Alignment of Interests

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

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

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

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

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

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

The basis of my suggestion is:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

But that’s not really the point!

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

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

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

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

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

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

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

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

The question of fee structure should not be ignored.

Push Back and Protest Bids

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

www.1150Investments.com

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

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

Now to the point:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Expanding the Product Line

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

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

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

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

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

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

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

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

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

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

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

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

Why is that?

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

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

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

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

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

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

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

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

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

A "Safe Haven"?

It’s been a busy month and I haven’t written as often as I usually do. I began thinking yesterday of what topics might be both timely and of interest for an end-of-month post.

There are many. It’s been a very active month for TRE.

LOTS of auctions; another volume record. Lots of new Sellers; some very interesting and some a little puzzling. Lots of established Sellers bringing new Account Debtors to the Exchange; again, some very interesting and some a little puzzling.

Those all suggest good topics.

TRE management has made significant and important efforts to enforce the requirement that Sellers update their financial statements on a more timely basis. Those new statements show that there have been some important swings in the condition of some Sellers: some in a positive direction and some negative.

It’s clear that 2009 was a tough year for many TRE Sellers. I’ve already commented on my own reactions to having to “let go of” some favorite Sellers and to become willing to buy from some Sellers that I’ve shunned in the past. There’s more than one good post in that topic.

And the bidding dynamics have continued to show changes in the relative strength of Buyers and Sellers and to provide some very interesting glimpses into the strategies and motivations of some market participants. Again, good topics to come back to.

But, as I sit here at the end of the day and the end of the month and the quarter, I have to pick a topic. And what strikes me as most important right now is “none of the above”.

I bought more auctions in June than in any of the 13 months that I’ve been an active Buyer. The average expected return on those auctions was higher than the average of any prior month.

I had more auctions close-out in June than in any prior month and none of those auctions was in any way problematic.

It wasn’t a month without some angst but most of that was self-inflicted and that goes with the territory in any investment medium.

And there’s the story…..

It was a month of increasing volume, increasing opportunity and increasing returns.

It was a month whose problems were the problems of managing opportunities.

Contrast that environment with the turmoil in stock market, the currency markets, the commodity markets or the sovereign debt markets. And then there were those who thought that bond yields couldn’t go any lower!

Who would have thought that buying receivables on an upstart electronic exchange would dampen portfolio volatility at the same time as providing incremental return!

Who would have considered this type of investment a “safe haven”.

Now, “safety” is relative and I am not going to downplay the potential risks involved in TRE transactions. I’ve taken pains to make some of those clear in prior posts. But I’m talking about the RELATIVE performance in an admittedly volatile period for other financial markets.

And, also admittedly, the volume of Exchange transactions is still too small to make a meaningful difference in the context of the portfolios of large investors.

But current experience has to be at least a LITTLE intriguing, even to the larger players, as we look forward to the day when TRE volume is a meaningful percentage of its potential.