Appropriate Compensation #1

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

We’ll take value where we can find it.

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.

It's a Balancing Act

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

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

What do we mean by quality?

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

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

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

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

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

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

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

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

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

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