A Brief Digression

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

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

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

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

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

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

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!

An Interesting Snapshot

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

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.

A Comment on Risk

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)

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.