The Failure of The Receivables Exchange - A New Book

How likely is it, I wonder, that any of those who subscribed to this Blog during the life of The Receivables Exchange will have email addresses that survive from that era? 

I don't know. But, on the off-chance that some do, I thought I'd let you know that, all these years later, I've written a book about the TRE failure. 

 Some of the issues that caused the Exchange's failure might be addressed by technology that did not exist at the time it was gasping for life. And some in the current finance community seem to be discussing ways to adapt new payment systems, blockchain technology, smart contracts, etc. to avoid some of the problems that TRE faced. 

Of course, the problems that can and should be laid at the feet of management just need to be acknowledged. 

 So, I've identified four principle problems with the structure of the TRE transactions, and several management and administrative errors that I believe can explain the failure of TRE. Many could and were identified at the time in this Blog and by others. 

But pehaps laying the problems out clearly, and with some benefit of hindsight, might be of value or, at least, of interest to some.

 The book is called,

"The Failure of The Receivables Exchange: A Bold Idea, Its Fatal Flaws, and Lessons Learned." 

 It is available on Amazon in both Kindle and Paperback versions. 

If any of you are still there and would like to discuss, or just touch base, I'd be happy to talk. 

 All the best. 

 Chuck

A Brief Digression

I had intended by now to post at least two additional pieces on the issue of appropriate compensation for risk in TRE transactions. But it’s been a busy month and I’m still in the process of gathering data and thinking through the analysis. I’ll get back to that important topic soon.

However, I had a conversation a couple of weeks ago that brings up an unrelated but, I think, interesting subject. So if you’ll permit me a brief digression…..

The conversation was with a prominent member of the traditional factoring community. He said that it was his opinion that a company whose only business was buying receivables via TRE was not in the factoring business. Rather, in his view, it was in the investment business.

Now, as I’ve written, my associates and I formed a new company last year whose sole occupation is buying receivables via TRE. So this is an issue of more than a little interest to me.

Having spent my entire business career in various investment businesses I could hardly take offense at being termed an investor. On the other hand, the implication in this case was negative: that there is something important lacking in the TRE Buyer that excludes him from being recognized as a part of the factoring community.

Putting aside for the moment the question of what that says about the relationship between the traditional factoring community and TRE, the topic is, in itself, an interesting one to consider.

Is a TRE Buyer in the factoring business?

A standard dictionary of business law provides the following definition of factoring (with a useful reference to a ‘factor company’):

“Factoring is a form of financing in which a business sells its receivables to a third party or ‘factor company’ at a discounted price. Under this arrangement, a factor company agrees to provide financing and other services to the selling business in return for interest and fees on the money that they advanced against the seller's accounts receivables.”

It is clear that a TRE Buyer DOES: a) buy the receivables of a business, b) at a discounted price, c) in return for fees on the money advanced.

That much of the definition cannot be argued. What, then, is lacking or could be said to be lacking?

The only thing that appears to me to be open to question is PROCESS.

The standard definition cites “other services” and it is (at least arguably) implied that the connection between the selling business and the ‘factor company’ is direct.

In the case of the TRE Buyer the provision of “other services”, such as collection of payments, accounting for and distribution of funds etc. is performed by a paid intermediary i.e. the Exchange.

It is also true that the Exchange, not the Buyer, establishes and maintains the direct relationship with the Seller and that it provides the Buyer with certain due diligence materials that the Buyer may use in its decision making.

I think that it is beyond question that a factoring transaction occurs when a business that is a TRE Seller sells invoices via the Exchange to a TRE Buyer. (Certainly the law of the State of Louisiana recognizes such a transaction as factoring.) It is the structure and process of the TRE factoring transaction that is unique.

But the uniqueness of the structure doesn’t, in my view, change the character of the transaction.

The person with whom I spoke on this subject actually argued that neither TRE nor the TRE Buyer was in the factoring business. But if a factoring transaction is taking place, surely SOMEONE has to be playing the role of “factor”.

Now, it might be argued that the sum of the parts equals “factoring” but none of the parts equals “factor”. I think that argument is hard to support.

Let’s walk through the functions and responsibilities.

TRE does the marketing. It finds the Sellers. TRE qualifies the Sellers in accordance with criteria agreed upon with the Buyers and it provides the Buyers a set of due diligence materials that the Buyers can analyze in their decision making.

TRE manages the process of packaging the Sellers’ invoices for sale, offering the packages to the Buyers, determining when sale criteria have been met, “closing” and funding the sale. It provides the accounting of the sale to both parties. It receives payments from account debtors, accounts for them and distributes them. It is responsible for the process of verifying invoices, for following up on payments and for certain defined matters in the event of payment defaults.

All of these are clearly important parts of the process.

What does the Buyer do?

First, the Buyer must decide to invest money in the purchase of accounts receivable. I don’t hesitate to use the term “invest”. Every factoring company is investing in the purchase of accounts receivable regardless of any fine distinction of language one might desire to make.

Having made the decision to invest in purchasing accounts receivable it is the Buyer’s responsibility to decide on certain portfolio-level matters, for instance: how much to invest, what concentration and diversification rules should be used, how will the due diligence materials provided by TRE be analyzed and evaluated, what due diligence activities and materials should be considered in addition to those provided by TRE, what Seller-experience criteria must be met prior to considering a purchase from that Seller and what account debtor experience criteria must be met before considering a purchase of that debtor’s invoices.

On the basis of those considerations, the Buyer must decide which Sellers to buy from, which account debtors’ invoices to buy and what pricing level is acceptable.

The unique additional responsibility of the TRE Buyer is that it must act in the arena of real-time competitive auction, which requires a discipline, an approach to decision making and a flexibility and sensitivity to changing real-time conditions that are not required of the traditional factoring company.

So, given that factoring transactions ARE unquestionably taking place, what can we say about the separation of functions in the TRE process: the division of responsibilities between the Exchange and the Buyers?

Well, I’ll tell you what I’d say.

In a nutshell, the TRE Buyer exercises the executive functions in the process while the Exchange is responsible for the technical functions.

Portfolio-level decisions are the Buyer’s. Risk management decisions are the Buyer’s. Seller acceptance and account debtor acceptance decisions are the Buyer’s. Pricing decisions are the Buyer’s.

If we were looking at a hypothetical factoring company office, the Buyer would occupy the CEO’s office on the top floor. The Buyer performs the CEO function.

The marketing, research, accounting and treasury offices are all down further in the building. They support and report to the CEO and any one of them can be outsourced and purchased on a pay-for-service basis.

And that’s precisely what TRE is: a multi-function, outsourced back-office combined with a unique transaction facilitation process.

Where is the ‘factoring company'?

I’d suggest that both the Buyer and TRE are in the factoring business but if I had to identify one ‘factoring company’ I think the typical analysis of a business structure suggests that the executive function, the locus of ultimate decision making, defines the business.

I spent many years in the real estate investment business. It frequently happened that a deal was brought to us by a broker. The broker typically provided a substantial amount of analytic material, had the direct relationship with the seller and acted as intermediary in the negotiation. After a property was purchased, its day-to-day operations were outsourced to independent property management and leasing companies.

Was I in the “real estate business”? None would argue.

With respect to those holding differing opinions in this case I would say: OF COURSE a company that buys receivables via TRE is in the factoring business. It’s disingenuous to argue otherwise.

That doesn’t mean that all TRE Buyers are GOOD at it. And it doesn’t mean that they actually DO perform all of the functions I’ve cited above.

I didn’t say that every TRE Buyer actually DOES all of those things. I said they were RESPONSIBLE for them.

If they avoid their responsibilities, make bad decisions, lose money, get mad, take their marbles and go home…..well they will have done what many in the traditional factoring business have done.

They will have failed.

But neither their failure nor their success will change the character of the business they were in.

Appropriate Compensation #1

For a few weeks in February and early March there was just a hint of a Buyers’ strike in the TRE auction dynamic. Many more auctions stayed open for hours or even days. Fewer buy-out bids were made. More Sellers adjusted pricing upward to close deals.

That hasn’t completely ended. We’re still seeing some egregious over-reaching by some Sellers and some push-back against that by Buyers.

One relatively new Seller this past week wound up agreeing to terms roughly double its initially-posted buy-out level. That says more about the unrealistic ask-price than the final auction terms, though.

The average returns to Buyers during March have fallen back from their brief February rise and it’s possible that we’ll close the month with new lows in average market-wide returns.

It’s not fair to say that TRE auctions are “priced for perfection”. They’re not.

But it IS fair, I think, to ask whether they are priced appropriately in light of the risk assumed by the Buyers.

So this is the first in a series of posts examining the question of what might be an appropriate level of compensation for risk in TRE auctions.

I think it’s useful at the start of this conversation to acknowledge that it can be perilous to try to analyze ANYTHING at the level of an entire market or to use market-wide averages as benchmarks. Compensation for risk is only one component of the total return required by investors, whether they are Buyers on TRE or involved in any other investment activity.

Cost of money, cost of operations, applicable taxation levels and an appropriate net profit also have to be considered.

If we were to look at the traditional factoring community we’d find that these individual variables tend towards a common level reflecting the similarities among the participants in a well-established industry. That would be true in any mature segment of the investment community. The economics of participants in a mature market tend to be shaped by the market over time and to converge around parameters that reflect the investment characteristics of that market.

That is not currently the case when we look at the TRE Buyer community. It is nowhere near as homogeneous a group as is the traditional factoring community or the community of firms that specialize in any other mature investment market.

In fact, the TRE Buyer community is an extremely diverse group. My guess is that there are substantial differences within the group in very basic characteristics like cost of funds and cost of operations.

And the motivations of the TRE Buyer community, as reflected in the determination of what might be an “appropriate” level of profit, are just as diverse.

Some might be simply looking for a place to “park” short-term funds at an expected rate better than the near-zero current money market returns. Their TRE activity is a side-line, at best; maybe even a short term experiment.

There are other Buyers, though, that are looking at TRE as potentially a primary business; one that has to both cover reasonable costs and generate reasonable profits.

So the total returns considered adequate by TRE Buyers will probably fall in a wider range than would the returns of either a fairly homogeneous industry or of a well-established asset class. TRE really represents neither of those at this point.

On the other hand, TRE DOES represent a closed system when the question of assessment of investment risk is concerned. All who choose to participate in the TRE market assume the risk that the market presents. They will react to that risk in different ways: i.e. via diversification rules, Seller-quality rules, auction-characteristic rules, etc. But they are nevertheless participating in a market that has some common risk parameters.

Our ability to define those parameters is limited by experience. TRE presents a new approach to its market and its history is short.

But some experiences external to TRE can be used with value to analyze risks that are specific to TRE. Because of the relative lack of experience with and information about TRE-specific risks I think we actually HAVE TO look outside of the limited experience of TRE itself if we are to have a meaningful discussion.

In some cases we’ll be able to offer quantitative data drawn from other sources and markets. In many we’ll only be able to suggest relative measures: e.g. that a certain TRE-specific risk is likely more than or less than that of an alternative.

But even if we can’t offer actual quantitative measures, it is still useful to consider a particular source of risk and to ask in some disciplined way whether the risk facing a TRE Buyer is likely to be greater than or less than that faced by participants in other markets that present similar challenges.

I don’t know yet how many posts this subject will occupy but I suspect it will be several; maybe half a dozen. So there’s plenty of opportunity for readers to help shape the conversation.

I welcome any suggestions of issues that should be examined in this conversation. And I’d be delighted to receive any information, especially good data, that anyone might be willing to share.

One of the things we’ll need to address, for instance, in establishing a relative benchmark, is the loss experience of the traditional factoring and receivables-finance markets. Some data on that is public, of course, but any good information that might be shared on that or any other relevant issue would be much appreciated.

We have to acknowledge at the beginning of this exercise that its primary value might be in the exercise itself as opposed to the conclusions. But that’s OK, too.

We’ll take value where we can find it.

Further on Alignment of Interests

In my last post I suggested that TRE modify its fee structure to eliminate distortions caused by the fixed component of the Buy-side Exchange fees. Those distortions are magnified in auctions with relatively short durations.

One auction in this week’s market activity caused me to look back at the question of distortions from a different point of view.

On Monday afternoon, a fairly seasoned TRE Seller posted an auction with pricing parameters that set a new record. The buy-out advance requested was higher than any in my memory and the buy-out monthly fee offered was the lowest in my memory.

The Seller is solid, but not gold-plated. The Debtor has an unquestioned capacity to pay and its performance in prior auctions appears to have been fine. I have bought an auction from this Seller, involving invoices due from this Debtor, and was quite satisfied with the result.

So the deal deserved a good price.

But the pricing requested in this transaction would have returned to the Buyer something closer to a CD rate than a return typically associated with receivables financing.

My first reaction was: What are they thinking?

My second was: Let’s try to actually understand what they’re thinking.

I have to admit that I have a Buy-side bias when it comes to analyzing auctions. I spend a lot of time on the subject of return to the Buyers. I really haven’t spent much time working on the cost of funds from the Seller’s point of view.

But the only way to answer the question: “What are they thinking?” is to look at the transaction from the “other side”.

I’m not going to say much about the TRE sell-side fee structure except to say that the basis of the fee is essentially the size of the auction and that the rate charged is variable depending on certain Seller characteristics. For my purposes I’m going to assume that the Seller in this case enjoys a rate at the low end of the range.

The auction under study has a probable duration that can be readily estimated. There has been a reasonable amount of past activity and actual payment experience has been quite consistent.

If we know the auction size and its pricing parameters, the duration is really the only remaining variable in the return calculation. So this particular example is a good one to use from that perspective.

It really is quite surprising how the view of the transaction changes, depending on one’s perspective!

I looked at two cases:

1) the initial buy-out pricing parameters, and

2) the actual final sale pricing parameters.

And I looked at the projected return to the Buyer in both cases and then the projected cost of money to the Seller in both cases.

Case 1: Using the initial buy-out pricing parameters, the net annualized yield to the Buyer would have been in the very low single digit range. But the net annualized cost of funds to the Seller would have been about 5 times that level!

The cost of funds would still have presented an extraordinarily attractive deal for the Seller, however --in the mid single-digits on a net annualized basis -- so there’s no mystery why the Buyers weren’t willing to play.

The point is that the gap between the return to Buyer and the cost to Seller, which is clearly a function of the fees earned by the Exchange, is a hugely distorting factor when pricing is extremely aggressive and duration is relatively short.

Case #2: Using the actual sale parameters, the distortion is much lower but it is still substantial. The return to the Buyer is just into the double-digit range while the cost to the Seller is in the high teens.

Now I don’t know how many Sellers look at their cost of funds in the same way that I have looked at it. But in this instance, while I would have been unwilling as a Buyer to accept the return generated by the deal; if I were in the Seller’s shoes I would probably have thought I was paying a pretty fair price for the money.

There’s the rub.

At this stage in its life TRE has a fairly small transaction base on which to generate fees. It’s clear that fees alone can’t cover its current expenses. It will need to grow by a significant amount to reach that point, I suspect.

On the other hand, given the need to grow substantially, the question of the impact of fee structure on growth potential is a fair one to ask.

Having gone through this exercise I have a greater sensitivity to the position of the Seller.

But my sensitivity doesn’t change my estimation of appropriate return to Buyers’ capital one bit. And it won’t change my actions at all.

[Except that the language I use when I see what appears to be an irrational Seller pricing structure might be somewhat more moderate.]

Only TRE needs to be sensitive to BOTH sides of the auction transaction. Buyers are going to look to their own interests and Sellers to theirs. That's the nature of the market. But TRE has to understand and act to ensure that both sides find the net benefits fair.

Otherwise, the growth that we all need and want is at risk of failing to materialize.

Alignment of Interests

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

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

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

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

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

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

The basis of my suggestion is:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

But that’s not really the point!

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

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

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

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

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

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

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

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

The question of fee structure should not be ignored.

A Comment on Risk

The downward pressure on auction pricing that began in late August has continued and intensified through November. I’ve suggested before that this might have more to do with excess liquidity than with either improved quality of Sellers or Debtors or with decreased transaction risk.

While auction volume has continued to increase it appears that liquidity has increased at a more rapid rate. One indicator of that is the percentage of auctions sold at their specified “buy-out” prices.

On one recent day, there was only one auction that DID NOT sell at its buy-out price.

I suspect that there is a substantial Buyer out there who has given instructions to a trader that he is not to BID on auctions; but rather only to BUY them.

So, no matter that an auction might be had on better terms, this Buyer pays the “ask” price. And that, of course, provides a powerful incentive for Sellers to drop their “buy-out” or “ask” pricing.

Now, I might very well be wrong about this and I have no knowledge of any other Buyer’s actual trading dynamics. I’m just speculating based on the activity as I see it.

Viewed from the perspective of both the Exchange and the Seller community, of course, the current dynamic is very attractive.

For the Exchange, it makes the job of attracting potential Sellers, and of retaining current ones, easier. Lower cost of funds and rapid auction closings provide the sales force with a strong "story" when marketing TRE to prospects.

For the Sellers, obviously, lower pricing is always desirable.

And Buyers could ultimately benefit as well to the extent that more Sellers might be attracted to the Exchange, although this benefit is a lagging function and is obviously offset by the lower yields available at least in the near term.

In the long run, the Exchange cannot thrive on the basis of a pricing level that does not, on average, compensate Buyers for: a) cost of funds, b) cost of operations, and c) risk assumed.

The TRE Buyer community is very diverse, not only in terms of the primary businesses they represent but also in terms of their motivation for participating in the Exchange. A Buyer that is not primarily in the receivables finance business; whose interest in TRE might principally be as a place to “park” cash balances in the short term; will have a very different view of acceptable pricing than will a Buyer whose principal business is buying accounts receivable.

It’s really impossible for anyone except the managers of the Exchange – who will know all of the Buyers and their reasons for participation -- to comment on the likely range of Buyers’ cost of funds, cost of operations or motives for participation.

But the risk involved in an Exchange transaction is the same regardless of the identity or motivation of the Buyer.

I’ve commented in previous posts about the differences between the typical business model of a company whose principal activity is the purchase of receivables and the model on which TRE is based.

In several respects the risks of buying invoices on TRE have to be acknowledged to be higher than is typically the case in the receivables finance business. Here I’m thinking of issues like the lack of personal guarantees and of blanket first liens on Sellers’ receivables.

On the other hand, there are offsetting advantages to the TRE model that are not inconsequential. The lock-box arrangement not typically available to a spot-factor, the advantageous nature of the Louisiana law and a generally higher-quality Debtor community, are examples.

Each Buyer, or potential Buyer, will make his own assessment of the balance between those advantages and disadvantages.

But today I want to revisit a risk-related topic that I’ve commented on before that has become a larger issue in the current pricing environment. It does not arise from the TRE operating model but is significantly affected by its pricing model: specifically the impact of its fee structure on auctions of very short duration.

Given the relatively brief history of TRE it’s very hard to devise a risk analysis that would result in a conclusion regarding the probability of loss in transactions with certain given characteristics.

We really can’t say, for example: “the probability of loss in a transaction in which Seller A is owed money by Debtor B for the provision of goods or services with characteristic C, under the terms of an agreement with characteristic D ---is in the range of X% to Y%”

We’re just not there yet.

But there is a way to make a STATEMENT regarding risk even without actually suggesting an actual evaluation of risk. The statement I’m referring to is grounded in the traditional payback-period calculation from Financial Analysis 101.

Applied to a TRE auction it would take the form of:

“It would take X successful transactions (with given characteristics) to offset 1 such transaction in which a total loss was suffered.”

That says nothing about the actual risk of loss, of course, but it can provide a useful means of:

a) conceptualizing the consequences of a default, and

b) providing a relative measure of loss consequence between and among transactions.

Looking to the actual auction activity from a recent day I can pull an example of a transaction made at the low end of the typical range of expected duration and discount rate; one at the high end; and one in the middle.

The analysis has two steps:

1) using the likely duration and actual transaction parameters, calculate the expected net dollars returned to the Buyer upon full payment of the invoices purchased, and

2) divide the total funds advanced, including transaction fees and costs, by the expected net dollars returned.

The low-return transaction example, because of its short duration and low discount rate, produces a small dollar-amount of expected return. If a Buyer were to suffer a total loss on an auction with these exact characteristics, it would take 489 successful transactions with the same characteristics to recapture the loss.

The high-return transaction example has a very long expected duration and an unusually high discount rate. It would take only 7 successful transactions with these characteristics to offset a total loss on one.

The mid-range example, which is more characteristic of the typical transaction, has a moderate expected duration and a discount rate somewhat higher than the current average (but closer to the historical average) than either of our “extreme” examples. In that case it would take 45 successful transactions to recapture one total loss.

To my knowledge there has been no default on auctions involving the Seller/Debtor pairings whose auctions I’ve used in these examples.

It SEEMS clear that the Buyer community assesses the relative risks among them quite differently. But I wonder…..

Let’s take the case of the low-end example above. I don’t know who is buying those auctions or others with similar characteristics. But I wonder if they actually consider the relative risk to be roughly 1/11 that of the mid-range example?

I don’t know.

But I do know that it’s wise to remember two things:

1) The typical receivables transaction is of very short duration when compared to most other fixed-income investments; meaning that the ratio of dollars earned to dollars risked in a single transaction is low, and,

2) The direction of errors in projecting (percentage)returns on an invoice-purchase transaction is almost always negative. Other than earning a slightly higher return than expected if durations extend, you can’t really get surprised on the upside.

As time passes and experience is accumulated we’ll be better able to quantify relative risk using appropriate statistical means. Until then we’ll have to do the best we can with what we’ve got.

But I think it pays to at least acknowledge the implicit judgments being made until we get to the point where explicit ones can be supported.

Going Long(er)

I became a Buyer on TRE in April 2009 with the specific commitment to refrain from bidding for 60 days. I wanted to watch the activity and get comfortable with the process before actually participating in TRE auctions.

As readers of this blog will know, I did get comfortable with the process and, after my 60-day “hide and watch” period, I did become an active Buyer.

My bet was still almost fully hedged, though.

It was clear that becoming more seriously committed to the TRE process required a judgment that the Exchange was likely to capture sufficient transaction volume and process/product credibility to sustain itself as a going-concern.

Since I began buying in June of 2009, several things have happened:

1) My experience as a Buyer has been successful,

2) Exchange volume is running at roughly 7 times its pace of 18 months ago,

3) TRE has attracted significant and credible new financial banking, and

4) The Corporate auction program, which I wrote about in my last post, appears likely to provide an additional revenue stream, giving the Exchange another leg-up towards break-even.

On the basis of those developments it now seems that the odds favor the long-term survival and success of the Exchange.

On that basis my associates and I have just taken off a part of our hedge.

We have formed and funded a new company to pursue an expanded commitment to investment in TRE-posted auctions.

That’s a big step for us and a significant commitment to the notion that there IS a long-term and significant role for TRE in the receivables-finance market.

It’s not a complete lifting of the hedge, however.

The Exchange volume is still short of that required to support either itself or an infrastructure of fully-committed participants.

And the buy and sell interests are still not balanced enough to avoid periods when prices get pushed – in either direction -- beyond what I’d consider rational given the level of risk.

Over the summer we saw yields to Buyers spike for a couple of months. Since the end of August the pricing has moved decidedly in favor of Sellers. Neither extreme has been driven by quality, in my opinion. I think it’s much more likely that, in both cases, the driver has been a supply-demand imbalance.

Short term swings in pricing power are just a fact of life in a market with a growth curve like that of TRE. New money entering a market like TRE is “lumpy”. And the pace of new Seller adoption is unpredictable.

In the short term there will be days that are good for Buyers and days that are good for Sellers.

Our bet is that, over time, a reasonable balance will be found. That, on average, Buyers will be compensated reasonably and Sellers will find fair value in the price/service proposition offered by TRE.

Have we gone “all in”?

No. It’s still too soon for that, in my view.

But our bet is long(er) than it was last week. And we’re comfortable with that.

One step at a time.

The Reverse Lurch

No, that’s not the patent-pending description of Tiger’s new putting stroke.

In my post of May 31, 2010: “A Lurch to the Left”, I commented on the fact that pricing of TRE auctions had taken a decided turn in favor of the Buyer-community.

Auction statistics over the six-week period prior to that post reflected a shift in pricing power away from the Sellers.

I also noted, though, that there had been periods when the balance of power had favored the Sellers and that it was reasonable to expect that TRE pricing dynamics would shift from time to time.

The shifts from Seller-power to Buyer-power and vice-versa can obviously reflect a variety of factors. New Buyers with a desire to put money to work quickly can push pricing down. A sudden increase in supply of auctions can have the reverse effect.

We’re also beginning to see some cyclical patterns reflecting the lumpy timing of invoice payments and the desire to quickly redeploy returned capital.

The” Reverse Lurch” I’m referring to now is a decided shift back toward the Sellers’ favor in auction pricing.

That’s been noticeable over the past few weeks but has been especially pronounced in just the past several trading sessions.

My guess is that one or more Buyers have either just begun to deploy capital on the Exchange or have significantly increased their allocations to Exchange activity.

Whatever the cause, the effect has been clear.

In the first three trading sessions in September I bid on a number of auctions at prices that would have had a high probability of acceptance a week or two ago. In several cases those auctions were bought by others very quickly at prices that reflected no desire to test the pricing possibilities.

By that I mean the Buyer accepted the “buy out” pricing parameters with no attempt to determine if a better deal might be available. In a number of cases there were other bids; some quite far away from the “buy out”; and the winning bidder jumped immediately to buy-out price level.

The character of the Exchange is such that none of us can really tell what motivations are at play in any given auction or at any given time. We can only observe what IS happening and speculate about patterns that emerge as we look back at what HAS happened.

Since the bidding of the first three days of September presented some unusual activity I decided to look back about six weeks to see what I might find.

I looked at four auctions that closed in the first three days of September. The Sellers were “regulars”. The Debtors had a good deal of payment history. So reasonable projections of duration could be made both for the new auctions and those that closed in late July. The sizes of the early September and the late July auctions were similar.

I plugged the parameters of the auctions into a model that estimates annualized net return.

The projected annualized net return from those four sample auctions averaged roughly HALF the levels those Sellers had to pay in the late July period for similar auctions of invoices due from the same Account Debtors.

That’s a MAJOR lurch!

Now, the AVERAGE auction has NOT fallen in yield in that way over the past six weeks. The pricing pressure is not indiscriminate. And it might well be that this shift is short-term and motivated by unusual Buyer dynamics.

The point of this post is to recall the reverse situation in late May and to point out that pricing DOES ebb and flow on TRE. My guess is that the magnitude of the swings will become less pronounced as the volume of Exchange transactions continues to increase.

One thing is clear: these “lurches” tend to be concentrated in auctions that might seem a bit “obvious”: meaning, for example, that the Debtor is a very well-known name.

There are still very good, if less-obvious, auctions to be had at better pricing levels.

And we should remember that it’s not clear that the “obvious” auctions necessarily deserve the pricing they receive.

There are three elements to analyze in any auction:

a) the capacity of the Seller to re-purchase if necessary,

b) the capacity of the Debtor to pay what it owes, and

c) the character and certainty of the rights and obligations connecting them.

A triple-A Debtor might appear to create an obvious “buy”.

But a triple-A Debtor that questions the obligation to pay can all of a sudden become the hardest collection case on the list.

Then it’s the Seller’s capacity to re-purchase that is the key issue in the analysis.

I'm not a golfer but I know enough to realize that a "lurch" is not a good thing in a putting stroke. But apparently it DOES happen from time to time; even to the best.

Tomorrow's another day!

Bringing a Knife to a Gunfight

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

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

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

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

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

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

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

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

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

But, what is the cure for cash flow insolvency?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The "Two-Feet-Deep" Danger

We’ve all heard the one about a man (hopefully a statistician) drowning in a river that is, on average, only two feet deep.

It’s not that the information about average depth is either inaccurate or unimportant. It’s just that it’s not ENOUGH information if you happen to be crossing at the wrong point.

In my last post I said that I’d write next about the 2nd quarter figures in the “National Summary of Domestic Trade Receivables” published by the Credit Research Foundation. The CRF has published this survey quarterly for 50 years.

I’ll only make broad comments because the material is copyrighted. See www.crfonline.org for subscription information and other products and services offered.

The CRF has devised and publishes a “Collection Effectiveness Index”, which is a single-figure indicator of the general health of the domestic trade receivables market.

That measure showed a significant improvement in 2Q-2010 compared to 1Q and a small improvement over the year-ago period. Most other aggregate measures they report showed similar improvements:

a) decreasing days-sales-outstanding,

b) decreasing delinquencies,

c) increasing percentage of accounts current, and

d) decreasing percentage of accounts over 91 days past due.

These high-level, market-wide measures are useful indicators that nevertheless have to be understood in the context of potential lag-effect, bias from sample size and bias from self-reporting.

The breakdown provided by industry group can be more valuable since it reveals substantial variances from the reported medians.

For example, in the category of “% Current” the range among industries in 2Q-2010 was from 39.13% to 94.76%.

Of particular interest to me as I studied the results was the disconnect between the improving picture painted in the CRF report and the anecdotal information that I’ve been hearing recently from clients and others. The message I’m hearing is that there has been a continued deterioration in the ability to collect money owed to small and mid-sized businesses.

I’ve written in prior posts about an organized and concerted movement by Wall Street houses to educate large, credit-worthy businesses on the virtue of substantially lengthening payment terms to their suppliers and then offering to accelerate payments at a discount.

This “squeeze the little guy” campaign demonstrates a cynical disregard for the long-term damage to the SMB community, which is so important a source of job creation. Its openly-stated purpose is to leverage the large companies’ access to cheap capital as a tool to force suppliers to reduce effective prices.

Let me add a few, admittedly anecdotal, data points from conversations I’ve had in just the past week:

1. A colleague told me the other day that he had knowledge that a large, multi-national company had instituted a new, purposely-draconian, “reject the invoice” policy. The AP staff of this company will now reject any invoice for ANY deviance from its increasingly complex and difficult-to-understand invoicing policy; requiring a revision and re-submission. And, of course, stringing out the time to payment.

2. A client told me this week that one of their customers; an architectural firm that had done a substantial amount of work for a large public hospital; had had to fight for over 120 days to get a check, which then bounced.

3. A colleague reported that a large, national customer recently notified a certain class of supplier that it suspected that there had been fraud on the part of some of those suppliers and so had put a freeze on ALL payments to ALL suppliers in that category until an audit could be completed. Completion of the audit is not expected until YEAR-END!

4. A professional services firm that has been in business since 1914 has had to enter into a workout payment arrangement with a subcontractor on some UNDISPUTED bills to a large municipal school construction agency that have been unpaid for nearly a YEAR.

5. A painting contractor that has been doing a significant volume of work for one of the largest residential property management firms in the area for over 20 years now has about 75% of its receivables at over 90 days.

These are just a few items that have come up in the past week.

It’s certainly possible that my experience reflects a regional bias. It’s possible that the lag effect is a partial explanation. It’s also possible that it reflects a bias toward the kind of client I typically deal with in my spot-factoring business.

But the anecdotal reports that I’ve been getting certainly paint a picture that is at variance with that of the 2Q CRF report.

I do not question the CRF results. I think that the information they compile and analyze is valuable and important and I’d recommend it to anyone interested in top-line industry trends. It might well be that the next quarterly report will show the sort of softening that current anecdotal information hints at.

What I do suggest is that the need for liquidity in the SMB market and, specifically, for acceleration of receivable collections in that market, continues to be among the top two or three problems facing business owners.

And that’s good for prospecting by the TRE Seller-marketing group.

Misfiring Synapses

Some days the coherence of a rifle shot gives way to the less-organized pattern of a scatter-gun. This is such a day.

Rather than a single topic, I have a scatter-shot list of points to make and issues to address.

So, here goes…..

1. This week we’ve marked the close-out of our 150th TRE auction. (We’ve bought all or part of 189 auctions to-date.)

I can no longer say that we have encountered NO repayment problems but I CAN say that the issues that we have encountered have been handled professionally and successfully.

2. It has ALWAYS been unrealistic to suggest or to believe that everything would always work smoothly in the environment of SMB factoring. It doesn’t and it won’t. The challenge is to anticipate and avoid situations with a higher likelihood of problems, even if that means refraining from bidding on auctions that seem very tempting.

3. I was reminded this week that holding-period duration can be every bit as important as discount rate. I made an error and bid on an auction that could potentially have been repaid so soon that the TRE fee structure would generate a negative or negligible return to the Buyer. As I was berating myself for the bidding error and hoping that somehow I could be spared “success” on that auction, another Buyer placed a more aggressive bid that I’m convinced was also an error on his part. Give thanks for dodged bullets!

4. I continue to believe that the TRE fee structure should be re-considered. It provides a powerful disincentive for Buyers to bid on short-duration auctions and, therefore, acts to damage Sellers’ ability to maximize utilization of the platform.

5. In last Friday’s “Liquidity Weekly” email, Bill Siegel noted that July was another record month for exchange volume. The actual volume figures are TRE’s, not mine, to make public. But I think I can add a specific data point of interest without violating the Buyer confidentiality agreement.

By my reckoning, July 2010 represented the 12th consecutive month during which auctions were closed on EVERY trading day of the month. That’s pretty cool—a full year without a zero on the daily volume chart.

6. As I was considering the last twelve months activity, I looked back just out of curiosity, at the activity in the last week of July 2009 versus that of the last week of July 2010. What I found was interesting.

A high percentage of the Sellers active in the current period were also active in the year-ago period. Some of that seemed coincidental. Two Sellers, for instance, that were active in July 2009 have been largely absent from the exchange over the past several months but happened to pop up in the last week of July 2010. And their auctions were treated very well buy Buyers.

In a couple of cases, Sellers that were active in both year-apart periods found that their pricing in the 2010 week was much different than in the 2009 week.

My interpretation of that is that the Buyers are paying more attention to the updated financial statements, to the strength and payment records of the Account Debtors and to the likely duration of auctions; and they are adjusting their bids accordingly.

In other words, the analytic process is improving, at least among the Buyers that have been active for a while. That’s a good and healthy development.

7. While there was a surprising number of Sellers active in each of the two periods studied, there has also been an interesting pattern of rotation in the more-active Sellers over the intervening months. One Seller will be a major driver of volume for a few months and then go “quiet”, for instance. Some of these are seasonal issues. Some seem to reflect the Seller acquiring more traditional financing sources.

8. The positive aspect of the historical pattern is that when one major Seller goes quiet another tends to come along to replace it in fairly short order. The volume pattern of the last year should not be interpreted as continually building on a base of established and reliable Sellers (although there are certainly quite a few in that category).

Rather, the pattern is more like “rotation” in the equity markets. Leadership changes and Seller -participation changes for a variety of reasons, but the top-line trajectory remains strongly positive.

9. It is to the Exchange’s credit that, so far, there have been new leaders brought on to replace those who go quiet in a fairly seamless pattern.

10. The Credit Research Foundation has just published its newest quarterly “National Summary of Domestic Trade Receivables”, which is quite interesting. I’ll write about that in my next post.

In the meantime, pardon the misfiring synapses of an August Friday afternoon!

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.

Business As Usual

I started buying TRE auctions on June 1 of last year. The Exchange was still in its fairly early days of operation and each new auction posted seemed to represent something of an event.

There were two days in the first half of last June, in fact, on which no auctions closed. It certainly seemed at that time that there were more dollars seeking auctions than there were auctions to bid on. So “losing” an auction was, at least for me, kind of a big thing.

There have been many changes in TRE operations and dynamics since that time. By my count, over the same period in June of this year there have been five times as many auctions sold as last year and the average daily dollar volume has increased by a similar factor.

The number of Sellers has continued to increase and, while there are quite a few that don’t make it through our screen, there are quite a few that do. There is now a significant number of Sellers, in fact, that I’m quite pleased to buy from.

One of the happy consequences of the continued maturation of the Exchange is that it no longer feels like such a big deal when an auction is “lost”.

A year ago, the process of analyzing a Seller; analyzing it’s Debtor(s); reviewing the invoices posted; considering the past auction history; deciding to bid; and then actually placing a bid; represented not only a significant investment of time and energy but had an emotional component as well.

It represented a serious commitment. To fail to win an auction after all that actually felt something like a failure.

Well, times have changed. I “lost” two auctions yesterday that I bid on actively. I liked the Sellers. I liked the Debtors. I’d had good experience with each and I offered competitive pricing—actually a series of increasingly competitive bids.

And then those auctions, that I really assumed I was going to win, were just gone; snapped up at prices that I suspect pleased the Sellers quite a bit but left me empty-handed.

But here’s the point……

I didn’t get THOSE two auctions--but later in the day I got two others.

And I know that the Sellers of the auctions I lost are likely to be back very soon and I’ll have another opportunity to buy some of their invoices.

It’s no longer an “occasion” when a good auction is posted for sale. It’s business-as-usual. If I miss one today I’ll have another chance tomorrow.

On the other side of the coin, if a Seller has to pay a little more today because of the dynamics of this particular day’s activity, he can probably count on evening the score on a day when the Buyers are feeling the pressure to put money to work.

In short, what was a novelty a year ago is not a novelty today.

When I log onto the TRE platform tomorrow morning I will have every expectation that I’m going to have the chance to do some business.

Some days will be better than others. You win some and you lose some.

But that’s what a market is about, right.

And that’s what the Exchange has now really become.

When the Evidence Changes

The last decade or so of stock market experience testifies to the truth of the admonition: “never fall in love with a stock”. I confess that I have done that to my ultimate disadvantage more than once.

In essence, the rule tells us that it is perilous to ignore changed conditions; to hold fast to prior decisions when the premises of those decisions change.

Roughly a year and a half into the active life of The Receivables Exchange we’re now getting some information on some longer-term Sellers that allows us to chart the trajectory of their operations and financial condition over a few comparable periods.

(As an aside: I wrote last year suggesting that TRE make an arrangement with a credible academic institution to try to isolate and study the impact of the TRE facility on the financial health of its Sellers and I still think that would be a very useful long-term project!)

My point today, though, is to suggest a TRE analog to the stock market maxim. That is: “never fall in love with a Seller”. And to suggest the inverse, of course: “never hold to a negative conclusion when the evidence turns positive.”

As easy as it might sound, it’s still hard to do!

After analyzing a Seller. And concluding that buying from that Seller is a sound decision. And then actually buying a number of auctions from that Seller. And after getting paid properly for those auctions. It is difficult to look at new information that shows a deterioration in that Seller’s financial condition and conclude that the buy-decision needs to change!

In fact, for me, it is more difficult to “let go” of a deteriorating Seller than it is to re-evaluate one that I’ve previously found too weak. It feels a little disloyal. After all, everything’s gone well…..so far!

But one of the advantages that I’ve suggested the TRE model provides is that new information can be acted on immediately. I CAN stop buying from a Seller just as soon as new information suggests that’s the right course. And I CAN recognize positive changes in the condition of a Seller and immediately move them onto the “buy list”.

I just have to be willing to act dispassionately based on all of the information in hand.

I have “let go” of a couple of Sellers recently: reluctantly, I’ll admit.

And I have recently bought from a couple of Sellers that were previously on my “don’t buy” list.

So far, I haven’t seen any pattern in the follow-on financial statements of longer-term TRE Sellers. The business of some active Sellers has gotten better over the past year or so and that of others has deteriorated. But it’s far too early in the life of the Exchange, and the economic environment of the past 18 months has been far too tumultuous, to draw any BROAD conclusions at this point.

But the evidence does suggest that consistent re-evaluation is necessary as new information becomes available.

And that we can't assume that today's evidence will necessarily support the same conclusion as yesterday’s.

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!

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!









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Rational Irrationality?

Ori and Rom Brafman, in their fascinating book: “Sway: The Irresistible Pull of Irrational Behavior” write about an experiment used by a business school professor on the first day of each new semester.

He auctions off a $20 bill to the students in his class.

Sound simple? At the time the book was written the highest price paid in those auctions had been $204!

Now there’s nothing special about the bills themselves; there’s no rarity value involved. So why would anyone be willing to pay any more than $20 for a $20 bill?

The answer lies in the motivation of the bidders, which reflects the rules of the auction.

In these auctions the winner gets the $20 bill BUT BOTH the winner and the runner-up have to pay what they’ve bid.

The bidder who comes in second has to make good on his bid, but he gets nothing in return; while the bidder who “wins” has to pay up, but at least he gets the $20.

So the motivation is not actually winning the auction, it’s avoiding the greater cost of losing the auction!

When I find myself unable to explain in any rational terms the actions of an auction participant I have to step back and remind myself that what appears to be irrational might be irrational only from my own frame of reference. The “winning” bidder might be operating under rules or influences, unknown to me, that explain his actions quite clearly.

At this stage in the life of The Receivables Exchange there are too few auctions involving too few Buyers to allow us to confidently equate value and price. And it is certainly too early to assert that price and risk are in any way firmly associated.

As we wrote in our post of August 19: “One Buyer with a perceived ‘need’ to put money to work in any significant quantity could easily … create a pricing environment that is not informed by any real risk assessment.”

The actions of such a Buyer might be primarily motivated by the desire to avoid the perceived “loss” incurred by not deploying allocated funds. In that case the loss avoidance behavior is captured in winning a certain quantity of auctions essentially regardless of price or quality. The perceived “loss” of failing to win is greater than the potential loss created by paying essentially whatever is asked or failing to assess the risk assumed.

In that type of environment, the price at which auctions are won is not a valid measure of value. Bidder behavior is driven by something other than the value of the item being auctioned.

The professor in the Brafmans’ book found that in almost every $20 bill auction, most participants realized when the bidding got to the $12 to $16 range that the correct decision, even at a level still below $20, was to withdraw from the auction.

While either unknown motivations or non-economic motivations control market action, the rational response is just to “hide and watch”.

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 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!