The Failure of The Receivables Exchange - A New Book

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

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

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

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

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

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

 The book is called,

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

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

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

 All the best. 

 Chuck

The Fat Lady Sings at Five

That’s not five o’clock in this case: it’s five years.

The first TRE auction to close was sold on November 24, 2008. So its 5th anniversary was just marked.

In the months following that first auction there were quite a few days on which no auctions were sold. It took some time for the exchange to gain any real momentum.

But the last day on which NO auctions were sold on the TRE platform (according to my records, in any case)was June 19, 2009.

Until today, that is.

I’m no longer an active TRE Buyer and so my information isn’t as good as it once was. But it’s good enough to know that no auctions are indicated to have been sold on the SMB platform today.

None.

And that’s not all. It appears that there are NO bids pending on any of the auctions that currently sit waiting on the platform for Buyer attention.

Which means, of course, that there IS no Buyer attention.

Volume on the SMB platform has been falling steadily over the past year. Over the past couple of months the volume numbers have been about 1/3 those recorded in the peak period prior to the management changes in 3Q 2012.

Does that suggest that there is also no management attention to the SMB business?

I suspect not. I suspect that the attention of management was acutely on the SMB platform – until it was not.

And why did that attention wane, and then apparently cease? Or did it just change form and focus? One can only speculate.

More on that later.

Don't Believe Everything You Read

It’s an interesting phenomenon that the average daily page-view statistics for this blog have increased since I stopped writing on a regular basis.

It’s instructive to watch the activity and to see which topics are drawing most attention as time passes.

The two general areas of discussion that seem to be of greatest interest are:

a) the size of the potential market, and

b) the assessment of risk.

So I’m going to come out of retirement to make a few points that I would want to make to anyone reading what I’ve written in the past.

(Caution: This won't be the only post-retirement post!)

First, I need to acknowledge an error in logic and analysis that anyone reading my prior analyses of potential market size should consider.

In the posts I wrote regarding potential market size I used data sources that could be verified and methods of analysis that I considered sound. However, I missed a step in the analysis that was critical and that I would caution others not to miss.

That step is an assessment of the ability of a business to pay for the liquidity it needs.

The potential size of the market for TRE, or for any other invoice-factoring entity, must be constrained by a reasonable assessment of the ability to pay.

If a business or an industry tends to operate on a pre-financing margin of 15% of revenue, for example, and it needs outside financing of about 75% of its costs; then it needs financing of about (85% x 75% = ) 64% of revenue. If it has to pay an annualized 25% all-in cost for the funds needed, the cost of financing essentially absorbs its entire margin.

Now, I know that’s a little simplistic and I know the arguments in favor of the spot-factoring solution. I’ve made them myself and they are perfectly valid in many cases, but usually in the short-run.

In order for such a solution to be viable on a long-term basis, the cost of the money has to bear a reasonable relationship to the margin generated by the business being funded. And when margins are being squeezed and money is most commonly needed, the price of the money rises; it does not fall.

The business owner can make short term adjustments and defer other expenses for a while. But he cannot do that forever.

Either the price of money changes, or the business changes its pricing model or its cost structure. But if those avenues aren’t available, the business owner is in an untenable position.

So, the two questions that have to be asked and answered in getting to a final number on potential market size are:

What is the anticipated all-in cost of the financing solution under study? and

What portion of the defined market segment can actually afford to pay that price for liquidity?

All else equal, the higher the cost of money (including exchange fees in the case of TRE) the smaller the size of the potential market.

And, the higher the margin commanded by a particular business or type of business, the less likely it is that it will need financing on an ongoing basis.

The textbooks tell us that the higher the risk, the higher the required return.

In this scenario, the higher the required return, the more likely that cost of money causes default.

So, what is the size of the potential market for TRE?

The answer has to be multiply-determined, with cost of funds and ability to pay among the determinants.

Whatever the number is, it should increase as cost declines.

Swans Do Not Sing Sweetly

The term “swan song” has come to mean “a final gesture, effort or performance given just before death or retirement”. Early in its history the term became associated with the myth that such a final song was expected to be soaringly beautiful and moving.

In fact, the noise that a swan makes both during and at the end of its life is not sweet at all but rather a kind of “honking, grunting and hissing.”

The swan song of the TRE Observer is neither the sweet and beautiful finale of the myth nor (I hope) an unlovely grunting and hissing.

It’s more a weary sigh.

In a few days TRE will mark the 4th anniversary of its first auction.

It’s been a long 4 years!

A lot has happened: some of it good, some not. A lot has been learned: some lessons have been expensive, some maddening and some just disconcerting; but all have been instructive.

Our interest in TRE, aside from the purely intellectual, has been in its potential to support an asset management business whose revenues would be generated from investing in TRE auctions on behalf of those who would pay a fee for the service.

Four years on, we are not close to the point where that is a feasible proposition. Maybe four years from now it will be, but we don’t have another four years to invest in the experiment.

So we are bowing out.

There is a lot that can be said about the reasons that TRE volume has disappointed. (It now looks like the exchange might achieve in 4Q 2012 the annualized volume projected for 4Q 2009.) And it’s hard, having spent so much time and effort on this project, to see a recent uptick in new Seller acquisition and in total auction volume and say it’s just “too little too late” for our purposes.

Bu it is, in fact, too little and too late for us.

Current returns from TRE auctions are roughly half the level we saw in the first few quarters of our experience with the platform. All else equal, that doubles the size of funds-under-management required to generate a minimal level of gross income to the asset management function.

That compounds the problem created by the much slower than expected volume ramp.

It might be argued that, after a summer of very low returns caused by excess liquidity, the current volume increases; coming as they do with concurrent yield increases; ought to make us willing to wait a bit longer. After all, we’ve lived through the lean times: why sit out the fat ones?

Well, as Aunt Bertha said, fat is relative.

It’s true that increased returns do compensate for some increased risk but, as I’ve written to my partners, we’ve just moved back from the ridiculous to the marginal.

But auction risk is not the only one faced by the TRE Buyer. While increased return might better compensate for some of the auction risk, it does not compensate for increased organizational and management risk.

TRE management changes have inserted a critical unknown into the risk equation.

It is quite possible that the future direction of the enterprise will be constructive for both its owners and its participants. We sincerely hope that it will. But it’s also possible that it won’t.

New leadership will take time to grapple with the issues that have hindered the healthy growth of the business. It will take time to decide how to move forward and even more time to determine whether those decisions have been correct.

If all goes well and those decisions are correct and their execution is disciplined and effective, then maybe a volume level sufficient to support an asset management business might be reached in a few more years.

But there’s also a chance that all will not go well -- and if it does not, the next move of the owners is unpredictable.

I began my investment career in a very bad real estate market. It became a commonplace during those years to observe that it might be the second or third or even fourth owner of a project who would ultimately make money from it.

The same is true, I believe, in the case of TRE. I continue to believe that the TRE concept was brilliantly insightful. But management did not execute as brilliantly as it dreamed.

Maybe the next generation will -- or the one after that. But, like a number of the very talented people brought together in the initial TRE team, who just couldn’t wait any longer, neither can we.

So, with all best wishes to TRE, to its owners and managers and to the communities of Buyers and Sellers with whom we’ve had the pleasure of exchanging ideas and support, the TRE Observer now signs off with a swan song that is neither soaring and lovely nor a grunt and a groan; but just with a bit of a weary and hopefully wiser sigh.

Good luck, and be careful out there.

(In)appropriate Compensation

In a series of 12 previous posts I wrote about the issues that seemed to me to affect the level of compensation a TRE Buyer should receive (or require) in exchange for taking the risk of supplying liquidity to TRE Sellers via the Exchange platform.

That series of posts ended on a rather inconclusive note because experience did not, at that time, allow an estimate of risk that seemed clearly well-supported.

There is no difficulty IDENTIFYING risks that face the TRE Buyer.

There are a number of quite significant risks the Buyer assumes and there is little argument that can be offered about their existence.

The issue is QUANTIFYING those risks, at this point in TRE history, either individually or in aggregate.

We know without question, for example, that unaudited, management-generated financial statements are more likely to contain errors or misstatements than are audited financials.

What level of incremental return should be required of a Buyer to compensate for that risk -- well, that’s the more difficult question.

The last of the series of "appropriate compensation" posts was written in September, 2011. At that time it seemed to me that we were still in an auction environment that justified serious examination of questions such as the incremental risk posed by different invoice verification methods and the presence or absence of Seller personal guarantees, for example.

The implicit assumption was that we were working within a pricing environment in which “appropriate” compensation was actually in view and that the adjustments required for the incremental risk issues were within the realm of reasonable discussion and expectation.

We are no longer in that environment.

Returns on TRE auctions have not just continued to trend lower. They have plummeted.

The average implied return to the Buyer from auctions sold in June fell by nearly one-third from their year-earlier levels and by roughly one-half from their level of 18 months earlier.

I have commented on more than one previous occasion that the risk management functions of TRE have been strengthened significantly over the past couple of years but, in my view, those improvements resulted in a movement to a level of risk that had already discounted their presence.

That is – risk was being previously underestimated and underpriced, in my opinion, and the improvements made by TRE management, significant though they have been, have just brought reality closer to prior expectation.

The compensation being accepted by TRE Buyers in today’s auction environment does not adequately compensate for the risk being assumed.

And as much as the June numbers were inadequate, a plot of initial July results looks like the trajectory of an egg rolling off a kitchen table.

That’s a trajectory that ends badly.

Thoughts at Three

This week marks the 3rd anniversary of this Blog. The pace of new posts has slowed in recent months for two reasons:

1) the structure and mechanics of TRE have already been discussed and there’s no value in repetition for its own sake, and

2) much of what I have not discussed I can’t discuss because of the confidentiality provisions of the TRE Member documents.

But I can’t let the anniversary pass without comment so I’ll share today (in my 118th post)as much of what’s on my mind as I am allowed.

I began observing TRE as a lurking Buyer in April 2009 and I began to actively bid on auctions as of June 1, 2009. Since that time I have bought all or part of 836 auctions of which 780 have been closed-out.

Those auctions have been purchased from 120 Sellers and included invoices due from 346 Debtors.

Total TRE auction volume over that period (in dollar terms) has increased ten-fold.

During that period, pricing parameters have changed significantly. The average implied net return to TRE Buyers today is roughly half what it was 3 years ago.

A ten-fold volume increase over 3 years is substantial but still it falls short of initial expectations.

I suspect that the ramp of volume is about 2 years behind initial projections. And, since a portion of TRE revenue is dependent on returns; as returns have fallen, the break-even TRE volume requirement has risen.

TRE has learned a LOT over the past three years. I’ve been quick to compliment its management in the past when I thought that was due.

The positive point that I would make today is that I think TRE is light-years ahead of where they were three years ago in the assessment and management of risk in the transactions that are sold on the Exchange. There is still plenty of room for improvement but I don’t think it can be denied that much progress has been made.

I think the Buyers who have stuck with TRE over the past three years would agree with me and I suspect that the drop in yields reflects, in part, an assessment by the Buyer community that transaction risk has fallen.

Unfortunately, though, I think that change in risk assessment only partially explains the drop in returns.

I’ve written previously about periods in which excess liquidity has been the principal driver of TRE pricing. We’ve been in such a period, in my opinion, for the past several months.

Watching the auction activity day after day for a long period is an instructive (if sometimes frustrating) exercise. But it does allow buying and pricing patterns to be observed. And the recent patterns are pretty clear.

There are active Buyers with substantial appetites whose motivations are clearly volume-driven rather than return-driven.

When “buy out” pricing is hit on multiple auctions nearly simultaneously the odds are that it is the activity of a single Buyer with a desire to deploy a certain level of funds right away.

So, what’s wrong with that?

There’s nothing wrong with the activity itself. It does give Sellers the "all clear" to continue to reduce pricing and it does make it hard for them to return to reality when the dynamic changes. But that’s ultimately what an auction market is about.

There is something “wrong” with what the pricing dynamic implies for the exchange, though.

Today’s auction activity does not suggest that TRE is becoming the “disruptive” force in the receivables market that I suggested it would be in my first post three years ago.

Even at current volume levels; even though they are 10 times what they were; TRE has captured only a very small percentage of the receivables market and only a small part of that has come by way of attracting Sellers from the more conventional factoring market.

While some investment vehicles have been formed for the sole purpose of trading receivables on TRE, the current volume and pricing levels do not make a stand-alone TRE investment vehicle an attractive proposition. It’s just not big enough and does not generate enough Buyer-revenue to support such entities.

So why is there excess liquidity? Doesn’t that suggest attractive economics?

The key to that question is: “attractive for whom?”

For Buyers whose principal business is not receivables financing; that have excess cash earning nearly nothing; putting some money to work in short-term, TRE-traded paper might look like an attractive proposition. They might be able to get several hundred basis points of “excess” return on cash balances. When the alternative opportunity is a zero return, the bar is not set very high.

But that is not the kind of healthy buying that will support the long term growth and success of TRE. It’s just “getting by”.

In the scheme of things, the amounts being invested in TRE don’t yet represent rounding error in the financial markets. Volume needs to grow by another ten-fold and pricing needs to make sense in the context of the risks and costs of receivables financing, rather than as an alternative to “zero”, if TRE is to realize its potential.

So why is TRE in the position it is in today i.e. a great idea that hasn’t yet been realized?

I think it’s because of two major, and maybe fatal, strategic errors:

1. The founders chose to alienate the traditional receivables-finance industry rather than to become a part of it and seek to change it from within, and

2. The founders adopted a “Henry Ford” mentality. (Ford famously said his customers could have any color car they wanted as long as it was black.)

Both errors represent a product vs service mentality.

Facilitating a transaction is fundamentally a service function.

The TRE platform and process is not a market: it is a means of facilitating a market. The difference is critical.

The seller of a service approaches its customers with an attitude of: “we can help you accomplish something that is important to you”.

Henry Ford had the attitude that he knew best and the customer could take it or leave it. That only works if the customer has no choice.

If TRE had approached the receivables-finance market as a service provider rather than with the attitude of a product monopolist, things might well be different today.

I know that others who are planning receivables exchanges in other countries have observed the TRE approach and are consciously choosing to position themselves differently. It will be interesting to see how those ventures fare.

I will say that there is an interesting indicator of a change in “substance over form” to be found on the TRE trading platform. The last press release posted on the trading platform is dated February 27.

What’s significant about the fact that the TRE PR machine seems to have gone quiet?

It might indicate that the resources have been redirected to more productive purposes.

Three years into this experiment I continue to believe that the fundamental concept of TRE is sound. I continue to believe that it can be disruptive. I continue to believe that the receivables-finance market can be, and ultimately will be, revolutionized.

Whether TRE as it is currently constituted will bring about that revolution is an open question.

Without a fundamental change in philosophy and approach I think the headwind is awfully strong.

The REST of the story...

REVISED 3/25/2012 CRL

I got a note after my last post from a regular reader who is smart and knowledgeable and very much a part of the supply-chain finance industry. He’s not directly involved with TRE but is quite familiar with the sell-side mechanics of the process.

I referred only briefly in that post to potential market reactions to recently-instituted fee changes. He wrote that he was unaware of any changes in the fee structure. But his comment was specific to the sell-side and was made in a way that suggested he might not be aware that Buyers also pay fees.

From a subsequent exchange of notes I learned that, in fact, he was NOT aware of the existence of Buyer fees. His assumption seemed to have been that the costs of TRE transactions were borne by Sellers only.

I asked myself: if this bright and well-informed person is unaware of the existence of fees charged by TRE to Buyers, who else might be trying to understand TRE auction dynamics knowing only a part of the story?

I’ve been curious about some Sellers who devise odd-looking pricing parameters that produce round numbers when the monthly discount is divided by the advance rate and the result is multiplied by 12. I ask myself: is it possible that this Seller really believes that such a fee structure is an appropriate way to think about either his cost of funds or the the return to the Buyer?

For example: does the Seller who prices an auction at 1.05% per month with an 90% advance rate really believe that he is “offering” the Buyer a 14% annualized return (.0105/.9 x 12 = .14)?

If so, that would actually explain a lot of Seller pricing and behavior that seems odd from the buy-side.

Those whose experience listening to radio news broadcasts goes back far enough will remember one of the most distinctive of radio personalities of the 20th century: Paul Harvey. Harvey ended his newscasts with a distinctively-delivered summary line:

“And now you know the REST of the story!”

So, for the benefit of those who might not be familiar with the existence of Buyer fees let me first assure you that TRE Buyers DO pay fees. I can’t actually tell you what the fees ARE but I can offer some general comments about them.

To the Seller (above) who might have thought he was “offering” the Buyer a 14% annualized return, I'd say that the ACTUAL annualized return to the Buyer will certainly be meaningfully lower than that and, in fact, depending on the auction size, duration and terms, it could be could be far lower. If the auction were paid back TOO quickly, the fees charged to the Buyer could actually exceed those earned on the auction!

TRE Buyers are charged fees that are based on the size of the auction and on the gross discount earned. The fees based on the size of the auction are paid when the auction is purchased and will vary depending on whether or not the auction is subject to risk-mitigation program charges.

I've written before about the importance of auction duration to the Buyer's return from a TRE auction. Because there is a fee component that is based on auction size, regardless of earnings, the shorter the duration of the auction (all else equal) the greater the portion of total earnings that are consumed by fees.

I can offer a current example...

I purchased an auction on March 16. The invoice in that auction had a due date of April 11 and prior history suggested that a payment date close to the due date could be reasonably expected. With an expected duration of about 26 days the anticipated return seemed fair to me.

But in fact, the invoice was paid quite early and the auction was closed out on March 23, producing an actual auction duration of only 7 days.

The impact of the very short duration was to magnify the effect of the fixed transaction fees, substantially increasing the proportion of the gross discount that was absorbed by fees. That, of course, substantially diluted my actual annualized return.

In fact, the only reason my actual return was positive, given such a short duration, was because the auction was not a part of the risk mitigation program. If it had been part of that program the total of all fees payable would have exceed the total gross earnings.

That sort of situation has happened before but, in fairness, it hasn't happened to me very often.

But because the calculation of a Buyer's total fees and costs has a number of variables, there is no simple way to describe the relationship between the "apparent return" that might be suggested by the basic auction pricing and either the actual expected return or the actual realized return to the Buyer on that auction.

The following statements are true, however:

--in any TRE auction, the Buyer will pay a meaningful percentage of the gross discount to TRE for the various Buyer fees charged,

--certain fairly common circumstances can produce auction economics in which the fees payable by the Buyer are equal to or greater than the income actually retained by the Buyer from an auction, and

--it is possible that, depending on actual circumstances, the "successful" Buyer of an auction can close out a deal at a loss even if all invoices purchased are paid in full.

None of this will come as any surprise to the experienced Buyer or to the Exchange. But I don't know how many TRE Sellers are actually aware of these circumstances.

It is unfortunate, in my view, that TRE chooses to maintain that all such matters must be kept confidential. Its competitors, while admittedly a long way behind TRE in market development, make their fee structures public. In such circumstances Sellers can tell quite easily what the actual returns to Buyers of their auctions will be.

Ultimately the Seller pays. The question is: "Who does the Seller pay?"

If the Seller thinks it is paying the Buyer compensation that is actually going to TRE, via the Buyer fees, that misconception can potentially distort market dynamics.

And that’s at least PART of the rest of the story!

A Little Off Balance

It’s been another month of half-written, then discarded posts. That might reflect, in part, my own uncertainties about TRE but I think it’s actually more a matter of the transitional nature of the times. My sense is that things are just a little off balance.

What’s transitional in TRE-land? A number of things:

--The increased volume that we saw last December, which represented a significant break-out after a plateau of many months duration, has thankfully persisted. It appears we have a new baseline volume that is about 50% higher than the former baseline. (As I write this I think it’s already fair to say that February will have set a new monthly volume record.)

--Average auction size, which also spiked last December, has also maintained its new level. In fact, the increased volume is almost solely attributable to increased average auction size, not to an increase in the number of auctions sold.

--The increased average auction size reflects the activity of a number of new Sellers whose businesses are much larger and whose auction appetite is much larger than the previous average Seller. Volume is more highly concentrated as a result, however, which has its own issues.

--Increased average auction size has meaningful implications for a Buyer's ability to construct a diversified portfolio. The opportunities and constraints are different for those who can buy 100% of the average auction versus those who cannot.

--We are still digesting the impact of the risk mitigation measures that went live last November. And by "we" I mean both Buyers and Sellers.

--We are still digesting the impact of the fee changes that took effect on January 1. (Same "we".)

--We have just begun to see the first of the new Sellers that would not have previously met the TRE registration criteria but do meet the new “smaller Seller” criteria.

For those who have watched the daily auction activity for any significant length of time, I think some changes will have been noticed during the first two months of 2012. It appears that an intra-month cycle of sorts might be developing, partially as a result of the structure of the risk mitigation program, for instance.

Whether those changes will persist is open question.

Whether the experience of this past 60 days will lead Buyers to react somewhat differently over the next 60 days is also an open question.

But things have been changing and I have a sense that many of us are feeling our way through those changes at this point. Which is the real cause of my relative silence – I’ve just not been sure what I’ve wanted to actually put in writing!

But there are some just straightforward factual issues that can be noted:

1. Weighted average returns to Buyers have been falling even as the spike in volume has persisted.

2. Pricing parameters have been migrating toward a band that shows much less recognition of Seller-quality differential.

3. (Some) Sellers have apparently not yet fully grasped the impact of the risk mitigation program.

4. New SMB Sellers have been appearing at a consistently more rapid pace than was the case at this time a year ago.

5. Corporate auction activity has increased in a meaningful way.

6. Organizational and operational changes continue to be made that seem to me to reflect a commitment to long-run business-building. TRE appears to me to continue to invest in its future even at the apparent expense of the near-term cash burn-rate.

7. According to my records, in February, TRE marked its 10,000th auction sold. (My records are missing a small bit of early data but not enough to shift the date of that milestone into January.) That’s a piece of data that I haven’t yet seen in a press release.

The issue of Appropriate Compensation is still very much on my mind and the question of the true value of (versus the cost of) the risk mitigation program is also very much still open.

Unfortunately, answering those questions remains very difficult because the answers are necessarily dependent on volume and actual measured risk.

Solutions to some problems come only at certain not-yet-attained volume levels. Projecting when those levels will be reached is an uncertain enterprise.

Solutions to other problems will come only with certain not-yet-available risk measurements. In that case only time will really tell.

So, we wait and watch. And some of us continue to buy. [We recorded our 750th purchase a couple of days ago!]

It’s interesting to note that the concept of an auction market for receivables is one that continues to attract attention and investment both in the US and abroad.

--The Market Invoice platform in the UK is the only such effort that I'm aware of that has actually generated a meaningful operating history. It has been active for over a year. While volume is not large, it is growing and participants with whom I’ve spoken have been pleased with initial results.

--The Receivables Market platform here in the US has been in development for some time but does not yet appear to be operational. An attempted launch over a year ago seemed to be stillborn but RMC has recently begun to reach out for participants and a good deal of work has been done on their website. From what I can see, though, it cannot be called a “trading platform” at this point.

--The EuroTRX platform in the UK is targeting a late-2Q launch and appears to be the most TRE-like of the new market entrants. EuroTRX appears to have studied the TRE model closely and to have identified several significant differentiation elements that they will attempt to exploit. My sense is that EuroTRX will have the edge over other new entrants if they are able to translate their concepts of process and structure into reality.

I continue to believe that that the concept of TRE was, and is, an excellent one.

First movers have to solve all the problems of a new business. Those who come later get to leverage the experience of the first movers.

One of the most important qualities of the first mover who wants to survive is flexibility; principally the flexibility to recognize when an initial idea is not working and needs to be changed.

I think it can be said that TRE’s initial concept and vision is essentially unchanged and is being validated; perhaps more slowly than initially hoped but nonetheless…..

It’s also fair to say that there have been a number of areas of implementation that have tested the flexibility of TRE’s management.

In many cases the need to change has been recognized quickly and responded to promptly.

In other areas, both recognition and response have taken longer; sometimes too long.

In still others, recognition might not yet have occurred.

Fishing in a Stocked Pond

Two press releases caught my eye on January 5, 2012.

The first was TRE’s announcement that it had reached the $1 billion mark in "funding" on the SMB platform. It caught my eye because it was from TRE and I’m always interested in TRE news. But it also caught my eye because I couldn’t understand how the number could be correct.

As far as I can tell, the only way for that release to be accurate is to change the language to say that $1 billion in transaction ACTIVITY has been completed. That’s different from saying $1 billion has been FUNDED. But I guess we can blame the PR folks. After all, PR folks are notoriously unconcerned with numbers, right?

The second press release that came out on the 5th was issued by the Ariba Network. Unlike TRE, Ariba buried its numbers in the middle of the release.

Quoting from the fifth paragraph, referring to Ariba, it reads in part: “Used by more than 730,000 companies around the world to transact more than $202 billion on an annual basis….”

How do you bury a sentence like that?

It’s huge!

The fact that those releases came out on the same day is not the only thing that connects them, of course.

The Ariba Network’s software has, as I understand it, a specially-constructed module that will allow an Ariba vendor to quickly and easily post its invoices for sale on the TRE platform.

Ariba and TRE have been working together virtually since TRE began operations to bring Ariba vendors onto the TRE platform and to make it as easy as possible for them to sell to TRE Buyers.

Let’s move past the obvious for a moment and ignore the 730,000 companies with $202 billion in annual transactions and consider the fact that transactions done via the Ariba Network provide a solution to the single most significant weakness in the TRE system i.e. the invoice verification process.

Prior to an Ariba Network invoice being posted for sale on TRE, the Account Debtor must acknowledge that the goods or services have been provided appropriately, that the invoice properly reflects the amount due, that the payment terms are accurate and that payment will be made in accordance with the terms.

That is the strongest affirmation of invoice validity available to a TRE Buyer.

Buying an Ariba Network invoice has obvious advantages for TRE Buyers, which means that it has obvious advantages for TRE. But the volume of Ariba invoices being sold on TRE has been decreasing rather than increasing.

Some time ago I heard that TRE was going to assign a dedicated marketing person to the Ariba relationship; specifically to try to move more Ariba volume onto the platform. If that was done it has not generated perceptible results.

To the TRE marketing people I would ask: What other pool of prospects is unified by a common operational and financial system; can be reached through a single communication channel; have available to them a ready-made auction posting tool; and bring with them a significant invoice verification advantage? And, to get back to the numbers, what other single pool of prospects is as large?

For TRE marketers, selling to Ariba is like fishing in a stocked pond. There’s never a guarantee of success but the odds are certainly skewed in your favor. And that’s worth a lot.

I’ve heard a number of explanations of why the Ariba volume on TRE has been anemic. Some of them sound reasonable, at least to a degree. But none of them would convince me that TRE shouldn’t be going after Ariba Sellers with every tool they have.

One tool that TRE might not have used, but that I suspect might be helpful, is price.

Sourcing Sellers from an identified pool, via an established communication network, with a built-in reference from Ariba, just has to be more efficient and less costly than prospecting elsewhere. And being relieved of the bulk of the cost of verification and, I would guess, having a lower cost of dealing with problem cases, also should afford TRE a meaningful advantage.

If TRE has had trouble attracting Ariba Sellers, why not offer them a better price by discounting the fees the Exchange charges to Ariba Sellers? Establishing a special class of Sellers for fee purposes has to be justifiable given the affinity-group efficiencies.

Now, let’s go back to the numbers. I know much more about the actual TRE volume numbers than I do about the Ariba numbers. For all I know, Ariba might count transaction volume like a VAT collector would count it: at each step along the way. But in the scheme of things, it doesn’t really matter. If the relevant comparison is to $101 billion in Ariba transactions rather than $202 billion, the argument still holds.

Not only is Ariba a pond stocked with the kind of fish TRE wants but it’s a very deep pond and TRE already has a license to fish there.

Several generations of marketing folks at TRE have been, for whatever reason, unsuccessful in marketing to Ariba members.

Maybe it’s time to try a different approach. Maybe it's the bait.

Musings at Year-End

Here we are at the end of December and I haven’t written anything since late November.

Actually, that’s not quite true… I’ve begun several posts in the past six weeks but I haven’t finished (or posted) any of them.

In a couple of those cases I didn’t finish because I realized I was writing in a state of frustration and confusion and that nothing written under those conditions ought to actually be shared.

In others cases I just decided I wasn’t sure that what I had to say was either correct or of any value.

And that kind of sums up the 4th quarter activity for me: It’s been a time of frustration, uncertainty and doubt about the future.

But I can’t let the year end without a few comments. So.....

Thankfully, the flood of liquidity that played havoc with pricing early in the quarter began to recede in November and by the second half of December it appeared that a reasonable balance had again been found.

That reasonable balance wasn’t necessarily reflected in pricing, though, because in early November the Exchange’s new risk mitigation program went live. And the initial reactions to that program had a significant impact on prices.

There’s not a lot that can be said about that program at this point except that I think it is both more and less than meets the eye.

It will take quite a while before anyone will be able to say what its real value is or what an appropriate pricing response actually should be. Meanwhile we’ll just have to muddle through making decisions on the basis of largely unproven assumptions.

TRE deserves much credit, I think, for a number of things as this 3rd full year of operation ends:

1. There are still a few hours left in the trading day as I write this but it is quite clear that December 2011 will set, by a very substantial margin, a new high water mark for SMB auction volume.

2. December has also seen the first new activity in the Corporate auction market since the NYSE relationship was completed in September. The new auctions were received positively and I suspect that all parties must be pleased.

3. The pace of new SMB Seller acquisition has clearly accelerated in the 2nd half of the year and some of the new Sellers have been unusual in both size and expected volume of activity. The Seller marketing team appears to have shifted its targeting in a way that might be really meaningful.

4. The roll-out of the new risk-mitigation program appeared to go quite smoothly. While it was delayed a bit in an effort to get it right before roll-out, that decision seems to have been a good one. Implementing that sort of program in a relatively seamless manner is tough. Both the tech people and the business people involved in the implementation appear to have done a very good job.

5. TRE’s administrative people have continued to tighten up their processes. The job of obtaining and posting updated financial data from Sellers has become much more disciplined, with more Sellers finding their postings delayed until the required data is provided. For a volume-dependent organization, it’s tough to exercise that sort of discipline.

6. The Member Services department which, among other things, handles the transaction reporting and cash management functions deserves a lot of credit. It's one of those functions that only gets noticed when there's a mistake. But, at least in my case, I can't think of a single error that has occurred this year in those functions. That's actually remarkable.

7. The risk management and loss control functions have been significantly strengthened, both in terms of people and processes.

8. The operation of the trading desk has been strengthened and communication between the desk and the Buyers has clearly been an operational focus.

9. TRE management has to be acutely aware that volume growth has been much slower than initially hoped. Many would be tempted, in such a situation, to scrimp on investment in the “nuts and bolts” improvements in systems, personnel and processes: especially in those functions that few people actually see. To their credit, TRE’s management did not take the short view. They have continued to invest in the platform and the processes even though it must hurt to do so.

10. And, of course, you’ve got to give TRE management full marks for PR! They DO get noticed and their name IS out there all the time.

On the other hand...

In order for any of us involved in the TRE enterprise to prosper, the business has to achieve substantial scale, and we’re a long way from any level that might be called “substantial” in the context of the market size.

A year ago the volume pattern could appropriately be called “encouraging”. But for most of 2011 we couldn’t really say that the pattern was encouraging.

After three full years of operation we have to look at things as they are, not just as they might be. And the way things ARE falls short.

There are two issues that are really cultural, as opposed to technical or strategic, that I frankly think TRE has gotten wrong and should reconsider in 2012.

The logical approach for those wanting to bring a new process to an existing industry is to attempt to align themselves with the opinion leaders in that industry or to at least create some strategic relationships within the industry. There will be differences of opinion as to why TRE has not done, or has not been able to do, that. But the fact is that TRE continues to be an outsider with respect to the established factoring community.

I happen to believe that the TRE model has much to recommend it as a way to substantially increase the penetration of the factoring function in our economy. And I think that there are ways for TRE and the established community to work together for common benefit. That is not happening. And I believe that at least some of the failure to achieve TRE volume goals can be attributed to a failure to capitalize on the opportunities that working with the established community might present.

Responsibility for that situation has to be shared. Finger pointing helps neither side. It’s time to mend the rift and move forward.

The second cultural issue manifests in a number of ways that I think hinder the growth and threaten the success of the TRE enterprise.

It is the implicit stance taken by TRE that it should be in complete control but at the same time be relieved of all liability. That approach, I believe, might prove to be the largest barrier to actually achieving scale. Because a lot of potential participants will “just say no”.

Shakespeare got it right when he wrote: "First we'll kill all the lawyers..."

There is only one way that I can conceive of a total-control strategy working; but that also goes against the TRE cultural grain. And it will certainly be rejected by its lawyers.

That approach is ... complete transparency.

The culture of control includes a total control of information about Exchange operations, participants, finances, defaults, etc.

The TRE PR machine cranks out positive releases on a seemingly round-the-clock basis.

But information about the real operation of the Exchange is held very tightly to the corporate vest.

Ultimately, an approach that is intended to protect the Exchange actually, in my view, makes TRE more vulnerable. It becomes the subject of unfounded rumors, inaccurate analysis and ill-informed attacks. It makes it appear that there is something to hide. And that’s counter-productive.

I have made this point to TRE in private communication, so this will come as no surprise, but I would strongly advise the Exchange and its management to adopt a policy of complete transparency and to foster, rather than hinder, a full range of communications among all market participants.

TRE should start acting like a public company.

It should make public a full range of operational and financial information just as if it were public.

It should support, rather than hinder, productive and even organized communications and associations among Buyers and Sellers and analysts.

It should stand ready to explain what has worked well and what has not and what has been done in response to the problems that it has faced.

No business, and certainly no new business, is going to escape problems and errors. The good ones acknowledge those problems and errors and respond to them openly and constructively. That stuff always comes out eventually, anyway, so why not take control of THAT and use it to advantage?

Finally, Happy New Year to all! And may 2012 be a year of growth, learning and prosperity for the entire community of TRE participants.

The Implicit Assumption

The issue of risk measurement and the relationship of perceived risk to expected return has been a principal occupation of finance theorists for the past several decades. It is received wisdom that as risk rises, return must also rise, and vice versa (perhaps with a lag).

That admittedly simplistic formulation suggests that when a risk-reducing element is added to an investment opportunity, the rationally expected return should fall.

We’ve all witnessed repeated failures of the rational-investor hypothesis, the efficient market hypothesis and of modern portfolio theory over the past decade.

We’ve witnessed the well documented flame-outs of risk pricing models demonstrating that the “greek” factors of financial math, when stressed, can be as reliable as Greek bond ratings.

So the question of the day is: when is it NOT rational for expected returns to fall when new risk-reducing conditions are introduced?

The answer… (drum roll, please)…is: when risk wasn’t being rationally priced PRIOR to the application of the new measures.

When returns fall in the face of new risk-mitigation measures, the implicit assumption is that pricing prior to the introduction of the new measure already correctly reflected risk.

The extent of the decline should rationally be a function of the gross risk reduction less the cost of the risk reduction, modified by the confidence that can be placed in the “before and after” risk measurements.

New risk-mitigation measures have been applied to some TRE transactions in recent days.

It is too early to draw conclusions about their long-term impact.

In the short term, though, the reaction has been clear. Returns have fallen sharply.

If the reduction in returns was observed only in the cases where risk mitigation measures have been introduced, the problem of analysis would be made more straightforward. But that has not been the case.

The deterioration in expected yields that we commented on in our last post has persisted. So returns had already begun to fall; apparently as a result of excess liquidity; before the reaction to the risk-mitigation measures began.

And there is not yet enough data to support an analysis allocating the overall decline between the two apparent sources.

On a preliminary basis, though, it does not appear to me that the extent of the initial price reaction can be rationally supported as a reflection of the net value of the risk mitigation measures.

And it is far from clear to me that risk was being appropriately compensated BEFORE this latest development.

Having written a rather lengthy series of posts on the subject of Appropriate Compensation, which is really all about risk; and having not yet proposed a definitive conclusion on that question; I can understand that Buyers of TRE auctions will and do analyze appropriate pricing differently.

But all Buyers and, indeed, all observers of TRE, suffer from a similar impediment in their assessments of risk i.e. lack of disclosure of actual TRE experience in sufficient detail to make reasonably informed risk assessments.

I have previously stated that the actual early experience of TRE might not be an appropriate basis on which to analyze current or forward-looking risk. And I continue to believe that.

Because TRE has responded in meaningful ways to its early experience I believe that risk today is lower than it was 2 years ago.

But a RELATIVE shift in risk says nothing particularly useful about the ABSOLUTE level of return necessary to compensate for that risk. And the absolute level of average expected return to Buyers has fallen far more over the last 2 years than warranted, in my opinion, by the change in auction risk profile.

It might be that the current price action is a temporary condition and that we’ll see an adjustment of the sort that occurred earlier this year. In that case we might look back on the current period as a temporary overreaction.

If that does not occur, and the current conditions persist, my guess is that we’ll see reactions within the Buyer community that will drain some of the current liquidity from the market.

Absolutely Relative vs Relatively Absolute

In September 2011 TRE announced its new affiliation with the New York Stock Exchange. I wrote in my post of September 13 that “the benefits to those whose involvement is limited to the SMB market (would be) pretty obvious and (would) become clear over time.”

The operative phrase there was “over time”.

It might have been coincidence; but I doubt it; that new Buyer money clearly came into the market as the “bell rang” on October 1. And since that time the pricing of SMB auctions has reflected the enthusiasm of increased demand relative to supply.

That also happened in 1Q 2011, when we saw a significant drop in average returns that lasted for about 90 days.

It appears that the combination of October’s influx of new money and structural issues arising from process changes recently instituted by TRE might now push returns even below the levels of 1Q 2011. Whether that will be a short-duration phenomenon, as was the dip in 1Q, or will have more lasting impact cannot yet be known.

But it does raise a question that I think is critical, more for those who look to the possibility of trading on TRE as a stand-alone business than for others, perhaps; but to TRE as well, in my view.

I’ve written previously about the difference between Buyers whose activities on TRE are ancillary to their principal business; who might be looking for short term, opportunistic means to improve returns on excess cash balances; as opposed to those whose business is actually investing in accounts receivable and are looking to make investing in TRE auctions a viable business on its own.

In the case of the short-term “money parkers”, the TRE market is probably viewed in an absolutely relative light.

If a Buyer, whose business is actually investing in other asset types, has excess cash balances from time to time on which very little can be earned, the prospect of picking up a few hundred basis points over Libor, for example, might look very attractive.

Such a Buyer might well have minimal marginal costs involved in its TRE activities and, unless (or until) it is faced with defaults, might be quite pleased with the incremental returns received.

But the nature of that Buyer’s activity is that it is driven by lack of sufficient opportunity in its primary business or in its usual short-term investment options. And as those opportunities and options improve it will likely move its cash back to its normal operations and withdraw liquidity from TRE.

The supply/demand balance in TRE trading is still delicate. Volume of auction activity has certainly grown over time but relative to other financial markets, TRE volume is still within rounding error. What might seem to some investors to be relatively small increases in funds allocated to TRE purchases can have a meaningful impact on the market.

In the short run, TRE probably has little control over Buyer allocations of funds or the impact of meaningful changes in market dynamics caused by shifts in those allocations.

In the longer run, however, I believe TRE should strive for the relative stability that would more likely come from a Buyer community largely composed of those who are approaching the Exchange as a part of their primary business activity.

It is that class of Buyer that can be expected to be consistently participating in the market and seeking to match growth in the market with growth in their own level of commitment.

But it should be recognized that the return requirement of that class of Buyer is not absolutely relative; rather, it is relatively absolute.

Those Buyers whose business is investing in accounts receivable will know that the TRE transaction structure has certain risks that are not typical in their normal activities and that those risks will have to be adequately compensated if the TRE activity is to be supported in the long run.

The cost of money might be similar when the absolutely relative Buyers are compared to the relatively absolute Buyers. But it’s likely that there will be meaningful differences between the two classes of Buyers in the areas of:

1. Operating costs
2. Credit loss assumptions, and
3. Net return requirement

The short term parkers of excess funds will probably attribute little, if any, marginal operating cost to their TRE trading activity.

Until they actually experience the potential risks involved in buying invoices in the TRE structure, it is likely that the credit loss assumptions of the absolutely relative Buyers will be minimal.

And the net return requirement of the absolutely relative Buyer will also likely be minimal. The Exchange activity of that Buyer is a footnote to its business plan. For the relatively absolute Buyer, its Exchange activity is the BASIS of its business plan!

The long term growth and prosperity of TRE, in my view, depends on attracting, retaining and supporting the activity of the relatively absolute Buyers.

To the extent that the absolutely relative Buyers threaten the ability of the relatively absolute Buyers to price transactions sensibly in light of the actual risks being assumed, they also threaten the long term success of TRE.

A Comment on Seller Marketing

I've been waiting for several weeks for the conditions to materialize that will allow me to comment on a new TRE risk-mitigation program. We're not there yet, so I still can't write about that initiative.

But, as I wait, the issues of risk and appropriate pricing are still at the top of my list and there was a trigger for comment on those topics last week.

An article, written by a senior officer of TRE, appeared in an industrial trade magazine published last week. The article was a marketing piece setting out a variety of reasons why owners of manufacturing concerns should consider an alternative financing facility like TRE.

The points made in favor of an alternative working capital facility were familiar and predictable to anyone with involvement in or knowledge of TRE. One of them, however, seemed to me to be overemphasized and not completely accurate.

The point was discussed under the heading: "Avoid Personal Guarantees". The discussion began with a comment on the typical working capital provider's requirement of a personal guarantee and of the potential impact on a business owner in the event of a default if a personal guarantee has been provided.

A fair enough comment.

But then the point is made that TRE does not require personal guarantees "because investors who are bidding for your receivables assess their risk based primarily on the credit rating of your customers, not your rating."

The author appropriately points out the obligation of the business to repurchase defaulted invoices but closes with the statement: "Most owners would rather assume this obligation than risk losing their house or savings because of a personal guarantee."

This emphasis is troubling in several respects:

1. In a post entitled "Pardon the Interruption" published June 28, 2011, I argued for the adoption of at least a contingent personal guarantee. At that time I suggested that it be contingent on the posting of non-conforming invoices for sale. That's not the only approach, of course. Such a contingent guarantee could also be triggered by a fraud test. But nothing has happened since June 28 that changes my opinion on that issue. If anything, I am more convinced than ever that TRE will eventually HAVE to move in that direction.

2. Speaking only as one Buyer I can say without hesitation that our buying decisions are not "based primarily on the credit rating of your (the Seller's) customers". The invoice verification process used by TRE does not allow that level of confidence. The uncertainty caused by that process is not an issue of Debtor strength but of confidence in the validity of the invoice. It does not matter if the Debtor is the most creditworthy company on earth. If the invoice is defective it won't get paid. So, the most important question to be asked is NOT whether the Debtor can pay the invoice, it is whether the Seller can pay it if the Debtor does not.

3. Selling the TRE facility on the basis of limited Seller risk is like throwing blood in a shark tank. It's an irresistible attraction to the Sellers that are most likely to become problems. Obviously those business owners; and they are out there; who are just crooks, will find the situation tempting. They don't even have to negotiate to get a personal guarantee requirement waived. It's not even a point of discussion. But even owners who are generally trustworthy can be tempted to act badly when the pressure gets strong enough. And in this economic environment, a lot of them are under pressure.

4. The tension between the sales and risk control functions that is felt in all credit-market institutions is heightened when so much is riding on volume growth. In the case of most banks, for example, there is a counter-force to be found in the requirements for public disclosure. If the credit metrics begin to move in the wrong direction, that will become apparent relatively quickly. That is not the case with TRE. Little data about auction performance is made available publicly and so the pressure on the sales and marketing functions from that source is largely absent. We have to rely on senior management to appropriately balance the growth objectives with a robust risk control environment.

The success of the TRE sales and marketing functions is in the best interest of all of us who are involved in the TRE enterprise. But it is only in our best interest to the extent that it is achieved in the context of effective control of risk and appropriate pricing of risk.

Emphasizing the limitation of owner liability in marketing efforts is, in my view, a dangerous approach to business building that is clearly tempting in the short term but is likely to be counter-productive in the long term.

Appropriate Compensation # 12: Another Tack

In our last post in this series we discussed the idea of risk analysis at the level of the Seller, on the assumption that a probability of default might be usefully considered in terms of a Seller-based metric.

That actually brings up an interesting distinction between the TRE model and that of traditional factoring relationships.

In the traditional full-line factoring relationship the factor will have funded a significant portion of the total receivables portfolio of the client. Not necessarily the entire portfolio, but perhaps all of the invoices due from specified debtors or all invoices due from specified debtors within a specified age limit, or something of the sort. And the factor will have a buffer against loss equal to the aggregate dollars held-back from all invoices funded plus (in many cases) additional value from invoices not actually funded.

In such a case, a debtor’s default on one invoice, or the default by one debtor among many, will not necessarily put the factor's advance position at risk; there might be enough value in the unfunded positions to cover the defaults.

In the spot-factoring model, particularly in the case where the lien is specific to the invoices purchased and there is no other security provided, the buyer of the invoice has fewer options to effect a cure of any default.

That is typically the case in a TRE transaction.

So, some might argue that the risk of loss might be better viewed at the level of the individual transaction rather than at the level of the Seller. I don’t necessarily agree but it does provide another interesting approach to risk analysis.

Let's say that we’re looking at a $50,000 single-invoice auction and that the terms of sale are: an 85% advance; a monthly discount fee of 1.5%; and, an expected duration of 30 days. The net earnings on an auction with those parameters will be approximately 1/79th of the initial advance.

In that case, just for illustration, if the buyer thought there was 1 chance in 79 of suffering a complete loss on an auction with similar characteristics, the net expected return after credit losses would be zero.

Inverting the analysis, if the buyer thought that a credit loss equal to 10% of the expected earnings was acceptable (just to keep the numbers round), he would have to attach a 1 in 790 probability of a total loss to this auction in order for it to meet his loss tolerance.

Using that approach a Buyer can fairly easily construct a loss tolerance distribution using variables for size, duration, rate and targeted loss levels. This won’t answer the question of what the probability of loss might actually be. But it will provide a measure against which the Buyer can test the reasonableness of various assumptions.

Let’s keep size, rate and targeted loss levels constant and test for the effects of duration change. If the duration were 15 days instead of 30 days, the net earnings expectation would be about 1/212th of the initial advance and, in order to hold losses to a 10% level, it would take about 2,120 successful auctions for each 1 that was a total loss.

If the duration were to be double the initial case i.e. 60 days, the expected earnings would be 1/35th of the advance amount and 1 auction in 350 could be allowed as a total loss while maintaining a 10% loss ratio.

We’ve noted that there is not enough data yet to reliably attach probabilities of loss to TRE auctions. And the variations among Seller and Debtor strength, experience, and other metrics are so wide that any analysis of the TRE market as a whole is perilous.

However, a Buyer CAN approach a single auction armed with the calculation of implied loss tolerance given the auction parameters and his own appetite for risk.

Loss tolerance calculation is not loss probability calculation. But it’s something.

It seems that we’ll soon be able to discuss a significant new risk-mitigation step being taken by TRE. When we CAN discuss it we will.

But the fact that mitigation actions are taken doesn’t relieve us of the need to assess the risk itself. It just imposes the additional requirement of analyzing the extent to which the mitigation measures actually affect the net loss probability.

Credit Where It's Due

This morning's announcement that NYSE Euronext has taken an equity position in TRE and is partnering with TRE to offer the TRE Corporate Receivables Program to NYSE-listed companies is a significant vote of confidence in the concept, the technology and the management of TRE.

This development is unambiguously good for all participants in the TRE enterprise including those of us who are Buyers and Sellers, regardless of whether we participate in the Corporate Receivables Program or not.

The benefits to those whose involvement is limited to the SMB market are, I think, pretty obvious and will, I suspect, become clear over time.

Those who were not yet convinced that TRE had proven itself as a going concern should take comfort in today's announcement.

In my first post on this blog I noted that just as "all beginnings are hard", so too the road toward success for TRE would be bumpy and difficult: mistakes would be made and changes in direction would be required.

It is clearly to the credit of TRE and its management that regardless of the difficulties faced and the course corrections required, the focus on moving forward, on facing up to problems, on seeking solutions and on pursuing opportunities has been maintained.

Today's announcement is a big thing for TRE and credit is due to its founders, its management, and to all who have been a part of sustaining it to this day.

Appropriate Compensation #11: Keep it Simple(r)

Here in post-Irene New Jersey many of us still have some recovery to attend to but, as the month ends, I want to quickly clarify the idea put forward in our last post.

This is what I mean by a Seller-based approach to an allowance for credit losses:

1. Let’s say that all active Sellers on TRE represent the same share of total auction activity. (Clearly, that’s unrealistic, but it’s just for illustration.) And let’s say that our analysis suggests that 3% of active Sellers will default in any given year. If we assume that every default results in a total loss, we might say that overall TRE pricing has to provide for an annual loss of 3% of capital (before recovery expenses).

That 3% loss provision is not based on the gross income of auctions purchased. It’s not a top-down calculation. It is an absolute loss provision that has to be included in auction pricing to compensate for perceived Seller-default risk.

That’s an extremely simplified example of a platform-level approach but, hopefully, it conveys the idea.

It’s not possible at this point, for a Buyer to “buy the Exchange” i.e. there is no single transaction that will expose the Buyer to a pro-rata position in the entire TRE portfolio. So an Exchange-level analysis, even if it were really possible in a statistically meaningful way, wouldn’t go far enough for the individual Buyer.

The individual Buyer will have to account for his own strategic portfolio and auction purchase decisions in creating an allowance.

2. Let’s say that a given Buyer has a portfolio diversification rule that limits his exposure to any one Seller to an amount equal to 10% of the Buyer’s capital. And let’s say that the Buyer believes that his Seller-qualification criteria allow an annual probability of default of 1 in 20. If a total loss on default were assumed, and the Buyer’s investment at the time of default were at its 10% maximum, the simplistic loss allowance should be about 5% of capital per year.

3. Let’s take the same situation as in #2 and assume that the Buyer actually expects a net loss recovery of 50% of defaulted amounts. In that case a net loss allowance of 2.5% of capital per year would be indicated.

Obviously, a Buyer projecting a loss of 2.5% of capital per year will think and act differently than one projecting a 5% loss. (And those making no conscious allowance for loss will be unpleasantly surprised sooner or later!)

There is not yet enough history of TRE operations to reasonably estimate the probability of a “typical” Seller defaulting. Nor is the information about actual default experience publicly available.

What we ARE able to say is that the experience of TRE to-date has caused it to make a number of meaningful changes to procedures, staffing and operations that affect both risk of default and likelihood of recovery post-default. And that those changes have been constructive.

However, it remains true that:

• There is a wide range of (reported) financial capacity among TRE Sellers.

• There is a wide range of financial capacity among TRE Account Debtors.

• There is a wide range of past experience among TRE Seller/Debtor pairings.

• There is a wide range of documentation strength provided in TRE transactions.

• There is a wide range of actual pricing in TRE transactions.

Because each Buyer’s actual and perceived risk/return profile is dependent on many individual portfolio construction and auction purchase decisions; and many assessments of risk are still largely subjective in the context of limited TRE history; the question of an appropriate loss reserve will also necessarily be both individual and largely subjective.

I might think, based on my own portfolio construction and auction purchase criteria, that an annual Seller default probability of 1 in 20 is reasonable. Another Buyer might find some other number to be more reasonable.

I might think that a net recovery expectation of 25% is reasonable. Another Buyer might think differently.

I’ll develop this idea further in subsequent posts but I hope this clarifies the distinction between a Seller-based analytical process and one that is Debtor-based.

I should note that I’m not ignoring the differential strength of Account Debtors. Regardless of Debtor capacity, it is the Seller that is ultimately responsible to make good on invoices sold. And, in the context of TRE notification/verification procedures, I think that the quality of the Debtor is best considered as one element in the assessment of Seller risk.

Appropriate Compensation #10 : The View from Below

In this series of posts we’ve identified a number of risks assumed by Buyers of TRE auctions that we’ve suggested deserve incremental compensation beyond that provided for the risk in typical factoring transactions.

From the start we’ve acknowledged that quantifying an appropriate level of incremental compensation is going to be difficult.

There is no evidence (that I am aware of) to support a rigorous quantitative analysis of the incremental risk associated with reliance on unaudited financial statements as opposed to audited ones. There is no evidence (that I am aware of) to support a rigorous quantitative analysis of having a limited lien position versus an “all asset” lien, or a junior lien as opposed to a first lien. And so on.

We all know that the additional risks assumed in TRE transactions DO exist and that they are real and that they are not trivial.

But how can we approach assigning a value to them?

In our post of May 11, 2011 I wrote, having provided some supporting data and analysis:

“It seems to me that an average credit loss allowance in the range of 10% to 12.5% of gross income in typical factoring transactions, over the course of a credit cycle, is not unreasonable.”

My expectation at that time was that, after examining the major factors that add risk to TRE transactions, I’d arrive at a suggested analogous number that might be used in analyzing TRE transactions.

The more I’ve thought about it, though, the more I’m drawn to a different approach.

Here’s why.

When we look at the factoring industry as a whole we’re looking at a highly competitive environment in which competition constrains the participants’ pricing power.

Average gross revenue is largely a market-determined number and the participants are challenged to operate their businesses within that revenue environment in a way that generates an adequate profit after costs.

A market-wide average credit loss experience will affect top-line, market-wide pricing only over the longer term. That is, increasing (or decreasing) credit losses will tend to affect FUTURE pricing to the extent that they appear to be a reflection of a structural change in overall risk. They are analyzed, calculated and reported in terms of their relationship to the market-driven gross fee environment.

They occupy one line in a top-down analysis of profitability.

The question we’re really asking in THIS analysis, it seems to me, is NOT one of the relative size of a number in a top-down profitability analysis but rather one of the ABSOLUTE size of a number in a bottom-up pricing structure.

The ultimate question is NOT how much of a relatively fixed top line should be reserved for losses but rather what level of loss expectation does the top line need to INCLUDE, as a compensation for risk, in the unique environment that TRE represents. The top line, rather than being relatively fixed, has to be flexible enough to expand to accommodate the risk assumed.

So, rather than stating the conclusion in terms of a percentage of income to be subtracted from the top line, we would state the conclusion in terms of a percentage of capital that must be included in the pricing of auctions to compensate for losses.

This is an approach that implicitly assumes that much more of the TRE Buyer’s risk is Seller-based than Debtor-based.

The question becomes not how many Account Debtors fail to pay invoices posted for sale but rather how many Sellers, for whatever reason, default on THEIR obligations.

That would include simple inability to make good on invoices not paid by their Debtors as well as Seller insolvency or default arising from one of the various forms of potential Seller fraud.

So we would ask:

a) What is the percentage of the total TRE Seller universe that is likely to default in any given period of time?

b) What is the percentage of total TRE auction volume that is likely to be represented by those Seller defaults?

c) What is the likely NET recovery rate (gross recoveries less costs of recovery) in cases of Seller default?

The answer to those questions gets us to a projected loss-of-capital allowance for the Exchange as a whole. Each Buyer is, of course, able to construct diversification and Seller-qualification strategies that he believes would mitigate either the absolute or risk-adjusted loss potential.

In the next post I’ll explore the impacts on pricing of a range of assumptions on these issues.

I invite anyone interested to share their own views of this approach and their thoughts about reasonable values to assign to the variables.

Appropriate Compensation #9: Upon Mature Reflection

I worked with a guy once who had a wonderful way of reversing his expressed opinion on a matter, which was particularly useful when he found that it conflicted with the boss’s opinion.

When it was clear that he’d dug himself into a hole, he’d invariably preface his remarks with: “Upon more MATURE reflection….”

We’ve identified a number of significant issues that we believe add risk to TRE transactions when compared to the typical factoring transaction. The financial statement issue; the personal guarantee issue; the lien priority issue; for example, are all significant and all clearly differentiate the TRE transaction.

Before moving to the question of what kind of pricing response might be appropriate I want to bring up another element that is perhaps the most difficult to analyze and probably impossible to quantify. It is, nevertheless, quite real.

It is the fact that a real-time, competitive auction environment creates a unique potential for self-defeating behavior: behavior that is influenced by the trading environment in a way that does not affect the typical factoring transaction.

There is a great deal of literature about the impact of bidder motivation and psychology on behavior in various auction environments.

The TRE auction environment is one in which, unlike some others, the Buyer does not have the practical option to exit the trade to correct a buying or bidding error. There is no opportunity to say: “Upon more MATURE reflection…..get me out of this thing!” And then to sell what might have been purchased in error, or in haste, or under pressure to put money to work or even just in a momentary fit of pique at having lost a number of auctions that day.

All of these things, and more, can be the cause of a Buyer looking up from an Awarded Auction Report and saying “I can’t believe I really did that.” The only thing to be done at that point is own up to the lapse and hope the thing actually gets paid.

That is not to say that the decisions of the typical factoring company are not subject to the motivations of competitive pressure and internal goal setting. Of course they are.

But they are not subject to the pressures of a real-time auction environment, which requires that decisions be made very quickly, usually without prior warning, frequently in the face of new information that has not been previously analyzed, often in an environment of excess market liquidity, and often in competition with others with differing motivations for participation.

One of the dynamics proven true in competitive auctions is the increase in the perceived “need” to win as the number of “lost” auctions increases. That is, a buyer’s propensity to act against his own bidding rules will tend to increase with the number of unsuccessful bids made. That’s a dangerous but very real temptation when being the successful bidder is defined in terms of “winning” the auction.

In fact, the successful bidder is the one who only bids according to his pre-established bidding rules.

And it might be that a consistently successful bidder is NOT particularly successful at keeping funds deployed in some market environments. But that’s a different question.

I can tell you that, based on my own experience, there is a dynamic in the competitive, real-time auction environment that has clear error-making potential. Some Buyers will be more susceptible to it and some less. So the actual level of incremental risk is as much Buyer-driven as process-driven.

Whatever the actual MEASURE of incremental risk, the fact of incremental risk in real-time, competitive auctions is well documented in academic literature and clearly felt in practice.

I confess that I have found myself (and I will bet that many other Buyers have as well), after placing a bid or winning an auction, wishing that “upon more mature reflection” there was an un-do function on the TRE platform!

It is no coincidence that the competitive nature of the TRE buying environment is stressed in TRE's marketing to SELLERS rather than to Buyers!

Appropriate Compensation #8: Once Removed

If I were forced to take a test that measured knowledge of genealogical matters I would fail abysmally!

I could get as far as defining a first cousin but I have no sense at all of what a second cousin might be and if that second cousin were twice removed I would have to assume it was for some sort of repetitive misbehavior.

In the case of my relationship with a TRE Seller, however, the idea of being “removed” is easily understood. In fact, it’s contractual.

I am prevented by agreement from having direct contact with a TRE Seller except under very narrowly-defined circumstances.

TRE provides Buyers a defined set of minimum due-diligence materials describing the Seller. That set of materials can be supplemented at the option of the Seller (and perhaps at the suggestion of TRE) to clarify or expand upon issues that the standard documents suggest need elaboration.

Public records and credit evaluation services can be utilized to augment the data available to assess the Seller’s business and financial condition, of course, and there are services that can be used to periodically scan media and public records to pick up items relating to specified companies.

So, what’s missing and how does the missing element contribute to the incremental risk of trading on TRE?

The short answer is that the TRE Sellers are “removed” from the Buyers. The Buyers’ relationship to the Sellers is intermediated via TRE.

It is a TRE person who sits across the table from a prospective Seller and talks about the Seller’s business. It is a TRE person who visits the Seller’s place of business and gets a sense of condition and activity. It is a TRE person who examines the prospective Seller’s financial records. It is a TRE person who gets a “feel” for the type of people who own and run the prospective Seller. It is a TRE person who determines that the prospective Seller appears to be credible and trustworthy.

TRE, of course, assumes no liability for its investigations or judgments but if it proves to be off-the-mark too frequently its business and reputation will certainly be damaged.

Once a Seller is approved and posting auctions for sale on the TRE platform, a Buyer may ask questions about the details of due diligence materials and about specific auctions. Those questions are asked of TRE, of course, and it is TRE that calls the Seller and relays back whatever information, if any, the Seller might provide.

I don’t agree with those who argue that the lack of liability will make TRE careless of its responsibilities to carry out its tasks prudently. But it does have to be acknowledged that, especially in the early growth phase of the business, TRE has a substantial incentive to approve Sellers. Sellers are harder to come by than Buyers (at least for the time being) and good Sellers are likely to be given the benefit of the doubt wherever reasonably possible.

But the fact is that the Buyers are limited in their decision making process to analysis of the available information, none of which will typically give them a sense of the PEOPLE on the other side of a transaction. The Buyers have no opportunity to form an opinion of the HONESTY of the Seller.

Why is that important?

As we’ve discussed, most financial statements provided by Sellers are internally generated. Anyone who has worked with Quickbooks or similar bookkeeping software packages will know just how easy it is to create a “second draft” of the statements. And, by the time the statements are posted, they are dated in any event.

As we’ve discussed, the invoice verification process used by TRE is not designed in a way that is likely to catch invoices that are actually fraudulent until damage has already been done.

And, as we’ve discussed, the owners and principals of the Sellers have no personal liability to TRE or its Buyers in the event of default.

Those issues and others make the assessment of a Seller’s character and honesty a critical part of the decision to buy. But the Buyer can’t make that assessment. The Buyer has to depend on TRE to be clear-eyed and unmoved by the incentive to attract Sellers.

A recent factoring industry survey quoted a contributor as saying “every factor experiences fraud every year”. The need for due diligence that extends beyond the four corners of a page of financial data is obvious.

The TRE Buyer is once-removed from one of the most important assessments in the decision to do business with a Seller.

I know that TRE takes the job of assessing Seller honesty seriously, even if it is not actually liable for the judgments made. I know that there have been situations in which prospective Sellers have been denied TRE membership because of uncertainty about character and veracity. And I know that TRE has to take the long view in balancing the desire for growth in the Seller base against the risk to which Buyers are subjected.

But I also know that face-to-face assessments of the counter-party in a transaction can have a big impact on decisions.

I know that having the ability to pick up the phone and ask a Seller direct questions about auctions, Debtors, invoices, changes in financial condition, and so forth, in real time, would have significant value. But the TRE Buyer can’t do that.

Being once-removed; being isolated from the Seller; unquestionably adds risk to the TRE Buyer's activity.

It is another risk element that deserves to be compensated.

Appropriate Compensation #7: The Lien Position

In this series of posts we've identified a number of ways in which the TRE Buyer is assuming incremental risk when compared to typical factoring transactions. The goal is to ultimately draw a conclusion regarding the appropriate level of incremental return necessary to compensate for that additional risk.

Today I want to return to the issue of the lien position that the TRE Buyer acquires in the assets of the TRE Seller. We’ve addressed this issue before.

Please see:

• Caveat Emptor #2: December 15,2009, and
• Blanket Security vs. a Security Blanket: June 29, 2009

There are two principal conditions in the Buyer’s lien position that give rise to risk in TRE transactions that would not normally be accepted in typical factoring transactions:

1) The TRE Buyer obtains a lien ONLY on the invoices purchased from the TRE Seller, and

2) It is often the case that other parties already hold prior liens on the receivables of a TRE Seller, so the TRE Buyer might hold a second or even more-junior lien position on the receivables it purchases.

The fact that the Buyer’s lien attaches only to the receivables purchased is made more problematic by the lack of a full notification process that we’ve recently discussed. If the invoice purchased is defective and the Buyer’s lien attaches only to that invoice, the value of the lien is questionable.

And the fact that other parties might have superior lien positions with respect to the assets of the TRE Seller, puts the TRE Buyer at risk that the rights and actions of others, which neither TRE nor the Buyer can control, can substantially reduce the value of the Buyer’s lien.

Compounding that problem is the fact that I know of no truly reliable warning system to alert the TRE Buyer to the existence of action or threatened action by a 3rd party in time for protective measures to be taken by either TRE or the Buyer.

In typical factoring relationships there is an opportunity for ongoing dialog and business-condition assessment. That is not the case in the TRE environment.

In the TRE environment the Buyer is almost always going to be behind the curve, learning of problems after the fact. Even if a Buyer is an astute analyst of financial data, able to tease out indicators of developing problems, the information available on the TRE platform is always dated. And, as we’ve discussed, the quality of the information contained in internally-generated financial statements – always less-assured than audited data – is far more likely to be inaccurate in conditions where Sellers are in trouble or heading in that direction.

Becoming aware of a threat to one’s position via notice of a superior lien-holder’s action is unpleasant.

On the subject of the breadth of the Buyer’s lien position I’d like to add a point to the prior conversation that I haven’t brought up before. The UCC filings in typical factoring relationships very often extend beyond creating a security interest in all accounts receivable. Often they are either “all-asset” liens; or extend to all of the personal property of the Seller in addition to its accounts; or specifically include other named property.

More and more often, especially in the cases of companies that are in the various “tech” sectors, the critical assets of the TRE Sellers are intangible. A Seller that is a software development firm, for instance, might have a copyright, trademark, patent or other intangible as its primary revenue-producing asset. Without some means to control or, at least, threaten that asset, the leverage of a creditor is substantially diminished.

This limited security position in the assets of the Seller is obviously quite attractive to the Seller. It is used to attract Sellers to the TRE platform in the same way the lack of a personal guarantee requirement is used. It has a flavor of the “you can’t get this anywhere else” to it.

Of course, there’s a reason it’s not generally available and that reason is that it increases the risk to the provider of funds.

It increases risk not only because the security might be defective or a because a superior lien position might be asserted but also because any action to cure a default that depends on attaching assets that have limited lives (i.e. the receivables portfolio of a Seller might be liquidated and its proceeds “evaporated” before any substantive court action can be commenced) carries the incremental risk of dependence on a wasting asset.

There is no question that the TRE Buyer should demand incremental compensation for the incremental risk assumed because of the limited security provided by its lien position.

[Note: To be fair, there is a potentially mitigating factor in the form of the right of TRE and its Buyers to attach Seller cash balances in the TRE lock-box. Mitigating factors will be discussed as a part of the wrap-up of this series of posts.]