Bringing a Knife to a Gunfight

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

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

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

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

First, insolvency and bankruptcy are two different things. And Dr. El-Erian would know quite well, given his background at the IMF, that countries cannot technically become bankrupt. Bankruptcy is a legal concept that does not extend to sovereign entities.

Insolvency, on the other hand, is a financial condition. More accurately, there are two financial conditions associated with the term insolvency.

1. “Balance sheet insolvency” is the condition in which liabilities exceed assets, and

2. “Cash flow insolvency”, meaning that a company cannot meet its payment obligations on time.

The cure for balance sheet insolvency is a capital cure; increasing assets, decreasing liabilities, or some combination of the two that results in a positive capital account.

But, what is the cure for cash flow insolvency?

The condition has two elements: a) payment capacity, and b) time.

So the approach to a cure for cash flow insolvency (absent a reduction in the actual amounts due) will have to be a combination of increased payment capacity and extended payment terms. Both of which are liquidity solutions.

In fact, absent the steps noted above with respect to balance sheet insolvency, the only REAL solutions for cash flow insolvency are LIQUIDITY solutions.

Moving from a discussion of the rarified issue of sovereign debt to the arena in which Buyers and Sellers on The Receivables Exchange spend their time, the realities include:

1. A large percentage of private businesses in the small-mid-size space are “balance sheet insolvent”.

The liability protections and the tax treatment of the S-Corp and the LLC, which dominate private business ownership structure, create a bias in favor of minimizing assets left in the business. Especially in companies with high depreciation expenses; these structures tend to generate negative net worth over time.

2. The balance sheets of many businesses in the SMB space tend to reflect the personal finances of the owners as much as they do the financial results of the companies.

For instance; often the liabilities that make the business “balance sheet insolvent” are loans due to the business owners, which would likely be treated as capital contributions in other circumstances. The odds of a business owner forcing a solvency crisis by accelerating a loan due him are (usually) low.

3. Many businesses in the SMB space are not far from the start-up phase and the early-period losses still dominate the balance sheet.

4. It is the income statement, or more-accurately, the BANK statement, that commands the attention of most private business owners. A high percentage will know their cash position every day. A very low percentage will examine their balance sheet in detail even quarterly.

5. Cash flow is the lifeblood of these businesses. If the bills can be paid and the owners can draw enough cash to meet their personal needs, the fact that the balance sheet shows a negative net worth is not likely to affect management’s decision making, at least in the short term.

6. But, as we all know, it is cash flow that has suffered most during the recent financial contraction and de-levering of credit-granting institutions. And the relative complacency of owners whose businesses are balance sheet insolvent does NOT apply equally to the case of cash flow insolvency.

7. Cash flow insolvency threatens the going-concern viability of small businesses to a far greater degree than balance sheet insolvency.

Many recent studies and surveys have documented that access to cash is the number one problem in the SMB market today.

It is precisely a LIQUIDITY solution that is required for a problem of cash flow insolvency. It might not be a permanent one. It might well be that a capital structure solution is required in the longer term.

But in today’s financing environment the acceleration of cash flow via the sale of accounts receivable might provide the BEST solution for many smaller businesses.

In the world of global sovereign debt finance there might be room to question the KIND of solution used for a financing problem. To a small business owner, though, the existence of ANY solution is a big, and a welcome, thing.

Maybe a knife doesn’t win in a fight against a gun. But if I don’t have any bullets for my gun, the knife looks like a pretty good alternative!

The Quality Issue -- Again

In my post of May 14 entitled “The Wheat From the Chaff” I said I’d write next about the recent comments from Bill Gross of PIMCO and the new work of Edward Altman of NYU on the issue of quality/credit ratings.

I got sidetracked a bit but now I want to return to that topic.

I’ve argued previously that, if TRE is to realize its growth aspirations, it will eventually have to provide SOME means for Buyers to more conveniently differentiate Seller financial strength and transaction quality.

The Exchange doesn’t have to actually DO that itself; it can outsource the function. Or it can co-operate with a 3rd party service provider who might see an opportunity to create a new business line or to leverage an existing one.

But the current system, which requires that each Buyer analyze the financial data made available by each Seller, and keep checking for and analyzing updates, is not going to work when there are actually hundreds or even thousands of Sellers.

In his May “Investment Outlook” piece, Bill Gross essentially dismisses the three big bond-rating agencies: Moody’s, S&P and Fitch, as purveyors of Kool-Aid to an “unsuspecting (and ignorant) investment public”. The solution for PIMCO is to have its own large credit staff that can “bypass, anticipate and front-run all three, benefiting from their timidity and lack of common sense”.

Now, when someone as smart as Gross can have so little respect for the analysis of a Moody’s or an S&P, even given the level of their experience and the quality of the information they have to work with, you have to ask whose analysis CAN be trusted.

I’ve written before about the condition of TRE Seller financial statements: not only about their quality but also their timeliness. The information that S&P has to work with in analyzing a bond issuer is, I suspect, much more likely to be accurate and timely than the financials provided by the majority of TRE Sellers.

Most TRE Buyers will not be able to follow the PIMCO lead and have large in-house credit analysis departments. They’re going to have to make do with less. They’re also not going to have the same quality of information. But that doesn’t mean that NOTHING can or should be done.

Edward Altman, developer of the well-known “Z-Score” Analysis has shown that near-term insolvency of businesses can be predicted with a high degree of accuracy based on metrics that are readily calculated from financial statements.

Altman and his associates have just published (March 2010) an updated version of their analytical tools, which appear to further improve their predictive power.

It’s true that these newer Altman metrics are more applicable to larger businesses than are currently found on the Exchange, but the notion that there are relatively easily-applied tests with strong predictive powers is still important.

There are three basic elements of risk assessment that are important to a TRE auction:

a) As to the Seller: the ability to make good on a defaulted invoice and the likelihood of its solvency in the near term,

b) As to the Account Debtor: the ability to pay its obligations and the likelihood of its solvency in the near term, and

c) As to the receivable purchased: the level of certainty that the obligation represents actual sums owing for work done or services properly provided under binding agreement between the parties. And the extent to which there are other claims that might be superior to that of the Buyer.

These are all issues that can be addressed, admittedly with varying levels of confidence. But SOME level of confidence, based on a reasonable attempt at analysis, is better than either guesswork, hope or blind faith.

I can understand that TRE might not want to present any analysis of its own, fearing liability in the event of loss. But that doesn’t mean it could not contract with a third-party provider to look at these three basic elements of risk analysis and assign a quality rating that reflects the three areas of fundamental risk listed above.

Such an analysis would be less robust than most in the financial world because of the quality of the data available, but it would have to add value when compared to the currently available information.

If the Exchange can convince its backers that there is a large enough potential volume of business to warrant their equity investments, I suspect it is persuasive enough to convince a 3rd-party analytical group to take on this quality-rating task!

Such an effort would benefit all who hope for Exchange success.