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.

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.

#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!

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.

Sizing It Up

In my March 21 post, “The Diet of 900 lb Gorillas”, I referred to the recently-published Morgan Stanley report on B2B Finance. That report raises a number of issues, only one of which was really addressed in that prior post, so I want to return to it again.

This time I want to point out a couple of statistics that are key to assessing the long-term potential of The Receivables Exchange.

The first of those statistics is the gross size of the SME (small to mid-sized enterprises) market. Morgan Stanley reports that the SME market accounts for about 45% of all business revenues in the US. Morgan defines the SME category as all businesses with annual revenues of less than $500 million.

Now for the purposes of discussing TRE’s near-to-intermediate term potential it’s unrealistic to assume that its addressable market includes businesses with $500 million in sales. So we have to adjust Morgan's 45% figure.

The smallest category Morgan uses comprises businesses with revenues of less than $25 million. That category accounts for 25% of total corporate revenues.

TRE requires Sellers to have annual revenues of about $1.5 million and, at present, a $25 million Seller would be at the upper end of the TRE size spectrum. So this is really the near-term target market-segment for TRE marketing efforts.

To eliminate those businesses that are too small to qualify for TRE Seller membership we have to reduce the 25% total. This is completely guesswork on my part but I suspect we wouldn’t be far off if we reduced the 25% figure to maybe 15-20% to eliminate the smallest businesses.

If we apply the 15-20% range to the estimate (based on the Fed’s flow-of-funds report) of the overall volume of annual B2B accounts receivable generation (about $18 Trillion), that suggests a potentially-addressable, near-term market size in the range of $2.7 to $3.6 Trillion.

That ignores the fact that some of those businesses, especially the smaller ones, probably do not extend trade credit, but it’s also the case that some large businesses extend very little trade credit. It’s hard to know how to adjust those volume figures with any confidence, so I’ll just let them stand with the caveat that there are potentials for error from a number of sources.

If we use the mid-point of that indicated range, or $3.15 Trillion, and we assume an average AR duration (days-to-pay) of 45; that suggests that the average outstanding AR balance on the books of that segment of the business community would be about $390 Billion.

That’s a big number!

The Morgan Stanley estimate of the total US factoring market is given at $136 Billion, suggesting that our estimate of the near-term, potential TRE-addressable market is three times the size of the entire current industry. But that's not really the appropriate comparison.

It is clear that the smallest businesses will account for no more than their relative percentage of the total factoring market and probably quite a bit less. How much less is a guess, but let’s just say for conversation that it’s overstated by 100%, or that the actual factoring activity in this smallest segment of the economy is half its representation in the total economy.

That would suggest that $10-$13 Billion is employed by the factoring community in the smallest segment of US business.

If that’s anywhere close to the mark, it implies a current market penetration of only 3% or so of indicated near-term potential.

If a realistic maximum penetration were, for argument's sake, to be measured at 25% of the currently-addressable market, the implied potential would be $390 Billion x .25 = $97.5 Billion, less (about) $12.5 billion (already served), or something in the range of $85 Billion in potential for capital employment.

That’s clearly a market worthwhile pursuing.

And that is without considering the potential ultimately afforded by businesses with revenues above $25 million, some of which, over time, should be attracted to the flexibility of an auction environment.

On the other hand, it has to be recognized that many smaller businesses are in no condition to be brought to TRE at this point.

TRE’s marketing effort has to include a long-range education program to bring potential Sellers to the realization that “clean” and accurate financial records and disciplined management of their billing and other AR functions are critical to positioning themselves for access to a market like TRE.

It’s easy to make the case that the market potential for TRE is substantial in the near-term and extremely substantial in the longer-term.

It’s not a stretch to view the TRE growth curve as exponential for some time to come.

But that doesn’t mean achieving that potential is a certainty.

There are difficult problems to be solved, not least of which is maintaining the discipline required to adequately vet potential Sellers and to strictly implement the safeguards in place to protect against abuses.

But it seems clear that the size of the opportunity makes tackling the problems well worth the effort.

A Comment on Risk

I heard a marketing presentation not long ago in which it was asserted that that “only three-tenths of 1% of invoices ultimately go unpaid”. The unspoken but implied conclusion was that buying invoices involves only minimal risk.

I asked for the source of the statistic quoted and was told that it came from the Credit Research Foundation. I contacted the CRF and obtained a copy of the quoted report, which is entitled “National Summary of Domestic Trade Receivables: 2008 Annual Bad-Debt Report”.

The top-line analysis is provided in two statements:

1) “Net bad-debt write-offs during 2008 totaled $30.00 per $100,000 of sales. This is a net change of $0.00 over 2007, and

2) Allowance for uncollectables during 2008 was 1.00% of receivables. This is an increase of .50% over 2007.”

(Not to be picky, but $30 per $100,000 is actually three one-hundredths of one percent, not three-tenths.)

A few observations:

• The number of respondents to this survey was 555. It is not clear how large a part of the overall economy this sample represents.

• The figures quoted in the summary statements above represent the median responses.

• While the write-off figure did not increase in 2008 over 2007, the allowance taken in 2008 was double that of 2007.

• In the case of the write-off figures, the upper-quartile break-point of the sample was at .19%, or about 6 times the median level.

• In the case of the allowance for uncollectables, the upper quartile break-point was at 3% of sales---100 times the level of the median write-off reported!

So you can choose to highlight the finding that the median write-off remained the same from one year to the next. Or you can take note that the expectation of losses, captured in the allowance figure, increased by 100%.

Or you can acknowledge that the upper-quartile, forward-looking statistic is 100 times the median backward-looking statistic.

The waters might not be as placid and shallow as they appear!

There’s another source of data that is more relevant to the operation of The Receivables Exchange. It is collected by The International Factoring Association. For 2008 this data represented the experience of 120 companies in the factoring business.

• The median write-off experience of that group in 2008 was .3% of gross invoices purchased, 10 times the median of the CRF sample. The average write-off experience was 1.3% of gross invoices purchased, more than 4 times the median.

• The IFA presents results broken down by size of respondent. The largest companies providing data; those with $100 million or more in gross receivables purchased; had the lowest loss experience, at .6% of invoices purchased. The smallest companies, buying less than $5 million per year, had an average loss experience of 2.5% of gross purchases.

• These figures, from companies actually involved in the industry, are far higher than those reported by the CRF. But more importantly, I think, these figures represent the experience of companies that KNOW the risks of buying invoices and take all of the normal precautions against losses.

I’ve detailed in other posts the ways in which the Exchange’s practices in qualifying Sellers, in obtaining security and in verifying invoices fall short of those in common use among buyers of individual invoices. (I've also pointed out some unusual benefits of the TRE process as well, however.)

I’ve argued that the TRE Buyers are exposed to incremental loss levels because of those shortcomings in risk mitigation.

It’s too soon to say what level of incremental return should be required by TRE Buyers to adequately offset the added risk.

It is not too soon to say, though, that the increment should be added to the IFA experience, not to the much lower CRE numbers.

And I would argue that the baseline point of the analysis should not be the experience of the largest companies but rather of the smallest, recognizing that the majority of TRE Sellers would not qualify for funding by the largest factoring companies.

We've all heard the one about the guy who drowned in a river that was only 6 inches deep, on average! Some statistics can be correct and irrelevant. Some can be correct and dangerous.

It's only coincidental that the first three letters of Treasuries, are TRE. We're not buying Treasuries here!

Half a Bubble Off Plumb!

In my “Happy Anniversary!” post of November 23, I wrote:

“From my point of view, the Exchange has tilted significantly toward the Seller community as it has attempted to bring on sufficient product to meet its volume targets.”

The degree of tilt is probably more than just “half a bubble”.

What has the Exchange done to “tilt” the playing field to favor the Sellers?

First let’s review where we began. From inception TRE:

--Has not required personal guarantees from the principals of Sellers,

--Has filed UCC Financing Statements encumbering ONLY the receivables sold on TRE (as opposed to getting a blanket lien on all receivables), and

--Has accepted internally-generated financial statements, frequently without any evidence of independent review.

Since the Exchange’s operations began, there have been a number of changes in policy or process that are good for Sellers but bad for Buyers.

What are some of those changes?

--Initially, invoices were to be verified by a third-party service provider. Now, the Exchange itself handles verification.

--Initially, the verification process was to include confirmation that goods had been delivered or services performed to the Account Debtor’s satisfaction. Now, verification is limited to obtaining confirmation that there is an invoice in the Debtor’s accounts payable system that matches the number, date and amount of the posted invoice. No actual affirmation of satisfaction is obtained. (Note that invoices from members of The Ariba Network do meet a more stringent standard.)

--Initially, all invoices were to be verified. Now, there is a sampling system.

--Initially, progress billings, which are common in the construction industry but present unusual risks, did not qualify for posting on the Exchange. That prohibition appears to have been relaxed.

These are significant procedural changes and they clearly increase the level of risk borne by Buyers on the Exchange.

I think it is clear that the changes have been made to allow TRE to attract more Sellers.

It might seem counter-intuitive that relaxation of procedural safeguards has been necessary to attract Sellers in the economic environment of the Exchange’s first year. After all, the papers have been full of stories about how difficult it is for businesses to find financing. But I don’t think the message is ambiguous.

TRE needs to ramp up volume to reach a level that makes it economically viable and proves to its equity investors that it is a viable operating entity for the long haul.

If the problem were attracting Buyers, any procedural changes affecting Sellers would be in the direction of tightening standards and procedures; making the risk profile more attractive to Buyers.

Changes in standards and procedures that increase risk to Buyers seem clearly to signal that the imbalance is on the Seller side.

The TRE calculus seems to be (this is my speculation only) that the Buyers will tolerate the increased risk as long as the risk is “potential” rather than “experienced”. That is, there are no significant Seller defaults and subsequent losses to Buyers. The implicit hope is that the Exchange can somehow control matters in the short term, avoiding any serious risk-related problems until it reaches its equilibrium level of volume.

At that time, maybe the process of moving back toward a level playing field can begin. If that IS what’s going on it’s a delicate and potentially perilous process.

On the positive side, while TRE will not hit its publically-stated volume targets this year, the volume HAS been ramping up significantly over the past few months and if we were to annualize current levels, the Exchange would come close to its volume goals on a run-rate basis.

If TRE can make meaningful progress on some of the impressive and important Seller-attraction initiatives already in place; including alliances with The Ariba Network, The American Staffing Association and Smyth Solutions, it is possible that it can reach a volume level in 2010 that can sustain its operations.

As it is approaching that critical volume level, however, it’s going to need some luck. The single greatest risk that it faces, I believe, is a nasty default and a public squabble over losses.

The additional risk in the system is real and “half a bubble” of tilt toward Seller-leniency is probably all the system can tolerate. Ultimately things will have to move back toward balance.

In the meantime: see my posts entitled “Caveat Emptor”.

Caveat Emptor # 2

In our post of June 20: “Blanket Security vs a Security Blanket” we discussed the fact that a Buyer of invoices on The Receivables Exchange obtains, via TRE, a lien on the receivables purchased and on any excess cash that might be available in the Seller’s lock-box account.

This is in contrast to the blanket lien on all of a Seller’s receivables that is often acquired as security by a factor or invoice purchaser; or, short of that, to the lien on all receivables due from one or more named Account Debtors.

The actual collateral providing security to a TRE Buyer is minimal relative to the industry norm.

The TRE Seller does provide an unconditional guaranty to repurchase a receivable sold on the Exchange if payment is not made to the Buyer by a date certain, which provides additional security to the Buyer. But that security is only as good as the Seller’s ability to perform.

So the importance of an accurate assessment of the Seller’s financial capacity actually increases in the context of a TRE transaction; because the specific collateral provided is more narrowly defined.

We’ve noted that the Exchange requires certain financial information to be provided by the Seller and that the TRE trading platform makes access to that information convenient. The Exchange itself, however, takes no responsibility for the accuracy or adequacy of the information provided and makes it clear that Buyers are responsible for their own due diligence and decisions.

As I’ve said before---that's fair enough, as long as we know the rules.

Those who have been in the business of buying receivables for any period of time will probably have had experience with transactions “gone bad”. Most would agree that more can be learned from one bad deal than from dozens of deals with which there have been no problems.

One of the things that I’ve learned is the importance of knowing whether I’ve really got a good, clear lien on an asset, and who else might pop up to make a claim on assets if things go bad for the debtor.

Not long ago an auction was posted on TRE by a first-time Seller. Besides financial statements, TRE makes available on its Seller Profile pages, a record of a UCC lien search. This tells us what claims have been recorded against the assets of the company and so has direct bearing on the strength of a Buyer’s collateral position.

In the case of this Seller, the prior UCC filings ran to 78 pages!

Now that, in itself, doesn’t mean that the position of the Buyer in the specific receivable being posted for sale is jeopardized.

It DOES mean, however, that the Buyer CANNOT know that its position is NOT jeopardized without devoting some significant time and attention to analyzing the prior filings. This is especially true because, in this case, there was no separate release of lien or subordination document provided for Buyer review.

A Buyer might have thought: “well let’s see if the financials are really strong and maybe I can take a chance making a bid even before I have the time to analyze the UCC filings”.

In this case it happened that the Seller’s most recent financials were noted as “internally prepared for use by management”. OK, that’s not really unusual, especially for interim accounting periods.

But in this case it happens that there is a single, large, intangible asset on the balance sheet that is roughly double the size of the company’s net worth. So, without that intangible asset, the net worth of the company would be negative rather than positive.

What’s my point?

I am NOT saying that this Seller shouldn’t be selling receivables on TRE.

I am NOT saying that TRE has failed in any way to provide what it has committed to provide to Buyers.

I AM saying, however, that TRE has made it clear that it is the BUYER’S responsibility to analyze the potential transaction and determine whether it has enough information to bid.

TRE has said “Caveat Emptor!”

I am willing to bet that in the period of time between the posting of the first auction by this new Seller and the time the first bid was recorded, no Buyer would have had time to analyze the 78 pages of UCC filings provided and determine whether or not the collateral provided was likely impaired by prior claims.

I am relatively sure that TRE will do all it can at this point in its life to try to work out any problems that arise with transactions on its platform.

But when TRE says, as it clearly does, that the Buyers and not TRE are responsible; it just makes sense to believe them.

The Buyer's first recourse is to the Seller, no matter who the Account Debtor might be and no matter what TRE might be willing to do to help out at this point.

So, indeed, let the Buyer beware!

Let's See the Numbers!

Companies that sell their invoices on The Receivables Exchange are required to provide two years of financial statements as a part of the Seller qualification process. Once approved as Sellers they are also supposed to provide quarterly updates to their financials.

Those updated financials are supposed to be posted to the Seller Profile pages, allowing Buyers to update their due diligence analysis.

As we approach the anniversary of the first TRE transaction I think it is appropriate to point out that the Exchange does not appear to be enforcing the requirement to update financial statements.

If it IS enforcing the requirement, it is NOT posting the updates to the Seller Profile pages.

The most recent financial information available, in many cases, is still as of year-end 2008. In nearly every case, the statements provided at the time a Seller posted its first auction are still the only ones available.

Given that the great majority of Sellers provide only internally-generated statements, it can hardly be argued that there hasn’t been time to update statements through at least the second calendar quarter.

As important as I think it is to Buyers to be able to make decisions on the basis of appropriately current information, the Exchange itself should also be looking closely at the changes in Sellers’ financials.

TRE has a significant stake in the impact of Seller use of the Exchange on Seller financial health.

I would hope, in fact, that the management of the Exchange has already made an arrangement with a credible third-party; perhaps a well-known business school, for instance; to study the impact of TRE’s unique platform on the subsequent financial health of its Sellers.

The job of attracting good-quality Sellers has been difficult. TRE does a good job of quantifying the theoretical value of accelerating cash receipts in its marketing efforts. If the theory is borne out we should be approaching the time when some ACTUAL value-added can be empirically demonstrated.

It would be a shame if the experience of the first TRE Sellers was not used to make the job of attracting subsequent Sellers easier.

Ultimately, proof of the value of TRE to its Sellers should be apparent in the analysis of subsequent financial results. If subsequent statements are not obtained by TRE and made available for analysis, not only will TRE Buyers be inappropriately under-informed, but a key analytical and marketing tool will be lost to TRE management and marketers.

The transparency of the auction process should be matched by transparency in the information flow.

So, let's see the numbers!

The Ariba Distinction

In our last post we addressed recent changes to the TRE invoice verification procedures. Two thoughtful and important comments have been posted in response and I’d call your attention to both.

The second of those comments, by Drew Hofler of The Ariba Supplier Network, highlights an issue that will (I hope) become increasingly important to all TRE Buyers.

Because a Seller that belongs to The Ariba Network brings added value to the table.

First of all--what is Ariba?

Quoting here from a press release:

“The Ariba Supplier Network is the world’s leading business collaboration platform, which combines technology and services to better match buyers and suppliers, automate transactions and optimize payments. Buyers and suppliers in 115 countries leverage the network to engage in transactions worth more than $110 billion a year and process one purchase order every two seconds. Leveraging the reputation and power of the Ariba Network, suppliers can lower the cost, risk and time associated with accessing capital.”

So, for our purposes, Ariba represents a VERY substantial volume of B2B receivables-creation, with a payment process that incorporates an automated, controlled, protected, invoice approval process.

Ariba and TRE have had a strategic alliance for some time now but the volume of Ariba invoices offered for sale on TRE has been minimal. That might be because of a lack of Ariba member education. It might be because the actual mechanics of uploading member invoices has not been as user-friendly as it might be.

In any event, Drew posted welcome news yesterday that I’d like to make sure to highlight. I quote from his comment to yesterday’s post…..

“This issue brings to light even more the value of invoices that are uploaded to the TRE platform directly from a supplier network such as Ariba. In the case of an Ariba supplier selling an invoice processed via the Ariba Network, both the issue brought up in the blog (verification) and the issue in the comment (quality of invoices/errors) are rendered moot.

1) Verification: When the next release of the Ariba Network (AN) comes out (4Q09), Ariba suppliers will be able to click a button and directly upload their approved invoices for sale to the TRE platform. Approved invoices are delivered directly to the AN from the Obligor's ERP, and are then transmitted directly to the TRE platform with no opportunity for the supplier to change any of the data contained within. Given the unbroken electronic chain of data, the need for verification is obviated.

2) Quality of Invoices & subsequent error correction: The nature of the Ariba Network is such that buyers/obligors set parameters up front that suppliers must meet in order for a submitted invoice to be considered in good order. This systematic quality control ensures that the vast majority of quality issues are filtered out before an invoice is even received by the Buyer/Obligor. So the issues brought up by Mr. Schmidt are largely removed for Ariba invoices.

Combine the above with the fact that eInvoicing via Ariba reduces invoice approval times down to an average of less than 5 days, and invoices sold by Ariba suppliers directly from the Ariba Network will offer TRE Buyers a qualitatively better option to reduce risk and extend returns.”

The critical issue to highlight in Drew’s comment, I believe, is that the Ariba system will actually provide a MORE robust verification process than had been offered by TRE even BEFORE its recent changes.

If I understand the mechanics of the network correctly—and I invite Drew to correct me or to amplify here—the invoices posted by an Ariba Seller will not only have been verified with respect to authenticity i.e. that there IS an invoice matching the Seller’s posting in the Account Debtor’s AP system, but the Account Debtor will have ACKNOWLEDGED that the goods provided have met the conditions of the agreement AND that the amount of the invoice is payable as and when indicated.

This provides a significant level of additional security to a TRE Buyer, which should result in preferential pricing of invoices originated by Ariba members.

A substantial increase in Ariba Seller activity would be a very good thing for TRE and, I suspect, for Ariba also. Let’s hope all interested parties work hard to make that happen!

Beware the Passage of Time

St. Augustine said: “Lord give me virtue -- but not yet.”

Augustine wasn’t talking about money, but the point is the same. Getting paid is a virtue. We want it-- but all in good time.

I’ve commented before on the perils of rapid repayment. I have to comment one more time. I just can’t help myself.

Included among the data provided by The Receivables Exchange on each Seller/Account Debtor relationship is a record of the Account Debtor’s payment velocity.

I personally think that TRE should report the figures on an “auction duration” basis; measured from the date of the sale of the Account Debtor’s invoice to the day that invoice is paid. That would tell the Buyers explicitly how long the funds used to buy the invoices were employed and it would tell the Seller's how much time they have "paid for".

But that is NOT what is provided and it is important to know that.

What IS provided is a record of the number of days from the DATE of the invoice to the date payment reaches the TRE lockbox. High, low and average figures are given.

So, in order to make an informed bid a Buyer needs to consider not just the payment history provided but also the age of the invoice at the time of purchase. Unless the payment history provided is analyzed in light of the current age of the invoice posted it can lead to unexpected results.

Let’s use an actual example:

A certain Account Debtor has a record of paying a certain Seller’s invoices in an average of 20 days. That is, 20 days from the date of the invoice.

That Seller posts a new auction. The invoice posted is 17 days old on the day of the posting. This invoice does not sell on the day of posting. In fact, three days later it still has not sold.

What is the position of a Buyer looking at that auction on the 20th day from the invoice date?

Based only on the history provided the answer is that he’s looking at a purchase with an expected duration of about ZERO days! The check could actually be hitting the lock box even as the payment for the invoice is being swept from the Buyer’s account.

In such a case what does the Buyer get?

He gets to pay the fixed exchange and transaction fees incurred in closing a purchase without earning anything at all. He gets to lose money on a deal that has been paid as agreed!

OK, so we have to be fair. The record shows that some payments have taken longer than 20 days to come in. So it’s possible that the Buyer will earn some revenue for his trouble. But, based on the record, it’s far from certain that he will earn enough to break even.

It’s also possible that the Seller knows something about the likely payment period of that specific invoice. Otherwise, why would he be willing to pay the Seller’s fees and transaction costs? He should hold that invoice and post a newer one for sale if he needs cash.

It’s also possible that the Seller has simply made an error and didn’t realize the implication of posting that particular invoice for sale. As a Buyer who has made errors while getting to know this new platform, I could both understand and sympathize.

It's also true that I don't know of an actual case in which the costs and fees of a transaction exceeded its revenue.

But the point still stands.

Taking the time to look at and understand the documentation supporting an auction is important and it’s clear that many auctions are completed without that being done.

As it happens, the auction described above sold on the 4th day after posting, or the 21st day after the date of the invoice. I considered making a bid calculated at the monthly discount rate necessary to break even on a one-day holding period but decided against it. Nobody likes a wiseguy!

The Perversity of Promptness

I’ve been buying receivables on The Receivable Exchange for several months now and I suspect that, in terms of the number of transactions, I’ve bought more than my fair share over that period.

A significant percentage of the auctions I’ve purchased have been closed-out: paid as agreed without problem. Those that remain open currently show no signs of problems: they appear to be running their natural course from purchase to close-out. And that’s, of course, a good thing.

During my time as an active Buyer I’ve learned a lot about the TRE Sellers and their Account Debtors, about the TRE platform and procedures and about the nuts-and-bolts mechanics of the buying, holding and close-out of transactions.

One of the things I had not anticipated is the promptness of some payments and the impact of that promptness on annualized transaction returns. The implications are significant and so I wanted to share the experience, at least in general terms (the TRE rules prevent my divulging actual transaction details).

However, since the result is a decision to refrain from bidding on some otherwise attractive receivables, I think the issue bears at least general discussion.

This issue arises because one of the fees charged to Buyers by TRE is a fixed percentage of the face amount of the receivables sold. The charge itself is a fraction of one percent and seems relatively insignificant; certainly not onerous. It’s impact becomes perverse only if payment is received very quickly.

For example: let’s consider the case of a single-invoice auction (or an auction of multiple invoices, all of which are paid at the same time). Let’s say that auction is paid off in 60 days. The impact of the up-front fixed fee is x times 360/60 in this case: or 6 times the fractional base. That will dilute the annualized return of the transaction, but not by an overly-significant amount.

On the other hand: let’s take a similar single-payment scenario when payment is received in 10 days. The initial fee impact in that case will be six times that of the case above. In other words the annualized return on the transaction will be diluted by 36 times the up-front fee, which now no longer looks so small!

What is the practical impact? Well, in my own case, I’m no longer willing to bid on the invoices of Account Debtors whose payments tend to come in very quickly. The dilution effect is just too substantial.

Now, it’s one thing to bid on an auction involving receivables due in 15 days, anticipating and aware of the likely dilution. It’s another to bid on an auction involving invoices payable in, say, sixty days and have them paid off in 10 days! That’s where the true perversity is felt!

Anomalies can always occur. Payments can be early or late for many reasons, some completely unpredictable.

But the TRE platform does provide Buyers the ability to research the past payment-velocity of each Account Debtor. Based on my own experience, Buyers should certainly take advantage of the opportunity to examine that history and take into account the probable velocity of payment receipt before bidding.

Bidding very aggressively on an auction that gets closed-out in just a few days is likely to lead to buyer’s remorse when the actual return on the closed deal is calculated!









.

A Quality Opportunity?

In our post of June 23 we wrote about the differences among the principal types of financial statements that privately-owned companies produce.

The companies that sell receivables on The Receivables Exchange are privately-owned firms that usually do not have audited financial statements. Many, in fact, don’t provide even “reviewed” or “compiled” statements; the financial statements available to a TRE Buyer are most often those of the management only, without independent review.

In our June post we quoted a report of the American Institute of Certified Public Accountants that a “compiled” financial statement carries with it “no assurance” of reliability from the accounting firm that has prepared the statement. Clearly a report that is prepared and presented by management alone can be considered no more credible than one complied by an independent CPA.

It’s not that management-prepared statements are necessarily less accurate than those prepared by independent accountants but I think it’s fair to say that the odds of material error or misstatement are far greater in a management-prepared financial statement than in one audited by an independent accountant.

If TRE is to become a major force in the receivables-finance industry, as we certainly hope it will, it will have to attract thousands of Sellers and it will have to attract sufficient Buyer capital to meet the needs of those Sellers. It will ultimately need to provide Buyers with more and better tools to make decisions regarding the quality of Sellers and the risks involved in buying the receivables of those Sellers.

Just as we suggested that eventually TRE would do well to go back to the model of having an independent invoice-verification agent, it also would do well to actively promote the establishment of an independent Seller-quality rating system.

It is unrealistic to expect that each Buyer will be able to maintain appropriate due-diligence information on thousands of TRE Sellers. It is also unrealistic to expect that TRE growth targets will be met unless Buyers have some source of risk analysis independent of TRE itself.

Many of the Buyers that TRE will certainly want to attract will be capital sources with some (at least internal) quality-rating requirements on funding. Recent experience in the markets for "new" financial products also suggests that those with oversight responsibility for the investments of potential Buyers will find it prudent to have third-party quality opinions.

At some point, attracting capital is inevitably going to require greater perceived objectivity and independence in analysis of Seller risk.

My guess is that TRE understands this. My hope is that they are working on it.

There are several possible models for establishing rating mechanisms. There are qualified entities already in the business of analyzing the financial condition of private companies. If a convincing case can be made for the ultimate success of TRE, and I think one can, there should be someone interested in providing a rating system of some sort for its Sellers.

There are just as many potential difficulties and inconveniences for TRE in dealing with an independent quality-rating system as there are with an independent invoice-verification system. Dealing with those inconveniences and solving those problems is part of the price of success.

It’s one of those examples of the paradox of control: the more control, in this case over the analysis of risk, that TRE is ultimately willing to give up, the more likely it is to actually accomplish its objective.

It's a Balancing Act

In our last post we discounted to some degree the technical problems required to manage a significantly increased deal flow on The Receivables Exchange. There ARE technical issues to be addressed and they ARE important, but the fundamental requirement of attracting more Buyers and more Sellers to the exchange is the true challenge.

But numbers alone are not enough. Quality and balance are equally important in these early days of the exchange’s growth.

What do we mean by quality?

In terms of Sellers, we mean that TRE has to attract Sellers that have the capacity to make good on their commitments to re-purchase invoices if their Account Debtors do not pay.

We’ve pointed out in prior posts the fact that TRE obtains only limited acknowledgments from Debtors and that those do NOT include affirmation of the acceptability of the goods provided or services performed. We’ve pointed out also that there are no personal guarantees to back up the Seller’s own corporate capacity and that the UCC filings obtained by TRE encumber only the receivables actually traded on the exchange.

If there haven’t been situations yet in which the Account Debtor justifiably refuses payment; rest assured there will be. And if the Seller doesn’t have the money to make good, all parties will be damaged, including TRE.

In terms of Buyers, we mean that TRE has to attract prudent investors concerned about the quality of the obligations being purchased and the strength of the Sellers they buy from. Buyers have to understand the quality (or lack thereof) of the financial information made available and the risks involved in dealing with smaller and financially weaker companies than they might be used to.

TRE needs to seek an orderly and balanced increase in the relationship between deal flow and Buyer demand. That’s a tough job; especially with so much riding on rapid growth assumptions.

The current deal flow cannot yet absorb really substantial cash inflows. One Buyer with a perceived “need” to put money to work in any significant quantity could easily absorb the entire current deal flow and create a pricing environment that is not informed by any real risk assessment.

Can TRE be expected to counsel caution to Buyers willing to take any deal that comes along?

Can TRE be expected to turn away Sellers whose financial capacity and business characteristics do not meet its own stated requirements?

Not only CAN it be expected to do those things. If it doesn’t do those things; if it doesn’t work very hard to create an orderly and rational trajectory to its growth; it runs the risk of suffering the unhappy fate of other new markets which were overly focused on near-term growth objectives and into which undisciplined capital was allowed to move too quickly.

None of us needs that; least of all the exchange itself.

It's Trivial, Really!

My brother is a professor of computer science and electrical engineering. He has an annoying habit of conversation that I suspect is common among those who deal in theory more than practice.

We might be talking about an issue that seems to me to be quite complex and in need of clarification before moving forward in the conversation. And he, (seemingly) oblivious of my need to understand, will say “it’s trivial, really” and just move on to the next step, leaving me behind.

It still annoys me but now at least I understand.

He just means that all of the information or the tools necessary to move from that step in the analysis to the next one are already known or in hand.

No matter how complex the transition might be, if the necessary math is known or the process or engineering problems have already been solved, then it isn’t necessary for the academic to spend any time discussing them.

What is important is the next UNSOLVED problem; everything else from his point of view is “trivial”.

In our last post: “Sipping From a Fire Hose” we calculated that it would take about 27,500 transactions per day at the current average deal size to keep $50 billion employed in TRE transactions. I got an email from a reader expressing some skepticism that a deal flow of that magnitude could be managed.

I suggest that managing the deal flow is actually not the issue. In the words of my brother: It’s Trivial, Really!

Consider this: there is commercially available and affordable software that has the capacity to continuously screen the activity of tens of thousands of stocks, bonds, futures, and options positions, and to alert an investor to situations that meet highly complex predefined analysis criteria.

Screens that search for combinations of precisely-defined fundamental metrics in combination with selected technical analytics and real-time inter-market pricing anomalies can be run using these tools on a $1,000 laptop wirelessly connected to a data source at poolside.

There is nothing more theoretically complicated in providing TRE buyers the ability to precisely define the transactions they want to look at and to ignore all the rest.

Four things are needed to reach the calculated volume numbers we quoted in our last post:

1. More Buyers,

2. More Sellers,

3. An increase in the number of searchable criteria provided by TRE, and

4. Software upgrades sufficient to allow Buyers to search for the deals they are interested in and, potentially, to manage bidding strategies.

Managing the deal flow requires both the increase in searchable criteria and the software improvements.

The software part really IS trivial. Those problems have been solved. The adaptation by TRE is simply a matter of resource allocation.

The issue of establishing searchable criteria is more challenging.

The information currently provided on the TRE platform that the exchange actually COULD make searchable is not adequate to narrow down a very large deal flow. TRE could currently allow buyers to search by industry, by size, by transaction history, by number and character of Account Debtors, by a few of the most recent financial statement entries, etc.

A dozen meaningful criteria might be actually possible to search on now. (They aren’t searchable now, but they could be.) That’s too few to support the potential volume of transactions.

A screen that gives me a thousand options is of little help in a real-time auction situation unless I can also design automated bidding strategies. But actually the technology for that is also currently available! Adaptation to TRE needs in that regard would also be “trivial”.

In fact, when you really get down to it, if the estimates of potential market size are anything close to correct—all of the technological and information-management issues are actually trivial.

Not that they are easy. Not that solving them would be without complication or challenge. But the technical problems of managing the potential deal flow have already been solved.

It's not MANAGING the deal flow that we need to be concerned about--it's GETTING it!

Sipping From a Fire Hose

In our last post, on the subject of the size of the potential TRE opportunity, we concluded:

“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.”

As I re-read that statement it actually sounds a little weak. Let me make it a little stronger.

I truly believe the TRE concept to be brilliant. And no one I’ve spoken with about it disagrees, at least in principal. The question usually becomes: does the current implementation effort allow the potential to be achieved?

And the answer has to be: NO!

Of course it doesn’t. But, then again, how could it?

In the last post we worked backward from the national income accounts to the potential market size. The view was from 30,000 feet, or from the moon, depending on your level of skepticism.

Now, let’s look at it from a different vantage point.

TRE reports that its average auction size is currently about $65,000. The average number of auctions per day is a statistic that I don’t think I’m allowed to divulge. But let’s look at what is required to meet the market potential we discussed in the last post.

For TRE to achieve an annual gross volume of $450 billion, which would keep about $50 billion of capital employed, it would take nearly 7 million transactions per year at the current average size. That equals about 27,500 transactions per business day. The total number of auctions completed since TRE's inception is only a few percent of that required daily figure!

A buyer trying to deal with that kind of volume would be sipping from a fire hose! The velocity of offerings would quickly overwhelm him. But the current system would not allow that many transactions to even REACH him.

Let’s take a step back.

TRE estimates it will generate about $1 billion in gross volume next year. At the current average auction size that would suggest a total of about 15 thousand transactions for the year. That would equate to about 60 per business day.

That would probably require some re-working of the current platform, and it’s probably a stretch, but at this stage of the process the exchange HAS to stretch; certainly in setting goals for itself.

It’s easy to look at big numbers and decide that something can’t be done. It’s better, if you believe in an opportunity, to try to figure out how the problems can be solved.

There’s no question that huge changes would have to be made to the current system to accommodate anything like the volume we wrote about in the last post. But huge changes were required to go from the Sony Walkman to the Apple Ipod!

It wasn’t that long ago that we thought it was a marvel to be able to carry an entire hour of music on a device that clipped onto our belt. Now we can carry hundreds (maybe thousands) of hours of music on a device that is hardly noticeable in a shirt pocket!

The question is not whether we can sip from a fire hose.

The question is: how can we control the flow of water from the hose in such a way as to allow us to take a sip!

One mindset assumes failure; the other assumes success given a sufficiently powerful incentive.

Water is a powerful incentive to the thirsty!

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!

Hold the pickles! On the virtue of sameness.

I spent a few years managing commodity futures investments.

The fundamental principle upon which the commodities business depends is sameness.

When you buy or sell a contract for the delivery of corn or coffee or oil or Swiss Francs, you know precisely what goods and services the contract requires: the quality, the quantity, the delivery date, the delivery location, the payment terms, etc. The only thing left to the operation of the market is price discovery.

In the classic fast-food differentiation war between Burger King and MacDonald’s, Burger King began the now famous “Hold the pickles” campaign in 1974.

BK promised that you could “have it your way”, customizing the product to your own particular tastes. While a brilliant marketing move, this also left BK open to a much higher incidence of customer complaints.

MacDonald’s promised to hand you a Big Mac, as standard (at that time) in its specifications as a futures contract on the wheat used in making its buns.

Burger King, on the other hand, promised to give you exactly what you asked for: “hold the pickles, hold the lettuce, no cheese, and extra mustard”; or, whatever.

MacDonald’s was the commodity provider; Burger King was the specialty supplier.

Here’s the point.

The odds of a complaint in a commodity transaction are significantly lower than the odds of a complaint in a specialty transaction. The Big Mac buyer can demand compensation if the burger is cold and dry. But the Whopper buyer who ordered it “his way” might have six other valid reasons for rejection of the product.

In our post of July 5 (An Inconvenient Essential—Part One) we pointed out that the TRE invoice verification process is limited in scope. TRE does NOT receive an assurance from the Account Debtor that the goods or services provided by the TRE Seller have met the specifications of the contract. All we know is that the invoice is in the Debtor’s Accounts Payable system. And that might only require that an invoice has been submitted by the vendor.

A Buyer considering the purchase of a TRE-posted receivable assumes some degree of risk that the obligation will be denied and payment refused (or that some negotiated compromise will be required). That risk should, of course, be reflected in the pricing of the transaction. The higher the risk that the goods or services might fail to meet contract requirements, the higher should be the appropriate return premium.

In pricing a transaction a Buyer has to ask: is the contract for a Big Mac or a Whopper?

In my traditional invoice-purchasing business I like to use the example of an excavation and demolition contractor who was an early client of mine. If my client had a contract to demolish a building I could go to the site and see that the building was demolished. If he had a contract to dig a foundation, I could go to see if there was a hole in the ground. It’s not perfect confirmation (maybe the hole in the ground is too deep) but there is some comfort in its simplicity.

When a client provides goods or services that are specialized, the question of risk becomes more complex and complexity requires compensation, especially in the absence of full verification.

When the product is “customized”, “specialized” or “turn-key”, I know that I’m not dealing with the guy who makes holes in the ground.

When the goods or services are based on “proprietary”, “innovative” or “patented” processes, I know I’m at the Burger King counter, not at MacDonald’s.

The more clearly I am dealing with a commodity, or a commodity-like service, the lower I can set my risk premium in bidding.

The more “customized” or “specialized” the product or service, the more I have to be compensated for the lack of assurance from the Debtor that he actually “got it his way”!

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.