledged to be higher than is typically the case in the receivables finance business. Here I’m thinking of issues like the lack of personal guarantees and of blanket first liens on Sellers’ receivables.

On the other hand, there are offsetting advantages to the TRE model that are not inconsequential. The lock-box arrangement not typically available to a spot-factor, the advantageous nature of the Louisiana law and a generally higher-quality Debtor community, are examples.

Each Buyer, or potential Buyer, will make his own assessment of the balance between those advantages and disadvantages.

But today I want to revisit a risk-related topic that I’ve commented on before that has become a larger issue in the current pricing environment. It does not arise from the TRE operating model but is significantly affected by its pricing model: specifically the impact of its fee structure on auctions of very short duration.

Given the relatively brief history of TRE it’s very hard to devise a risk analysis that would result in a conclusion regarding the probability of loss in transactions with certain given characteristics.

We really can’t say, for example: “the probability of loss in a transaction in which Seller A is owed money by Debtor B for the provision of goods or services with characteristic C, under the terms of an agreement with characteristic D ---is in the range of X% to Y%”

We’re just not there yet.

But there is a way to make a STATEMENT regarding risk even without actually suggesting an actual evaluation of risk. The statement I’m referring to is grounded in the traditional payback-period calculation from Financial Analysis 101.

Applied to a TRE auction it would take the form of:

“It would take X successful transactions (with given characteristics) to offset 1 such transaction in which a total loss was suffered.”

That says nothing about the actual risk of loss, of course, but it can provide a useful means of:

a) conceptualizing the consequences of a default, and

b) providing a relative measure of loss consequence between and among transactions.

Looking to the actual auction activity from a recent day I can pull an example of a transaction made at the low end of the typical range of expected duration and discount rate; one at the high end; and one in the middle.

The analysis has two steps:

1) using the likely duration and actual transaction parameters, calculate the expected net dollars returned to the Buyer upon full payment of the invoices purchased, and

2) divide the total funds advanced, including transaction fees and costs, by the expected net dollars returned.

The low-return transaction example, because of its short duration and low discount rate, produces a small dollar-amount of expected return. If a Buyer were to suffer a total loss on an auction with these exact characteristics, it would take 489 successful transactions with the same characteristics to recapture the loss.

The high-return transaction example has a very long expected duration and an unusually high discount rate. It would take only 7 successful transactions with these characteristics to offset a total loss on one.

The mid-range example, which is more characteristic of the typical transaction, has a moderate expected duration and a discount rate somewhat higher than the current average (but closer to the historical average) than either of our “extreme” examples. In that case it would take 45 successful transactions to recapture one total loss.

To my knowledge there has been no default on auctions involving the Seller/Debtor pairings whose auctions I’ve used in these examples.

It SEEMS clear that the Buyer community assesses the relative risks among them quite differently. But I wonder…..

Let’s take the case of the low-end example above. I don’t know who is buying those auctions or others with similar characteristics. But I wonder if they actually consider the relative risk to be roughly 1/11 that of the mid-range example?

I don’t know.

But I do know that it’s wise to remember two things:

1) The typical receivables transaction is of very short duration when compared to most other fixed-income investments; meaning that the ratio of dollars earned to dollars risked in a single transaction is low, and,

2) The direction of errors in projecting (percentage)returns on an invoice-purchase transaction is almost always negative. Other than earning a slightly higher return than expected if durations extend, you can’t really get surprised on the upside.

As time passes and experience is accumulated we’ll be better able to quantify relative risk using appropriate statistical means. Until then we’ll have to do the best we can with what we’ve got.

But I think it pays to at least acknowledge the implicit judgments being made until we get to the point where explicit ones can be supported.

Going Long(er)

2010-11-04T15:48:00.000-04:00

I became a Buyer on TRE in April 2009 with the specific commitment to refrain from bidding for 60 days. I wanted to watch the activity and get comfortable with the process before actually participating in TRE auctions.

As readers of this blog will know, I did get comfortable with the process and, after my 60-day “hide and watch” period, I did become an active Buyer.

My bet was still almost fully hedged, though.

It was clear that becoming more seriously committed to the TRE process required a judgment that the Exchange was likely to capture sufficient transaction volume and process/product credibility to sustain itself as a going-concern.

Since I began buying in June of 2009, several things have happened:

1) My experience as a Buyer has been successful,

2) Exchange volume is running at roughly 7 times its pace of 18 months ago,

3) TRE has attracted significant and credible new financial banking, and

4) The Corporate auction program, which I wrote about in my last post, appears likely to provide an additional revenue stream, giving the Exchange another leg-up towards break-even.

On the basis of those developments it now seems that the odds favor the long-term survival and success of the Exchange.

On that basis my associates and I have just taken off a part of our hedge.

We have formed and funded a new company to pursue an expanded commitment to investment in TRE-posted auctions.

That’s a big step for us and a significant commitment to the notion that there IS a long-term and significant role for TRE in the receivables-finance market.

It’s not a complete lifting of the hedge, however.

The Exchange volume is still short of that required to support either itself or an infrastructure of fully-committed participants.

And the buy and sell interests are still not balanced enough to avoid periods when prices get pushed – in either direction -- beyond what I’d consider rational given the level of risk.

Over the summer we saw yields to Buyers spike for a couple of months. Since the end of August the pricing has moved decidedly in favor of Sellers. Neither extreme has been driven by quality, in my opinion. I think it’s much more likely that, in both cases, the driver has been a supply-demand imbalance.

Short term swings in pricing power are just a fact of life in a market with a growth curve like that of TRE. New money entering a market like TRE is “lumpy”. And the pace of new Seller adoption is unpredictable.

In the short term there will be days that are good for Buyers and days that are good for Sellers.

Our bet is that, over time, a reasonable balance will be found. That, on average, Buyers will be compensated reasonably and Sellers will find fair value in the price/service proposition offered by TRE.

Have we gone “all in”?

No. It’s still too soon for that, in my view.

But our bet is long(er) than it was last week. And we’re comfortable with that.

One step at a time.

Expanding the Product Line

2010-10-10T15:22:00.000-04:00

The Receivables Exchange announced a new initiative last week: a facility to be operated separate from but in tandem with its current on-line market for the receivables of small-to-medium sized businesses.

The new facility is called the “Corporate Auctions” program, as distinguished from the current “SMB” program. It targets Sellers in the Fortune 1000 category of size and quality.

This is yet another big step for TRE and has significant implications for both current and prospective TRE Members on both the Buy and Sell sides of the market.

At the time of its announcement TRE also announced that a Fortune 10 company has signed up as the first Seller in the Corporate Auction program.

The identity of that Seller was not made public but I can say that you can find multiple products of that company in every American household (and most households and businesses throughout the developed world, for that matter).

TRE Buyers on the SMB platform will have to be separately approved to buy on the Corporate platform; and the size, character, bidding methods and pricing parameters will certainly be different on the Corporate platform than on the SMB platform.

The average transaction size will certainly be significantly larger in the Corporate program. And the returns to the Buyers will be significantly lower; reflecting the credit quality and the reliability of the financial data available on the Sellers and Account Debtors in that program.

After all, the great majority of the SMB Sellers are private companies providing Buyers only internally generated, unaudited financial information.

In the Corporate program the Sellers will very likely be large public companies with complete, easily accessed, audited financial statements already studied and commented upon by professional financial analysts.

Clearly, these markets will appeal to different types of Buyers with different risk appetites, costs of capital and motivations for participating.

This is an unambiguously good thing for the Exchange. Especially with the announcement of a “whale” as an initial Corporate program Seller.

But it is also an unambiguously good thing for those Members of the Exchange that stick to the SMB program.

Why is that?

First, this is an additional revenue stream for TRE. Obviously TRE is still in the stage of its evolution when it is burning through venture capital cash as it aims for break-even operations. The added revenue stream of the new program presumably advances the date on which break-even can be projected and thus it reduces the risk of all current participants, whether owners, Buyers or Sellers.

Second, to the extent that some types of Buyers are unable, because of the character of the SMB receivables, to participate in that program, this new initiative provides the potential for those Buyers to enter the market. This will bring not only their cash and their names to the Exchange but it will broaden the universe of financial market participants with actual Exchange experience. The more broadly the Exchange is known and understood in the financial markets the better, in the long run, for us all.

Third, to the extent that there are Buyers now active on the SMB platform whose actual needs and motivations are more aligned with the Corporate-type risk/reward profile, those Buyers now have an option to get what they really want, leaving the SMB program to those whose appetite and objectives more closely match it.

Fourth, while this might be considered a “stretch”, I see no reason why TRE could not go searching down the Corporate program supply chain for additional SMB Sellers. If we know that there is funding moving down the supply chain from a Corporate program Seller, that knowledge affects the assessment of the risk of buying paper due from a third or fourth-tier supplier of labor or material in that chain.

Fifth, if TRE can cite the participation of some very high quality Corporate program Sellers, it will very likely help them to attract new SMB Sellers. Even though the programs are different, the impact of quality-by-association should not be ignored. The imprimatur of a Fortune 10 industrial conglomerate does mean something to the owner of a smaller, privately-owned business.

I am not sure when TRE will be able to make more information publically available about this new program. And until TRE makes it public, confidentiality agreements keep the rest of us from doing it.

But, from my point of view, this is as big a deal as the announcement of the Bain funding earlier this year.

Both events take TRE a big step closer to an assured future.

Both mean that evolution in the receivables finance market continues to advance.

Another Milestone

2010-09-29T08:17:00.000-04:00

We received a payment from The Receivables Exchange this morning that closed out an auction we purchased on July 28.

It was a small auction; the first we had bought from that Seller. It contained invoices due from one regional firm based in California that I had never heard of before (but that turned out, on examination, to be quite solid) and one company known and respected world-wide.

The payment history was interestingly indicative of current patterns: the regional company paid in 14 days; the worldwide behemoth paid in 62 days.

We’ve written before about the move of larger, more credit-worthy companies to extend payment terms. One of the interesting consequences of this, for TRE and its Buyers, is that it tends to increase the working capital needs of companies that sell to those large credit-worthy firms.

The impact might be only marginal but it is to put generally upward pressure on the credit quality of the Account Debtors brought to auction by TRE Sellers.

The counter-point, obviously, is that it’s clearly NOT a good thing for the Sellers. While it’s great that TRE provides a ready market to liquefy the invoices of those Account Debtors, the net impact on the Sellers’ profitability is negative.

But that discussion is not the reason for this post.

I’m writing because the payment received this morning brought our total of closed-out auctions to the 200 figure!

That’s cool; at least it is to me.

Next stop = 500.

An Award & Bigfoot Lives

2010-09-27T08:23:00.000-04:00

In the special Technology section of this morning’s Wall Street Journal ,The Receivables Exchange is named winner of the Journal’s 2010 Technology Innovation Award in the category of e-Commerce.

This is a well-deserved recognition of the TRE Platform, which is made even more impressive by the fact that there has not been a winner in this category since 2004.

Considering the e-commerce innovations that have come to market since 2004, that have NOT been considered worthy of an award, this is quite a compliment to the Exchange’s management and technology teams.

It’s one thing to have an important and innovative idea. It’s quite another to be able to actually make it work.

TRE has been able to do that both in terms of the basic concept of providing a liquid market for the receivables of small-mid-sized businesses and in terms of doing it in a real-time online environment that is so integrated from Seller through Exchange to Buyer, and back, that money flows, fully accounted-for, on the basis of a one-day turn-around.

A brilliant concept is of little value unless it can be made to work.

TRE makes it work and it’s making it work better all the time. Updates and upgrades to the platform are made on an essentially continuous basis. As the volume of TRE transactions continues to grow, significant additional platform development will be necessary. But history to-date provides a convincing case that the management of the Exchange and its tech people will more than keep up with the demand.

Another day of congratulations to TRE!

On another subject: to update my last post on the “reverse lurch” -- the shift of pricing power to the Sellers has continued throughout the month of September.

Bigfoot continues to make his presence felt as more and more auctions are closed by a leap to the buy-out pricing parameters. It’s difficult to tell if this is one new Buyer or a Buyer with a significant increase in allocated funds. But the tracks that Bigfoot leaves are pretty easy to follow.

When a price-insensitive Buyer is in action, fewer auctions are left for the rest of the players. That increases competition and depresses returns on the deals that Bigfoot does not buy.

To the extent that the new money is acting on the basis of lower cost, and the volume of auctions does not appreciably rise, pricing will likely remain at the lower levels. But, to the extent that some part of Bigfoot’s behavior might be modified over time as pricing lessons are learned, or the volume of product available increases sufficiently to offset his demand, pricing might well take another swing back toward the Buy-side.

That’s happened in several cycles over the relatively short life of the Exchange and I suspect it will happen again.

Ultimately, more liquidity will draw more product to the market just as more product (that the Buyers find attractive) ultimately draws more liquidity. This sort of cyclical pattern of pricing should be expected in a developing market.

Patience is a virtue, they say.

The Reverse Lurch

2010-09-06T16:37:00.000-04:00

No, that’s not the patent-pending description of Tiger’s new putting stroke.

In my post of May 31, 2010: “A Lurch to the Left”, I commented on the fact that pricing of TRE auctions had taken a decided turn in favor of the Buyer-community.

Auction statistics over the six-week period prior to that post reflected a shift in pricing power away from the Sellers.

I also noted, though, that there had been periods when the balance of power had favored the Sellers and that it was reasonable to expect that TRE pricing dynamics would shift from time to time.

The shifts from Seller-power to Buyer-power and vice-versa can obviously reflect a variety of factors. New Buyers with a desire to put money to work quickly can push pricing down. A sudden increase in supply of auctions can have the reverse effect.

We’re also beginning to see some cyclical patterns reflecting the lumpy timing of invoice payments and the desire to quickly redeploy returned capital.

The” Reverse Lurch” I’m referring to now is a decided shift back toward the Sellers’ favor in auction pricing.

That’s been noticeable over the past few weeks but has been especially pronounced in just the past several trading sessions.

My guess is that one or more Buyers have either just begun to deploy capital on the Exchange or have significantly increased their allocations to Exchange activity.

Whatever the cause, the effect has been clear.

In the first three trading sessions in September I bid on a number of auctions at prices that would have had a high probability of acceptance a week or two ago. In several cases those auctions were bought by others very quickly at prices that reflected no desire to test the pricing possibilities.

By that I mean the Buyer accepted the “buy out” pricing parameters with no attempt to determine if a better deal might be available. In a number of cases there were other bids; some quite far away from the “buy out”; and the winning bidder jumped immediately to buy-out price level.

The character of the Exchange is such that none of us can really tell what motivations are at play in any given auction or at any given time. We can only observe what IS happening and speculate about patterns that emerge as we look back at what HAS happened.

Since the bidding of the first three days of September presented some unusual activity I decided to look back about six weeks to see what I might find.

I looked at four auctions that closed in the first three days of September. The Sellers were “regulars”. The Debtors had a good deal of payment history. So reasonable projections of duration could be made both for the new auctions and those that closed in late July. The sizes of the early September and the late July auctions were similar.

I plugged the parameters of the auctions into a model that estimates annualized net return.

The projected annualized net return from those four sample auctions averaged roughly HALF the levels those Sellers had to pay in the late July period for similar auctions of invoices due from the same Account Debtors.

That’s a MAJOR lurch!

Now, the AVERAGE auction has NOT fallen in yield in that way over the past six weeks. The pricing pressure is not indiscriminate. And it might well be that this shift is short-term and motivated by unusual Buyer dynamics.

The point of this post is to recall the reverse situation in late May and to point out that pricing DOES ebb and flow on TRE. My guess is that the magnitude of the swings will become less pronounced as the volume of Exchange transactions continues to increase.

One thing is clear: these “lurches” tend to be concentrated in auctions that might seem a bit “obvious”: meaning, for example, that the Debtor is a very well-known name.

There are still very good, if less-obvious, auctions to be had at better pricing levels.

And we should remember that it’s not clear that the “obvious” auctions necessarily deserve the pricing they receive.

There are three elements to analyze in any auction:

a) the capacity of the Seller to re-purchase if necessary,

b) the capacity of the Debtor to pay what it owes, and

c) the character and certainty of the rights and obligations connecting them.

A triple-A Debtor might appear to create an obvious “buy”.

But a triple-A Debtor that questions the obligation to pay can all of a sudden become the hardest collection case on the list.

Then it’s the Seller’s capacity to re-purchase that is the key issue in the analysis.

I'm not a golfer but I know enough to realize that a "lurch" is not a good thing in a putting stroke. But apparently it DOES happen from time to time; even to the best.

Tomorrow's another day!

In the Way of St. Augustine

2010-08-30T08:10:00.000-04:00

St. Augustine of Hippo is famously known for pleading: “Lord, grant me chastity-- but not yet!”

Augustine clearly viewed chastity as a good thing but he wasn’t quite ready to enjoy its benefits.

In the receivables purchasing business, getting paid is a good thing. But getting paid much more quickly than expected – not so much.

The “good” in a payment pattern is more a function of predictability than absolute timing.

Regular readers might now anticipate my returning to a pet peeve. But hear me out.

An auction that I purchased recently was closed out last week: paid as agreed; which, in itself, is certainly a good thing.

But it wasn’t paid either “as expected”, or “as advertised”. And that’s not such a good thing.

When I first started buying receivables in my spot factoring business I made the mistake of telling a couple of prospective clients that I was looking for invoices that would pay in the range of 45 days, give or take. It’s been my good fortune to have gotten many of my clients via referral from other clients. And it’s amazing how often I’m told that a referred prospect’s payment expectation is about 45 days!

Word spread from those initial clients, of course, that that’s what I wanted to hear—so that’s what I’m invariably told. But those prospective sellers are most often saying “45 days” when the truth is that payments will take LONGER. They know it and I know it.

The phenomenon I’ve griped about in prior posts with respect to TRE auctions is having invoices presumably due in 45 or 60 days that get paid in 7 or 9 days.

Why do I gripe about that? Not because it happens once in a while -- that can be just the luck of the draw.

But recently the number of instances of significant disparity between the posted payment expectation and the actual payment experience has been increasing. This is the case both in auctions that I’ve bought and in those I’ve just been monitoring.

The trigger for this post is that the auction I referred to above, which was paid last week, was “due” to pay out in about 30 days. In fact, the actual weighted average duration was 3.7 days!

The result was that my actual net earnings on that auction were roughly zero. That was a “successful” but still unsatisfying transaction.

I had bought several auctions from that Seller prior to the one I’m describing and all had performed as expected. I have actually been quite happy with the experience.

And as annoyed as I was with the result of that one auction, I was prepared to assume it was just bad luck. That for some unknown and unusual reason the Account Debtor just paid very early.

And so I bought another auction from the same Seller even before this one had closed-out.

The first payment on the NEW auction was made ONE DAY after the auction closed. The invoices that were paid were not “due” until mid September.

With that additional experience, as much as I have been pleased with the initial auctions bought from this Seller, I’m now going to have to stay away from those auctions until there is evidence that these are anomalous situations and that a predictable relationship between the posted due dates and the actual payment expectations can be anticipated.

The reason, of course, is that acceptable pricing changes significantly as the duration of auctions changes. This is particularly true in cases of very rapid payment.

The marginal impact on return of payments expected in 45 days but received in 30 is actually pretty minimal. But the impact of a payment expected in 45 but received in 10 is quite significant.

I am not suggesting that the Seller in this case deliberately misstated the payment expectation. I don’t believe that is the case. Actually, I suspect that this transaction will have been as unsatisfactory for the Seller as for the Buyer.

Because of the TRE fee structure, the costs to the Seller on this auction will have been as high on a relative basis as the return to the Buyer was low.

But there is a small number of Sellers whose actual payment experience appears to be consistently more rapid than “expected”. That creates a credibility problem—-for me, at least. And I’m no longer willing to bid on those auctions.

Ultimately it is to everyone’s benefit for there to be a rational relationship between the posted “due date”, the Seller’s posted “expected payment date”, and the actual payment experience.

I’m not suggesting that there won’t always be outliers in payment patterns, in both directions. Of course there will.

But when the pattern itself is of “outlier” events – it has to be the posted due date or posted payment expectation that is called into question.

Bringing a Knife to a Gunfight

2010-08-18T14:17:00.000-04:00

Last Friday I was listening to Bloomberg radio as I drove to a meeting.

Mohammed El-Erian, the brilliant CEO of PIMCO, was being interviewed on the question of European sovereign debt. Commenting on the assistance provided the Greek government he said that the program amounted to “applying a liquidity solution to an insolvency problem”. The implication was that, in his opinion, the weapon did not suit the battle.

As others might put it, the Euros were bringing a knife to a gunfight.

El-Erian’s words stuck with me, so I thought I ought to brush up on some definitions.

First, insolvency and bankruptcy are two different things. And Dr. El-Erian would know quite well, given his background at the IMF, that countries cannot technically become bankrupt. Bankruptcy is a legal concept that does not extend to sovereign entities.

Insolvency, on the other hand, is a financial condition. More accurately, there are two financial conditions associated with the term insolvency.

1. “Balance sheet insolvency” is the condition in which liabilities exceed assets, and

2. “Cash flow insolvency”, meaning that a company cannot meet its payment obligations on time.

The cure for balance sheet insolvency is a capital cure; increasing assets, decreasing liabilities, or some combination of the two that results in a positive capital account.

But, what is the cure for cash flow insolvency?

The condition has two elements: a) payment capacity, and b) time.

So the approach to a cure for cash flow insolvency (absent a reduction in the actual amounts due) will have to be a combination of increased payment capacity and extended payment terms. Both of which are liquidity solutions.

In fact, absent the steps noted above with respect to balance sheet insolvency, the only REAL solutions for cash flow insolvency are LIQUIDITY solutions.

Moving from a discussion of the rarified issue of sovereign debt to the arena in which Buyers and Sellers on The Receivables Exchange spend their time, the realities include:

1. A large percentage of private businesses in the small-mid-size space are “balance sheet insolvent”.

The liability protections and the tax treatment of the S-Corp and the LLC, which dominate private business ownership structure, create a bias in favor of minimizing assets left in the business. Especially in companies with high depreciation expenses; these structures tend to generate negative net worth over time.

2. The balance sheets of many businesses in the SMB space tend to reflect the personal finances of the owners as much as they do the financial results of the companies.

For instance; often the liabilities that make the business “balance sheet insolvent” are loans due to the business owners, which would likely be treated as capital contributions in other circumstances. The odds of a business owner forcing a solvency crisis by accelerating a loan due him are (usually) low.

3. Many businesses in the SMB space are not far from the start-up phase and the early-period losses still dominate the balance sheet.

4. It is the income statement, or more-accurately, the BANK statement, that commands the attention of most private business owners. A high percentage will know their cash position every day. A very low percentage will examine their balance sheet in detail even quarterly.

5. Cash flow is the lifeblood of these businesses. If the bills can be paid and the owners can draw enough cash to meet their personal needs, the fact that the balance sheet shows a negative net worth is not likely to affect management’s decision making, at least in the short term.

6. But, as we all know, it is cash flow that has suffered most during the recent financial contraction and de-levering of credit-granting institutions. And the relative complacency of owners whose businesses are balance sheet insolvent does NOT apply equally to the case of cash flow insolvency.

7. Cash flow insolvency threatens the going-concern viability of small businesses to a far greater degree than balance sheet insolvency.

Many recent studies and surveys have documented that access to cash is the number one problem in the SMB market today.

It is precisely a LIQUIDITY solution that is required for a problem of cash flow insolvency. It might not be a permanent one. It might well be that a capital structure solution is required in the longer term.

But in today’s financing environment the acceleration of cash flow via the sale of accounts receivable might provide the BEST solution for many smaller businesses.

In the world of global sovereign debt finance there might be room to question the KIND of solution used for a financing problem. To a small business owner, though, the existence of ANY solution is a big, and a welcome, thing.

Maybe a knife doesn’t win in a fight against a gun. But if I don’t have any bullets for my gun, the knife looks like a pretty good alternative!

The "Two-Feet-Deep" Danger

2010-08-15T13:16:00.000-04:00

We’ve all heard the one about a man (hopefully a statistician) drowning in a river that is, on average, only two feet deep.

It’s not that the information about average depth is either inaccurate or unimportant. It’s just that it’s not ENOUGH information if you happen to be crossing at the wrong point.

In my last post I said that I’d write next about the 2nd quarter figures in the “National Summary of Domestic Trade Receivables” published by the Credit Research Foundation. The CRF has published this survey quarterly for 50 years.

I’ll only make broad comments because the material is copyrighted. See www.crfonline.org for subscription information and other products and services offered.

The CRF has devised and publishes a “Collection Effectiveness Index”, which is a single-figure indicator of the general health of the domestic trade receivables market.

That measure showed a significant improvement in 2Q-2010 compared to 1Q and a small improvement over the year-ago period. Most other aggregate measures they report showed similar improvements:

a) decreasing days-sales-outstanding,

b) decreasing delinquencies,

c) increasing percentage of accounts current, and

d) decreasing percentage of accounts over 91 days past due.

These high-level, market-wide measures are useful indicators that nevertheless have to be understood in the context of potential lag-effect, bias from sample size and bias from self-reporting.

The breakdown provided by industry group can be more valuable since it reveals substantial variances from the reported medians.

For example, in the category of “% Current” the range among industries in 2Q-2010 was from 39.13% to 94.76%.

Of particular interest to me as I studied the results was the disconnect between the improving picture painted in the CRF report and the anecdotal information that I’ve been hearing recently from clients and others. The message I’m hearing is that there has been a continued deterioration in the ability to collect money owed to small and mid-sized businesses.

I’ve written in prior posts about an organized and concerted movement by Wall Street houses to educate large, credit-worthy businesses on the virtue of substantially lengthening payment terms to their suppliers and then offering to accelerate payments at a discount.

This “squeeze the little guy” campaign demonstrates a cynical disregard for the long-term damage to the SMB community, which is so important a source of job creation. Its openly-stated purpose is to leverage the large companies’ access to cheap capital as a tool to force suppliers to reduce effective prices.

Let me add a few, admittedly anecdotal, data points from conversations I’ve had in just the past week:

1. A colleague told me the other day that he had knowledge that a large, multi-national company had instituted a new, purposely-draconian, “reject the invoice” policy. The AP staff of this company will now reject any invoice for ANY deviance from its increasingly complex and difficult-to-understand invoicing policy; requiring a revision and re-submission. And, of course, stringing out the time to payment.

2. A client told me this week that one of their customers; an architectural firm that had done a substantial amount of work for a large public hospital; had had to fight for over 120 days to get a check, which then bounced.

3. A colleague reported that a large, national customer recently notified a certain class of supplier that it suspected that there had been fraud on the part of some of those suppliers and so had put a freeze on ALL payments to ALL suppliers in that category until an audit could be completed. Completion of the audit is not expected until YEAR-END!

4. A professional services firm that has been in business since 1914 has had to enter into a workout payment arrangement with a subcontractor on some UNDISPUTED bills to a large municipal school construction agency that have been unpaid for nearly a YEAR.

5. A painting contractor that has been doing a significant volume of work for one of the largest residential property management firms in the area for over 20 years now has about 75% of its receivables at over 90 days.

These are just a few items that have come up in the past week.

It’s certainly possible that my experience reflects a regional bias. It’s possible that the lag effect is a partial explanation. It’s also possible that it reflects a bias toward the kind of client I typically deal with in my spot-factoring business.

But the anecdotal reports that I’ve been getting certainly paint a picture that is at variance with that of the 2Q CRF report.

I do not question the CRF results. I think that the information they compile and analyze is valuable and important and I’d recommend it to anyone interested in top-line industry trends. It might well be that the next quarterly report will show the sort of softening that current anecdotal information hints at.

What I do suggest is that the need for liquidity in the SMB market and, specifically, for acceleration of receivable collections in that market, continues to be among the top two or three problems facing business owners.

And that’s good for prospecting by the TRE Seller-marketing group.

Misfiring Synapses

2010-08-06T13:59:00.000-04:00

Some days the coherence of a rifle shot gives way to the less-organized pattern of a scatter-gun. This is such a day.

Rather than a single topic, I have a scatter-shot list of points to make and issues to address.

So, here goes…..

1. This week we’ve marked the close-out of our 150th TRE auction. (We’ve bought all or part of 189 auctions to-date.)

I can no longer say that we have encountered NO repayment problems but I CAN say that the issues that we have encountered have been handled professionally and successfully.

2. It has ALWAYS been unrealistic to suggest or to believe that everything would always work smoothly in the environment of SMB factoring. It doesn’t and it won’t. The challenge is to anticipate and avoid situations with a higher likelihood of problems, even if that means refraining from bidding on auctions that seem very tempting.

3. I was reminded this week that holding-period duration can be every bit as important as discount rate. I made an error and bid on an auction that could potentially have been repaid so soon that the TRE fee structure would generate a negative or negligible return to the Buyer. As I was berating myself for the bidding error and hoping that somehow I could be spared “success” on that auction, another Buyer placed a more aggressive bid that I’m convinced was also an error on his part. Give thanks for dodged bullets!

4. I continue to believe that the TRE fee structure should be re-considered. It provides a powerful disincentive for Buyers to bid on short-duration auctions and, therefore, acts to damage Sellers’ ability to maximize utilization of the platform.

5. In last Friday’s “Liquidity Weekly” email, Bill Siegel noted that July was another record month for exchange volume. The actual volume figures are TRE’s, not mine, to make public. But I think I can add a specific data point of interest without violating the Buyer confidentiality agreement.

By my reckoning, July 2010 represented the 12th consecutive month during which auctions were closed on EVERY trading day of the month. That’s pretty cool—a full year without a zero on the daily volume chart.

6. As I was considering the last twelve months activity, I looked back just out of curiosity, at the activity in the last week of July 2009 versus that of the last week of July 2010. What I found was interesting.

A high percentage of the Sellers active in the current period were also active in the year-ago period. Some of that seemed coincidental. Two Sellers, for instance, that were active in July 2009 have been largely absent from the exchange over the past several months but happened to pop up in the last week of July 2010. And their auctions were treated very well buy Buyers.

In a couple of cases, Sellers that were active in both year-apart periods found that their pricing in the 2010 week was much different than in the 2009 week.

My interpretation of that is that the Buyers are paying more attention to the updated financial statements, to the strength and payment records of the Account Debtors and to the likely duration of auctions; and they are adjusting their bids accordingly.

In other words, the analytic process is improving, at least among the Buyers that have been active for a while. That’s a good and healthy development.

7. While there was a surprising number of Sellers active in each of the two periods studied, there has also been an interesting pattern of rotation in the more-active Sellers over the intervening months. One Seller will be a major driver of volume for a few months and then go “quiet”, for instance. Some of these are seasonal issues. Some seem to reflect the Seller acquiring more traditional financing sources.

8. The positive aspect of the historical pattern is that when one major Seller goes quiet another tends to come along to replace it in fairly short order. The volume pattern of the last year should not be interpreted as continually building on a base of established and reliable Sellers (although there are certainly quite a few in that category).

Rather, the pattern is more like “rotation” in the equity markets. Leadership changes and Seller -participation changes for a variety of reasons, but the top-line trajectory remains strongly positive.

9. It is to the Exchange’s credit that, so far, there have been new leaders brought on to replace those who go quiet in a fairly seamless pattern.

10. The Credit Research Foundation has just published its newest quarterly “National Summary of Domestic Trade Receivables”, which is quite interesting. I’ll write about that in my next post.

In the meantime, pardon the misfiring synapses of an August Friday afternoon!

Remembering Jerry Maguire

2010-07-21T11:25:00.000-04:00

There’s a great scene in the movie “Jerry Maguire” in which Tom Cruise is pleading with a prospective client. He says, again and again:

“Help me help you. Help ME help YOU!”

Without Cruise’s inflection it sounds a little flat but he was really PLEADING.

Suspend disbelief for a moment and let some of that pleading tone seep into your reading of this post!

In my June 30 post I complimented the TRE management on the job they’ve been doing at getting Sellers to post updated financial statements in a more timely manner (as required, by the way, in their program agreements). It’s an issue that I and others, I know, have been concerned about and things are moving in the right direction.

Now I’d like to make another suggestion. I can’t communicate directly with TRE Sellers. That’s not allowed. So I’ll make it in this forum and hope that it somehow gets transmitted through other channels.

Here’s the issue…..

As I sit here, there is a live auction on the platform that I might well be interested in, EXCEPT that the updated financial statements show what is to me a serious and inexplicable trend in the ratio of accounts receivable to gross sales. The number is so far out of the ordinary and the trend is so definite that, without some explanation, I just can’t bid.

The Seller MUST recognize that this is a red-flag item.

Absent some other explanation I have to assume that there is an unappealing reason why receivables are such an unusual percentage of sales. But maybe there IS another explanation. If the Seller were encouraged to post an explanatory note that solved the riddle, there might be a greater level of interest in its auction.

So.....“XYZ Corp, help US help YOU!”

Give the community of Buyers SOMETHING to explain the weird numbers!

I met the other day with a colleague and, among other things; we discussed some of the companies on my “bid vs. no-bid” list. In scanning my list he saw a name that I had categorized as “no bid”.

My colleague happens to know this company and its background. He told me that, while he is aware that they’ve had a history of very substantial losses and have a current a balance sheet that ”must look horrible”, he suspected the company’s backers were quite willing to continue funding it.

That’s information that is not available from the material provided on the TRE platform, from the credit information I had obtained on the company or from the data available from a quick online search. (I admit that, given the looks of the financial statements, I did not spend a great deal of time trying to find reasons to qualify the Seller.)

But in this case, too, some explanatory notes from management could be made available on the TRE platform to help Buyers understand in a more nuanced way the financial situation of the company.

And helping Buyers understand the Seller’s situation will ultimately help the Seller.

One more example and I’ll leave this alone.

There are several Sellers that have very substantial, unexplained, Intangible Asset entries on their balance sheets. In some cases the only net equity on the balance sheet results from these intangibles.

With no explanation of the nature of the intangible it’s hard to give its stated value any significant credence. A note of explanation COULD make the difference between having many interested Buyers vs. few and an attractive pricing vs. one less attractive.

The nature of the relationship between TRE Buyer and Seller is unusual. We can’t pick up the phone and ask the Seller questions. But the answers to some obvious questions could be of real benefit to all parties.

So, while I have no standing to make a request on behalf of all Buyers, I’ll say to both the Sellers and to TRE:

"Help us help you!”

Added clarity on financial statement items that are obvious red flags can only benefit the Sellers.

The Very Good Gets Much Better

2010-07-13T08:11:00.000-04:00

One of the first items I discussed on this blog was the advantage of the Louisiana treatment of receivables transactions. The so-called “true sale” provision of the LA version of UCC Section 9 largely removes the potential that a purchase of receivables might be subsequently deemed a financing rather than an asset sale.

That’s a big deal and one of the reasons that TRE chose New Orleans as its headquarters.

Now that benefit has been significantly expanded and essentially “tailored” to specifically include transactions on the Exchange.

Governor Bobby Jindal took time out from his work on the BP oil spill to sign into law Louisiana Senate Bill No. 256 (Act 958) entitled the “Louisiana Exchange Sale of Receivables Act”.

The title of the law itself signals one of its principal benefits to TRE.

It does not apply to ALL transactions involving receivables sold in Louisiana. Rather, it deals only with those receivables transactions that take place “over electronic and other types of exchanges located in” Louisiana.

In other words: transactions that occur on TRE.

To make its aims quite clear, the stated legislative intent is specific i.e. “to encourage and promote businesses to offer sellers the ability to sell their receivables to qualified buyers over electronic and other types of exchanges in this state, thereby availing themselves of Louisiana civil law principles not found in common law jurisdictions…”

A few of the new advantages accorded exchange-based transactions are:

1. Clear and specific language affirming that exchange-based transactions are included under the very strong “true sale” protections already in the Louisiana law.

2. Clear and specific language affirming that exchange-based transactions will not be re-characterized as financing transactions even when seller-guarantees of repayment are provided and even when the seller might be entitled to subsequent additional payments for the receivables sold.

3. Clear and specific rejection of common law theories under which sale of receivables have been considered financing transactions in other jurisdictions.

4. Expansion of the definition of “receivable” to include other third-party domestic and international payment obligations that are not subject to the Uniform Commercial Code.

5. Provisions requiring anyone who attempts to re-characterize receivables transactions as financing transactions to pay the exchange-buyer’s costs to defend itself.

6. Clear, strong and specific language regarding the application of Louisiana law, and of these provisions particularly, regardless of the legal domicile of the seller, the buyer or the account debtor.

7. Provisions making clear the right of a buyer of exchange-traded receivables to resell the receivables purchased and to pledge or grant a security interest in the receivables purchased: in other words, facilitating a buyer’s securing financing to purchase exchange-traded receivables.

I again remind everyone that I’m not a lawyer, but as I see it there are some really big things in this bill, which should probably be titled the “Let’s Help TRE As Much As We Can ” Act.

Clarifying the “true sale” status of exchange-traded transactions is a very good thing. And this is the principal benefit discussed in the press release from TRE on this new legislation.

Specifically prohibiting re-characterization of exchange-based transactions is a good thing.

Providing for buyers’ entitlement to recover costs is a good thing.

But, from my point of view, the really BIG things in the bill are:

a) The expansion of the definition of “receivables”. This is not discussed in the TRE release but opens the door to new markets that could be of major benefit to the Exchange and its participants.

b) The specific provisions allowing exchange-traded receivables to be pledged as security. This will certainly aid those buyers looking to obtain leverage without pledging other assets as security.

c) The provisions that basically say “our law is THE law and the rest of you can go to hell”. The language of the Louisiana legislature is very strong on this point and while there has not been, to my knowledge, a test of the choice-of-law provisions in the TRE participant agreements, this language looks to have been crafted by a lawyer wanting to pre-empt any challenge of those provisions.

The “true sale” issue is obviously important but I think these three provisions might actually provide the more important springboard for TRE’s growth.

My guess is that we’ll see some creative use made of these new provisions sooner rather than later.

Congratulations, TRE! And congratulations Louisiana!

Well done.

An Important Contingency

2010-07-08T14:04:00.000-04:00

In the arcane world of receivables purchasing, there is a small corner of the industry that is even more arcane than the norm.

I’m referring to construction trades and to the various disciplines; such as architecture, engineering and other related fields that service or interact with the construction trades.

Often these professional services firms work for owners, including governmental entities, via subcontracts from firms that hold the primary contracts.

An example, for instance, is a client of mine: a cost-estimating firm that typically acts as a subcontractor to architecture or engineering firms. Sometimes the ultimate source of funds is the developer of a real estate project; sometimes it is a governmental or quasi-governmental entity contracting for public works projects.

I’m not going to attempt to describe the unusual problems raised in buying construction invoices. That is beyond the scope of a post like this. But suffice it to say that there are good reasons why construction invoice purchasing is a small and specialized sector of the factoring community.

The issue I want to address today is the frequently contingent nature of payment obligations in the construction or associated professional service businesses. Specifically, the impact of “pay when paid” or “pay if paid” clauses frequently found in contracts with those businesses.

These payment conditions are usually quite clearly stated and the substance of the language is enough to give any buyer pause.

In concept, they read, for example: “We’ll pay you WHEN we get paid” or “We’re only obligated to pay you IF we get paid.”

I am not an attorney and this is not to be understood in any way as legal advice, but those of us who do get involved in buying invoices from businesses like these are usually very quick to ask for a copy of the contract provisions dealing with payment, regardless of the apparent strength of either the Seller or the Account Debtor.

If either of these provisions is found in the contract, the first thing that a prospective Buyer can do is forget any stated due date on the invoices being reviewed for purchase. Those dates just don’t really matter.

The second thing that a Buyer might do is to request a full history of the invoices submitted and payments received under the contract in question.

The third thing might be to determine how the law in the applicable State treats “pay when paid” and “pay if paid” clauses. There has been a substantial amount of litigation on these clauses and there is not an answer that is universally applicable.

Some state courts; those of New York and California for instance; have ruled that a “pay IF paid” clause is against “public policy” and is unenforceable in those states. So a “pay IF paid” clause will be treated as a “pay WHEN paid” clause in those jurisdictions.

But what does that mean? In general, I understand that has been held to mean that payment will be made within some “reasonable” period. The effect of that, it seems to me, is to render the due date on an invoice essentially moot.

Other states have ruled that “pay IF paid” is an enforceable condition under certain circumstances. That’s scary.

When an invoice is posted by a TRE Seller whose business is like that of the client I mentioned above, for instance -- that might work for an architecture or engineering firm or for a construction manager – whose source of funds for the payment of subcontractors’ work is a third-party; it is very important to understand the payment provisions of the contract.

Currently, the Sellers on TRE do NOT post information that would allow a Buyer to determine whether the invoices being posted contain “pay when paid” or “pay if paid” provisions. If the Seller is in the type of business in which contracts often contain those clauses, the Buyer might be assuming an unknown and un-priced risk.

The point?

In some cases, regardless of the apparent strength of the Seller or the Account Debtor, or the validation of the invoice, or the satisfactory completion of the work required for payment, it is still possible to be exposed to either non-payment or very late payment.

Awareness of that possibility is the first line of defense.

A "Safe Haven"?

2010-06-30T17:49:00.000-04:00

It’s been a busy month and I haven’t written as often as I usually do. I began thinking yesterday of what topics might be both timely and of interest for an end-of-month post.

There are many. It’s been a very active month for TRE.

LOTS of auctions; another volume record. Lots of new Sellers; some very interesting and some a little puzzling. Lots of established Sellers bringing new Account Debtors to the Exchange; again, some very interesting and some a little puzzling.

Those all suggest good topics.

TRE management has made significant and important efforts to enforce the requirement that Sellers update their financial statements on a more timely basis. Those new statements show that there have been some important swings in the condition of some Sellers: some in a positive direction and some negative.

It’s clear that 2009 was a tough year for many TRE Sellers. I’ve already commented on my own reactions to having to “let go of” some favorite Sellers and to become willing to buy from some Sellers that I’ve shunned in the past. There’s more than one good post in that topic.

And the bidding dynamics have continued to show changes in the relative strength of Buyers and Sellers and to provide some very interesting glimpses into the strategies and motivations of some market participants. Again, good topics to come back to.

But, as I sit here at the end of the day and the end of the month and the quarter, I have to pick a topic. And what strikes me as most important right now is “none of the above”.

I bought more auctions in June than in any of the 13 months that I’ve been an active Buyer. The average expected return on those auctions was higher than the average of any prior month.

I had more auctions close-out in June than in any prior month and none of those auctions was in any way problematic.

It wasn’t a month without some angst but most of that was self-inflicted and that goes with the territory in any investment medium.

And there’s the story…..

It was a month of increasing volume, increasing opportunity and increasing returns.

It was a month whose problems were the problems of managing opportunities.

Contrast that environment with the turmoil in stock market, the currency markets, the commodity markets or the sovereign debt markets. And then there were those who thought that bond yields couldn’t go any lower!

Who would have thought that buying receivables on an upstart electronic exchange would dampen portfolio volatility at the same time as providing incremental return!

Who would have considered this type of investment a “safe haven”.

Now, “safety” is relative and I am not going to downplay the potential risks involved in TRE transactions. I’ve taken pains to make some of those clear in prior posts. But I’m talking about the RELATIVE performance in an admittedly volatile period for other financial markets.

And, also admittedly, the volume of Exchange transactions is still too small to make a meaningful difference in the context of the portfolios of large investors.

But current experience has to be at least a LITTLE intriguing, even to the larger players, as we look forward to the day when TRE volume is a meaningful percentage of its potential.

Business As Usual

2010-06-22T17:08:00.000-04:00

I started buying TRE auctions on June 1 of last year. The Exchange was still in its fairly early days of operation and each new auction posted seemed to represent something of an event.

There were two days in the first half of last June, in fact, on which no auctions closed. It certainly seemed at that time that there were more dollars seeking auctions than there were auctions to bid on. So “losing” an auction was, at least for me, kind of a big thing.

There have been many changes in TRE operations and dynamics since that time. By my count, over the same period in June of this year there have been five times as many auctions sold as last year and the average daily dollar volume has increased by a similar factor.

The number of Sellers has continued to increase and, while there are quite a few that don’t make it through our screen, there are quite a few that do. There is now a significant number of Sellers, in fact, that I’m quite pleased to buy from.

One of the happy consequences of the continued maturation of the Exchange is that it no longer feels like such a big deal when an auction is “lost”.

A year ago, the process of analyzing a Seller; analyzing it’s Debtor(s); reviewing the invoices posted; considering the past auction history; deciding to bid; and then actually placing a bid; represented not only a significant investment of time and energy but had an emotional component as well.

It represented a serious commitment. To fail to win an auction after all that actually felt something like a failure.

Well, times have changed. I “lost” two auctions yesterday that I bid on actively. I liked the Sellers. I liked the Debtors. I’d had good experience with each and I offered competitive pricing—actually a series of increasingly competitive bids.

And then those auctions, that I really assumed I was going to win, were just gone; snapped up at prices that I suspect pleased the Sellers quite a bit but left me empty-handed.

But here’s the point……

I didn’t get THOSE two auctions--but later in the day I got two others.

And I know that the Sellers of the auctions I lost are likely to be back very soon and I’ll have another opportunity to buy some of their invoices.

It’s no longer an “occasion” when a good auction is posted for sale. It’s business-as-usual. If I miss one today I’ll have another chance tomorrow.

On the other side of the coin, if a Seller has to pay a little more today because of the dynamics of this particular day’s activity, he can probably count on evening the score on a day when the Buyers are feeling the pressure to put money to work.

In short, what was a novelty a year ago is not a novelty today.

When I log onto the TRE platform tomorrow morning I will have every expectation that I’m going to have the chance to do some business.

Some days will be better than others. You win some and you lose some.

But that’s what a market is about, right.

And that’s what the Exchange has now really become.

When the Evidence Changes

2010-06-10T12:51:00.001-04:00

The last decade or so of stock market experience testifies to the truth of the admonition: “never fall in love with a stock”. I confess that I have done that to my ultimate disadvantage more than once.

In essence, the rule tells us that it is perilous to ignore changed conditions; to hold fast to prior decisions when the premises of those decisions change.

Roughly a year and a half into the active life of The Receivables Exchange we’re now getting some information on some longer-term Sellers that allows us to chart the trajectory of their operations and financial condition over a few comparable periods.

(As an aside: I wrote last year suggesting that TRE make an arrangement with a credible academic institution to try to isolate and study the impact of the TRE facility on the financial health of its Sellers and I still think that would be a very useful long-term project!)

My point today, though, is to suggest a TRE analog to the stock market maxim. That is: “never fall in love with a Seller”. And to suggest the inverse, of course: “never hold to a negative conclusion when the evidence turns positive.”

As easy as it might sound, it’s still hard to do!

After analyzing a Seller. And concluding that buying from that Seller is a sound decision. And then actually buying a number of auctions from that Seller. And after getting paid properly for those auctions. It is difficult to look at new information that shows a deterioration in that Seller’s financial condition and conclude that the buy-decision needs to change!

In fact, for me, it is more difficult to “let go” of a deteriorating Seller than it is to re-evaluate one that I’ve previously found too weak. It feels a little disloyal. After all, everything’s gone well…..so far!

But one of the advantages that I’ve suggested the TRE model provides is that new information can be acted on immediately. I CAN stop buying from a Seller just as soon as new information suggests that’s the right course. And I CAN recognize positive changes in the condition of a Seller and immediately move them onto the “buy list”.

I just have to be willing to act dispassionately based on all of the information in hand.

I have “let go” of a couple of Sellers recently: reluctantly, I’ll admit.

And I have recently bought from a couple of Sellers that were previously on my “don’t buy” list.

So far, I haven’t seen any pattern in the follow-on financial statements of longer-term TRE Sellers. The business of some active Sellers has gotten better over the past year or so and that of others has deteriorated. But it’s far too early in the life of the Exchange, and the economic environment of the past 18 months has been far too tumultuous, to draw any BROAD conclusions at this point.

But the evidence does suggest that consistent re-evaluation is necessary as new information becomes available.

And that we can't assume that today's evidence will necessarily support the same conclusion as yesterday’s.

A Lurch to the Left

2010-05-31T16:19:00.000-04:00

No, this is not a political comment.

At the end of each day I print out a nicely-formatted spreadsheet provided on the TRE trading platform that displays certain data regarding the auctions closed that day. Before entering the data in my records I manually note on the spreadsheet the actual terms of each sale.

The format of the spreadsheet includes columns for “Minimum Advance %” and “Maximum 30-day Fee”. This represents the highest price the Seller is willing to pay for the funds it seeks.

To the right of those two columns are two additional columns representing the “Buyout Advance %” and the Buyout 30-day Fee%”. These are the pricing parameters that a Buyer has to meet in order to close out the bidding and be assured that he will be awarded the auction.

If an auction sells at or near the highest cost of money the Seller is willing to pay, the pricing will be at or near the figures found in the columns to the left. This suggests the Buyer has the greater power in the auction.

If the Seller has the greater power, the pricing will be at or near the figures in the right-hand columns.

A very low-tech way to get a sense of the relative power of the parties is to just mark the cells of the spreadsheet that come closest to representing the actual terms of sale.

If the Sellers were “in charge” that day, the marks will cluster in the right-hand columns. If the Buyers were “in charge”, however, the marks will cluster in the left-hand columns.You get a very quick visual picture of current market dynamics.

Then, borrowing the equally low-tech methods of early cartoonists, you can pick up a stack of these marked-up daily spreadsheets and just riffle through the stack. You’ll see a representation of the shifts in power over time.

If you were to do that for the past six weeks or so you’d see that the pricing of TRE auctions has taken a decided “lurch to the left” during that period.

Pricing power has shifted to the Buyers.

There HAVE been periods previously when the power has been decidedly on the side of the Sellers. And it’s reasonable to expect that market dynamics will change from time to time. But this period really HAS been a lurch as opposed to a gentle shift and it’s interesting to speculate about the reasons.

First, there have been many new Sellers brought to the market over the last 4 to 6 weeks and newer Sellers tend to command less attractive terms.

Second, volume has increased significantly and so, all else equal, it should be expected that increasing the supply of auctions should result in somewhat higher cost of funds.

Third, (and some might disagree here) I think there has been a decrease in average quality. A number of high quality Sellers have been relatively inactive and a number of lower-quality Sellers have increased their activity.

Fourth, the average terms of sale have shifted. There have been more and more auctions of invoices due in 45 days or 60 days, and some even in 90 days, than has been the case previously. Holding constant, just for argument, the supply of Buyers’ funds, a lengthening of the average auction duration will reduce the Buyers’ capacity to absorb supply.

Combining increased volume and increased duration compounds the pressure on funding required and, presumably, the pressure on pricing.

Now, I’m not suggesting that there is a shortage of Buyers’ funds. While volume has increased substantially, it still hasn’t reached a level that would come close to taxing the ACTUAL resources of the community of Buyers. It might, however, be a factor when measured against the ALLOCATED resources of some Buyers.

At the margin; increased volume, increased duration, decreased quality and a higher proportion of new Sellers should be expected to put upward pressure on cost of funds.

And that’s what we’ve seen.

If the brief history of the Exchange is a guide; as the new Sellers prove themselves over time the pricing for their auctions will improve. As some of the higher-quality Sellers that have had seasonal reductions in activity come back to the market, their renewed demand should reduce average pricing levels (but perhaps put even more upward pressure on the lower quality Sellers).

The macro issue that I wonder about is the impact on Buyers’ funds of the increased volatility in other financial markets.

May was obviously a month of increased volatility in both equity and fixed-income markets. TRE is still too small and too new to provide any real alternative to those major asset classes. But, over time, assuming its success, the month of May might have been a period when some marginal liquidity might have found its way from those other markets to an alternative destination like the Exchange.

That would likely cause a “lurch to the right”, which is precisely what we did NOT see this time. So I think it’s fair to assume that the aggregate allocated funding of TRE Buyers still represents a fairly small and “closed” system, responding more to internal trading dynamics than to either macroeconomic forces or the dynamics of more traditional financial markets.

So we lurch into the Exchange’s second summer still gathering experience, information and, hopefully, momentum.

The Year-on Perspective

2010-05-28T09:52:00.000-04:00

This is the first anniversary of The TRE Observer!

Sixty-seven blog posts later; one hundred and thirty-nine transactions later; several TRE platform upgrades later; TRE volume growth of several hundred percent later; several significant operating and marketing changes later; one major TRE funding round later; I re-read my initial post of 5/28/09 this morning.

And I think there is some value in just re-posting it today. It doesn't hurt to look back on the thoughts of the past.

As I do I find that I could say almost exactly the same things today. So, without apology for lack of new material, here again is the first TRE Observer post, one-year on.

---------------------------------------

"On November 17, 2008 the first transaction on The Receivables Exchange (TRE) was completed. I think we will look back on that day and that transaction as the start of a new era in the financing of small business.

TRE is a real-time, on-line auction market for accounts receivable. Some call it, I think derisively, “an EBay” for invoices. Those who would minimize the importance of providing a means to efficiently and economically liquefy one of the largest balance-sheet items of the most liquidity-starved segment of the business community are simply missing the elephant in the room.

TRE is new and it is far from perfect. It will inevitably be required to make adjustments as experience teaches its operators and its users some valuable (and some potentially expensive) lessons. All beginnings are hard.

But TRE is a game-changer. It is disruptive.

Those whose businesses face disruption will scoff at first and then resist but they will ultimately adjust to the new reality because they will have no choice.

I first learned of TRE in early March 2009. By April 1, 2009 I had signed up as a Buyer.

I told the TRE staff at that time that I would not trade on the exchange until I had observed it for a reasonable period and felt that I understood it. So I have been lurking for nearly two months: watching and taking notes, compiling a database and asking questions about technical details. TRE personnel have been very forthcoming in addressing my questions and concerns. They have been open to my suggestions and understanding of my criticisms.

I have reached a number of conclusions about both the current TRE operation and what I would change if it were up to me. I have also determined with some specificity what criteria I would use to participate in the TRE activity. And I have decided to not only begin to trade but also to write about the exchange, its operations, its strengths and its weaknesses.

It is not often that a truly new market is created. When one is created, though, it inevitably spawns an infrastructure of support facilities and activities, among them comment and analysis by third-party observers.That is the purpose of this blog…to observe and comment on both the good and the bad of TRE.

I look forward to this. It is a journey and an experience that I invite you to share."

The Quality Issue -- Again

2010-05-21T10:39:00.000-04:00

In my post of May 14 entitled “The Wheat From the Chaff” I said I’d write next about the recent comments from Bill Gross of PIMCO and the new work of Edward Altman of NYU on the issue of quality/credit ratings.

I got sidetracked a bit but now I want to return to that topic.

I’ve argued previously that, if TRE is to realize its growth aspirations, it will eventually have to provide SOME means for Buyers to more conveniently differentiate Seller financial strength and transaction quality.

The Exchange doesn’t have to actually DO that itself; it can outsource the function. Or it can co-operate with a 3rd party service provider who might see an opportunity to create a new business line or to leverage an existing one.

But the current system, which requires that each Buyer analyze the financial data made available by each Seller, and keep checking for and analyzing updates, is not going to work when there are actually hundreds or even thousands of Sellers.

In his May “Investment Outlook” piece, Bill Gross essentially dismisses the three big bond-rating agencies: Moody’s, S&P and Fitch, as purveyors of Kool-Aid to an “unsuspecting (and ignorant) investment public”. The solution for PIMCO is to have its own large credit staff that can “bypass, anticipate and front-run all three, benefiting from their timidity and lack of common sense”.

Now, when someone as smart as Gross can have so little respect for the analysis of a Moody’s or an S&P, even given the level of their experience and the quality of the information they have to work with, you have to ask whose analysis CAN be trusted.

I’ve written before about the condition of TRE Seller financial statements: not only about their quality but also their timeliness. The information that S&P has to work with in analyzing a bond issuer is, I suspect, much more likely to be accurate and timely than the financials provided by the majority of TRE Sellers.

Most TRE Buyers will not be able to follow the PIMCO lead and have large in-house credit analysis departments. They’re going to have to make do with less. They’re also not going to have the same quality of information. But that doesn’t mean that NOTHING can or should be done.

Edward Altman, developer of the well-known “Z-Score” Analysis has shown that near-term insolvency of businesses can be predicted with a high degree of accuracy based on metrics that are readily calculated from financial statements.

Altman and his associates have just published (March 2010) an updated version of their analytical tools, which appear to further improve their predictive power.

It’s true that these newer Altman metrics are more applicable to larger businesses than are currently found on the Exchange, but the notion that there are relatively easily-applied tests with strong predictive powers is still important.

There are three basic elements of risk assessment that are important to a TRE auction:

a) As to the Seller: the ability to make good on a defaulted invoice and the likelihood of its solvency in the near term,

b) As to the Account Debtor: the ability to pay its obligations and the likelihood of its solvency in the near term, and

c) As to the receivable purchased: the level of certainty that the obligation represents actual sums owing for work done or services properly provided under binding agreement between the parties. And the extent to which there are other claims that might be superior to that of the Buyer.

These are all issues that can be addressed, admittedly with varying levels of confidence. But SOME level of confidence, based on a reasonable attempt at analysis, is better than either guesswork, hope or blind faith.

I can understand that TRE might not want to present any analysis of its own, fearing liability in the event of loss. But that doesn’t mean it could not contract with a third-party provider to look at these three basic elements of risk analysis and assign a quality rating that reflects the three areas of fundamental risk listed above.

Such an analysis would be less robust than most in the financial world because of the quality of the data available, but it would have to add value when compared to the currently available information.

If the Exchange can convince its backers that there is a large enough potential volume of business to warrant their equity investments, I suspect it is persuasive enough to convince a 3rd-party analytical group to take on this quality-rating task!

Such an effort would benefit all who hope for Exchange success.

Fear of Commitment

2010-05-14T16:31:00.000-04:00

In a former life I was a lender, as I’ve mentioned before in these posts. One of the realities of the business was that when we issued a loan commitment we got a commitment fee.

The prospective borrower could walk away from the deal but if he did he’d forfeit the fee. That would at least partially compensate us for “reserving” the funds committed and for doing the work necessary to underwrite the loan.

I’ve been thinking about the value of “reserving” funds in light of the recent activity on The Receivables Exchange and that’s led me to post this unscheduled comment on a Friday afternoon.

We’re in a period of rapidly rising auction volume, which is great. Predictably, though, with a rapid increase in the demand for funds, the price of funds has also firmed a bit. The presence of a substantial number of new Sellers, whose auctions have not yet “proven” themselves, also tends to lift overall pricing levels.

While the pricing of auctions at the time of sale has firmed, the initial asking prices have remained pretty much constant. So the percentage of auctions sold at “buy-out” pricing has fallen. One consequence of this is that auction duration has lengthened.

So, what’s the issue to write about on a Friday afternoon?

It’s this—any bid except a buy-out bid is a commitment of funds without any corresponding compensation. And the longer the auction period, the longer the potential uncompensated commitment.

Let’s say there’s an auction posted with a stated duration of 5 days and a buy-out price of 85% advance and 1.5% per month discount. Let’s say, further, that recent experience suggests that auction should actually sell at 80% x 2.0%.

If I bid 80% x 2.0% as soon as the auction appears, I am agreeing to hold the funds at that price for up to 5 days, giving the Seller the option to take the deal at any time but being unable to re-allocate the funds until the Seller acts.

My incentive in such a situation is to avoid bidding early; to hold back, assuming the auction will sit on the shelf for a while, and react to others’ bids rather than take the initiative myself.

In that way I can maintain the flexibility to bid on something else that comes up in the interim.

In that way I avoid giving the Seller a free 5-day put option; a fee-free commitment of funds.

That situation is not really good for anyone.

All parties: the Seller, the Buyer and the Exchange, benefit from auctions that sell quickly. But if both price and time are barriers to bidding, what’s to be done?

I suspect that few Sellers are going to adjust their asking prices in a meaningful way except to reflect changed invoice payment terms or Account Debtor quality. (We HAVE seen pricing change in some cases to reflect short payment terms, which is rational and positive.)

My suggestion in this situation would be to shorten the auction duration.

We’ve seen some auctions come to the board with terms as long as 14 days! The idea of getting stuck allocating funds for that long is really unattractive. But even the more typical 5 day auction period causes problems.

If the Seller doesn’t want to adjust pricing to the level of the current market, why not counsel that Seller to post auctions with single-day durations?

Absent a buy-out bid, real price discovery frequently happens shortly before (sometimes VERY shortly before) expiration.

So accelerate the expiration!

Post an auction at 9:30 am expiring at 3:00 pm and find out what the pricing really is on that day.

If it doesn’t sell, post it again the next day. But then the previous day’s unsuccessful bidders are released to re-think the situation and the Seller can re-think the pricing if that seems appropriate.

When the shoe is on the other foot, and there is more demand than supply, the Buyers jump at good product. They pay up, and quickly, to make sure that they get the product they’re looking for.

The Sellers need to adjust in the same way when the cycle happens to be going in the Buyers’ favor. It won’t last forever!

The Wheat from the Chaff

2010-05-12T11:02:00.000-04:00

I’ve written before about the need for TRE to provide Buyers with the means to discriminate among auctions offered: a screening capacity based on a range of filtering criteria.

Some of those filters would be relatively easy and probably inexpensive. Those would include such straightforward criteria as: size of auction, auction experience of Seller, auction experience of Account Debtor, Seller industry, etc.

There should also be a Buyer-defined screening capacity that would eliminate from the displayed auctions any Sellers, Account Debtors (or classes of either) that a Buyer might choose to ignore.

When there were only a handful of auctions live at any one time it was possible, after some experience, to just “know” who was who and what was what. But now there are frequently 30 or more live auctions at any one time.

The day will soon come, I suspect, when that number will be 100.

And, if the Exchange were to grow to the size of 10% of the current factoring market in the US, it is likely that there would be an average of about 1,000 auctions per day.

So TRE needs to be working on adding those relatively simple screening functions. Hopefully they are.

The other screening metric I’ve argued for in the past is a Seller-quality rating system. I’ve suggested that an affiliation with a third-party credit rating agency might provide an arm’s-length approach to both analyze differential risk and support better informed pricing.

Since I last wrote on that subject TRE has brought on many new Sellers and both they and we and, presumably, the rest of the Buyer community have gotten more experience in analyzing the financial information made available on TRE Sellers.

Tuesday afternoon, in our shop, is the time when we look at the financial information on all new Sellers brought to the Exchange in the prior week and the financial statement updates posted by existing Sellers.

We then decide whether the new Sellers go on the “OK to Bid” list (which would still be conditional, requiring a certain level of experience) or the “No Bid” list.

And we decide whether new financial information posted by existing Sellers changes our prior decisions about Seller acceptability, for better or worse. (And that subsequent information HAS caused us to move Sellers from OK to Not OK, and vice versa.)

There have been several Tuesdays recently when the quality of the information available has caused more Sellers to end up on the “No Bid” list than I’d like and maybe more than actually SHOULD be on that list.

Unfortunately, we sometimes just can't really TELL whether a Seller is of lesser financial strength than we’d like. It’s too often the case that the numbers just look so odd that we can’t be comfortable that we really understand them. And if we can’t understand them they go on the ‘No Bid” list.

That might be fair or unfair in terms of the actual financial health of the Seller but if the Seller can’t present its financial statements in way that makes a believable case for its health, it’s got only itself to blame.

The books of privately-owned businesses often reflect idiosyncratic practices and motivations – to state the case kindly.

But, since the TRE Buyer has to look to the Seller for ultimate recourse, TRE Sellers are going to have to be led to adopt financial statement presentation methods that are more accurate, understandable and generally accepted.

But that would just get us to the point where we could apply whatever analysis tools we think appropriate in decision-making. Until the data available appears to be reliable enough to analyze credibly, the selection of analysis tools and methods is a moot point as to that Seller.

Coincidentally, both Bill Gross of PIMCO and Professor Roger Altman of “Z-Score” fame, have written recently about rating tools, agencies and analysis methods.

In our next post we’ll comment on their recent work as it might apply to the analysis of TRE Sellers.

Bottom-line here, though: while TRE can't be responsible for the Seller's financial statements, it CAN and SHOULD advise both existing and prospective Sellers about the parameters of acceptable statement preparation and perhaps provide referrals to accounting professionals who could help clean up the Seller's numbers.

Today I am 100

2010-05-07T10:58:00.000-04:00

I began writing this post on Wednesday afternoon when there were 35 “live" auctions on the TRE platform.

The original subject was a revisiting of the topic addressed in my post of August 7, 2009: “Sipping from a Fire Hose”.

I wrote in that post about the inevitable need to manage the auction site differently as volume increases; to provide an efficient means to differentiate among classes of auctions.

I’ll pick up that topic and write the post I had planned on Sunday.

Today, however, I just want to report that we received payment this morning closing out our 100th auction!

We’ve now bought 125 auctions and 100 have been closed-out: all paid-as-agreed.

We’ve bought auctions from 33 Sellers including invoices of 64 Account Debtors.

The weighted average total days to close-out has been 43.

The weighted average actual duration (receiving multiple payments over the life of an auction decreases the average dollars-outstanding during the holding period) has been 35 days.

Weighted average net annualized return, after TRE fees and costs, has fallen slightly since last June, which was our first month as an active Buyer. But the decrease has been minimal: our monthly figures have varied within a range of only about 100 basis points.

That stability of return is more a reflection of our buying parameters than the overall Exchange activity, however.

We’ll address the increasingly-apparent “tiering” of the TRE pricing environment in another post.

But today—I just wanted to mark our 100th anniversary!

And, while I'm at it --- since the question recently came up in conversation --- over the course of closing-out 100 auctions there have been only two or three minor glitches in transaction reporting or the movement of funds. All of those were identified and corrected within one day by the TRE Member Services team, which does a great job.

"Time, time, time...is on my side..."

2010-04-25T11:45:00.001-04:00

I began my business career as a commercial mortgage lender.

Among the issues that had to be negotiated in every deal were the length of the period during which prepayment was not allowed and the size of the penalty that had to be paid when prepayment became possible.

In the mid-70’s we were not very sophisticated in our approach to these issues. We tended to just present a structure that might have been, for example: “closed for five years; open thereafter with a penalty beginning at 3% and decreasing at the rate of ½% each year thereafter”.

We would receive a memo from to time time from the corporate office telling us what the prepayment criteria needed to be and, without much thought, we’d usually just present that to the borrower as an edict from “on high” that was non-negotiable.

After a few years I moved into the equity side of the real estate business and I missed the evolution in thinking about prepayment that occurred in the ‘80s. I heard scraps of conversation in the hallways about the value of the “embedded put” that an open prepayment provision gave a borrower; but I didn’t pay a lot of attention to it.

I just knew that I was mightily annoyed when a lender refused to allow prepayment of a loan on a property purchase I was working on, for instance, or, in one case I remember well, quoted a 36% penalty for the right to prepay.

Why do I bring this up?

First: the more financially sophisticated analysis of the value of prepayment, which evolved during my absence from the lending business, was quite correct.

Second: the fundamental issue involved derives principally from the problem of asymmetrical commitments in the presence of prepayment options.

What’s asymmetrical about the commitments?

The lender might be agreeing to receive a fixed rate of return for 30 years but the prepayment option might allow the borrower to pay back the loan in 5 years. Because the duration of commitment is not symmetrical, neither is the risk.

If rates fall sharply from the level at which the loan is made, the right to prepay: a) allows the borrower to refinance into a lower-cost loan, arguably both decreasing his carrying costs and increasing his equity value, and b) puts the lender in the position of having to reinvest relatively high-yielding funds into instruments with lower returns for a potentially long period of time.

Running the numbers on an option of that sort is what produced the annoyingly high proposed prepayment penalty I quoted above.

The same mathematics apply in essentially all fixed income environments. We all know that time has value in financial terms.

But the ability to CONTROL time, compounds that value. The greater the control the greater the value.

The Receivables Exchange, being a marketplace for INVOICES rather than for receivables portfolios, is, by its nature, a very short-duration investing environment.

The weighted average life of the 91 TRE transactions that we have now closed-out has been about 35 days.

Granted, there’s not much we can do at this point to affect the speed of payment after we’ve bought an auction. But the period during which we are exposed to interest-rate risk is quite short. And the risk we are exposed to attaches only to those transactions that have been purchased and not yet repaid.

We have no obligation to buy or bid on the next auction that appears.

We have no obligation to offer the same terms on auctions after lunch as we did before lunch.

Our pricing can change from one moment to the next as can our willingness to participate either at the level of the Exchange or with respect to any particular Seller.

New information with respect to the economy, an industry or a Seller can be acted upon immediately.

Duration and pricing risks are symmetrical (rather than asymmetrical) as between Buyer and Seller.

In a period of rapidly rising interest rates, a TRE Buyer can respond very quickly; adjusting pricing on new transactions immediately and limiting exposure to potential increased cost of capital for a very short period.

It’s quite true that the knife cuts both ways and that, in a period of rapidly falling rates, the TRE Buyer might face a falling price environment more quickly than he would in some other markets.

But at this point I suspect we face another asymmetry.

What’s the risk of rapidly falling rates in the next couple of years versus rapidly rising rates?

In this environment my guess is that the greater value of the flexibility offered by TRE is on the side of the Buyer rather than the Seller.

There are plenty of points to make in the TRE value proposition for Sellers.

But I think the value of the options related to TIME is currently on the side of the Buyer.

The Luddite Trajectory

2010-04-20T11:11:00.000-04:00

Lud•dite (lŭd'īt) n.

1. Any of a group of British workers who between 1811 and 1816 rioted and destroyed laborsaving textile machinery in the belief that such machinery would diminish employment.

2. One who opposes technical or technological change.
[After Ned Ludd, an English laborer who was supposed to have destroyed weaving machinery around 1779.]

I have to confess these things:

• I remember when the first ATM’s became available and I was unwilling to use them to make a deposit.

• I remember when electronic deposit of paychecks became available and I was unwilling to trust it; preferring to have a paper check in-hand on Friday afternoon.

• My first job was with a large financial institution in an investment department that routinely took weeks to process transactions because so much analysis was done via calculator. We had access to a leased-time mainframe computer which my boss never failed to term “the confuser”.

The Luddites could not change the course of the industrial revolution. My resistance to changes in banking technology was fear-driven and counterproductive. My first boss rendered himself obsolete (or “redundant” in the land of Ludd) in a few short years.

So, where is this going? Three data points:

The first:

I read a report from a British business newspaper this morning about the difficulty that smaller businesses are having collecting money owed them. The reporter made the point that a large percentage of the affected businesses had done nothing yet to change their processes to cope with the cash flow problems.

But, he reported, “9% have turned to invoice discounting and 8% have used factoring”! That was presented in a way that implied that the numbers seem small!

In the US market, achieving a 9% penetration in the invoice discounting business would translate to (at least) tens of billions of dollars of additional employed capital in the industry.

The second:

In this week’s edition of The Economist, also a British publication, an article on small business finance appeared, entitled “Markets for Minnows”. Among the points it makes are:

• Large businesses in developed economies can once again raise capital with ease, principally via the bond market.

• Spreads on loans to smaller businesses (however) are at their highest level in a decade.

• US banks holdings in commercial loans fell in the first quarter at an astonishing annual rate of 21% (this as we are supposed to be in recovery mode).

• Syndicated lending to medium-sized business is at less than half of peak levels.

• “Demand for factoring has fallen over the past year because businesses had fewer invoices to pledge, but is likely to rise sharply as small businesses struggle to finance an upturn in orders….”

• The head of Wells Fargo’s trade capital division sees the factoring market growing by 6-8% per year.

• “Another new form of invoice-based financing is The Receivables Exchange…..which helps users to overcome…the decline of traditional small-business finance and the stretching out of payment by their customers…”

The third:

• An article in last week’s Wall Street Journal (4/15 p B6) analyzed the extent to which small businesses, prior to the housing bust, depended on tapping real estate equity for working capital.

• In 2007 one survey showed that “30% of respondents tapped home loans for funding” their business working capital needs.

• In 2009 that figure had fallen to 7%.

• Based on that comparison, alone, 23% of small businesses have, in a very short time, lost access to one of their principal funding sources.

There is no question that small business MUST find alternate sources of working capital if they are to survive and prosper!

Last month we saw Morgan Stanley identifying TRE as a new and potentially important player on the invoice discounting landscape.

This month The Economist gives it prominent mention as an alternative.

Just last week I was shown promotional material of a company that appeared to be marketing a “copycat” program, which on further investigation actually offered nothing but some additional potential visibility for the Exchange, itself.

Here’s my take-away:

The British and the Europeans, in general, are far in front of the US in the adoption of invoice discounting in the SME community. We can and should learn from them (just this once).

Wells Fargo, now the largest player in the domestic factoring market, sees a 6-8% growth rate in the traditional-factoring sector of the business. That’s hardly a steep growth curve from present levels and hardly an answer for the smaller end of the market.

The SME market for invoice discounting in the US, while relatively immature and small, is one of the only avenues that will be available to meet the financing needs of the SME market going forward.

TRE, for all that it is neither perfect nor mature, offers a true alternative; efficient and scalable.

If it could provide the mechanism to take the US market just halfway from its current invoice-discounting penetration to the 9% level found in the British study quoted above, it would represent a significant avenue for employment of capital, a meaningful stimulus of economic growth and an important engine for job creation.

It took me a couple of years to trust ATM machines and electronic deposits. But thankfully both the world and I change faster now.

New questions are asked. New challenges posed. And in the great American tradition, new answers become available.

The job is to introduce the question to the answer.

A Question of Morality

2010-04-11T16:40:00.000-04:00

In prior posts (see "Caveat Emptor”, from November 2009 and “Blanket Security vs A Security Blanket” from June 2009) I’ve commented on The Receivables Exchange’s policies regarding both filing UCC Financing Statements to provide additional security for Buyers, and its practices regarding existing UCC Statements that have a position of priority with respect to the TRE filings.

First, as a reminder, the TRE filings encumber only those receivables that the Sellers sell on the Exchange. This is as opposed to the practice followed by many (I could probably say “most” without being inaccurate) in the industry to obtain a lien on ALL of the receivables of a factoring customer.

Second, early descriptions of the Exchange’s work on behalf of Buyers suggested that efforts would be made to obtain releases of or subordinations of liens held by others that have claims prior to those of TRE.

As one who considers this an important issue, I actually DO review the UCC filings of new TRE Sellers and, when it appears that there is a prior claim on receivables, I DO check for evidence of the lien holder’s release or subordination.

I must say that there are many instances where prior liens encumbering a Seller’s receivables do exist but that there are relatively few such instances where I also find a release or subordination.

It’s not fair to say, based on that evidence alone, that efforts to obtain releases are not made. I don’t know how hard the Exchange tries to get those releases. I do know that, in my own non-TRE business, it’s tough to get any bank or other entity that holds a security position today on ANYTHING, to release it!

But that’s only the lead-in to my real point today.

A couple of weeks ago I was in a conversation with a number of traditional factors and the issue of buying an invoice in the presence of a prior UCC filing came up. An opinion was voiced that not only was it a poor business practice to buy in such a situation but that it was actually IMMORAL! The theory was that someone else had a security interest in that receivable and purchasing it deprived that person of a portion of his rightful protection.

While I acknowledge that there are situations in which buying invoices in the presence of a prior lien might be poor business practice, I’ve thought about this question a good deal since then, and I cannot find any justification for an assertion that it is IMMORAL!

In my normal business I almost never buy when a prior lien exists but there have been two instances in which I have. In one case, every time I made a purchase from the client I withheld enough cash to make the payments to the prior lien holder for a certain period of time and I actually made those payments myself in order to assure that there would be no default during the period my funds were outstanding.

In the second case, the prior lien secured a loan whose balance was small, representing a de minimus percentage of the typical receivables balance and, to my mind, a de minimus risk of loss even in the event of default.

There are cases of TRE Sellers where it is clear that the obligations secured by the liens are very significant and, in the event of a default, could become really problematic for a Buyer.

There are also cases where the documentation of UCC filings is quite lengthy (there was a case not too long ago where the UCC file ran to 104 pages, for instance) and it’s a real job to try to figure out what’s still current and what is encumbered by whom).

Each Buyer will approach the question of assessing the risk posed in such cases differently. Some will just steer clear of auctions in which prior liens exist. Some will simply ignore them and hope for the best. Some will take the position that the filing is only problematic in case of a default by the Seller giving rise to action by the lien holder, and attempt to assess that risk.

One of the problems in assessing such a risk is that, often, it is unclear from the Seller’s financial statements, what the size of the secured obligation is. Another is that, often, the age of the financial statements makes the accuracy of the PRESENT liability structure uncertain.

Yet another is the uncertainty of a Seller’s disclosing the presence of any litigation that might have arisen potentially triggering the right to levy on receivables (although I would hope that the TRE fraud-protection group would devote a decent amount of time to this).

(Did anyone read this week-end about the apparent practice of many large banks of drastically reducing borrowing in the days immediately preceding financial-statement dates, only to dramatically increase borrowings during the middle of a quarter?)

So, my point is that the assessment of and response to the business risk of buying in the presence of prior liens, is obviously being approached differently by different Buyers.

But what about the MORALITY of the issue?

I have to say that, while I respect the individual whose position I quoted above, I just can’t see that this is a matter of morality.

At the most obvious level, an invoice-purchase transaction, of itself, takes nothing significant away from the security of the lien holder. A less-liquid asset, the invoice, is removed from the balance sheet. And a more-liquid asset, cash, replaces it (at least to the immediate extent of the advance amount).

Any well-written UCC filing will include in the description of security some language that extends the lien to the proceeds of the sale of any encumbered assets. So it could be argued that, as long as the proceeds of sale remain in some way in the business, the aggregate security of the lien holder is not damaged.

Conceptually, it can also be argued, I think, that to the extent that the assets encumbered exceed the value of the debt, restricting either the Seller or the TRE Buyer from converting the excess, less-liquid assets into more liquid assets, would be an unfair restriction of management. In such a case, it might be analogous to a first mortgage-holder prohibiting or preventing a property owner from using the proceeds of a second-mortgage to put a new roof on the house.

And from a purely practical point of view, except in the case of some kind of court-ordered immediate action to freeze (or seize) operations, it is highly unlikely that the ACTUAL invoices being bought by a factor would still be on the books of the seller by the time the holder of the first lien could get through the legal process required to levy on them.

Others might have different experience, but my own has been that the time required to get to the point of actually levying on receivables is so long that the AR Schedule at the time of levy bears little resemblance to the one at the time of default.

The issue of buying receivables in the presence of a prior lien raises all sorts of real and difficult business risk problems.

But I don’t find it to be a MORAL issue.

Do you?

Sizing It Up

2010-04-07T14:04:00.000-04:00

In my March 21 post, “The Diet of 900 lb Gorillas”, I referred to the recently-published Morgan Stanley report on B2B Finance. That report raises a number of issues, only one of which was really addressed in that prior post, so I want to return to it again.

This time I want to point out a couple of statistics that are key to assessing the long-term potential of The Receivables Exchange.

The first of those statistics is the gross size of the SME (small to mid-sized enterprises) market. Morgan Stanley reports that the SME market accounts for about 45% of all business revenues in the US. Morgan defines the SME category as all businesses with annual revenues of less than $500 million.

Now for the purposes of discussing TRE’s near-to-intermediate term potential it’s unrealistic to assume that its addressable market includes businesses with $500 million in sales. So we have to adjust Morgan's 45% figure.

The smallest category Morgan uses comprises businesses with revenues of less than $25 million. That category accounts for 25% of total corporate revenues.

TRE requires Sellers to have annual revenues of about $1.5 million and, at present, a $25 million Seller would be at the upper end of the TRE size spectrum. So this is really the near-term target market-segment for TRE marketing efforts.

To eliminate those businesses that are too small to qualify for TRE Seller membership we have to reduce the 25% total. This is completely guesswork on my part but I suspect we wouldn’t be far off if we reduced the 25% figure to maybe 15-20% to eliminate the smallest businesses.

If we apply the 15-20% range to the estimate (based on the Fed’s flow-of-funds report) of the overall volume of annual B2B accounts receivable generation (about $18 Trillion), that suggests a potentially-addressable, near-term market size in the range of $2.7 to $3.6 Trillion.

That ignores the fact that some of those businesses, especially the smaller ones, probably do not extend trade credit, but it’s also the case that some large businesses extend very little trade credit. It’s hard to know how to adjust those volume figures with any confidence, so I’ll just let them stand with the caveat that there are potentials for error from a number of sources.

If we use the mid-point of that indicated range, or $3.15 Trillion, and we assume an average AR duration (days-to-pay) of 45; that suggests that the average outstanding AR balance on the books of that segment of the business community would be about $390 Billion.

That’s a big number!

The Morgan Stanley estimate of the total US factoring market is given at $136 Billion, suggesting that our estimate of the near-term, potential TRE-addressable market is three times the size of the entire current industry. But that's not really the appropriate comparison.

It is clear that the smallest businesses will account for no more than their relative percentage of the total factoring market and probably quite a bit less. How much less is a guess, but let’s just say for conversation that it’s overstated by 100%, or that the actual factoring activity in this smallest segment of the economy is half its representation in the total economy.

That would suggest that $10-$13 Billion is employed by the factoring community in the smallest segment of US business.

If that’s anywhere close to the mark, it implies a current market penetration of only 3% or so of indicated near-term potential.

If a realistic maximum penetration were, for argument's sake, to be measured at 25% of the currently-addressable market, the implied potential would be $390 Billion x .25 = $97.5 Billion, less (about) $12.5 billion (already served), or something in the range of $85 Billion in potential for capital employment.

That’s clearly a market worthwhile pursuing.

And that is without considering the potential ultimately afforded by businesses with revenues above $25 million, some of which, over time, should be attracted to the flexibility of an auction environment.

On the other hand, it has to be recognized that many smaller businesses are in no condition to be brought to TRE at this point.

TRE’s marketing effort has to include a long-range education program to bring potential Sellers to the realization that “clean” and accurate financial records and disciplined management of their billing and other AR functions are critical to positioning themselves for access to a market like TRE.

It’s easy to make the case that the market potential for TRE is substantial in the near-term and extremely substantial in the longer-term.

It’s not a stretch to view the TRE growth curve as exponential for some time to come.

But that doesn’t mean achieving that potential is a certainty.

There are difficult problems to be solved, not least of which is maintaining the discipline required to adequately vet potential Sellers and to strictly implement the safeguards in place to protect against abuses.

But it seems clear that the size of the opportunity makes tackling the problems well worth the effort.

Restraint of Trade -- Revisited

2010-03-31T15:11:00.000-04:00

It’s the afternoon of the last day of the month and The Receivables Exchange has been well into record monthly-volume territory for a few days now. This is clearly going to be the best month in the Exchange’s history by a wide margin.

In addition, as I write, the currently-live auctions are of the largest average size that I can recall at any single time. These are clearly significant positives from the point of view of TRE.

There is also an issue that I think is both significant and positive for both the Exchange and the community of TRE Buyers.

On January 12, I wrote in a post entitled “Restraint of Trade” about a Seller that had been posting auctions of the invoices of a certain Account Debtor quite frequently and in substantial amounts. For a time those auctions had been very well accepted and the pricing demanded by Buyers continued to trend downward.

Then a point was reached at which a large amount of this paper had been sold but none had been paid, and pricing began to back up. I wrote at that time to make the point that this was rational behavior on the Buyers’ part and that it was good to see that sort of restraint.

Since that time, that Seller has continued to be quite active. There have been payments made by that Account Debtor and there has been no indication that any default has occurred. But the dollar-value of open auctions relative to the financial capacity of the Seller has continued to increase.

As that has occurred and as the Buyer-experience has matured with respect to this Seller, the pricing has continued (in general) to firm and the appetite for the Seller’s auctions has clearly diminished.

The message is being sent that there is a limited appetite for more of this Seller's auctions. It’s not that there is NO appetite. But there is a limit.

And that, I think, is a another positive message for Buyers to send.

The message was positive in January when the pricing began to firm and it is more positive now when even firmer pricing doesn’t necessarily attract interest.

In an open-outcry auction market, sentiment and motivation can both be pretty literally “in your face”. In an anonymous, on-line auction market, reading sentiment and motivation is a much less immediate process.

This particular case has been playing out over the course of many weeks and many transactions, but the evidence of market reaction continues to be rational and positive.

Congratulations to TRE on a big month!

The Diet of 900 lb Gorillas

2010-03-21T12:38:00.003-04:00

In my post of March 11, “The Perversity of the Possible”, I wrote about large companies unilaterally changing payment terms for their obligations to suppliers.

My thanks to Dave Schmidt for his response to the post and confirmation of the problem!

Coincidentally, a report by Morgan Stanley was released at about the same time. It offers Morgan’s help to large firms in devising programs to leverage their cost-of-capital advantage to essentially squeeze discounts out of their suppliers.

This is presented as a win-win proposition, but that’s clearly just a smoke-screen.

Morgan Stanley’s suggestion is really that large firms with excess cash or credit capacity propose to pay suppliers early at a 4% discount. For those who chose not to participate, the unacknowledged flip-side would be a lengthening of payment terms.

Morgan uses relatively large print and bold typeface to trumpet its conclusions that these transactions increase profitability of BOTH the large companies that would be Morgan’s clients and their suppliers.

In the small-typeface, cramped-format analysis, however, we find that the assumption on which these conclusions are based is a 100-day acceleration of the supplier’s payment!

What is Morgan Stanley saying here?

It is saying that the large company, the 900-lb Gorilla, will force the supplier to either take a 4% discount or wait 100 days to get paid. This is very close to the situation I described in my March 11 post.

Let’s be clear, here. This is in no way an attempt to find a win-win solution. This is Morgan offering to coach large companies in the fine art of squeezing small ones. As if that were necessary!

To put an even finer point on it—this is Morgan Stanley offering to provide 3rd party justification for such squeezing so that the leaders of the large companies have the cover of expert advice as a defense for their actions.

Now, the Morgan report does introduce The Receivables Exchange as a potential alternative to using the large companies own excess working capital capacity. Its presentation of TRE and its process and benefits is flattering (if not completely accurate). And that is a good thing for TRE.

But the point of their bringing TRE into the report is as a thinly-veiled option for squeezing the suppliers WITHOUT using the large company’s own working capital.

They’re saying, even if you don’t HAVE the excess capacity yourself, you can STILL force extended payment terms on your suppliers by simultaneously suggesting that the suppliers utilize TRE to compensate for the extended payment terms.

Make no mistake. Morgan is not in this to help the supplier.

The Morgan report explicitly states that it is not a product of their research unit. This is a marketing initiative to help Morgan generate fee revenue by coaching large companies in the creation of accounts-payable strategies that increase their own profits at the expense of their smaller, weaker and less-well-capitalized suppliers.

I’m sure that Morgan publishes a list of its annual charitable initiatives. This isn’t one of them!

In individual or isolated instances, squeezing the suppliers as recommended by Morgan can work. It cannot work as a wide-spread, systematic shift in large-company AP strategies. At least, not without compensating pricing adjustments.

There might be room in the forest for one or two 900-lb Gorillas. But if all gorillas were that big there wouldn’t be enough food to sustain them, and some would have to die off or change their diet in order to restore balance.

Another Milestone!

2010-03-16T16:10:00.000-04:00

On March 17, 2009; one year ago tomorrow; I read a comment about The Receivables Exchange in a message by Paul Ellis to the Factoring Professionals Group of the LinkedIn network.

That was the first time I had heard of TRE.

Today I bought my 100th TRE auction.

Of those 100 auctions, 76 have been closed-out so far: all paid-as-agreed.

I have bought invoices from 26 TRE Sellers representing 47 Account Debtors.

The average period of time from purchase to close-out has been about 45 days. The weighted average duration has been about 35 days (because many auctions include multiple invoices and some get paid more quickly than others.)

I don’t think the Exchange Rules allow me to cite the actual annualized returns generated from the 76 auctions that have been closed-out, but I think I can say this:

--The TRE web site gives a range of monthly discount fees at which auctions have been sold.

--Advances, on average, tend to fall in the 80% to 85% of face value range (sometimes more, sometimes less).

--My actual annualized returns have been consistent with auctions selling at slightly higher than the mid-point of the publicized discount fee range, adjusted for my actual duration experience, average advance rates and actual TRE fees charged.

I can say that I have been unwilling to compete at either extreme of the auction pricing spectrum and that my actual results have been consistent with my bias toward a conservative approach to "qualifying" Sellers and a moderate approach toward bidding.

I’ve gotten what I bargained for--what more could I ask?

The Perversity of the Possible

2010-03-11T18:15:00.001-05:00

On Tuesday of this week a national association that tracks the conditions and sentiment of smaller businesses reported that the net percentage of small business owners whose outlook on the economy was positive had fallen from +2% in December, to +1% in January to a -9% in February.

An 11% net sentiment swing in three months is substantial.

On the other hand, this morning’s Wall Street Journal, on its front page, reported on the surprisingly strong rebound in the market for corporate debt. Large bond issues have been getting a surprisingly strong reception in the institutional market, reflecting an improvement in perceived business conditions and a corresponding reduction in risk.

So the small businesses are seeing increasingly cloudy skies while the big ones are enjoying more and more sunshine (pardon the imagery: I’m going to Miami for the week-end!).

Only a very few will have read a piece of news I found quite interesting on Wednesday; the day between these two much more widely-circulated reports.

On Wednesday a TRE Seller posted an auction of invoices that carried an unusually long days-to-pay number; almost triple the usual terms between that Seller and its Account Debtor.

Obviously anticipating Buyers’ questioning the terms, the Seller posted a letter explaining that its Account Debtor had, apparently unilaterally, notified its suppliers that it was only going to pay its bills once every three months. So the bills submitted early in it's 90-day cycle would take a long time to get paid.

That’s hardly the first time I’ve heard or read of such heavy-handed treatment of smaller businesses recently.

In two cases involving businesses that are among the largest in the nation I have recently heard of: a) a blanket imposition of 90 day terms, and b) a selective but significant imposition of 120 day terms.

I cannot say with certainty that there has been no opportunity for price adjustment in these cases but it is my understanding that there has not.

These larger companies are climbing out of the recession, in part, on the backs of their smaller suppliers. They are extending payment terms because they CAN.

So why do I use the term “perversity” in the title of this post?

Because squeezing the profit margins of the smaller businesses by forcing them to either reduce their production volume due to lack of working capital or to increase their costs in order to pay for financing, has a direct impact on their ability to grow and generate new jobs.

It is well documented that the bulk of job growth, particularly in the early stages of a recovery, comes from the small business sector. It is that job growth that generates the end-user demand for the goods and services of those large companies whose outlook is now relatively rosy. Without the job growth, their prospects dim.

So–perversely—the larger companies that are using their purchasing power to extend payment terms to UNUSUAL or UNANTICIPATED levels are, at least in aggregate, acting against their own long-run best interests. (Normal and expected payment durations are assumed to be built into the suppliers business models.)

I found myself wondering what this Seller would have done if it had received such a notice from a major customer and NOT been able to post the invoices for sale on TRE.

It will certainly cost more to preserve their cash flow velocity now, but if they had no way to compensate for the slower payments, their only option might have been to throttle back their production and reduce their staffing, taking more potential consumers out of the market for their Debtor’s product!

The possible CAN be perverse!

The Price of Perception

2010-03-07T14:37:00.000-05:00

I’ve written in prior posts about Buyer-pricing that has seemed to me to ignore the risks that are inherent in the activity of invoice purchasing.

It is one thing to comment on the absolute level of return implied by a particular transaction. It is another to look at the range of returns implied by pricing within an array of transactions.

In the past few days of trading we’ve seen a very wide spread between the best terms offered to Sellers and the worst terms. Some of that spread is explained by the relative experience of the Sellers on the Exchange. Some of it is explained by the relative strength of both Sellers and Account Debtors. Some is explained by the pattern of transaction volume presented to Buyers recently.

But, whatever the explanation, I thought it would be interesting to just consider the size of the spread in pricing between the lowest implied cost of (return on) funds and the highest.

I’m not going to use absolute numbers at the risk of running afoul the Exchange’s rules on disclosure.

And the numbers that I’ll use are those I estimate to be the likely, annualized net return to a Buyer after all costs charged to the Buyer by TRE. The model I use to calculate expected net annualized return is sensitive to: transaction size, duration, advance percentage and monthly discount rate; and it incorporates all TRE-charged fees and costs including such incidental items as wire transfer fees.

I will not disclose the actual fee schedule charged to Buyers by TRE but, as I’ve written before, it acts to penalize returns when transactions are closed-out quickly. So a combination of small size, high advance, low discount rate and fast close-out produces the lowest net annualized return.

In order to avoid disclosing actual numbers, I am going to establish the lowest implied pricing of the last few days as the benchmark with an “index” value of 1.

That says nothing about the absolute return—it just means that it represents the lowest annualized return produced by putting the terms of the transaction into my little model.

If inputting the terms of another transaction into the model produced a value of 2, that would mean the expected net annualized return on that transaction is double that of the index transaction.

So, what was the range of implied return expectations on the deals done over the period examined?

Take a guess.

The answer is 5.6.

That is, the deal that generated the highest implied return expectation to the Buyer had an expectation 5.6 times that of the deal with the lowest implied return.

That’s quite a spread!

But, in my view, that is very good news. It means that the Buyers are recognizing and demanding compensation for differential quality and risk perception.

There are many days on which this kind of analysis would produce a much narrower differential. And, again, I’ve said nothing about the absolute level of return expectation.

But this particular period provided the data to make the point pretty dramatically.

TRE Buyers ARE currently discriminating on the basis of perceived quality differential and TRE Sellers, whether happy about it or not, ARE closing deals that recognize the difference in Buyers’ quality perceptions.

Those are both healthy signs!

It's a Bad Bet?

2010-03-04T18:37:00.000-05:00

I was discussing my criteria for screening TRE Sellers with a friend the other day. This is a knowledgeable person who understands TRE quite well but is not a Member.

I told him what percentage of the TRE Sellers are on my “Do Not Bid” list. He asked how many losses had been incurred by Buyers who WERE willing to buy from those Sellers. I explained that, as far as I know, there hasn’t been an actual write-off at this point.

His reaction was “so you’ve bet wrong on X percent of the Sellers so far.”

NO! I don’t accept that analysis.

The fact that a loss has not yet occurred does not mean that buying would have been a “good bet”.

The fact that I might walk alone down a dangerous street late at night and not get mugged doesn’t mean it was wise to take the walk. And if I did it five times and didn’t get mugged, well, it was still unwise.

I was looking at the updated financial statements of one of the Sellers on my “Do Not Bid” list today.

A few data points:

 Accounts Payable = 4 times Accounts Receivable

 Current Liabilities = 10 times Current Assets

 Negative Retained Earnings; Negative Equity; Negative Net Income; Negative Cash Flow from Operations; Negative Cash on Hand.

Now, the Buyer’s recourse in the event of a problem with payment is to the Seller.

The notion that there are no circumstances under which an Account Debtor might justifiably refuse payment is a fiction.

In such a case the Buyer must look to the Seller: not to the Debtor, not to the Exchange, and not to the individual owners of the Seller. No---just to the corporate entity that is the Seller. (To be fair, there is a possibility that excess cash received by TRE on the Sellers account might be available to cure a default but that should hardly be counted on.)

There are those who might be willing to look at the financials I was looking at this afternoon and bid anyway. There are those who might bid without looking at the financials at all. And they might well avoid being mugged…once or twice or five times.

That doesn’t persuade me that buying would be a “good bet”.

Because, based on the Seller’s own, internally-prepared financial statements, it is unlikely to be able to cure a significant Account Debtor payment failure.

It’s a great thing to have really high quality Account Debtors. And I’ve commented recently and quite favorably on the success TRE has had in bringing a high percentage of good credit Debtors to the Exchange.

But at the end of the day, if the Seller can’t make good on an invoice gone bad, the Buyer is going to have a problem.

The Seller I described above is on my “Do Not Bid” list and it will stay there until its financial condition dramatically improves, no matter how many auctions it might successfully complete.

The Lost Decade

2010-02-28T17:27:00.000-05:00

Today marks the 10th anniversary of the date of my best-ever brokerage account statement. The NASDAQ peaked on March 10, 2000. According to the February, 2000 statement I was a bloody genius!

In fact, they could have just addressed the statement to “Resident Genius” at my street address and I wouldn’t have had any trouble knowing who it was for.

It’s been a long ten years!

The pundits are calling it “the lost decade”, at least for stock investors. According to a report in this week’s Economist, Treasury Bills have outperformed the S&P over the past 10 years.

But some people made a lot of money over the past decade. They weren’t the buy-and-hold stock investors. They weren’t the buy-and-hold bond or currency or real estate investors either.

For the most part, the people who made a lot of money over the past 10 years have been those who have taken simple financial ideas and products and created highly complex financial products and markets from them. Particularly those who were able to do so utilizing massive amounts of leverage.

The idea of a sub-prime mortgage is simple. Creating a market based on the theory that a whole lot of sub-prime paper, carved up and leveraged smartly would produce AAA securities, was brilliant. Getting the government to essentially REQUIRE that these deals be done was genius—until it wasn’t, which didn't take long.

The ideas behind credit default swaps and collateralized debt obligations are not terribly complex but when the pricing of risk is based on horribly flawed measurements of it and, again, there is strong incentive to massively over-produce these instruments, the risk to the financial system is understated on an equally massive basis.

It’s perilous enough that market participants were given the incentive to produce huge quantities of complex and relatively illiquid assets. But when the government, in its dubious wisdom and false caution, mandated mark-to-market rules for major players in these illiquid assets, they nearly guaranteed that a meltdown would occur at SOME point.

When the markets for relatively illiquid assets freeze-up, as they all do from time to time, the issue of valuation becomes a very difficult one. When the small, or off-market, or marginal, or forced transaction becomes the only benchmark for assigning value to huge pools of assets, the result is a price graph that looks like the side of a cliff. And when other assets are derivatives of the one whose graph looks like that, the dominoes really start to fall.

What’s my point?

As has been well demonstrated by a number of analysts over the past year or so, the mathematics of risk measurement on which the last ten years of financial engineering has been based, was flawed. The fact that the occurrence of a particular event is highly improbable does not mean that it is impossible. And it does not mean that its risk can be ignored. People win the lottery every day. The highly improbable happens all the time.

Some people (relatively few) made a whole lot of money over the past 10 years on the theory that financial instrument risks were being appropriately measured. When it turned out that they were not, the economy as a whole very nearly imploded and we and our children will be paying the price for that for many years to come.

Here’s my point.

It has been shown that it is extremely difficult to accurately assess the risk of the sort of highly complex financial structures and instruments that have proliferated in the past decade. In fact, some say that it is impossible to foresee all of the ways in which some of these structures can go bad. And if we can’t foresee a risk it’s awfully hard to protect against it.

The creation of an invoice is a simple financial transaction. The structure of the obligation is straightforward. The mechanics of its fulfillment are straightforward.

The purchase of an invoice is a little trickier but still, in the scheme of financial transactions, pretty simple. The risks involved can be itemized with some assurance and the assessment of those risks does not require rocket science or rooms-full of PhDs with access to supercomputers.

Buying an invoice is essentially a low-tech financial transaction. But the pool of invoices created each year is enormous.

The traditional participants in the market have managed only minimal penetration.

But there is now a means of participating in that market in a way that is simple, efficient and scalable: courtesy of The Receivables Exchange.

TRE is not where it needs to be yet to absorb a great deal of capital. It has a lot to do before it becomes a real player in the big-money financial markets. But it’s still early days.

All things being equal, TRE offers the potential of size and simplicity as opposed to the sort of size and complexity that have caused such problems recently. After the past 10 years, SIMPLE sounds pretty good to me.

But, then, I’m not the genius I was 10 years ago!

Whiskey on a Troop Train

2010-02-23T18:31:00.000-05:00

An early mentor of mine, when unimpressed with someone’s ability or job performance, used to quip: “He couldn’t sell whiskey on a troop train!”

There are (at least) two things in the current economy that are widely assumed to be as easy as selling whiskey on a troop train:

1) buying distressed real estate in markets like Las Vegas when you’ve got the cash to close immediately, and

2) putting money to work in the SMB (small-to-medium sized business) market.

In the first case there has been such carnage and the outlook remains so glum that the idea that you’d have a hard time BUYING rather than selling just doesn’t seem credible.

In the second, the news has been so full of stories about the lack of financing for small businesses that it is assumed that anyone willing to provide financing to that market should have no trouble.

I thought of my old friend this morning when I read the article in the Wall Street Journal (p A3) headlined “National Housing Bargains Drying Up”. The article chronicles the difficulties that prospective buyers of foreclosed houses are facing today.

If you’re willing to look for bargains in inner-city Detroit, they can be found (depending on your definition of “bargain”). But in places where you might really want to live, the supply is “dwindling” and “bidding wars are the norm on foreclosed homes”.

In the SMB space, the bankers who have been pilloried for dramatic reductions in business loans have argued that:

1) part of the reduction in lending reflects reduced demand. Business is slow and so business spending is down and loan demand is down, and

2) the portion of reduced lending that reflects tightened standards is justified by the increased risk that weaker loan applicants pose.

I confess that a year ago, when the banks were pulling back as quickly as they could, I thought that ramping up volume in the receivables finance business was a pretty sure bet. But I have to admit that the bankers’ arguments are more valid than not.

I’d state it this way: while lending has become more restrictive and the SMB market is suffering from a lack of liquidity, risk-adjusted financing demand IS actually down.

That doesn’t mean that total demand is down. I don’t know that to be the case. But I think it IS true that the overall quality level of the business that is available is lower than it was, say, two years ago.

When I talk to people about TRE the common reaction reminds me of my old friend. In effect, they say: how hard can it be to put money to work when there’s no one else out there willing to provide capital?

Well, I wouldn’t have thought it would be hard to buy a foreclosed house in Las Vegas, either.

Anybody can put money out. The trick is getting it back!

The growth of TRE, I suspect, has NOT been helped by the financial crisis, as counter-intuitive as that might seem. Because the TRE Buyers DO want their money back and WILL (generally) exercise a reasonable degree of prudence in determining what to bid on and how to price their bids.

I think the crisis has actually acted as a pretty strong headwind for TRE in its first 15 months of operation.

Finding QUALIFIED sellers is a tough job in this market. It is NOT like selling whiskey on a troop train.

It’s probably as hard, in fact, as it would be to keep whiskey OFF a troop train!

Selling the Counter-intuitive

2010-02-21T15:02:00.000-05:00

In my traditional invoice-purchase business, one of the most difficult points to make to a new seller is that their interests are NOT best served by trying to sell the invoices of their WORST paying customers.

It is most often the case that they are best served by offering for sale the invoices of their most RELIABLE customers. In this case I look at reliability in terms of both credit strength and predictability of payment.

The first impulse of the seller is often to try to find a buyer for their problematic invoices; on the theory that they then become the buyer’s problem. But because we require both personal guaranties and first liens on all receivables, that logic is flawed. In fact, an Account Debtor that is predictably problematic might well become even more so when they become aware that their obligations have been sold.

Most often the best solution is for the seller to offer for sale the invoices that present the LEAST UNCERTAINTY to the buyer. That doesn’t mean that they’ll necessarily be paid the quickest; there are a lot of very good customers that pay reliably in 45 or 50 or even 60 days.

But a customer with good credit that pays reliably in 50 days might be a much better solution to the seller’s cash needs than either: 1) a customer that pays reliably in ten days, or 2) one whose credit history is either poor or whose payment timing is erratic.

The customer that pays very quickly is probably not the source of the seller’s cash flow need in any event; and the buyer then faces the need to rapidly re-deploy the funds returned, having earned a relatively small fee for its efforts.

On the other hand, the reliable customer whose obligations are outstanding for a reasonable and predictable period presents not only a lower overall risk profile but also requires lower re-investment velocity and the likelihood of maintaining a higher percentage of funds employed.

Over time, that sort of Account Debtor should command the lowest fees from the buyers and provide the sellers with the least expensive solution to their cash needs.

In the specific case of The Receivables Exchange, this issue of least uncertainty is even more important.

Because the Buyers on TRE do not have the protection of personal guaranties or first liens on all receivables; and the TRE notification and verification processes are not as strong as is usually the case in single invoice purchases; there is limited scope for managing transaction risk.

Essentially, the TRE formula presents the Buyer a “barbell” shaped risk analysis problem.

The Buyer can make a decision regarding the Seller and one regarding the Account Debtor. But some important elements that constitute the relationship between the two are unavailable to, and not under the control of, the TRE Buyer.

As we’ve written a number of times before, the TRE Seller-marketing team has an inherent incentive to “reach” deeply into the pool of possible Sellers to ramp up volume. And we’ve seen some Sellers that clearly appear to have questionable financial capacity.

Often transactions involving Sellers of questionable financial capacity, even Sellers that have not yet completed a single TRE round-trip transaction, are priced quite favorably by TRE Buyers. And the reason for that is usually quite clear: the other end of the barbell, the Seller, is a well-known and established firm.

The current statistics on the TRE website show that 81% of the Account Debtors whose invoices are offered for sale on the Exchange are “Investment Grade”. Debtors whose stock is publicly traded represent 58% of the transactions. And those whose stock is among the S&P 500 represent 50% of the transactions.

While the strength of the Account Debtor might make little ACTUAL difference in many conceivable instances in which a transaction might become problematic, it is certain that a strong Debtor reduces at least the APPARENT risk in a transaction.

I have heard the TRE Seller-marketing argument on this point. They stress quite effectively the point that Sellers are best served by offering the invoices of their BEST customers for sale. Offering the least apparent risk attracts the broadest interest, the best pricing and ultimately the lowest-cost solution to the Seller’s cash flow problem.

A Seller with marginal credit credentials can get a lot of attention by offering the invoices of an S&P 500 Debtor, even though it is ultimately the Seller’s financial capacity that the Buyer must depend upon.

The statistics above make it clear that the TRE Seller-marketing team is doing a very good job at convincing Sellers to offer the most attractive invoices they have, rather than trying to unload their problems. Such an attempt would ultimately fail in any event, damaging both the reputations of the Exchange and the Seller.

The argument is still, at least initially, counter-intuitive. It’s not an easy sell. And TRE should be complimented for making it well and successfully.

To Discriminate: v. di-skrim-uh-neyt

2010-02-01T09:13:00.000-05:00

The Bain announcement is now old news. It’s still good news...very good news, in fact.

But a new day and month are upon us.

The problem of FUNDING continued growth and development of The Receivables Exchange has been solved for the time being.

Now there are other problems to solve.

I heard it said last week that perhaps Bain could help to bring in new Buyers. And that might well be so. But if that is their principle follow-on benefit, the TRE proposition might still fail.

The TRE challenge is not availability of Buyer funds. Any one of a number of current Buyers could probably absorb the entire current deal flow without any great problem.

On the Buyer side the best possible solution would be for a steady addition of Buyers who commit NOT to flood the market with liquidity, but rather to limit their activity to provide a balance between supply of and demand for funds.

The challenge for TRE, without any doubt, is attracting qualified Sellers.

A friend who knows her way around QuickBooks told me the other day that she had been asked by a relative to help him organize the financial data of his business. The business has been in operation for quite some time. Until the current downturn in its industry it had grossed nearly $20 million per year. And it is of a type that might qualify for Seller-membership in TRE.

She told me that she found that her relative had no real idea of the financial condition of the business; that he could not even tell her how much cash was in the bank; that essentially all of his family’s personal expenses had been run through the company, making analysis of the profitability of the business itself very difficult; and, that the only real “control” mechanism exercised was at the level of pricing bids for new work.

This might be a good business; it probably is; but no one can really tell because of the way that it’s being managed. And I would bet that there are hundreds and thousands of businesses all over the country that fit this same description. Over time, with some outside help and some discipline, this business owner might be able to change his practices and create a financial track-record that would support an application to sell invoices on the Exchange. But that won’t happen in one year.

Penetrating this segment of the potential TRE Seller market is a long-term project. But TRE needs to ramp volume in a serious way in the short-term. How might it do that?

Remember when “to discriminate” simply meant “to distinguish by discerning or exposing differences; especially: to distinguish from another like object”?

I've argued in more than one prior post for the establishment of a quality rating system to distinguish among Sellers so that Buyers might be better able to support risk analysis and pricing differences. That idea, like the education of the class of business owners discussed above, is a longer-term project.

But there is a variation on that idea that would NOT take substantial time.

There is a class of business that finances its receivables through factoring companies or divisions that require audited financial statements. The rates that these companies have come to expect are at the lowest-end of the range that TRE Sellers currently command.

Those companies have not become TRE Sellers and the financing firms that currently serve them have not become TRE Buyers.

But these are the big fish on both sides of the transaction equation!

There is no question that TRE needs to continue to work very hard on expanding its book of smaller, higher-rate-paying Sellers. But in the near term it also needs to go after some of the bigger fish.

What’s the bait for that enterprise?

Why not create a separate class, or designation, of Seller? Why not discriminate? Not in function; just in terms of designation.

Given that the guarantee of the TRE Seller to re-purchase invoices not paid by Account Debtors is the principle security of a TRE Buyer (whether recognized or not). And given that almost no current Seller financial statements are actually audited. Why not create a class of Seller distinguished simply by their ability to provide audited financial statements? And add some sort of designation to the description of that Seller to distinguish it from the others. Or collect the auctions of those Sellers on separate "page". Or....you get the idea.

This would assure the potential Sellers that they will be presented to the Buyer community in a way that recognizes that they are qualitatively distinguished from companies like that of my friend’s relative; presenting greater assurance and, therefore, less risk.

This would allow potential Buyers whose internal controls require audited financials to at least consider TRE membership.

This would provide a simple, logical and supportable means of differential risk assessment and transaction pricing.

And, it could be implemented immediately and without cost.

It is, at best, a proxy for a real system of quality discrimination.

But even a proxy has value!

Congratulations to the TRE Team!

2010-01-27T09:41:00.000-05:00

The Receivables Exchange announced this morning that it has received $17 million in additional funding from a group led by Bain Capital Ventures to continue to scale its operations and to substantially expand its reach into the B2B receivables financing space.

Funding of this magnitude from sources as respected as Bain, Redpoint Ventures and Prism Ventureworks is a major vote of confidence in the future of this platform and this marketplace.

TRE, its founders and its entire team are to be congratulated on this accomplishment.

For those of us who have already voted with our time, effort and capital on the TRE concept, this is also a significant day.

Only if the Exchange itself succeeds will our early efforts have laid the groundwork for the establishment of significant Exchange-based businesses.

If TRE ultimately fails it will not be because of a failure of vision. If it ultimately succeeds it will have been in spite of the opposition of much of the traditional factoring community.

I am among the first to criticize and to point out what I perceive as flaws in TRE practices.

But I can only be complimentary of the founders’ identification of a potentially huge under-served market and their vision of a solution to one of the most widespread and pressing needs in the business community.

Too many within the traditional industry have been, in my opinion, unable to conceive of a solution on anything approaching the true scale of the problem.

TRE might be criticized for hubris and for being insensitive to the influential players in the current market.

But the truth is that the current industry leaders haven’t produced a potential solution that even approaches the creativity and vision of the Exchange’s.

This is a day that the entire TRE team can celebrate and an accomplishment in which they can take well-deserved pride.

But tomorrow it’s back to work with an even steeper hill to climb!

The Punch Bowl

2010-01-24T14:04:00.000-05:00

The teams that will meet in the Super Bowl will be decided this afternoon.

We’ve already seen the Rose Bowl and the Sugar Bowl, the Orange Bowl and the Hula Bowl. For many business owners those bowls only briefly take their minds off the most important bowl of them all…

Yes .... it’s the Punch Bowl.

Ever since someone described the essential job of the Federal Reserve Board as taking away the punch bowl just as the party is getting started, the term has been understood as describing the fuel that gets a party going.

In economic terms that’s understood to mean cheap money, or low interest rates; and more specifically, low interest rates in the commercial banking system. Because that’s what’s generally considered the necessary ingredient to get a stagnant economy moving.

But the Fed’s punch this time around doesn’t have the kick it used to. The central bank been keeping the cost of money at an all-time low level and the party, for many businesses has been all but canceled.

The punch in this year’s punch bowl is a punch in the stomach!

That’s what it feels like after a business owner, used to being able to access traditional credit markets at SOME cost, gets turned down flat again and again. There's no bank money for him at ANY cost.

It’s well documented that the Fed’s monetary stimulus is fueling a powerful carry-trade allowing banks to rebuild capital at the ultimate expense of the national debt we leave to our children.

The cheap money is being used, not to make loans to businesses, but to play the yield curve. It shouldn’t surprise anyone. It’s a perfectly natural and logical, low-risk way to repair some of the damage done when punch was really punch.

I was looking over the financial statements of a TRE Seller this morning. This particular Seller provided audited statements for the year 2007; before the current liquidity crisis began and during the period when low interest rates still fueled (arguably over-fueled) business expansion.

The Notes to the 2007 Statements described an accounts receivable financing facility provided by a commercial bank.

The borrower was not in great financial shape at that time. It recorded a substantial net loss for that year and had obviously been restructuring its equity financing to compensate for operating losses.

I was struck by the financing terms that this borrower had been able to secure from its bank. The rate was pegged at a fixed increment BELOW a widely-used benchmark. And the absolute level of interest cost produced by that formula was, to my mind, quite low in light of the quality of the credit.

The punch still had its kick!

It could be argued that this sort of lending was a symptom of the problem that would rock the financial system shortly thereafter and, therefore, the terms of that facility should not be considered a fair benchmark for comparison to a cost-of-funds today. And that’s a fair argument.

But it’s still useful for dramatic effect.

The pricing that the Seller has indicated as acceptable for current invoices to be sold on The Receivables Exchange is roughly TRIPLE the rate it was paying just over two years ago on its former bank facility!

Now it’s true that the former facility was probably under-priced. And the TRE pricing might well come down as the Seller becomes better-known. And the Seller HAS continued to lose money in the interim periods; so it’s appropriate that its cost of money should have risen. But the magnitude of the change in cost-of-funds is still dramatic.

Let’s say, for argument, that the appropriate measure of the increased cost represents a doubling rather than a tripling of rate. An increase in financing cost of that magnitude over a relatively short time period HAS to require compensating changes in business models.

But the biggest change required in business models is not actually compensating for COST of funds. It is compensating for AVAILABILITY of funds.

For a very large segment of small to medium sized-businesses, the traditional funding sources are just not available.

There are non-traditional sources for some of them, of course. But most of those non-traditional sources are relatively small when viewed in the context of the size of the current national problem.

The Receivables Exchange aims to provide an alternative financing platform on a major scale at prices that will be generally lower than, and with a process generally more flexible than, the existing non-traditional sources.

I suspect this Seller might still feel like he’s been punched in the gut at the prices he’ll have to pay to get his first few deals funded.

But I suspect that he’ll nonetheless be happy to just be able to play the game; that is, to keep his business going; even if it feels like he's playing in the punch bowl!

The Low-Risk Assertion

2010-01-19T15:34:00.000-05:00

I’ve written in these posts about risk; about the assessment of it, the protection from it and the appropriate compensation for it; probably more than about any other topic.

It has been asserted that accounts receivable purchasing constitutes a low-risk asset class.

Let me share a little bit of a current story with you.

I settled a case of payment default in my traditional invoice purchase business last week. I have now recovered the funds originally advanced as well as a portion of my costs of litigation and collection and a portion of the modest post-judgment interest allowed in the state where the dispute occurred.

In the scheme of these things, that’s a “win”. But the financial result doesn’t capture the story.

I had done 76 transactions with this client over the course of nearly two years and so I had a degree of confidence in the process.

I had a first lien position via UCC filing on ALL of their receivables. I also had personal guarantees from two principals.

Then the default occurred. I’m not going to talk about either the identities of the parties or the details of the default; the PROCESS is the point of this story.

Following the default, the client and I met to discuss options and we agreed on a plan for payments to be made over the course of some months to clear up the problem. Given the transaction history, I thought then that it made sense to do that and I’d probably do it again today. And several payments WERE subsequently made; but not in the amounts or on the schedule agreed.

Then the payments stopped.

When it became clear that the co-operation of the client had ended I sued the client and both of the individual guarantors.

Ultimately I obtained judgments against all three parties. Meanwhile, however, the client corporation had merged with another entity, muddying the waters substantially on that claim. The two principals of the original client had parted ways. One had declared personal bankruptcy and the other had gone to work for another company in a different industry.

It takes only a few words to relate that outcome. Consider, though, that the definition of “ultimately” is two years of work and aggravation and the word “meanwhile” is its synonym.

From the time of default to the time of final settlement this issue will have consumed nearly four years, and hundreds of hours of my time and attention that could have been put to more productive use.

A lawyer who doesn’t specialize in collections work might be impressed with the idea that I was in the “right”; that I had a “solid claim”. But a lawyer whose job is to actually find and extract cash from uncooperative or desperate debtors will know better than to minimize the difficulty of actually getting paid even on an apparently clear claim.

In the end I will have gotten a portion of my money from a receivable that I had not actually purchased; a portion will have come from property seized on my behalf by the sheriff under court order; a portion will have come in the form of small monthly payments in lieu of a wage garnishment; and a portion will have been paid by one guarantor in exchange for an assignment of my rights against the other guarantor and the original client corporation.

If I had not had the personal guarantees, this outcome would not have been possible. If my UCC filing had encumbered only the receivable actually purchased, or if there had been a UCC filing senior to mine, I would have been out of luck.

This client had been in business for many years and was well-known in its industry. I had done dozens of transactions with the client before the default. But when the situation started to go bad it went very bad very quickly. And then it was a long, painful, expensive and maddening process to recover what I was owed.

My guess is that anyone who has been buying receivables for any length of time will have had similar experiences. And will know that the idea that this is a “low-risk” business reflects wishful thinking. It’s only low-risk until it’s not.

There HAS to be a risk premium built into the pricing of receivables purchases. That premium needs to accurately reflect the security of the buyer’s position and as each layer of potential security is stripped away; the price that the deal should command needs to be adjusted.

I began this year’s posts talking about the unusual nature of the TRE Buyer community and the impact of that on the auction process.

Those Buyers who are in the “short-term-parking” business will probably not have had the experience of having to pay a sheriffs department’s mileage costs to serve a writ of execution on a bank to try to seize a debtor’s funds. Or of having to wait a specified time period before the writ can be presented; allowing, of course, the funds in the account to be moved. Or of having to sit and watch as the myriad schemes of the professional judgment debtor are played out at his expense.

But those experiences do make a difference as one reaches to hit the “submit bid” button!

Restraint of Trade

2010-01-12T18:10:00.000-05:00

In our post of January 4 entitled “Back to the Big Picture” we said that it would be up to the TRE Buyers to provide the counter-weight to the Exchange’s clear incentive to push for volume at the expense of quality. And in assessing the likelihood of that we said that the evidence at this point is mixed.

A number of instances of Buyer restraint can be pointed to in making the case on the positive side. I’d like to point out just one today, because I’ve been watching this situation and wondering how it would play out.

There is an active Seller that has been posting the invoices of a high-name-recognition Debtor since mid-October. The terms of the invoices call for payment in 60 days.

The Seller has been posting invoices of this Debtor at the rate of more than one per week and the auctions are of greater than average size, so a significant amount of money is involved.

I’ve been watching to see how the payment pattern would actually develop. After all, high name recognition doesn’t mean they pay well!

To date, there is no record on the TRE platform of a payment having been received from this Debtor, and the invoices included in the earlier auctions are now well beyond their 60 day terms.

It is important to note that none of the auctions has reached its re-purchase date. So I’m not suggesting that there is any default in the offing. I am using the situation only as a way to analyze and discuss the bidding pattern.

This Seller had sold invoices due from a number of other Debtors before the first auction of this Debtor’s invoices. So Buyers were used to seeing the Seller’s name. And the name of this new Debtor is a good one. So the auction was well-received. It sold right in the middle of the posted range.

Over the next ten, or so, transactions involving this Seller/Debtor pair, the pricing tended to decrease i.e. the discount demanded by the Buyers fell until it hit a low point about 48 days after the first auction. At that time, of course, no payment from the Debtor had been received.

Now, TRE management frequently points out a pattern of declining cost as auction history is amassed by a Seller.

I’ve never quite understood why the prices should get better for the Sellers until a pattern of actual payment has been established. From my point of view the greater the volume of unpaid invoices from a particular Debtor the higher (as opposed to lower) the discount should be on the next deal. But that’s just me, I guess.

But what has actually happened in this case does show some Buyer restraint.

Since that low-point in pricing was reached, half-a-dozen more auctions of this Seller/Debtor pair have been sold. There has been a clear movement toward higher discounts as those additional invoices have been brought to market while the lock-box has remained empty.

Buyers can argue about the attractiveness of this Seller and they can argue about the absolute level of pricing. They can even argue about the length of time it took for the pattern of pricing to change.

But, on a big-picture basis, the shift in pricing as more and more of the paper was sold without a history of payments being made, is rational.

The discount SHOULD go up under those circumstances. And maybe, when payments begin coming in, the pricing pattern will reverse.

But, in the meantime, a little restraint of trade is a positive sign.

Short Term Parking

2010-01-10T15:21:00.000-05:00

In our post of September 17, 2009 entitled “The Company Capital Keeps” we commented on the fact that the TRE Buyer community is an unusual one.

In most, better-established financial markets, the professionals who provide capital have relatively similar motivations: they approach the markets in which they are active with similar analytical tools; they assess opportunities and risks relatively similarly; and their differences are usually apparent “at the margin”. Their assessment of appropriate pricing, for instance, will vary; but there is usually a fairly narrow range of central tendency.

In our last post we asked whether the TRE Buyers would provide the discipline required to act as an effective counter-weight to the Exchange’s understandable incentive to ramp up volume at the expense of quality.

These two issues are related.

The motivations of the TRE Buyers, as a group, are not as homogeneous as are typically found in more well-developed capital markets.

The TRE website, in its “Become a Buyer” section states: “Commercial banks, hedge funds and asset-based lenders are looking for new classes of high-yield investments to diversify their portfolios.”

Absent from this list (and from the “Become a Buyer” discussion generally) is any mention of the factoring community: the long and well-established industry of those whose business is buying accounts receivable.

TRE obviously seeks Buyer-members from the factoring community, but it is just as obvious that it has a strong emphasis on attracting capital from those NOT already in the business of buying accounts receivable.

In the list of benefits that TRE Buyers are provided by the Exchange, the short-term nature of the receivables purchase is specifically mentioned three times. References to the ability to “deploy more capital” or otherwise “access” a new market or “increase originations” are also a dominant theme of the advantages outlined in “Become a Buyer”.

The message sent to the reader, I believe, is that TRE provides a new place for investors whose business is NOT buying receivables to get some incremental yield on excess capital without committing money for a lengthy period.

So a hedge fund, for instance, that has cash sitting on the sidelines earning next-to-nothing, can pick up some extra income on that cash while retaining the ability to move the money fairly quickly into its more traditional business when opportunities arise.

This is the “TRE as short-term parking” model.

This model is likely to be employed by those committing only a small percentage of their capital to the receivables market. The combination of a relatively small commitment and a short duration provide two legs of a stool supporting the attractiveness of TRE to some of these potential Buyers. The third leg is the name-recognition factor of some Account Debtors.

TRE points out, quite accurately, that a significant percentage of the Account Debtors whose obligations are being offered on the Exchange are household names.

When the added yield and the lack of a significant time commitment is combined with the idea that the Debtor is a substantial, well-known, perhaps-public company, the decision process might seem quite simple i.e. “if I can pick up several hundred basis points of added yield on my cash position on a short-term instrument due from a AAA credit, why not?”

In the town where I live, the parking meters have a little button that you can push that gives you 10 minutes of free parking. So if you’re just going to run in to a store a pick up something quickly, it costs you nothing. But if you overstay the free period, the cost of a parking ticket will be the equivalent of your having put money in the meter 120 times! My guess is that the town makes a lot of money by giving away the first 10 minutes.

Those who employ the short-term parking model on TRE are not assessing risk in the same way that those whose principal business is buying receivables think about risk. They take comfort from the AAA Debtor name without, perhaps, fully realizing that it is the Seller, not the Account Debtor, that is really backing the obligation. And that many of the Sellers have much less than impressive financial capacity.

They take comfort in the notion that all invoices are verified by TRE when, in fact, that is no longer the case. They take comfort, perhaps, in the description of receivables as “attractive, low-risk investment opportunities”. Attractive? Yes. Low risk? Well, that depends.

The receivables-purchasing business has a very long history. There is much evidence to be used in assessing risk. That evidence should not be ignored.

The short-term parkers are providing buying power that TRE currently needs. But ultimately the short-term parkers are not the ones that, in my opinion, are going to prove the TRE concept.

Their money is “fast”, their interest is ultimately in other markets, and one deal gone bad may be all it takes to lose their participation.

Nor are they the Buyers that will provide an effective counter-weight to the risk of the Exchange’s clear growth-rate bias.

More to come on this subject.

Back to the Big Picture

2010-01-04T14:33:00.000-05:00

My last post addressed one relatively small element of my own proof-of-concept question as a Buyer Member of The Receivables Exchange.

But this is the year in which the larger Exchange-level, proof-of-concept question will have to be answered: i.e. will TRE, in its current format, prove its economic viability?

The principals of TRE are actively seeking additional capital. This would be their third “round” of funding for the Exchange. This is not an unexpected development. Even at its own initial estimate of 2009 transaction volume the Exchange would not have reached break-even last year. So an additional round (at least one) of capital-raising was probably always in the cards.

I have no information on how the process is going but I would guess that they will succeed in raising enough funds to make it through 2010. At the end of this year, if the operation isn’t pretty close to breaking even, a fourth round of financing is likely to be a pretty hard sell. At that point the question of ownership structure and operating format would almost certainly come into play.

For those of us who have invested significant time, effort and money in the TRE concept there is an understandable desire to see the effort succeed; to see the concept proven; and to participate in the fruits of that success. And so I, for one, have to admit a bias on the positive side. The challenge is to avoid allowing that bias to affect either my analysis or my actions as a Buyer.

While my bias puts me on the same side of the larger conceptual issue as the Exchange itself, there is an important difference between the impact of the bias on an individual Buyer and the impact on the Exchange.

The essential trade-off in all financial markets is risk vs. reward.

In the context of the Exchange operations that trade-off is expressed in terms of volume vs. quality. We’ve commented before on the clear incentive the Exchange has to sacrifice quality for volume as it stretches to reach its proof-of-concept economic goal. There is an internal TRE counter-weight, however, provided by the very real need to control defaults and losses in this period. There’s only so far that TRE can afford to go in ramping up the aggressiveness of its Seller-marketing.

But the closer the time comes for clear proof-of-concept demonstration, the less effective a counter-weight that internal caution will provide.

The true counter-weight has to come from the Buyers.

If Buyers, who by definition have made a bet that the potential of the Exchange is worth their devoting time, effort and capital to it, hold a bias that is directionally similar to that of the Exchange, how can they be expected to provide an effective counter-weight?

The Buyers have to refuse to buy when the risk-reward proposition defies logic. If Buyers do not reject auctions that should be rejected, the message to the Seller-marketing group is “you haven’t yet found our pain threshold”. And the quality envelope will inevitably be pushed a bit farther.

There are those who would argue that rejection of auctions is not an appropriate response; that pricing should provide a clearing mechanism for any transaction. In theory, and on a large scale, that is true. But anyone who has had to try to enforce a judgment and collect funds from a defaulted receivables purchase will testify that there are some deals that just shouldn’t be done at any price. There just isn’t enough reward available to balance the risk. The cost in time and irritation exceeds any possible financial reward.

Will the Buyers provide the discipline to balance the Exchange’s clear incentive to push for growth?

There is mixed evidence at this point.

That question and its implications will be the subject of our next few posts.

Proof of Concept

2009-12-30T04:52:00.000-05:00

Dateline: Tel Aviv

After seven months of active trading on The Receivables Exchange I can say that a number of significant “proof of concept” questions have been answered in the affirmative; both at the level of the Exchange operations and from my own point of view as a Buyer. Some questions are still open, of course, and will be answered with more time and experience (and money).

This will not be a long post, partly because I’m here to visit family and not to write blog posts, and partly because I’m writing on an HP Mini that has a keyboard that is friendly only to fingers the size of my 4-year-old granddaughter Emma’s.

But this has been my first opportunity to run a significant test of an important (to me) attribute of the TRE platform and process.

In my normal business of buying invoices it is important that I be in close contact, frequently in person, with those I’m buying from. An attraction of the TRE process for me is that it shouldn’t matter whether I’m in New Jersey or Tel Aviv (except for the circadian disruption of a 7 hour time difference). I ought to be able to do anything I need to do to be an active and effective Buyer from any location, or from a different location every day, if I should choose.

I’ve now proven to my own satisfaction that that element of the concept is valid.

I’ve bought two auctions in the last two days using a wireless high-speed internet connection and this almost toy-like little netbook.

Admittedly, the administrative part of things is a bit more cumbersome than if I were in my office with all of my files and support equipment. But the short-term essentials, including buying, record-keeping and moving money around can be done quite readily via wireless connection.

If my business were strictly TRE-based I would have no problem making a permanent location change over a week-end, whether I was moving across the street or from one continent to another.

That’s cool.

May 2010 be a healthy, happy and prosperous year for us all.

A Comment on Risk

2009-12-20T17:14:00.000-05:00

I heard a marketing presentation not long ago in which it was asserted that that “only three-tenths of 1% of invoices ultimately go unpaid”. The unspoken but implied conclusion was that buying invoices involves only minimal risk.

I asked for the source of the statistic quoted and was told that it came from the Credit Research Foundation. I contacted the CRF and obtained a copy of the quoted report, which is entitled “National Summary of Domestic Trade Receivables: 2008 Annual Bad-Debt Report”.

The top-line analysis is provided in two statements:

1) “Net bad-debt write-offs during 2008 totaled $30.00 per $100,000 of sales. This is a net change of $0.00 over 2007, and

2) Allowance for uncollectables during 2008 was 1.00% of receivables. This is an increase of .50% over 2007.”

(Not to be picky, but $30 per $100,000 is actually three one-hundredths of one percent, not three-tenths.)

A few observations:

• The number of respondents to this survey was 555. It is not clear how large a part of the overall economy this sample represents.

• The figures quoted in the summary statements above represent the median responses.

• While the write-off figure did not increase in 2008 over 2007, the allowance taken in 2008 was double that of 2007.

• In the case of the write-off figures, the upper-quartile break-point of the sample was at .19%, or about 6 times the median level.

• In the case of the allowance for uncollectables, the upper quartile break-point was at 3% of sales---100 times the level of the median write-off reported!

So you can choose to highlight the finding that the median write-off remained the same from one year to the next. Or you can take note that the expectation of losses, captured in the allowance figure, increased by 100%.

Or you can acknowledge that the upper-quartile, forward-looking statistic is 100 times the median backward-looking statistic.

The waters might not be as placid and shallow as they appear!

There’s another source of data that is more relevant to the operation of The Receivables Exchange. It is collected by The International Factoring Association. For 2008 this data represented the experience of 120 companies in the factoring business.

• The median write-off experience of that group in 2008 was .3% of gross invoices purchased, 10 times the median of the CRF sample. The average write-off experience was 1.3% of gross invoices purchased, more than 4 times the median.

• The IFA presents results broken down by size of respondent. The largest companies providing data; those with $100 million or more in gross receivables purchased; had the lowest loss experience, at .6% of invoices purchased. The smallest companies, buying less than $5 million per year, had an average loss experience of 2.5% of gross purchases.

• These figures, from companies actually involved in the industry, are far higher than those reported by the CRF. But more importantly, I think, these figures represent the experience of companies that KNOW the risks of buying invoices and take all of the normal precautions against losses.

I’ve detailed in other posts the ways in which the Exchange’s practices in qualifying Sellers, in obtaining security and in verifying invoices fall short of those in common use among buyers of individual invoices. (I've also pointed out some unusual benefits of the TRE process as well, however.)

I’ve argued that the TRE Buyers are exposed to incremental loss levels because of those shortcomings in risk mitigation.

It’s too soon to say what level of incremental return should be required by TRE Buyers to adequately offset the added risk.

It is not too soon to say, though, that the increment should be added to the IFA experience, not to the much lower CRE numbers.

And I would argue that the baseline point of the analysis should not be the experience of the largest companies but rather of the smallest, recognizing that the majority of TRE Sellers would not qualify for funding by the largest factoring companies.

We've all heard the one about the guy who drowned in a river that was only 6 inches deep, on average! Some statistics can be correct and irrelevant. Some can be correct and dangerous.

It's only coincidental that the first three letters of Treasuries, are TRE. We're not buying Treasuries here!

It's BLT or Toast!

2009-12-13T15:46:00.001-05:00

I was talking with a man a couple of days ago who runs a factoring company. He called to ask about my experience with The Receivables Exchange. Before I could begin to really answer he launched into a bit of a diatribe regarding the impossibility of TRE’s ever becoming successful.

As he delivered his “I know more than you do” lecture I thought of that wonderful quote from Hebert Spencer:

“There is a principle which is a bar against all information, which is a proof against all arguments and which can not fail to keep a man in everlasting ignorance—that principle is contempt prior to investigation.”

Now this man had done some investigation and he’s a bright and experienced person. But he has a view of what is possible that is strongly influenced by a desire to maintain the status quo.

The problem is that once the genie is out of the bottle, the status quo cannot be maintained. The nature of a disruptive idea, process or event is that it DISRUPTS, no matter how inconvenient that disruption might be.

I believe that the IDEA of TRE is disruptive.

The question, in my view, is not WHETHER there will be a successful online auction market for accounts receivable. Now that the idea is out there, the question becomes whether the specific TRE model and process will be the one that survives and prospers or, if it fails, what changes to the TRE model will be necessary for the NEXT such venture to succeed.

As much as the traditional factoring industry pushes back at the TRE model, I haven’t heard anyone say that the basic idea is a bad one. The devil is in the details. Those who offer opinions that the Exchange can never work often point out perfectly valid weaknesses in its process.

But anyone can do that! I’ve done that; often and publically. It’s not hard. But they tend to stop before suggesting a solution. And there ARE solutions. They might be hard. But a lot of things are hard; that doesn’t make them impossible.

Here’s what’s hard, in my view.

To think BIG, not small. To think LONG TERM, not short.

Federal Reserve data suggest that about $18 Trillion of B2B receivables are created in the US each year. That’s a BIG market. The factoring industry touches less than 3% of that volume. It might be threatening to suggest that a highly professional and well-developed financial market is actually quite small compared to its potential. Especially if the idea comes from a source outside the industry!

In this case, thinking BIG is not a matter of a few percent points change in growth rate. Thinking BIG requires conceiving of exponential growth!

When you’re ass-deep in alligators, as many have been over the past year or two, short-term thinking is critical. Survival is the priority. And in that kind of environment it’s very hard to shift gears and think long-term. But when confronted with a disruptive idea, the only way to craft an appropriate response is to detach from the present crisis and look out to the horizon.

Is it possible that there is room in the industry for a very different model to work? And not only to work but to add value in an important way? Not to replace the current model, which is probably the best one for many clients. But to provide a solution for those whose needs are best met with a different approach.

There’s no question that there are many elements of the TRE model that deserve to be addressed in a critical way and a few of them might well be make-or-break practices or polices.

But in the long term let me suggest that it doesn’t really MATTER whether TRE gets it right or not …or even if TRE itself survives or not.

What matters is that the idea is now out there and the real-time, real-money, market experiment is well underway. If TRE fails it will leave behind valuable evidence of the cause of failure and the next venture will have a much better chance of succeeding.

I’ll get back to criticizing in my next post. Today’s message is to those who practice the Spencer principle of contempt prior to investigation.

In the face of disruption think BLT (Big and Long-Term) or (risk becoming) toast!

For the Record

2009-12-11T15:17:00.000-05:00

Just for the record, this afternoon we bought our fiftieth TRE auction since going “live” as an active Buyer.

We’ve bought from sixteen Sellers.

We’ve bought invoices due from twenty-nine Account Debtors.

Thirty-five of our auctions have been paid-in-full.

I’ve been targeting 50 purchases for a while now as a kind of milestone. It's just cool to have hit it. That's all.

Next stop = 100!

I'll write on a subject of broader interest over the week-end.

The Quality Rating Question

2009-12-06T16:45:00.000-05:00

The credibility of credit rating agencies has taken a major hit during the financial turmoil of the past year. In most cases the credit rating agencies had before them audited financial statements to work with in making their judgments.

In some cases, the judgments themselves seem to have been faulty. In others, the data given the agencies has been faulty, even if audited.

PriceWaterhouseCoopers recently published its “Global Economic Crime Survey 2009”.

Quoting from their report: “…nearly one in three organisations around the world reported they were the victims of economic crime during the past 12 months. Of those, 43 percent said that the incidences of fraud in their organisations had increased during the period…Asset misappropriation or theft, cited by 67 per cent of those who reported crime, was the most pervasive, followed by financial statement fraud, cited by 38 percent…”

A representative of the accounting firm commented: “The global economic downturn has heightened the pressures and incentives to commit fraud…In these tough times, the temptation to inflate results or take part in other forms of financial statement fraud may overcome ethical values…”

If there is pervasive opportunity for misstatements among larger, more closely-scrutinized companies, how much greater is the opportunity among smaller, privately-owned businesses whose financial reports are not audited, or in many cases, even reviewed?

Add increased opportunity to increased incentive and the tests of “ethical values” are likely to be even more severe.

We’ve commented more than once in past posts about the fact that most TRE Sellers do not provide audited or reviewed financial statements. We’ve also made the point that it is the SELLER that makes the promise to re-purchase an unpaid invoice. The credit of the SELLER is actually more important in the TRE format than in many other factoring formats.

It is the nature of privately-owned businesses, many of which are in S-Corp or LLC formats for tax purposes, to allow tax considerations to influence financial reporting practices. It’s not unusual or even unexpected to be told that getting a picture of the “real” operations and profitability of such a company requires the books to be adjusted.

Some of the financial statements provided by TRE Sellers show obvious signs of such “adjustments” and some of those adjustments appear to be made clearly in order to present a more palatable view of their operations to TRE Buyers.

There’s not necessarily anything wrong with that!

The picture that a privately-owned business presents for tax purposes might actually be a seriously unfair view of it as an operating entity for any number of reasons.

But, to the extent that getting approved as a Seller on the Exchange provides incentive for erring on the side of optimism, the prospective Sellers have both opportunity and incentive to overstate their financial health. And that clearly increases the risk to the Buyer.

TRE has, on its staff, former FBI experts in detecting financial fraud. That’s a good thing.

A better thing, in my opinion, would be to also have a third-party rating entity on contract to examine all of the financial statements provided by Sellers and prospective Sellers and to attach quality ratings to all Sellers posting auctions for sale on the Exchange. Since Buyers are prohibited from contacting Sellers directly, there is little realistic opportunity for Buyers themselves to question financial statements provided by Sellers.

The Sellers have a conflict of interest that is clear.

The Exchange itself has conflicting incentives: a) it needs to bring in a substantial volume of new Sellers and so it needs to make the process as easy as possible for them, and b) it needs to protect against embarrassing defaults and losses.

A third party, without such conflicts, would provide the more credible solution.

Does the admittedly tarnished reputation of rating agencies, in general, damage the credibility of that suggestion?

I don’t think so.

There’s no Fannie Mae or AIG or Lehman Brothers, with the clout to bully a rating agency, among the smaller, privately-owned TRE Sellers. If anything, the balance of power between the rating agency and the Sellers would probably invert the opportunity for pressure in the process.

Any Buyer that has looked closely at the financial statements provided by TRE Sellers would, I wager, agree that a third-party assessment would be both welcome and valuable.

Maybe there's a Smyth Solution possible?

Credit Where It's Due

2009-12-01T09:27:00.000-05:00

In my last post I said that TRE had, in its effort to meet volume goals, tilted its policies and procedures in favor of the Seller community. That is both a strategic and tactical decision whose logic I think we can understand whether or not we like it or agree with it.

Today I’d like to put issues of Exchange strategy aside for a moment and make a few points about nuts and bolts.

Today marks my six-month anniversary as an active Buyer (following two months acquiring some education as a very active observer).

And I have been an ACTIVE Buyer during that period.

As a percentage of the total dollar volume of auctions my activity hasn’t been a very significant factor. But as a percentage of the actual number of transactions, my activity has been significant. I say that to make the point that I speak from experience.

I’d like to share a bit of that experience:

--About two-thirds of the auctions I’ve purchased have, as of today, been paid-as-agreed; closed-out without the need for any action on my part after purchase.

--None of those that remain open give, as of today, any sign that there is a cause for concern.

--The auction platform, itself, works very well. It has been improved significantly during the past six months. There are many enhancements that could, and hopefully will, be made in the future. But the fact that it works as well as it does at this stage of the Exchange’s life is a tribute to its creators and to TRE.

--The Liquidity Desk operation in New York is professional and responsive. Questions are answered quickly and issues that need to be addressed get addressed.

--The Member Services group in New Orleans provides excellent service. They send out all the reports of awarded auctions, coordinate the flow of funding for auctions, report on payments received from Account Debtors, and generally act as the interface for all financial and accounting matters from the purchase of an auction until it is closed out.

Counting all of the individual transactions and reports generated by our trading activity over the past six months there have been literally hundreds of opportunities for errors in the accounting and funds-flow systems. There have been less than a handful of minor issues and not all of those were the responsibility of Member Services. In each case, the Member Services people have been responsive, professional and diligent in finding and correcting the problems.

--The Operations Department, as a whole, has also been quite helpful. I’ve had occasion to ask a number of questions that have been referred to Operations for response and the responses have been timely and to the point.

What’s MY point?

The TRE trading platform and its operations system WORK!

That’s a BIG thing and the Exchange is to be commended on its accomplishment.

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Half a Bubble Off Plumb!

2009-11-30T08:20:00.000-05:00

In my “Happy Anniversary!” post of November 23, I wrote:

“From my point of view, the Exchange has tilted significantly toward the Seller community as it has attempted to bring on sufficient product to meet its volume targets.”

The degree of tilt is probably more than just “half a bubble”.

What has the Exchange done to “tilt” the playing field to favor the Sellers?

First let’s review where we began. From inception TRE:

--Has not required personal guarantees from the principals of Sellers,

--Has filed UCC Financing Statements encumbering ONLY the receivables sold on TRE (as opposed to getting a blanket lien on all receivables), and

--Has accepted internally-generated financial statements, frequently without any evidence of independent review.

Since the Exchange’s operations began, there have been a number of changes in policy or process that are good for Sellers but bad for Buyers.

What are some of those changes?

--Initially, invoices were to be verified by a third-party service provider. Now, the Exchange itself handles verification.

--Initially, the verification process was to include confirmation that goods had been delivered or services performed to the Account Debtor’s satisfaction. Now, verification is limited to obtaining confirmation that there is an invoice in the Debtor’s accounts payable system that matches the number, date and amount of the posted invoice. No actual affirmation of satisfaction is obtained. (Note that invoices from members of The Ariba Network do meet a more stringent standard.)

--Initially, all invoices were to be verified. Now, there is a sampling system.

--Initially, progress billings, which are common in the construction industry but present unusual risks, did not qualify for posting on the Exchange. That prohibition appears to have been relaxed.

These are significant procedural changes and they clearly increase the level of risk borne by Buyers on the Exchange.

I think it is clear that the changes have been made to allow TRE to attract more Sellers.

It might seem counter-intuitive that relaxation of procedural safeguards has been necessary to attract Sellers in the economic environment of the Exchange’s first year. After all, the papers have been full of stories about how difficult it is for businesses to find financing. But I don’t think the message is ambiguous.

TRE needs to ramp up volume to reach a level that makes it economically viable and proves to its equity investors that it is a viable operating entity for the long haul.

If the problem were attracting Buyers, any procedural changes affecting Sellers would be in the direction of tightening standards and procedures; making the risk profile more attractive to Buyers.

Changes in standards and procedures that increase risk to Buyers seem clearly to signal that the imbalance is on the Seller side.

The TRE calculus seems to be (this is my speculation only) that the Buyers will tolerate the increased risk as long as the risk is “potential” rather than “experienced”. That is, there are no significant Seller defaults and subsequent losses to Buyers. The implicit hope is that the Exchange can somehow control matters in the short term, avoiding any serious risk-related problems until it reaches its equilibrium level of volume.

At that time, maybe the process of moving back toward a level playing field can begin. If that IS what’s going on it’s a delicate and potentially perilous process.

On the positive side, while TRE will not hit its publically-stated volume targets this year, the volume HAS been ramping up significantly over the past few months and if we were to annualize current levels, the Exchange would come close to its volume goals on a run-rate basis.

If TRE can make meaningful progress on some of the impressive and important Seller-attraction initiatives already in place; including alliances with The Ariba Network, The American Staffing Association and Smyth Solutions, it is possible that it can reach a volume level in 2010 that can sustain its operations.

As it is approaching that critical volume level, however, it’s going to need some luck. The single greatest risk that it faces, I believe, is a nasty default and a public squabble over losses.

The additional risk in the system is real and “half a bubble” of tilt toward Seller-leniency is probably all the system can tolerate. Ultimately things will have to move back toward balance.

In the meantime: see my posts entitled “Caveat Emptor”.