Sizing Up the Opportunity

Recent economic headlines have desensitized us to very large numbers. “A billion here and a billion there” has become “a trillion here and a trillion there”.

Numbers that large tend to lose real meaning to us whether they represent government spending proposals or distances in interstellar space.

When I talk about The Receivables Exchange to people, eyes tend to glaze over at the TRE “headline” market size number of $17 trillion to $18 trillion. It’s just too big to get your arms around.

So I’d like to do a little rough reality check on the size of the TRE opportunity. These are my thoughts, not those of TRE, which might actually consider me a little conservative.

The Federal Reserve Board publishes a quarterly analysis of the constituent segments of the US economy. Table B-102 on page 103 of the Fed’s July 11 report contains its 1Q 2009 analysis of the “Nonfarm, Nonfinancial Corporate Business” segment of the US economy.

I’d reproduce the Table here for the readers’ convenience but I’ve already wasted hours unsuccessfully trying to format it in this blog software! So I’ll have to try to tell you what it says rather than show you.

At the end of Q1 2009 the total “Trade Receivables” of the nonfarm, nonfinancial corporate business segment of the US economy was $2,165.8 billion.

The average of the five prior year-end figures was $2,095.9 billion. (The range was from a low year-end figure of $1,831.3 billion in 2004 to a high of $2,263.1 billion in 2007.)

To convert a point-in-time balance to an annual volume we have to apply an estimate of receivables turnover i.e. how many cycles of payment are there in a year. Most estimates of payment velocity fall between 30 and 60 days with a central tendency in the 40 to 50 day range.

A 40-day turnover rate produces a multiplier of (365/40) 9.1 and a 50-day rate produces a multiplier of (365/50) of 7.3.

If we apply that range to the 5-year average of the Fed’s numbers we get an indicated total annual figure of $15.3 trillion to $19.1 trillion.

This shorthand calculation bears out the TRE estimates. The size of the aggregate corporate receivables market DOES actually appear to be in the vicinity of the $17 trillion annual figure the exchange uses in its materials.

But that’s just a starting point for estimating actual market potential.

There are many categories of receivables that are not eligible for posting on the exchange: a large volume of such ineligible receivables represent the progress payments typical in the construction industry, for example. Other significant excluded categories are related-party transactions and receivables of businesses too small to be TRE Sellers.

It’s tough to quantify the values of the various classes of receivables that are ineligible for TRE posting but, since we’ve managed to roughly verify their overall volume figures, it feels a bit safer to accept, for argument’s sake, their estimate of the actual addressable market i.e. what’s left after excluding all of the ineligible items.

A range of $2.5 trillion to $3.0 trillion is used in various TRE sources, which is about 15% of the total. Excluding 85% of the total market seems, on its face, to be conservative. But is there a way to get a quick confirmation of that?

Well, the government’s Bureau of Economic Analysis publishes a quarterly report on national income accounts that can give Ambien a run for its money.

It might be reasonable (or at least interesting) to compare the income attributable to “proprietors” as a proxy for the TRE-ineligible small, non-corporate sector of the economy, to that of the “corporate” sector.

The “proprietors” income, according to the BEA, represents about 41% of that total (see p15/D-16 Table 1.12 “National Income by Type of Income”)

If we accept that about 40% of the 85% might be represented by the small, non-corporate sector, it doesn’t seem unreasonable to attribute the balance to the other ineligible categories. Again, it seems OK on that basis to accept the TRE-estimate of the net addressable market. We’re just looking for broad-brush confirmation here, in any event.

Now, the next step.

If we assume that the average duration of TRE-eligible receivables roughly equals 45 days, the average outstanding eligible receivables balance at any point in time would be between:

$2.5 trillion / (365 days / 45 days) = $308 billion, and
$3.0 trillion / (365 days / 45 days) = $370 billion.

And, if we further assume that available capital can be actually employed about 85% of the time, the range of capital needed to serve that market would be between about $360 billion and $435 billion.

To pick a point in the middle, we can estimate that the market might have the potential to employ about $400 billion in capital on an ongoing basis. That assumes, of course, that the entire addressable market is captured, which is not reasonable.

So, one more step.

What level of potential TRE business opportunity does that really represent?

Let’s start with another report, this time from the Commercial Finance Association. The CFA reports that receivables factoring volume in 2007 amounted to $135 billion. And let’s convert that figure back to ongoing capital requirement using our same parameters i.e. a 45 day pay period and an 85% utilization rate. The total capital required to support the 2007 actual volume was roughly $20 billion, or just 5% of the indicated potential.

So the indicated potential market is 20 times the current volume of receivables factoring.

Now, some businesses obtain working capital financing using means other than factoring receivables. There are bank lines available to many businesses and various asset-based borrowing facilities. The CFA estimates 2007 asset based lending amounted to nearly $500 billion. If (and this is just a wild guess) about half of that figure is backed by receivables, and we apply the same parameters to calculating ongoing capital needs, the indicated ongoing capital requirement would be about $30 billion (rounded).

We’ve now accounted in a very rough way for about $50 billion of the estimated addressable market.

Many of the better-quality businesses that have wanted to use their receivables as a source of accelerated liquidity have had the opportunity to do so. But many businesses that have been able to liquify their receivables in the past have now lost their funding facilities. And some will undoubtedly find the TRE platform more convenient and attractive than the options they currently employ.

Just for fun, let’s say that 20% of the current factoring and receivables-based asset lending market can be enticed to TRE. That would generate an ongoing capital need of about $10 billion. (Some of the customers of those existing platforms will want to stay with them for a variety of reasons including the “full AR service” that traditional factors provide.)

And let’s say that 12.5%% of the currently un-served market can be enticed to the TRE platform. That would generate an ongoing capital need of about $45 billion (rounded).

So, based on the current volume of economic activity, the total capital deployment opportunity might be about $55 billion (rounded) and the total gross volume of transactions would be between $500 billion (40 day average turn) and about $400 billion (50 day average turn.)

Let’s, again, just pick a point in the middle and call that $450 billion.

If TRE could generate $450 billion in annual transaction activity that would represent a bit over 2.6% of the total volume of annual nonfarm, nonfinancial corporate receivables generated in the US.

A projected market penetration of less than 3% with a platform as unique as that of TRE does not seem to strain credulity.

A market with an ongoing capital need of over $50 billion demands the attention of anyone involved in the receivables-finance business.

It’s not only likely to entice customers away from traditional market participants but it’s likely to impact pricing, packaging and process throughout the market.

TRE certainly won't reach its potential overnight. It will take some years. It will probably also take some changes in rules, format and process. But the traditional players in the business need to be looking over their shoulders.

TRE cannot be ignored.

The Freedom of the Uncommitted

Early in my career I was in the commercial mortgage business. A colleague used to warn me that as long as the money had not been disbursed the lender had the power. But as soon as the check had cleared, the balance of power shifted toward the borrower: the larger the loan, the greater the shift in power.

When things start to get tough, the analysis of who has more to lose in an investment relationship begins to change.

The underlying cause for the shift in power in that business was two-fold:

1) the size of the investment relative to the assets of the borrower, and
2) the duration of the commitment.

In the case of a mortgage the lender will typically have a much more substantial investment than the borrower. A long-term commitment is formed in which the lender has a significant stake in the health of both its collateral and its borrower. And when times get tough the lender often will find itself essentially forced to help keep the borrower and the property afloat in order to protect its investment.

Behavior also changes as the duration of the commitment increases. In a traditional factoring arrangement, for instance, there might be an agreement to do a minimum volume of business for perhaps a year. Commitments are made whose duration extends beyond the immediately predictable horizon. Relationships are inevitably formed.

Even in the business of single-invoice purchasing, commitments can become implicit even if not explicit.

I had one client, for example, with whom I did 180 consecutive weekly transactions. I had no legal obligation to fund the 100th transaction any more than I did the third transaction, for instance; but by that time there was a relationship; both business and personal; and I felt a moral and personal commitment even in the absence of a legal one.

So, what’s the point? How does this relate to The Receivables Exchange?

Pardon the analogy, but the TRE formula is modeled on the commitment level of the “one-night stand”.

No relationships are formed; no commitments are made; the duration is limited; the shift in power is relatively predictable; and, the risk calculation has fewer variables.

Applying that analogy to an investment program….

As a TRE Buyer; at any moment of any day I can choose to just say no. I can stop buying altogether or I can stop buying the invoices of a particular Seller.

On the other hand, if I want to exit a stock portfolio or a real estate portfolio I have to take action: I have to sell.

If I want to exit a bond portfolio I have to either sell or wait for a potentially substantial length of time for a portfolio to self-liquidate.

If I want to exit a portfolio of options or futures I have to either sell or hold to expiration with significant uncertainty of exit price.

As a Buyer on The Receivables Exchange I can just stop buying and my portfolio will self-liquidate at a substantially-predictable price over a substantially-predictable period.

I can stop Buying without needing to negotiate a termination agreement.

I can stop buying the invoices of a particular Seller without having to sit across the table from someone with whom I have a relationship and having a “break-up” conversation.

TRE provides a platform in which there is no commitment, no relationship, no unspoken promises; in betting parlance: “no tears”.

That works for me!

Danger! Paper wake

One of the realities of rapidly-evolving organizations is that they tend to create a “wake” of ideas that have been considered and rejected.

Unlike the wake behind a moving vessel, which quickly disappears without a trace, ideas discarded in the early days of an organization’s life can leave a persistent trail—a kind of paper wake. And if you see the wake of a discarded idea without a trace of its rejection, you might assume that it had been adopted.

So this post is for the benefit of any who have been concerned, as I have, about the informational advantage apparently, but not actually, granted by TRE to its “Tier One” Members.

Tier One Members are Buyers with very substantial resources that are allowed to purchase equity stakes in TRE and, in exchange, are offered certain preferences beyond the typical benefits of ownership.

I invite anyone interested to view the Buyers' Webinar on the TRE website. Toward the end of that presentation you’ll find a discussion of Tier One membership and a slide that lists the advantages offered to those Members.

Two categories of the preferences presented there seem to me to be quite reasonable and without harm to Buyers that are not in the Tier One category.

A third category of preference, though, lists several types of information, important to the analysis of trading opportunities, that would be available to the Tier One Members but not available (or available in some limited way)to the other Buyers.

This has troubled me a good deal and it has been an issue regarding the TRE process and structure that I’ve been unable to justify.

I felt it was appropriate to bring the issue to the attention of readers of The TRE Observer and to offer my opinion that ANY preferential access to information critical to trading is inappropriate and unjustified.

I am pleased to report that, after discussing the issue with TRE, I understand that:

a) the Tier One information preferences described in the Webinar have NOT, in fact, been offered to Tier One Members,

b) the information itself is not yet actually available to be offered to any Members, and

c) when it IS available, the only preference expected to be given to Tier One Members is that they would get the data without charge. Other Members would have access to all of the data but there would be a cost for that access.

Investment in the exchange SHOULD have its privileges.

Providing some information free to Tier One Members that other Members have to pay for seems perfectly reasonable to me.

As long as all Buyers have the opportunity to access all of the same data, the test of fairness is met, in my opinion.

When Foundations Crumble

Bill Siegel of The Receivables Exchange wrote in his Liquidity Weekly post last Friday about the troubles facing CIT Group, Inc. CIT provides financing to hundreds of thousands of small to medium sized businesses (the SME sector).

Articles in the Wall Street Journal on both Saturday (7/11/09) and today make it clear that the failure of CIT would cause a great deal of harm to the SME sector of the economy, which generates the majority of new US jobs. CIT was founded in 1908 and has been one of the foundations of US commercial finance for decades.

We’ve seen no shortage of crumbling foundations in the global financial and business community in the past year. When names like Lehman Brothers and Bear Stearns cease to be; when the viability of AIG and Citigroup are seriously questioned; when the US becomes majority owner of General Motors; the assumptions on which many of us based our concept of economic reality are called into question.

But even more fundamental than the value and viability of such major enterprises are the conceptual foundations on which our understanding of financial reality itself have been built.

WSJ articles in on 7/10/09 and 7/11/09 raise questions about two of those conceptual foundations.

On page 1 of the WSJ last Friday was an article entitled: “Failure of a Fail-Safe Strategy Sends Investors Scrambling”. The “fail-safe strategy” discussed in that piece is asset allocation. It has been a foundation principle of finance that spreading investments across asset classes whose risk and return patterns are different will reduce portfolio risk and increase risk-adjusted return.

It can be argued, I think, that much of the structure of the global investment business reflects this one, single, powerful and pervasive assumption.

But what if it’s wrong?

That’s the question raised by the WSJ piece. There is too much at stake in the answer to that question to expect true objectivity from industry participants. Some of those quoted in the piece take the position that asset allocation has clearly failed. Others argue that it worked but not as well as expected. Others looked to the possibility that the rules of the system change under conditions of extreme systemic stress.

The very fact that the question is being seriously debated, however, has significant long-term implications.

A second foundation principle in modern US finance derives largely from research popularized by Professor Jeremy Siegel of the Wharton School of Business at the University of Pennsylvania. In 1994 Siegel published a widely-used study of the characteristics of stock market returns called “Stocks for the Long Run”.

As the title of his book implies, Siegel argues that over long periods of time equities generate a “remarkably constant” average return and that “the risks of holding stocks decrease over time”. Siegel wasn’t the first to make the case for long-term stock ownership, of course. It had been around for some time. But his research popularized the less-accessible work of some important predecessors.

Interpreted and articulated by persuasive Wall Street marketing departments, Siegel’s work (and others) helped convince both institutional and individual investors to both increase their equity exposure and to hang tough during volatile market “episodes”.

Siegel’s research was influential, in part, because of the duration of the data he used in reaching his conclusions. The return series reached back to 1802! The credibility of conclusions reached when a series of that duration is tested obviously seems higher.

But the piece in Saturday’s WSJ called into question the data used by Siegel for the early period of his research. The author, Jason Zweig, concludes that: “The 1802-1870 stock indexes are rotten with methodological flaws. So we have only the periods since then…to base our long term investment decisions on.” So the data series that Zweig finds reliable is about 1/3 shorter than Siegel’s study accepts.

Now it is natural in a period such as this to call into question the reasons for the failures of our systems. And not all of the answers will ultimately prove correct.

But I think that there is one thing that we can say with a high level of probability: we’ve come so close to total financial melt-down and so much faith has been lost in some fundamental concepts on which our system has been based, that investors will be looking diligently for alternative approaches and alternative vehicles.

The thesis of Bill Siegel’s piece on Friday was that the troubles being faced by CIT might ultimately provide a boost to the business of The Receivables Exchange.

I suspect that he is correct.

But I also think that, more importantly than the impact of any single entity or event, the business of investing in accounts receivable and the vehicle provided by The Receivables Exchange are likely beneficiaries of the re-evaluation of larger, foundational concepts in the business of finance.

An Inconvenient Essential--Part Two

In our last post we identified the invoice verification process as a potential source of “friction” in TRE operations; potentially a threat to both its speed of growth and even to its scale.

We discussed the steps taken by TRE to mitigate the friction and concluded that there appears to be a reasonable balance between: a) the risks posed by forgoing certain typical verification requirements, and b) the risk-mitigation elements in the TRE process.

But the issue cannot be left there. The fact that there are procedural protections that mitigate the apparent risk does not address the question raised by the fact that TRE, itself, verifies the receivables proposed for sale.

Given TRE’s rapid growth goal and the potential for the verification process to impede that growth, there is a potential conflict of interest that has to be acknowledged.

According to the materials available on the TRE website, it was initially expected that the verification process would be outsourced. The idea that a reputable third-party would be handling the verification process was expected, I assume, to give Buyers comfort that there was no potential conflict.

In fact, however, the process in place does not include an independent verification agent.

I do not know what caused the change in direction so my comments here have to be understood as no more than my own speculation.

If I were going to identify a list of candidates for the job of verification agent I would probably start with the big accounting firms: well-known, respected and knowledgeable; the names you find on public companies’ audit reports. They also employ hordes of relatively inexpensive, entry-level professionals.

The second group that I’d reach out to would be the credit rating firms with high name recognition i.e. D&B, Experian, Equifax, etc. These firms also employ large numbers of relatively inexpensive information gatherers.

From the perspective of an accounts payable person in a Debtor’s office it would probably not seem unusual to get a request to verify information from either a well known accounting firm or from a credit reporting agency.

From there, though, I begin to scratch my head. I’m not sure what other type of firm would have the capacity, the name-recognition, the staff resources and a willingness to consider the job, at a pricing level that would make sense.

If a well-established accounting firm or credit reporting agency were to consider the assignment, what would be the likely outcome? My guess is that they would quickly get tied-up in problems of definition, procedure, authority, work product and potential liability.

What level of authority must the individual providing verification possess? How is that authority ascertained? What reason can the verification agent give for wanting the information? After all, the Debtor isn’t told the invoice has been sold. What is the minimum evidence of acceptable confirmation? What specific assertions are required? How does the verification agent assure TRE that it has actually obtained the information if it is obtained only orally? Would it be feasible to obtain any written verification and, if so, at what cost in terms of transaction speed? What level of liability, if any, would the verification agent assume for the accuracy of its information? If no liability is assumed, what is the quality-control leverage?

You get the point!

The IDEA of an independent verification agent is unquestionably an appropriate one. The difficulties in implementing the idea are just as obvious.

The question now becomes: given that there IS an apparent potential for conflict, how real is the likely risk to a buyer?

In order for TRE to grow as it wants to grow, it needs more than anything else to establish credibility early. Better to lose potential business through excessive caution than to subject Buyers to losses through lax underwriting.

There is also meaningful value to TRE, I suspect, in doing the job itself (at least for a time), since the experience it gains will help it better fashion an effective relationship with a third-party should it attempt that in the future.

My own view is that, while the potential for conflict is obvious, the current risk is minimal. The stakes for TRE are too high at this point to jeopardize its long term goal by taking shortcuts this early in its development.

However, as the exchange ages a bit and the time approaches to actually meet the growth goals on which its establishment and financing were based, the level of risk could well rise.

As one who wishes success to the TRE enterprise, I hope that its management plans to ultimately establish the independent verification process that was apparently contemplated in its initial conception of the exchange.

An Inconvenient Essential--Part One

Among the essential numerical values that we learn in high school physics is the number that defines the speed of light. If we go on to other, non-scientific pursuits in our lives, it is likely that we’ll forget an important qualification in that definition. The number we learned represents the speed of light in a vacuum. In the presence of any source of friction, that speed cannot be reached.

In our last post we noted the desire of The Receivables Exchange to become a very large-volume platform. Growing from an initial transaction in late 2008 to a targeted $1 billion in volume in 2010 might not challenge the speed of light in literal terms but it comes close in financial terms. An essential element in its success must be the elimination of as much friction as possible.

We’ve already identified a few of the sources of friction usually encountered in purchasing individual invoices and the ways that TRE has devised to lessen their impact.

Now we need to address another major one: the issue of invoice verification. The buyer of a receivable needs to verify that the receivable is valid.

Most buyers of individual invoices will want assurances that: the Account Debtor acknowledges that it contracted to purchase the goods or services; that the goods or services have actually been provided; that they meet the criteria established in the contract; that the invoice being purchased states the correct amount due and the correct terms of payment; and, that the invoice is scheduled to be paid.

That’s a lot of friction! It’s often difficult or impossible to find anyone in a Debtor’s organization willing to sign-off on such assurances.

After the initial qualification of a client, the invoice verification process represents the major impediment to the speed of invoice purchase transactions. Given the need for TRE to minimize such impediments, it’s clear that this issue has had to be a focus of their operational design.

TRE has to have a process that provides appropriate comfort on the verification issue without causing so much friction in the system that it is impossible to meet their speed-of-growth and scale objectives.

The procedural solution is a compromise. Many of the typical elements of “full verification” are sacrificed, but the loss of those assurances is balanced by other elements of the TRE system.

What are the assurances that are sacrificed?

1) Neither TRE nor the Buyer has a direct relationship with the Account Debtor; so the Debtor does not provide either TRE or the Buyer with a direct assurance of the existence of a contract or purchase order.

2) The Debtor does not provide a direct assurance of the receipt of the goods or services.

3) The Debtor does not provide a direct assurance that the goods or services meet the requirements of the contract.

4) The Debtor does not provide a direct assurance that payment will be made.

In what ways is the sacrifice of those assurances balanced?

1) Prior to approving the invoices of a Debtor for posting on the exchange, TRE will investigate the history of transactions between the Seller and the Debtor to determine that a relationship does exist.

2) The history of the relationship between the Seller and Debtor will be examined to provide context for the analysis of invoices proposed for future sale.

3) The agreement of the Debtor to make all future payments to the TRE lock-box provides additional evidence of the validity of the relationship.

4) TRE will independently acquire contact information allowing it to access appropriate individuals within the Debtor organization who can verify that an invoice is “in the system for payment”.

5) TRE employs experienced fraud investigators to help it to detect any potentially fraudulent relationships or transactions.

The only piece of directly-sourced information regarding a specific invoice is that it is “in the Debtor’s accounts payable system”. That might seem to provide much less security than typically required by single-invoice buyers.

However, by the time a TRE Buyer sees that invoice posted for sale, the invoice will have been analyzed within the context of a great deal of previously-verified information about the relationship and the historical transactions between the Seller and the Debtor.

It’s certainly possible that, from time to time, specific invoices will prove problematic; and it is possible that the TRE verification process will have failed to uncover those problems in advance.

On the other hand, if such a problem occurs:

a) Within a verified pattern of transactions between the Seller and the Debtor,
b) In the presence of a continuing payment-direction agreement,
c) In the context of a security system that provides meaningful recourse, and
d) In an environment of a robust fraud-detection effort,

it is likely that a solution to an isolated problem can be found.

There is no guarantee that no losses will occur, but losses can occur when buyers obtain ALL of the typical assurances. Stuff happens!

There is a good argument to be made, I think, that the sacrifices made in the TRE verification system, for the sake of reducing friction and accommodating scale, are reasonable and that the apparent additional risks are balanced within the operational system of the exchange.

An important question remains, however, that will be addressed in our next post.

TRE itself, with its very aggressive growth goals, acts as its own verification agent. The question of potential conflict between growth goals and transaction quality goals has to be addressed.

Blanket Security vs a Security Blanket

In prior posts we’ve noted that a TRE Seller must unconditionally commit to repurchase any sold receivable that is not paid by a stated date. We’ve also discussed the advantage of Louisiana law in that regard and we’ve expressed our opinion that the financial capacity of the Seller has to be seen as the “first line of defense” in protecting a Buyer against loss.

It’s not the ONLY defense, however.

TRE, as agent for its Buyers, also obtains a lien on the receivables sold by the Sellers on the exchange and on all of the money deposited for the Seller’s account in the TRE lock-box.

TRE files a UCC Financing Statement putting everyone on notice of its liens.

The TRE approach is unusual. It is ingenious in some respects but it's also important to acknowledge its limitations.

(I have to remind readers that I’m not a lawyer; so interested parties should consult their own counsel.)

In what ways is the TRE approach ingenious?

1) Many potential TRE Sellers will already have financing in place that encumbers ALL of their receivables. In order to convey clear title to a traded receivable, any prior lien has to be released. Otherwise it would be like trying to put a first mortgage on a house when there's already a first mortgage in place.

It’s much easier for the TRE Seller to convince its lender to release its lien ONLY with respect to the receivables sold on the exchange rather than to release it altogether. I suspect this middle-ground solution allows many companies to become potential TRE Sellers that would otherwise be unable to deliver good title to their receivables.

2) If a TRE Seller wants to sell any of the receivables due from one of its customers, it has to direct that ALL of the payments due from that customer go to the TRE lock-box. So it’s possible that payments might be received in the lock-box for invoices that have not been sold. Those payments would then, in theory at least, be available to cure defaults in payment for receivables that HAVE been sold.

3) A TRE Seller might register multiple customers with the exchange. The payments from all of those customers would go to the lock-box. Under the TRE security strategy, even the payments from other customers, not involved in a defaulted transaction, might be available to make good a default.

In what ways is the TRE approach limited?

1) As we’ve noted above, the typical receivables financing relationship requires a UCC filing encumbering ALL of the seller’s receivables. The TRE UCC filing on a Seller’s receivables is limited to the receivables traded on TRE.

2) If there is another party with a first lien on the Seller’s non-TRE receivables and those other receivables represent a substantial part of the Seller’s assets, that prior lien position could limit a Buyer’s ability to enforce the Seller’s commitment to repurchase.

3) If cash is deposited in the TRE lock-box for receivables that were not traded on TRE, and those receivables were actually subject to another party’s first lien, I suspect there could be a challenge to TRE’s use of those funds to cure an unrelated default.

The Receivables Exchange wants to be a very high volume trading platform. In order for it to reach high volume it has to be a workable platform for a great many Sellers.

In order for it to be workable for a great many Sellers, the common problem of prior “blanket” liens on Sellers’ receivables had to be addressed.

The solution TRE has apparently adopted is to give up some of the value of the typical blanket lien on receivables, in exchange for the potential to receive and withhold other funds of the Seller to cure potential defaults.

From a business point of view: when added to the advantage of the “True Sale” language of Louisiana law, and the unconditional commitment to repurchase; I think the approach makes a lot of sense.

It is NOT blanket security…but it IS a security blanket. It is comforting, to be sure, but only as an addition to the primary protection i.e. the actual financial capacity of the Seller to meet its repurchase commitment.

The Financial Statement Assurance Continuum

When a company sells a receivable on The Receivables Exchange, the Seller agrees to repurchase the receivable if the Account Debtor (the Seller’s customer) does not pay it.

The Seller’s commitment to repurchase is the Buyer’s initial line of defense against loss.

The strength of that defense is a function of the Seller’s ability to fulfill its commitment.

If the Seller’s customer doesn’t pay, how likely is it that the Seller will be able to pay as required?

The bulk of the information available to help answer that question will come from the Sellers themselves, principally in the form of financial statements. (Even if a Buyer obtains supplementary credit information from an independent provider, much of the information will have been sourced from the company itself.)

Two threshold questions always have to be asked: a) does it appear from the information provided that the Seller has the capacity to fulfill its commitment, and b) what level of confidence should we have in the information provided?

Each Buyer will look at financial statements somewhat differently but any analysis is only as good as the information available to analyze. So we’ll focus here on the question of confidence.

There are four generally-recognized types of financial statements produced by corporate entities: 1) audited, 2) reviewed, 3) compiled, and 4) internally-generated.

In the first three cases, an independent accountant or accounting firm has had some degree of involvement in the preparation of the statements. Statements that are internally-generated have no third-party whose name and reputation is associated with the data provided.

There are important procedural, technical and legal distinctions that have to be made to accurately distinguish among the first three types of statements. For our purposes, however, I think we can use a convenient “shorthand” distinction that appeared in a paper published in March 2008 by the Reliability Task Force of the American Institute of CPAs.

That paper presents an “Assurance Continuum” that positions each of the three types of financial statements on a line that proceeds from the highest level of assurance that the information is reliable to the lowest level of assurance.

In the language of that Task Force Report:

An audited financial statement has a “High Assurance” of reliability.
A reviewed financial statement has a “Limited Assurance” of reliability.
A compiled financial statement has “No Assurance” of reliability.

It follows, I think, that an internally prepared statement, which has had no independent accountant’s review, would also fall in the “no assurance” category.

Now, the fact that an accountant has not certified the accuracy of the data presented in a financial statement doesn’t mean the data is NOT accurate. And we’re all aware of cases in which apparently diligent audits have proven inaccurate.

We also have to acknowledge that the staff of The Receivables Exchange does spend time and effort vetting potential Sellers.

All that said, however: it is still only reasonable to acknowledge that there is a higher level of reliability in the financial statements of a company whose books have been audited by a third-party professional than there is in the books of a firm that internally generates its own statements.

The level of risk in a Buyer’s analysis does, without question, vary with the reliability of the financial data.

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.

Liability: It's Not Personal.

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.

If the transaction goes bad, the personal guarantee can become critical in ultimately recovering the money advanced for the invoice purchased. One of the reasons is that, if litigation is required, the litigation process can take so long that other pledged security, such as other receivables and other financial assets, can be long gone by the time there is actually a judgment for the buyer to attempt to enforce.

The Receivables Exchange does not obtain personal guarantees from its Sellers. So the Buyers’ avenues of recourse in the event payments are not properly received are more limited.

Why would personal guarantees not be obtained by TRE and what are the implications?

I think there are a few pretty obvious answers to the first question.

1) TRE aims to become a very large-volume marketplace. As a practical matter, scaling up gross transaction volume requires two components: a) more Sellers, and b) larger average transaction sizes.

2) Larger average transaction size implies larger Sellers and the larger and more substantial the Seller the less likely its principals will be willing to provide personal guarantees.

3) In order for a personal guarantee to affect a Buyer’s assessment of risk, the substance of the guarantee would have to be known to the Buyer. Few individuals, especially owners or principals of more substantial Sellers, would be willing to have their personal financial information made broadly available to Buyers with whom they have no direct relationship and over whose use of the information they would have little effective control.

As to the implications, again, I think there are a few.

1) Analysis of the Seller’s financial condition and capacity becomes more critical. If a payment is not received for a purchased receivable, does the Seller have the ability to make good the Buyer’s loss?

2) Analysis of the validity of the receivable proposed for sale, which is always critical of course, becomes even more so.

3) Analysis of the Account Debtor’s capacity to pay and likelihood of paying the invoice likewise becomes more critical.

4) In short, when one source of security is removed, all of those that remain become more important.

I think it’s quite understandable that TRE does not obtain personal guarantees from its Sellers. But that doesn’t mean that there is no impact on risk assessment. And if there is an impact on risk assessment there should be an impact on pricing.

It does mean that analysis of the Seller’s financial condition, the validity of the invoices posted for sale and the ability and likelihood of the Account Debtors to pay those invoices, all take on heightened importance.

If analysis of the Sellers' financial condition becomes more important, reliability of the financial information provided (or otherwise available to Buyers) is key.

In our next post we’ll discuss the issue of the level of assurance that can be attributed to information in various types of Seller financial statements.

"Does this dress make me look fat?"

Wisdom from a good friend, older and wiser than I…

1. If you are asked: “Does this dress make me look fat?” and the questioner is your significant other, the appropriate answer is always “No!”. Honesty is neither virtuous (nor necessarily safe).

2. If that same person has a piece of parsley stuck in her teeth, on the other hand, you’ve just got to point it out.

I am a friend of The Receivables Exchange. I am a Buyer on TRE, so I am committed to it, and in my last several posts I’ve expressed very positive opinions on several major aspects of TRE structure, concept and operations.

But in my first post (scroll down or select the May 28 post from the sidebar) I did write:

“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.”

So, in the next few posts I’m going to be discussing some aspects of TRE operations that I think are analogous to parsley in the teeth. You’re no less a friend for pointing it out; arguably you’re a better one; but it's less comfortable than delivering a compliment.

The issues to be discussed all bear on the assessment and pricing of risk.

More to follow.

"You've Got Bank!"

Have you heard the ads that some banks are running on the radio these days? How your banker really, really understands you and is on your side, working nights and week-ends to make sure you get great service?

Please……….

If you have a small business, or even a pretty good-size business, going to your bank for financing is as pleasant as a root canal…and the odds of success these days are much lower.

The Receivables Exchange provides a truly unique alternative to traditional financing. It is not a borrowing. It is a sale of an asset. You are converting one asset…money due to you from a customer…to another asset…cash.

A Seller on TRE can choose which of its receivables it wants to sell, when it wants to sell them and how much it wants to pay for the ability to convert the bulk of that receivable into cash.

Of course, the Seller has to meet certain qualifications. The companies that actually owe the money have to agree to re-direct payment to the TRE lock-box. And there has to be a Buyer willing to bid on the receivable you want to sell.

But the qualification process appears to be reasonable and timely. I’ve already written about the benefits of the lock-box arrangement. And I understand that over 99% of the listed auctions are ultimately funded. That doesn’t mean the Seller got the terms requested; but the terms were apparently acceptable…because an agreement was ultimately reached.

The truly dazzling feature of the process is the speed. I have seen TRE transactions disappear from the auction list in, literally, a matter of seconds!

Imagine… as the owner or the CFO of a TRE Seller you determine you need some cash. You select a receivable due from a pre-qualified customer. You post the receivable for sale on TRE, specifying the pricing you’d like to obtain. Your desire gets communicated to all TRE Buyers, who are then able to bid on your receivable. When a Buyer makes a bid, you see it immediately and, at your option, you can accept it or wait for a better offer. When you do accept an offer the auction is closed and both parties are notified of the agreed-upon terms.

Now, I’m a Buyer, not a Seller, so I don’t actually know what message the Seller gets when an auction closes. But in effect the message is….

“You’ve got Bank!”

You’ve requested financing and gotten a commitment for essentially immediate funding, on terms that will not be changed by someone higher up the chain. And you’ve done it without ever having to talk to a banker.

How cool is that?