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 Quality Rating Question

The credibility of credit rating agencies has taken a major hit during the financial turmoil of the past year. In most cases the credit rating agencies had before them audited financial statements to work with in making their judgments.

In some cases, the judgments themselves seem to have been faulty. In others, the data given the agencies has been faulty, even if audited.

PriceWaterhouseCoopers recently published its “Global Economic Crime Survey 2009”.

Quoting from their report: “…nearly one in three organisations around the world reported they were the victims of economic crime during the past 12 months. Of those, 43 percent said that the incidences of fraud in their organisations had increased during the period…Asset misappropriation or theft, cited by 67 per cent of those who reported crime, was the most pervasive, followed by financial statement fraud, cited by 38 percent…”

A representative of the accounting firm commented: “The global economic downturn has heightened the pressures and incentives to commit fraud…In these tough times, the temptation to inflate results or take part in other forms of financial statement fraud may overcome ethical values…”

If there is pervasive opportunity for misstatements among larger, more closely-scrutinized companies, how much greater is the opportunity among smaller, privately-owned businesses whose financial reports are not audited, or in many cases, even reviewed?

Add increased opportunity to increased incentive and the tests of “ethical values” are likely to be even more severe.

We’ve commented more than once in past posts about the fact that most TRE Sellers do not provide audited or reviewed financial statements. We’ve also made the point that it is the SELLER that makes the promise to re-purchase an unpaid invoice. The credit of the SELLER is actually more important in the TRE format than in many other factoring formats.

It is the nature of privately-owned businesses, many of which are in S-Corp or LLC formats for tax purposes, to allow tax considerations to influence financial reporting practices. It’s not unusual or even unexpected to be told that getting a picture of the “real” operations and profitability of such a company requires the books to be adjusted.

Some of the financial statements provided by TRE Sellers show obvious signs of such “adjustments” and some of those adjustments appear to be made clearly in order to present a more palatable view of their operations to TRE Buyers.

There’s not necessarily anything wrong with that!

The picture that a privately-owned business presents for tax purposes might actually be a seriously unfair view of it as an operating entity for any number of reasons.

But, to the extent that getting approved as a Seller on the Exchange provides incentive for erring on the side of optimism, the prospective Sellers have both opportunity and incentive to overstate their financial health. And that clearly increases the risk to the Buyer.

TRE has, on its staff, former FBI experts in detecting financial fraud. That’s a good thing.

A better thing, in my opinion, would be to also have a third-party rating entity on contract to examine all of the financial statements provided by Sellers and prospective Sellers and to attach quality ratings to all Sellers posting auctions for sale on the Exchange. Since Buyers are prohibited from contacting Sellers directly, there is little realistic opportunity for Buyers themselves to question financial statements provided by Sellers.

The Sellers have a conflict of interest that is clear.

The Exchange itself has conflicting incentives: a) it needs to bring in a substantial volume of new Sellers and so it needs to make the process as easy as possible for them, and b) it needs to protect against embarrassing defaults and losses.

A third party, without such conflicts, would provide the more credible solution.

Does the admittedly tarnished reputation of rating agencies, in general, damage the credibility of that suggestion?

I don’t think so.

There’s no Fannie Mae or AIG or Lehman Brothers, with the clout to bully a rating agency, among the smaller, privately-owned TRE Sellers. If anything, the balance of power between the rating agency and the Sellers would probably invert the opportunity for pressure in the process.

Any Buyer that has looked closely at the financial statements provided by TRE Sellers would, I wager, agree that a third-party assessment would be both welcome and valuable.

Maybe there's a Smyth Solution possible?

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.