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.

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.

More Evidence of a Turn

In my last post I reported that there was evidence in the bidding dynamic that TRE auction pricing levels were stabilizing. An excess of liquidity in the market had helped push Buyers' yields down substantially and consistently since last September.

But there was evidence at the end of January that the deterioration in yields might be ending. At mid-February that evidence is stronger.

By our calculations the weighted average expected returns for all auctions sold in the first half of February was essentially the same as that for all auctions sold in January. The deterioration in yields, at least in the short term, had ended.

That doesn't mean things can't change rapidly; but to add a few data points to the conclusion suggested by market-wide averages, let me offer the following:

1. The stabilization in yields has occurred on LOWER volume. Now, nobody can be too pleased with lower volume, but if yields stabilize on lower volume it suggests that the demand has decreased at a rate greater than supply. So some of the enthusiasm of the new Buyers in December and January might have been dampened as they came to realize just how low they had pushed returns.

2. The velocity of closings has slowed substantially. Auctions are remaining on the screen for hours or days, in some cases, rather than seconds.

3. Bidding has returned to the auction dynamic. More and more auctions are starting at higher bids and attracting competing offers before closing.

4. Some auctions are again being sold to multiple Buyers, suggesting the deeper-pocket Buyers are not quite as driven to hit the buy-out button on larger transactions.

5. Asking prices are starting to creep back up from their rock-bottom levels of a few weeks ago. This is not a uniform phenomenon but we're seeing it from some of the Sellers that had really tested the lower-limits of pricing structure.

6. One Seller who sold at prices at the lowest end of the spectrum just a few weeks ago, sold three auctions today at projected yields more than double those of its average January transactions.

Let me stress again that all it would take for these initial indications of a firming, and perhaps a turning, in the market would be for money-flow to resume its rise at a rate greater than supply.

That could easily happen tomorrow.

But today, and for the first half of the month, it seems possible that the bottom in yields has been found, at least for the time being.

And that feels good.

#350 and Whac-a-Mole

We bought our 350th TRE auction this morning. Of that number, 293 have been re-paid to date.

We have now bought auctions offered by 71 Sellers including invoices due from 162 Account Debtors.

The Sellers break down as follows, by type of business:

Service 39%
Manufacturing 32%
Staffing 13%
Technology 10%
Trade 6%

The Account Debtors break down as follows, by ownership structure:

Public Companies 37% (including subsidiaries and divisions)
Privately-Owned Companies 63%

Two auctions were sold this morning before we bought #350 that we WOULD have bought based on our view of the Seller, the Account Debtor(s), the transaction history and the pricing available. Neither of those became #350 because they were bought before we could see them.

I mean that literally.

I was at my desk, watching the activity, ready to bid. As soon as these auctions appeared I moved to pull up the bidding screen. Before the screen loaded, buy-out bids had been recorded.

For the past several weeks it’s become a “Whac-a-Mole” market.

The Buyer with the fastest internet connection and processor gets first chance at the auction.

That’s troublesome on many levels.

First, I’ve got to upgrade my tech capacity. But that’s just a symptom, really.

The real problem continues to be excess liquidity in the market. And that excess liquidity does not just drive down pricing. It also alters both Buyer and Seller behavior.

As I write, there are more live auctions on the TRE screen than there have been at this time of day for quite a while. But that’s the exception.

The rule has been that Buyers have been so motivated to deploy funds that they’ve been willing to accept ever lower returns with less and less evidence of deal quality.

A couple of days ago a deal offered by a first-time Seller, involving an invoice from a first-time Debtor, sold very quickly at a pricing level that would normally reflect a well-known Seller with a substantial amount of transaction experience with the Debtor.

That deal might well work out just fine. But sooner or later the odds favor disappointment from that sort of bidding.

And now it’s confession time:

I bought deal #348 yesterday morning. It was only the third time in 350 purchases when I said immediately afterward: “Damn, that was a mistake!”

It wasn’t a mistake because of the Seller. I’d actually been waiting for that Seller to post an auction for some time. I’ve bought quite a few of their auctions, I like them and they hadn’t posted an auction for sale in over a month.

It wasn’t a mistake because of the Debtors. I have had good experience with all of them.

And it wasn’t even a mistake because of the terms of sale. The price represented a much lower return than that Seller had offered in the past, but in the current climate I was prepared for that.

It was a mistake because I acted too quickly. I got into the Whac-a-Mole game.

I saw the Seller that I’d been looking for. I saw Debtors that I knew. I saw pricing that was marginal but at least it was marginal. And I acted.

Only after I “won” the auction and looked more closely at the invoice terms did I realize that the likely duration was too short to reasonably support the pricing parameters. The TRE fees were going to eat up much more of the gross return than was acceptable.

I had succumbed to the Whac-a-Mole motivation and in doing so I missed the duration issue that I’ve written about on a number of occasions.

To make matters worse, as I was berating myself for being so dumb, the same Seller posted another auction at the same pricing but with a likely duration that WAS reasonable and I couldn’t get to it fast enough to try to mitigate my error. It was gone before I could load the page.

In the end, I have every expectation that the auction will be paid properly. And it was small. I’ll make a little money and that one auction does no significant or lasting damage. Unless I don’t learn from it.

So, I acknowledge this dumb mistake publicly because the motivation to avoid another such public confession is stronger than the motivation to win at Whac-a-Mole!

An Interesting Snapshot

I was doing a little long-overdue organizing yesterday and one of the stacks of paper that I happened upon contained the printout of daily TRE auction results from this time last year. In fact, it contained the record of auctions closed on 1/11/10.

Since I came across it on 1/11/11 I thought I’d look at the two days, exactly one year apart, and see what I might find. The comparison was quite interesting.

Here are some highlights of the “snapshot” look at history:

1. There were 3.5 times as many auctions closed on 1/11/11 as on 1/11/10.

2. The value of the auctions closed yesterday was 2.6 times that of the closed auctions a year ago.

3. The average auction size yesterday was 75% of that in the 1/11/10 list. (From day to day, though, that number can bounce around quite a bit. The actual average auction size increased by about 50% over the course of 2010.)

4. Fully half of the Sellers that closed auctions on 1/10/10 are no longer active on TRE, which says something about the difficulty of the sell-side job for TRE. Churn is a real issue and net gains in volume mask the actual efforts required of the Seller-attraction team.

5. Interestingly, for our purposes, there was one Seller common to both days. That is, this Seller closed an auction on both 1/11/10 and 1/11/11.

Analyzing the year-apart auctions of that one common Seller we find:

• In both auctions, the Account Debtors were of good quality and had established payment records on TRE,

• The auction that closed yesterday was larger than the one that closed in 2010 but both were very close to the average auction size for the period in which they were closed,

• Both would be expected to have a duration somewhat longer than average.

• Our calculations of the likely returns to the Buyer of these two auctions suggests that the auction that closed yesterday would yield the Buyer a net annualized return of just over half (actually about 55%) of that expected of the year-ago auction.

Now, as we’ve written, we’re in a period of excess liquidity in the TRE market and a portion of the decrease in return to the Buyer can be attributed to that excess liquidity.

A portion of the decrease in return can be attributed to the fact that the Seller has continued, over the course of the past year, to sell auctions that have performed well.

And a portion of the decrease might be attributable to the maturation of the Exchange itself and a reduction in perceived platform-level risk.

But a (roughly) 50% drop in yield is a lot!

As one who believes that average yields are too low currently I’m quite interested to see how Sellers and auction pricing respond if and when we begin to move back toward a more balanced market liquidity position.

The Moderator Moderates

I’ve been quiet lately. Mostly that’s because I haven’t had much to say that I thought would be of value.

Volume growth on TRE has been sluggish.

Buy-side liquidity growth has not been.

I’ve been commenting since last September on the erosion in average yields. That trend accelerated into year end.

I’ve also commented on the increasing percentage of auctions being sold at buy-out pricing and at the speed of auction closings. Those trends also accelerated into year-end.

One has to ask if we truly have an “auction” market if the principal competitive issue seems to be who can hit the “Buy-out” button most quickly.

But there’s no mystery here.

The supply of Buyer money has increased more quickly than the supply of Seller auctions.

The cause of that can be debated. It’s clear that TRE is well aware of the issue. It’s clear, to me in any case, that TRE is taking steps to address the issue.

Time will tell if those steps are adequate to resolve the problem.

It’s also clear, though, that the situation is causing concern and consternation among the Buyers. My guess is that the earlier Buyers will be the most affected, having seen dramatic changes in both the pricing and the dynamic of auction activity.

Which brings me to the real point of this post.

As owner and moderator of this blog I have the option to screen responses to my posts before allowing them to become public and a part of the permanent record of the discussion.

I’ve gotten a few responses recently from anonymous readers that reflect frustration with the changed character of the auction dynamic.

I have no issue with the expression of such frustration: I share it.

But comments have been made and opinions offered that I am not willing to allow to be posted here without the writer identifying him or herself.

It’s not for me to provide a forum for anonymous TRE-bashing.

So here’s the deal.

I’m not going to allow egregious bashing to be posted—full stop.

I have no problem with reasonably-supported and civilly-voiced opinion, whether that’s positive or negative.

I have no problem with criticism, suggestion for improvement, the pointing out of weaknesses, etc.

But as moderator I reserve the right to set a price for a seat at the table. And that price, at my option, can be the waiver of anonymity.

I have no problem with anonymous responses, per se.

But if you want to “sound off” you’ve got to be willing to identify yourself.

We’re all professionals here and ought to be willing to own the opinions we voice.

So if you’ve sent in a reply to one of my posts recently and you don’t see it on the blog, I invite you to write or call me to discuss the reason why I haven’t allowed your reply to be posted.

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!

In the Way of St. Augustine

St. Augustine of Hippo is famously known for pleading: “Lord, grant me chastity-- but not yet!”

Augustine clearly viewed chastity as a good thing but he wasn’t quite ready to enjoy its benefits.

In the receivables purchasing business, getting paid is a good thing. But getting paid much more quickly than expected – not so much.

The “good” in a payment pattern is more a function of predictability than absolute timing.

Regular readers might now anticipate my returning to a pet peeve. But hear me out.

An auction that I purchased recently was closed out last week: paid as agreed; which, in itself, is certainly a good thing.

But it wasn’t paid either “as expected”, or “as advertised”. And that’s not such a good thing.

When I first started buying receivables in my spot factoring business I made the mistake of telling a couple of prospective clients that I was looking for invoices that would pay in the range of 45 days, give or take. It’s been my good fortune to have gotten many of my clients via referral from other clients. And it’s amazing how often I’m told that a referred prospect’s payment expectation is about 45 days!

Word spread from those initial clients, of course, that that’s what I wanted to hear—so that’s what I’m invariably told. But those prospective sellers are most often saying “45 days” when the truth is that payments will take LONGER. They know it and I know it.

The phenomenon I’ve griped about in prior posts with respect to TRE auctions is having invoices presumably due in 45 or 60 days that get paid in 7 or 9 days.

Why do I gripe about that? Not because it happens once in a while -- that can be just the luck of the draw.

But recently the number of instances of significant disparity between the posted payment expectation and the actual payment experience has been increasing. This is the case both in auctions that I’ve bought and in those I’ve just been monitoring.

The trigger for this post is that the auction I referred to above, which was paid last week, was “due” to pay out in about 30 days. In fact, the actual weighted average duration was 3.7 days!

The result was that my actual net earnings on that auction were roughly zero. That was a “successful” but still unsatisfying transaction.

I had bought several auctions from that Seller prior to the one I’m describing and all had performed as expected. I have actually been quite happy with the experience.

And as annoyed as I was with the result of that one auction, I was prepared to assume it was just bad luck. That for some unknown and unusual reason the Account Debtor just paid very early.

And so I bought another auction from the same Seller even before this one had closed-out.

The first payment on the NEW auction was made ONE DAY after the auction closed. The invoices that were paid were not “due” until mid September.

With that additional experience, as much as I have been pleased with the initial auctions bought from this Seller, I’m now going to have to stay away from those auctions until there is evidence that these are anomalous situations and that a predictable relationship between the posted due dates and the actual payment expectations can be anticipated.

The reason, of course, is that acceptable pricing changes significantly as the duration of auctions changes. This is particularly true in cases of very rapid payment.

The marginal impact on return of payments expected in 45 days but received in 30 is actually pretty minimal. But the impact of a payment expected in 45 but received in 10 is quite significant.

I am not suggesting that the Seller in this case deliberately misstated the payment expectation. I don’t believe that is the case. Actually, I suspect that this transaction will have been as unsatisfactory for the Seller as for the Buyer.

Because of the TRE fee structure, the costs to the Seller on this auction will have been as high on a relative basis as the return to the Buyer was low.

But there is a small number of Sellers whose actual payment experience appears to be consistently more rapid than “expected”. That creates a credibility problem—-for me, at least. And I’m no longer willing to bid on those auctions.

Ultimately it is to everyone’s benefit for there to be a rational relationship between the posted “due date”, the Seller’s posted “expected payment date”, and the actual payment experience.

I’m not suggesting that there won’t always be outliers in payment patterns, in both directions. Of course there will.

But when the pattern itself is of “outlier” events – it has to be the posted due date or posted payment expectation that is called into question.

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!

Remembering Jerry Maguire

There’s a great scene in the movie “Jerry Maguire” in which Tom Cruise is pleading with a prospective client. He says, again and again:

“Help me help you. Help ME help YOU!”

Without Cruise’s inflection it sounds a little flat but he was really PLEADING.

Suspend disbelief for a moment and let some of that pleading tone seep into your reading of this post!

In my June 30 post I complimented the TRE management on the job they’ve been doing at getting Sellers to post updated financial statements in a more timely manner (as required, by the way, in their program agreements). It’s an issue that I and others, I know, have been concerned about and things are moving in the right direction.

Now I’d like to make another suggestion. I can’t communicate directly with TRE Sellers. That’s not allowed. So I’ll make it in this forum and hope that it somehow gets transmitted through other channels.

Here’s the issue…..

As I sit here, there is a live auction on the platform that I might well be interested in, EXCEPT that the updated financial statements show what is to me a serious and inexplicable trend in the ratio of accounts receivable to gross sales. The number is so far out of the ordinary and the trend is so definite that, without some explanation, I just can’t bid.

The Seller MUST recognize that this is a red-flag item.

Absent some other explanation I have to assume that there is an unappealing reason why receivables are such an unusual percentage of sales. But maybe there IS another explanation. If the Seller were encouraged to post an explanatory note that solved the riddle, there might be a greater level of interest in its auction.

So.....“XYZ Corp, help US help YOU!”

Give the community of Buyers SOMETHING to explain the weird numbers!

I met the other day with a colleague and, among other things; we discussed some of the companies on my “bid vs. no-bid” list. In scanning my list he saw a name that I had categorized as “no bid”.

My colleague happens to know this company and its background. He told me that, while he is aware that they’ve had a history of very substantial losses and have a current a balance sheet that ”must look horrible”, he suspected the company’s backers were quite willing to continue funding it.

That’s information that is not available from the material provided on the TRE platform, from the credit information I had obtained on the company or from the data available from a quick online search. (I admit that, given the looks of the financial statements, I did not spend a great deal of time trying to find reasons to qualify the Seller.)

But in this case, too, some explanatory notes from management could be made available on the TRE platform to help Buyers understand in a more nuanced way the financial situation of the company.

And helping Buyers understand the Seller’s situation will ultimately help the Seller.

One more example and I’ll leave this alone.

There are several Sellers that have very substantial, unexplained, Intangible Asset entries on their balance sheets. In some cases the only net equity on the balance sheet results from these intangibles.

With no explanation of the nature of the intangible it’s hard to give its stated value any significant credence. A note of explanation COULD make the difference between having many interested Buyers vs. few and an attractive pricing vs. one less attractive.

The nature of the relationship between TRE Buyer and Seller is unusual. We can’t pick up the phone and ask the Seller questions. But the answers to some obvious questions could be of real benefit to all parties.

So, while I have no standing to make a request on behalf of all Buyers, I’ll say to both the Sellers and to TRE:

"Help us help you!”

Added clarity on financial statement items that are obvious red flags can only benefit the Sellers.

The Very Good Gets Much Better

One of the first items I discussed on this blog was the advantage of the Louisiana treatment of receivables transactions. The so-called “true sale” provision of the LA version of UCC Section 9 largely removes the potential that a purchase of receivables might be subsequently deemed a financing rather than an asset sale.

That’s a big deal and one of the reasons that TRE chose New Orleans as its headquarters.

Now that benefit has been significantly expanded and essentially “tailored” to specifically include transactions on the Exchange.

Governor Bobby Jindal took time out from his work on the BP oil spill to sign into law Louisiana Senate Bill No. 256 (Act 958) entitled the “Louisiana Exchange Sale of Receivables Act”.

The title of the law itself signals one of its principal benefits to TRE.

It does not apply to ALL transactions involving receivables sold in Louisiana. Rather, it deals only with those receivables transactions that take place “over electronic and other types of exchanges located in” Louisiana.

In other words: transactions that occur on TRE.

To make its aims quite clear, the stated legislative intent is specific i.e. “to encourage and promote businesses to offer sellers the ability to sell their receivables to qualified buyers over electronic and other types of exchanges in this state, thereby availing themselves of Louisiana civil law principles not found in common law jurisdictions…”

A few of the new advantages accorded exchange-based transactions are:

1. Clear and specific language affirming that exchange-based transactions are included under the very strong “true sale” protections already in the Louisiana law.

2. Clear and specific language affirming that exchange-based transactions will not be re-characterized as financing transactions even when seller-guarantees of repayment are provided and even when the seller might be entitled to subsequent additional payments for the receivables sold.

3. Clear and specific rejection of common law theories under which sale of receivables have been considered financing transactions in other jurisdictions.

4. Expansion of the definition of “receivable” to include other third-party domestic and international payment obligations that are not subject to the Uniform Commercial Code.

5. Provisions requiring anyone who attempts to re-characterize receivables transactions as financing transactions to pay the exchange-buyer’s costs to defend itself.

6. Clear, strong and specific language regarding the application of Louisiana law, and of these provisions particularly, regardless of the legal domicile of the seller, the buyer or the account debtor.

7. Provisions making clear the right of a buyer of exchange-traded receivables to resell the receivables purchased and to pledge or grant a security interest in the receivables purchased: in other words, facilitating a buyer’s securing financing to purchase exchange-traded receivables.

I again remind everyone that I’m not a lawyer, but as I see it there are some really big things in this bill, which should probably be titled the “Let’s Help TRE As Much As We Can ” Act.

Clarifying the “true sale” status of exchange-traded transactions is a very good thing. And this is the principal benefit discussed in the press release from TRE on this new legislation.

Specifically prohibiting re-characterization of exchange-based transactions is a good thing.

Providing for buyers’ entitlement to recover costs is a good thing.

But, from my point of view, the really BIG things in the bill are:

a) The expansion of the definition of “receivables”. This is not discussed in the TRE release but opens the door to new markets that could be of major benefit to the Exchange and its participants.

b) The specific provisions allowing exchange-traded receivables to be pledged as security. This will certainly aid those buyers looking to obtain leverage without pledging other assets as security.

c) The provisions that basically say “our law is THE law and the rest of you can go to hell”. The language of the Louisiana legislature is very strong on this point and while there has not been, to my knowledge, a test of the choice-of-law provisions in the TRE participant agreements, this language looks to have been crafted by a lawyer wanting to pre-empt any challenge of those provisions.

The “true sale” issue is obviously important but I think these three provisions might actually provide the more important springboard for TRE’s growth.

My guess is that we’ll see some creative use made of these new provisions sooner rather than later.

Congratulations, TRE! And congratulations Louisiana!

Well done.

An Important Contingency

In the arcane world of receivables purchasing, there is a small corner of the industry that is even more arcane than the norm.

I’m referring to construction trades and to the various disciplines; such as architecture, engineering and other related fields that service or interact with the construction trades.

Often these professional services firms work for owners, including governmental entities, via subcontracts from firms that hold the primary contracts.

An example, for instance, is a client of mine: a cost-estimating firm that typically acts as a subcontractor to architecture or engineering firms. Sometimes the ultimate source of funds is the developer of a real estate project; sometimes it is a governmental or quasi-governmental entity contracting for public works projects.

I’m not going to attempt to describe the unusual problems raised in buying construction invoices. That is beyond the scope of a post like this. But suffice it to say that there are good reasons why construction invoice purchasing is a small and specialized sector of the factoring community.

The issue I want to address today is the frequently contingent nature of payment obligations in the construction or associated professional service businesses. Specifically, the impact of “pay when paid” or “pay if paid” clauses frequently found in contracts with those businesses.

These payment conditions are usually quite clearly stated and the substance of the language is enough to give any buyer pause.

In concept, they read, for example: “We’ll pay you WHEN we get paid” or “We’re only obligated to pay you IF we get paid.”

I am not an attorney and this is not to be understood in any way as legal advice, but those of us who do get involved in buying invoices from businesses like these are usually very quick to ask for a copy of the contract provisions dealing with payment, regardless of the apparent strength of either the Seller or the Account Debtor.

If either of these provisions is found in the contract, the first thing that a prospective Buyer can do is forget any stated due date on the invoices being reviewed for purchase. Those dates just don’t really matter.

The second thing that a Buyer might do is to request a full history of the invoices submitted and payments received under the contract in question.

The third thing might be to determine how the law in the applicable State treats “pay when paid” and “pay if paid” clauses. There has been a substantial amount of litigation on these clauses and there is not an answer that is universally applicable.

Some state courts; those of New York and California for instance; have ruled that a “pay IF paid” clause is against “public policy” and is unenforceable in those states. So a “pay IF paid” clause will be treated as a “pay WHEN paid” clause in those jurisdictions.

But what does that mean? In general, I understand that has been held to mean that payment will be made within some “reasonable” period. The effect of that, it seems to me, is to render the due date on an invoice essentially moot.

Other states have ruled that “pay IF paid” is an enforceable condition under certain circumstances. That’s scary.

When an invoice is posted by a TRE Seller whose business is like that of the client I mentioned above, for instance -- that might work for an architecture or engineering firm or for a construction manager – whose source of funds for the payment of subcontractors’ work is a third-party; it is very important to understand the payment provisions of the contract.

Currently, the Sellers on TRE do NOT post information that would allow a Buyer to determine whether the invoices being posted contain “pay when paid” or “pay if paid” provisions. If the Seller is in the type of business in which contracts often contain those clauses, the Buyer might be assuming an unknown and un-priced risk.

The point?

In some cases, regardless of the apparent strength of the Seller or the Account Debtor, or the validation of the invoice, or the satisfactory completion of the work required for payment, it is still possible to be exposed to either non-payment or very late payment.

Awareness of that possibility is the first line of defense.

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.

The Quality Issue -- Again

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Luddite Trajectory

Lud•dite (lŭd'īt) n.

1. Any of a group of British workers who between 1811 and 1816 rioted and destroyed laborsaving textile machinery in the belief that such machinery would diminish employment.

2. One who opposes technical or technological change.
[After Ned Ludd, an English laborer who was supposed to have destroyed weaving machinery around 1779.]

I have to confess these things:

• I remember when the first ATM’s became available and I was unwilling to use them to make a deposit.

• I remember when electronic deposit of paychecks became available and I was unwilling to trust it; preferring to have a paper check in-hand on Friday afternoon.

• My first job was with a large financial institution in an investment department that routinely took weeks to process transactions because so much analysis was done via calculator. We had access to a leased-time mainframe computer which my boss never failed to term “the confuser”.

The Luddites could not change the course of the industrial revolution. My resistance to changes in banking technology was fear-driven and counterproductive. My first boss rendered himself obsolete (or “redundant” in the land of Ludd) in a few short years.

So, where is this going? Three data points:

The first:

I read a report from a British business newspaper this morning about the difficulty that smaller businesses are having collecting money owed them. The reporter made the point that a large percentage of the affected businesses had done nothing yet to change their processes to cope with the cash flow problems.

But, he reported, “9% have turned to invoice discounting and 8% have used factoring”! That was presented in a way that implied that the numbers seem small!

In the US market, achieving a 9% penetration in the invoice discounting business would translate to (at least) tens of billions of dollars of additional employed capital in the industry.

The second:

In this week’s edition of The Economist, also a British publication, an article on small business finance appeared, entitled “Markets for Minnows”. Among the points it makes are:

• Large businesses in developed economies can once again raise capital with ease, principally via the bond market.

• Spreads on loans to smaller businesses (however) are at their highest level in a decade.

• US banks holdings in commercial loans fell in the first quarter at an astonishing annual rate of 21% (this as we are supposed to be in recovery mode).

• Syndicated lending to medium-sized business is at less than half of peak levels.

• “Demand for factoring has fallen over the past year because businesses had fewer invoices to pledge, but is likely to rise sharply as small businesses struggle to finance an upturn in orders….”

• The head of Wells Fargo’s trade capital division sees the factoring market growing by 6-8% per year.

• “Another new form of invoice-based financing is The Receivables Exchange…..which helps users to overcome…the decline of traditional small-business finance and the stretching out of payment by their customers…”

The third:

• An article in last week’s Wall Street Journal (4/15 p B6) analyzed the extent to which small businesses, prior to the housing bust, depended on tapping real estate equity for working capital.

• In 2007 one survey showed that “30% of respondents tapped home loans for funding” their business working capital needs.

• In 2009 that figure had fallen to 7%.

• Based on that comparison, alone, 23% of small businesses have, in a very short time, lost access to one of their principal funding sources.

There is no question that small business MUST find alternate sources of working capital if they are to survive and prosper!

Last month we saw Morgan Stanley identifying TRE as a new and potentially important player on the invoice discounting landscape.

This month The Economist gives it prominent mention as an alternative.

Just last week I was shown promotional material of a company that appeared to be marketing a “copycat” program, which on further investigation actually offered nothing but some additional potential visibility for the Exchange, itself.

Here’s my take-away:

The British and the Europeans, in general, are far in front of the US in the adoption of invoice discounting in the SME community. We can and should learn from them (just this once).

Wells Fargo, now the largest player in the domestic factoring market, sees a 6-8% growth rate in the traditional-factoring sector of the business. That’s hardly a steep growth curve from present levels and hardly an answer for the smaller end of the market.

The SME market for invoice discounting in the US, while relatively immature and small, is one of the only avenues that will be available to meet the financing needs of the SME market going forward.

TRE, for all that it is neither perfect nor mature, offers a true alternative; efficient and scalable.

If it could provide the mechanism to take the US market just halfway from its current invoice-discounting penetration to the 9% level found in the British study quoted above, it would represent a significant avenue for employment of capital, a meaningful stimulus of economic growth and an important engine for job creation.

It took me a couple of years to trust ATM machines and electronic deposits. But thankfully both the world and I change faster now.

New questions are asked. New challenges posed. And in the great American tradition, new answers become available.

The job is to introduce the question to the answer.

Sizing It Up

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

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

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

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

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

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

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

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

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

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

That’s a big number!

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

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

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

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

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

That’s clearly a market worthwhile pursuing.

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

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

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

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

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

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

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

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

The Diet of 900 lb Gorillas

In my post of March 11, “The Perversity of the Possible”, I wrote about large companies unilaterally changing payment terms for their obligations to suppliers.

My thanks to Dave Schmidt for his response to the post and confirmation of the problem!

Coincidentally, a report by Morgan Stanley was released at about the same time. It offers Morgan’s help to large firms in devising programs to leverage their cost-of-capital advantage to essentially squeeze discounts out of their suppliers.

This is presented as a win-win proposition, but that’s clearly just a smoke-screen.

Morgan Stanley’s suggestion is really that large firms with excess cash or credit capacity propose to pay suppliers early at a 4% discount. For those who chose not to participate, the unacknowledged flip-side would be a lengthening of payment terms.

Morgan uses relatively large print and bold typeface to trumpet its conclusions that these transactions increase profitability of BOTH the large companies that would be Morgan’s clients and their suppliers.

In the small-typeface, cramped-format analysis, however, we find that the assumption on which these conclusions are based is a 100-day acceleration of the supplier’s payment!

What is Morgan Stanley saying here?

It is saying that the large company, the 900-lb Gorilla, will force the supplier to either take a 4% discount or wait 100 days to get paid. This is very close to the situation I described in my March 11 post.

Let’s be clear, here. This is in no way an attempt to find a win-win solution. This is Morgan offering to coach large companies in the fine art of squeezing small ones. As if that were necessary!

To put an even finer point on it—this is Morgan Stanley offering to provide 3rd party justification for such squeezing so that the leaders of the large companies have the cover of expert advice as a defense for their actions.

Now, the Morgan report does introduce The Receivables Exchange as a potential alternative to using the large companies own excess working capital capacity. Its presentation of TRE and its process and benefits is flattering (if not completely accurate). And that is a good thing for TRE.

But the point of their bringing TRE into the report is as a thinly-veiled option for squeezing the suppliers WITHOUT using the large company’s own working capital.

They’re saying, even if you don’t HAVE the excess capacity yourself, you can STILL force extended payment terms on your suppliers by simultaneously suggesting that the suppliers utilize TRE to compensate for the extended payment terms.

Make no mistake. Morgan is not in this to help the supplier.

The Morgan report explicitly states that it is not a product of their research unit. This is a marketing initiative to help Morgan generate fee revenue by coaching large companies in the creation of accounts-payable strategies that increase their own profits at the expense of their smaller, weaker and less-well-capitalized suppliers.

I’m sure that Morgan publishes a list of its annual charitable initiatives. This isn’t one of them!

In individual or isolated instances, squeezing the suppliers as recommended by Morgan can work. It cannot work as a wide-spread, systematic shift in large-company AP strategies. At least, not without compensating pricing adjustments.

There might be room in the forest for one or two 900-lb Gorillas. But if all gorillas were that big there wouldn’t be enough food to sustain them, and some would have to die off or change their diet in order to restore balance.