An Important Contingency

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The point?

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

Awareness of that possibility is the first line of defense.

A "Safe Haven"?

It’s been a busy month and I haven’t written as often as I usually do. I began thinking yesterday of what topics might be both timely and of interest for an end-of-month post.

There are many. It’s been a very active month for TRE.

LOTS of auctions; another volume record. Lots of new Sellers; some very interesting and some a little puzzling. Lots of established Sellers bringing new Account Debtors to the Exchange; again, some very interesting and some a little puzzling.

Those all suggest good topics.

TRE management has made significant and important efforts to enforce the requirement that Sellers update their financial statements on a more timely basis. Those new statements show that there have been some important swings in the condition of some Sellers: some in a positive direction and some negative.

It’s clear that 2009 was a tough year for many TRE Sellers. I’ve already commented on my own reactions to having to “let go of” some favorite Sellers and to become willing to buy from some Sellers that I’ve shunned in the past. There’s more than one good post in that topic.

And the bidding dynamics have continued to show changes in the relative strength of Buyers and Sellers and to provide some very interesting glimpses into the strategies and motivations of some market participants. Again, good topics to come back to.

But, as I sit here at the end of the day and the end of the month and the quarter, I have to pick a topic. And what strikes me as most important right now is “none of the above”.

I bought more auctions in June than in any of the 13 months that I’ve been an active Buyer. The average expected return on those auctions was higher than the average of any prior month.

I had more auctions close-out in June than in any prior month and none of those auctions was in any way problematic.

It wasn’t a month without some angst but most of that was self-inflicted and that goes with the territory in any investment medium.

And there’s the story…..

It was a month of increasing volume, increasing opportunity and increasing returns.

It was a month whose problems were the problems of managing opportunities.

Contrast that environment with the turmoil in stock market, the currency markets, the commodity markets or the sovereign debt markets. And then there were those who thought that bond yields couldn’t go any lower!

Who would have thought that buying receivables on an upstart electronic exchange would dampen portfolio volatility at the same time as providing incremental return!

Who would have considered this type of investment a “safe haven”.

Now, “safety” is relative and I am not going to downplay the potential risks involved in TRE transactions. I’ve taken pains to make some of those clear in prior posts. But I’m talking about the RELATIVE performance in an admittedly volatile period for other financial markets.

And, also admittedly, the volume of Exchange transactions is still too small to make a meaningful difference in the context of the portfolios of large investors.

But current experience has to be at least a LITTLE intriguing, even to the larger players, as we look forward to the day when TRE volume is a meaningful percentage of its potential.

When the Evidence Changes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A Comment on Risk

I heard a marketing presentation not long ago in which it was asserted that that “only three-tenths of 1% of invoices ultimately go unpaid”. The unspoken but implied conclusion was that buying invoices involves only minimal risk.

I asked for the source of the statistic quoted and was told that it came from the Credit Research Foundation. I contacted the CRF and obtained a copy of the quoted report, which is entitled “National Summary of Domestic Trade Receivables: 2008 Annual Bad-Debt Report”.

The top-line analysis is provided in two statements:

1) “Net bad-debt write-offs during 2008 totaled $30.00 per $100,000 of sales. This is a net change of $0.00 over 2007, and

2) Allowance for uncollectables during 2008 was 1.00% of receivables. This is an increase of .50% over 2007.”

(Not to be picky, but $30 per $100,000 is actually three one-hundredths of one percent, not three-tenths.)

A few observations:

• The number of respondents to this survey was 555. It is not clear how large a part of the overall economy this sample represents.

• The figures quoted in the summary statements above represent the median responses.

• While the write-off figure did not increase in 2008 over 2007, the allowance taken in 2008 was double that of 2007.

• In the case of the write-off figures, the upper-quartile break-point of the sample was at .19%, or about 6 times the median level.

• In the case of the allowance for uncollectables, the upper quartile break-point was at 3% of sales---100 times the level of the median write-off reported!

So you can choose to highlight the finding that the median write-off remained the same from one year to the next. Or you can take note that the expectation of losses, captured in the allowance figure, increased by 100%.

Or you can acknowledge that the upper-quartile, forward-looking statistic is 100 times the median backward-looking statistic.

The waters might not be as placid and shallow as they appear!

There’s another source of data that is more relevant to the operation of The Receivables Exchange. It is collected by The International Factoring Association. For 2008 this data represented the experience of 120 companies in the factoring business.

• The median write-off experience of that group in 2008 was .3% of gross invoices purchased, 10 times the median of the CRF sample. The average write-off experience was 1.3% of gross invoices purchased, more than 4 times the median.

• The IFA presents results broken down by size of respondent. The largest companies providing data; those with $100 million or more in gross receivables purchased; had the lowest loss experience, at .6% of invoices purchased. The smallest companies, buying less than $5 million per year, had an average loss experience of 2.5% of gross purchases.

• These figures, from companies actually involved in the industry, are far higher than those reported by the CRF. But more importantly, I think, these figures represent the experience of companies that KNOW the risks of buying invoices and take all of the normal precautions against losses.

I’ve detailed in other posts the ways in which the Exchange’s practices in qualifying Sellers, in obtaining security and in verifying invoices fall short of those in common use among buyers of individual invoices. (I've also pointed out some unusual benefits of the TRE process as well, however.)

I’ve argued that the TRE Buyers are exposed to incremental loss levels because of those shortcomings in risk mitigation.

It’s too soon to say what level of incremental return should be required by TRE Buyers to adequately offset the added risk.

It is not too soon to say, though, that the increment should be added to the IFA experience, not to the much lower CRE numbers.

And I would argue that the baseline point of the analysis should not be the experience of the largest companies but rather of the smallest, recognizing that the majority of TRE Sellers would not qualify for funding by the largest factoring companies.

We've all heard the one about the guy who drowned in a river that was only 6 inches deep, on average! Some statistics can be correct and irrelevant. Some can be correct and dangerous.

It's only coincidental that the first three letters of Treasuries, are TRE. We're not buying Treasuries here!

Half a Bubble Off Plumb!

In my “Happy Anniversary!” post of November 23, I wrote:

“From my point of view, the Exchange has tilted significantly toward the Seller community as it has attempted to bring on sufficient product to meet its volume targets.”

The degree of tilt is probably more than just “half a bubble”.

What has the Exchange done to “tilt” the playing field to favor the Sellers?

First let’s review where we began. From inception TRE:

--Has not required personal guarantees from the principals of Sellers,

--Has filed UCC Financing Statements encumbering ONLY the receivables sold on TRE (as opposed to getting a blanket lien on all receivables), and

--Has accepted internally-generated financial statements, frequently without any evidence of independent review.

Since the Exchange’s operations began, there have been a number of changes in policy or process that are good for Sellers but bad for Buyers.

What are some of those changes?

--Initially, invoices were to be verified by a third-party service provider. Now, the Exchange itself handles verification.

--Initially, the verification process was to include confirmation that goods had been delivered or services performed to the Account Debtor’s satisfaction. Now, verification is limited to obtaining confirmation that there is an invoice in the Debtor’s accounts payable system that matches the number, date and amount of the posted invoice. No actual affirmation of satisfaction is obtained. (Note that invoices from members of The Ariba Network do meet a more stringent standard.)

--Initially, all invoices were to be verified. Now, there is a sampling system.

--Initially, progress billings, which are common in the construction industry but present unusual risks, did not qualify for posting on the Exchange. That prohibition appears to have been relaxed.

These are significant procedural changes and they clearly increase the level of risk borne by Buyers on the Exchange.

I think it is clear that the changes have been made to allow TRE to attract more Sellers.

It might seem counter-intuitive that relaxation of procedural safeguards has been necessary to attract Sellers in the economic environment of the Exchange’s first year. After all, the papers have been full of stories about how difficult it is for businesses to find financing. But I don’t think the message is ambiguous.

TRE needs to ramp up volume to reach a level that makes it economically viable and proves to its equity investors that it is a viable operating entity for the long haul.

If the problem were attracting Buyers, any procedural changes affecting Sellers would be in the direction of tightening standards and procedures; making the risk profile more attractive to Buyers.

Changes in standards and procedures that increase risk to Buyers seem clearly to signal that the imbalance is on the Seller side.

The TRE calculus seems to be (this is my speculation only) that the Buyers will tolerate the increased risk as long as the risk is “potential” rather than “experienced”. That is, there are no significant Seller defaults and subsequent losses to Buyers. The implicit hope is that the Exchange can somehow control matters in the short term, avoiding any serious risk-related problems until it reaches its equilibrium level of volume.

At that time, maybe the process of moving back toward a level playing field can begin. If that IS what’s going on it’s a delicate and potentially perilous process.

On the positive side, while TRE will not hit its publically-stated volume targets this year, the volume HAS been ramping up significantly over the past few months and if we were to annualize current levels, the Exchange would come close to its volume goals on a run-rate basis.

If TRE can make meaningful progress on some of the impressive and important Seller-attraction initiatives already in place; including alliances with The Ariba Network, The American Staffing Association and Smyth Solutions, it is possible that it can reach a volume level in 2010 that can sustain its operations.

As it is approaching that critical volume level, however, it’s going to need some luck. The single greatest risk that it faces, I believe, is a nasty default and a public squabble over losses.

The additional risk in the system is real and “half a bubble” of tilt toward Seller-leniency is probably all the system can tolerate. Ultimately things will have to move back toward balance.

In the meantime: see my posts entitled “Caveat Emptor”.

Caveat Emptor #1

In our post of November 3 we urged The Receivables Exchange to adhere to its policy of requiring quarterly updated financial statements from TRE Sellers and posting those statements to the TRE Platform.

In early posts on this blog (see particularly those in June and July) we made the point that TRE, itself, takes no responsibility for the accuracy or adequacy of the information provided to Buyers. It is the Buyer’s responsibility to perform whatever due diligence it considers appropriate.

Caveat Emptor: “Let the Buyer Beware”; is the position taken in the TRE documents.

Fair enough--as long as we know the rules.

On the other hand, while I stand by my compliment to the TRE Seller-sales staff in our last post. And, while I understand that bringing more product to the market is a critical TRE objective at this point. It is also in the long-run best interests of the Exchange to balance its attention between the interests of the Seller community and those of the Buyers.

Providing updated financials would be one way to illustrate that balance. The basic point I made on November 3 was that it is important to Buyers to track changes in the financial condition of Sellers after their initial qualification.

I had a reminder of that this morning.

One of my disciplines as a Buyer is to get third-party credit information on all Sellers that make it through my initial analytic filters. Some providers of credit information send out “alerts” to those who purchase information, communicating subsequent changes.

I received such an alert this morning on a company that is a TRE Seller.

This company has completed a number of transactions on TRE since the spring, apparently without problem. The financial statements made available at the time of its first transaction were as of April 30. No updates have been provided.

As a Buyer, I would hope that the Seller’s use of TRE would have allowed it to better its financial position over the course of its experience with the Exchange. But I got an alert this morning that it’s rating for “risk of late payment” has deteriorated and that a state tax lien had been filed against it.

Now, neither of these alerts constitutes a “life threatening” event. But both convey information that is important to me.

If an auction by that Seller is posted today I will have to approach it more cautiously than I would have last week. Until I can see updated financial statements I will have to assume that they would be weaker than those I have in hand.

That might be fair, or it might not. But that’s the position that “caveat emptor” requires.

The Ariba Distinction

In our last post we addressed recent changes to the TRE invoice verification procedures. Two thoughtful and important comments have been posted in response and I’d call your attention to both.

The second of those comments, by Drew Hofler of The Ariba Supplier Network, highlights an issue that will (I hope) become increasingly important to all TRE Buyers.

Because a Seller that belongs to The Ariba Network brings added value to the table.

First of all--what is Ariba?

Quoting here from a press release:

“The Ariba Supplier Network is the world’s leading business collaboration platform, which combines technology and services to better match buyers and suppliers, automate transactions and optimize payments. Buyers and suppliers in 115 countries leverage the network to engage in transactions worth more than $110 billion a year and process one purchase order every two seconds. Leveraging the reputation and power of the Ariba Network, suppliers can lower the cost, risk and time associated with accessing capital.”

So, for our purposes, Ariba represents a VERY substantial volume of B2B receivables-creation, with a payment process that incorporates an automated, controlled, protected, invoice approval process.

Ariba and TRE have had a strategic alliance for some time now but the volume of Ariba invoices offered for sale on TRE has been minimal. That might be because of a lack of Ariba member education. It might be because the actual mechanics of uploading member invoices has not been as user-friendly as it might be.

In any event, Drew posted welcome news yesterday that I’d like to make sure to highlight. I quote from his comment to yesterday’s post…..

“This issue brings to light even more the value of invoices that are uploaded to the TRE platform directly from a supplier network such as Ariba. In the case of an Ariba supplier selling an invoice processed via the Ariba Network, both the issue brought up in the blog (verification) and the issue in the comment (quality of invoices/errors) are rendered moot.

1) Verification: When the next release of the Ariba Network (AN) comes out (4Q09), Ariba suppliers will be able to click a button and directly upload their approved invoices for sale to the TRE platform. Approved invoices are delivered directly to the AN from the Obligor's ERP, and are then transmitted directly to the TRE platform with no opportunity for the supplier to change any of the data contained within. Given the unbroken electronic chain of data, the need for verification is obviated.

2) Quality of Invoices & subsequent error correction: The nature of the Ariba Network is such that buyers/obligors set parameters up front that suppliers must meet in order for a submitted invoice to be considered in good order. This systematic quality control ensures that the vast majority of quality issues are filtered out before an invoice is even received by the Buyer/Obligor. So the issues brought up by Mr. Schmidt are largely removed for Ariba invoices.

Combine the above with the fact that eInvoicing via Ariba reduces invoice approval times down to an average of less than 5 days, and invoices sold by Ariba suppliers directly from the Ariba Network will offer TRE Buyers a qualitatively better option to reduce risk and extend returns.”

The critical issue to highlight in Drew’s comment, I believe, is that the Ariba system will actually provide a MORE robust verification process than had been offered by TRE even BEFORE its recent changes.

If I understand the mechanics of the network correctly—and I invite Drew to correct me or to amplify here—the invoices posted by an Ariba Seller will not only have been verified with respect to authenticity i.e. that there IS an invoice matching the Seller’s posting in the Account Debtor’s AP system, but the Account Debtor will have ACKNOWLEDGED that the goods provided have met the conditions of the agreement AND that the amount of the invoice is payable as and when indicated.

This provides a significant level of additional security to a TRE Buyer, which should result in preferential pricing of invoices originated by Ariba members.

A substantial increase in Ariba Seller activity would be a very good thing for TRE and, I suspect, for Ariba also. Let’s hope all interested parties work hard to make that happen!

Beware the Passage of Time

St. Augustine said: “Lord give me virtue -- but not yet.”

Augustine wasn’t talking about money, but the point is the same. Getting paid is a virtue. We want it-- but all in good time.

I’ve commented before on the perils of rapid repayment. I have to comment one more time. I just can’t help myself.

Included among the data provided by The Receivables Exchange on each Seller/Account Debtor relationship is a record of the Account Debtor’s payment velocity.

I personally think that TRE should report the figures on an “auction duration” basis; measured from the date of the sale of the Account Debtor’s invoice to the day that invoice is paid. That would tell the Buyers explicitly how long the funds used to buy the invoices were employed and it would tell the Seller's how much time they have "paid for".

But that is NOT what is provided and it is important to know that.

What IS provided is a record of the number of days from the DATE of the invoice to the date payment reaches the TRE lockbox. High, low and average figures are given.

So, in order to make an informed bid a Buyer needs to consider not just the payment history provided but also the age of the invoice at the time of purchase. Unless the payment history provided is analyzed in light of the current age of the invoice posted it can lead to unexpected results.

Let’s use an actual example:

A certain Account Debtor has a record of paying a certain Seller’s invoices in an average of 20 days. That is, 20 days from the date of the invoice.

That Seller posts a new auction. The invoice posted is 17 days old on the day of the posting. This invoice does not sell on the day of posting. In fact, three days later it still has not sold.

What is the position of a Buyer looking at that auction on the 20th day from the invoice date?

Based only on the history provided the answer is that he’s looking at a purchase with an expected duration of about ZERO days! The check could actually be hitting the lock box even as the payment for the invoice is being swept from the Buyer’s account.

In such a case what does the Buyer get?

He gets to pay the fixed exchange and transaction fees incurred in closing a purchase without earning anything at all. He gets to lose money on a deal that has been paid as agreed!

OK, so we have to be fair. The record shows that some payments have taken longer than 20 days to come in. So it’s possible that the Buyer will earn some revenue for his trouble. But, based on the record, it’s far from certain that he will earn enough to break even.

It’s also possible that the Seller knows something about the likely payment period of that specific invoice. Otherwise, why would he be willing to pay the Seller’s fees and transaction costs? He should hold that invoice and post a newer one for sale if he needs cash.

It’s also possible that the Seller has simply made an error and didn’t realize the implication of posting that particular invoice for sale. As a Buyer who has made errors while getting to know this new platform, I could both understand and sympathize.

It's also true that I don't know of an actual case in which the costs and fees of a transaction exceeded its revenue.

But the point still stands.

Taking the time to look at and understand the documentation supporting an auction is important and it’s clear that many auctions are completed without that being done.

As it happens, the auction described above sold on the 4th day after posting, or the 21st day after the date of the invoice. I considered making a bid calculated at the monthly discount rate necessary to break even on a one-day holding period but decided against it. Nobody likes a wiseguy!

A Quality Opportunity?

In our post of June 23 we wrote about the differences among the principal types of financial statements that privately-owned companies produce.

The companies that sell receivables on The Receivables Exchange are privately-owned firms that usually do not have audited financial statements. Many, in fact, don’t provide even “reviewed” or “compiled” statements; the financial statements available to a TRE Buyer are most often those of the management only, without independent review.

In our June post we quoted a report of the American Institute of Certified Public Accountants that a “compiled” financial statement carries with it “no assurance” of reliability from the accounting firm that has prepared the statement. Clearly a report that is prepared and presented by management alone can be considered no more credible than one complied by an independent CPA.

It’s not that management-prepared statements are necessarily less accurate than those prepared by independent accountants but I think it’s fair to say that the odds of material error or misstatement are far greater in a management-prepared financial statement than in one audited by an independent accountant.

If TRE is to become a major force in the receivables-finance industry, as we certainly hope it will, it will have to attract thousands of Sellers and it will have to attract sufficient Buyer capital to meet the needs of those Sellers. It will ultimately need to provide Buyers with more and better tools to make decisions regarding the quality of Sellers and the risks involved in buying the receivables of those Sellers.

Just as we suggested that eventually TRE would do well to go back to the model of having an independent invoice-verification agent, it also would do well to actively promote the establishment of an independent Seller-quality rating system.

It is unrealistic to expect that each Buyer will be able to maintain appropriate due-diligence information on thousands of TRE Sellers. It is also unrealistic to expect that TRE growth targets will be met unless Buyers have some source of risk analysis independent of TRE itself.

Many of the Buyers that TRE will certainly want to attract will be capital sources with some (at least internal) quality-rating requirements on funding. Recent experience in the markets for "new" financial products also suggests that those with oversight responsibility for the investments of potential Buyers will find it prudent to have third-party quality opinions.

At some point, attracting capital is inevitably going to require greater perceived objectivity and independence in analysis of Seller risk.

My guess is that TRE understands this. My hope is that they are working on it.

There are several possible models for establishing rating mechanisms. There are qualified entities already in the business of analyzing the financial condition of private companies. If a convincing case can be made for the ultimate success of TRE, and I think one can, there should be someone interested in providing a rating system of some sort for its Sellers.

There are just as many potential difficulties and inconveniences for TRE in dealing with an independent quality-rating system as there are with an independent invoice-verification system. Dealing with those inconveniences and solving those problems is part of the price of success.

It’s one of those examples of the paradox of control: the more control, in this case over the analysis of risk, that TRE is ultimately willing to give up, the more likely it is to actually accomplish its objective.

The Freedom of the Uncommitted

Early in my career I was in the commercial mortgage business. A colleague used to warn me that as long as the money had not been disbursed the lender had the power. But as soon as the check had cleared, the balance of power shifted toward the borrower: the larger the loan, the greater the shift in power.

When things start to get tough, the analysis of who has more to lose in an investment relationship begins to change.

The underlying cause for the shift in power in that business was two-fold:

1) the size of the investment relative to the assets of the borrower, and
2) the duration of the commitment.

In the case of a mortgage the lender will typically have a much more substantial investment than the borrower. A long-term commitment is formed in which the lender has a significant stake in the health of both its collateral and its borrower. And when times get tough the lender often will find itself essentially forced to help keep the borrower and the property afloat in order to protect its investment.

Behavior also changes as the duration of the commitment increases. In a traditional factoring arrangement, for instance, there might be an agreement to do a minimum volume of business for perhaps a year. Commitments are made whose duration extends beyond the immediately predictable horizon. Relationships are inevitably formed.

Even in the business of single-invoice purchasing, commitments can become implicit even if not explicit.

I had one client, for example, with whom I did 180 consecutive weekly transactions. I had no legal obligation to fund the 100th transaction any more than I did the third transaction, for instance; but by that time there was a relationship; both business and personal; and I felt a moral and personal commitment even in the absence of a legal one.

So, what’s the point? How does this relate to The Receivables Exchange?

Pardon the analogy, but the TRE formula is modeled on the commitment level of the “one-night stand”.

No relationships are formed; no commitments are made; the duration is limited; the shift in power is relatively predictable; and, the risk calculation has fewer variables.

Applying that analogy to an investment program….

As a TRE Buyer; at any moment of any day I can choose to just say no. I can stop buying altogether or I can stop buying the invoices of a particular Seller.

On the other hand, if I want to exit a stock portfolio or a real estate portfolio I have to take action: I have to sell.

If I want to exit a bond portfolio I have to either sell or wait for a potentially substantial length of time for a portfolio to self-liquidate.

If I want to exit a portfolio of options or futures I have to either sell or hold to expiration with significant uncertainty of exit price.

As a Buyer on The Receivables Exchange I can just stop buying and my portfolio will self-liquidate at a substantially-predictable price over a substantially-predictable period.

I can stop Buying without needing to negotiate a termination agreement.

I can stop buying the invoices of a particular Seller without having to sit across the table from someone with whom I have a relationship and having a “break-up” conversation.

TRE provides a platform in which there is no commitment, no relationship, no unspoken promises; in betting parlance: “no tears”.

That works for me!

Hold the pickles! On the virtue of sameness.

I spent a few years managing commodity futures investments.

The fundamental principle upon which the commodities business depends is sameness.

When you buy or sell a contract for the delivery of corn or coffee or oil or Swiss Francs, you know precisely what goods and services the contract requires: the quality, the quantity, the delivery date, the delivery location, the payment terms, etc. The only thing left to the operation of the market is price discovery.

In the classic fast-food differentiation war between Burger King and MacDonald’s, Burger King began the now famous “Hold the pickles” campaign in 1974.

BK promised that you could “have it your way”, customizing the product to your own particular tastes. While a brilliant marketing move, this also left BK open to a much higher incidence of customer complaints.

MacDonald’s promised to hand you a Big Mac, as standard (at that time) in its specifications as a futures contract on the wheat used in making its buns.

Burger King, on the other hand, promised to give you exactly what you asked for: “hold the pickles, hold the lettuce, no cheese, and extra mustard”; or, whatever.

MacDonald’s was the commodity provider; Burger King was the specialty supplier.

Here’s the point.

The odds of a complaint in a commodity transaction are significantly lower than the odds of a complaint in a specialty transaction. The Big Mac buyer can demand compensation if the burger is cold and dry. But the Whopper buyer who ordered it “his way” might have six other valid reasons for rejection of the product.

In our post of July 5 (An Inconvenient Essential—Part One) we pointed out that the TRE invoice verification process is limited in scope. TRE does NOT receive an assurance from the Account Debtor that the goods or services provided by the TRE Seller have met the specifications of the contract. All we know is that the invoice is in the Debtor’s Accounts Payable system. And that might only require that an invoice has been submitted by the vendor.

A Buyer considering the purchase of a TRE-posted receivable assumes some degree of risk that the obligation will be denied and payment refused (or that some negotiated compromise will be required). That risk should, of course, be reflected in the pricing of the transaction. The higher the risk that the goods or services might fail to meet contract requirements, the higher should be the appropriate return premium.

In pricing a transaction a Buyer has to ask: is the contract for a Big Mac or a Whopper?

In my traditional invoice-purchasing business I like to use the example of an excavation and demolition contractor who was an early client of mine. If my client had a contract to demolish a building I could go to the site and see that the building was demolished. If he had a contract to dig a foundation, I could go to see if there was a hole in the ground. It’s not perfect confirmation (maybe the hole in the ground is too deep) but there is some comfort in its simplicity.

When a client provides goods or services that are specialized, the question of risk becomes more complex and complexity requires compensation, especially in the absence of full verification.

When the product is “customized”, “specialized” or “turn-key”, I know that I’m not dealing with the guy who makes holes in the ground.

When the goods or services are based on “proprietary”, “innovative” or “patented” processes, I know I’m at the Burger King counter, not at MacDonald’s.

The more clearly I am dealing with a commodity, or a commodity-like service, the lower I can set my risk premium in bidding.

The more “customized” or “specialized” the product or service, the more I have to be compensated for the lack of assurance from the Debtor that he actually “got it his way”!

When Foundations Crumble

Bill Siegel of The Receivables Exchange wrote in his Liquidity Weekly post last Friday about the troubles facing CIT Group, Inc. CIT provides financing to hundreds of thousands of small to medium sized businesses (the SME sector).

Articles in the Wall Street Journal on both Saturday (7/11/09) and today make it clear that the failure of CIT would cause a great deal of harm to the SME sector of the economy, which generates the majority of new US jobs. CIT was founded in 1908 and has been one of the foundations of US commercial finance for decades.

We’ve seen no shortage of crumbling foundations in the global financial and business community in the past year. When names like Lehman Brothers and Bear Stearns cease to be; when the viability of AIG and Citigroup are seriously questioned; when the US becomes majority owner of General Motors; the assumptions on which many of us based our concept of economic reality are called into question.

But even more fundamental than the value and viability of such major enterprises are the conceptual foundations on which our understanding of financial reality itself have been built.

WSJ articles in on 7/10/09 and 7/11/09 raise questions about two of those conceptual foundations.

On page 1 of the WSJ last Friday was an article entitled: “Failure of a Fail-Safe Strategy Sends Investors Scrambling”. The “fail-safe strategy” discussed in that piece is asset allocation. It has been a foundation principle of finance that spreading investments across asset classes whose risk and return patterns are different will reduce portfolio risk and increase risk-adjusted return.

It can be argued, I think, that much of the structure of the global investment business reflects this one, single, powerful and pervasive assumption.

But what if it’s wrong?

That’s the question raised by the WSJ piece. There is too much at stake in the answer to that question to expect true objectivity from industry participants. Some of those quoted in the piece take the position that asset allocation has clearly failed. Others argue that it worked but not as well as expected. Others looked to the possibility that the rules of the system change under conditions of extreme systemic stress.

The very fact that the question is being seriously debated, however, has significant long-term implications.

A second foundation principle in modern US finance derives largely from research popularized by Professor Jeremy Siegel of the Wharton School of Business at the University of Pennsylvania. In 1994 Siegel published a widely-used study of the characteristics of stock market returns called “Stocks for the Long Run”.

As the title of his book implies, Siegel argues that over long periods of time equities generate a “remarkably constant” average return and that “the risks of holding stocks decrease over time”. Siegel wasn’t the first to make the case for long-term stock ownership, of course. It had been around for some time. But his research popularized the less-accessible work of some important predecessors.

Interpreted and articulated by persuasive Wall Street marketing departments, Siegel’s work (and others) helped convince both institutional and individual investors to both increase their equity exposure and to hang tough during volatile market “episodes”.

Siegel’s research was influential, in part, because of the duration of the data he used in reaching his conclusions. The return series reached back to 1802! The credibility of conclusions reached when a series of that duration is tested obviously seems higher.

But the piece in Saturday’s WSJ called into question the data used by Siegel for the early period of his research. The author, Jason Zweig, concludes that: “The 1802-1870 stock indexes are rotten with methodological flaws. So we have only the periods since then…to base our long term investment decisions on.” So the data series that Zweig finds reliable is about 1/3 shorter than Siegel’s study accepts.

Now it is natural in a period such as this to call into question the reasons for the failures of our systems. And not all of the answers will ultimately prove correct.

But I think that there is one thing that we can say with a high level of probability: we’ve come so close to total financial melt-down and so much faith has been lost in some fundamental concepts on which our system has been based, that investors will be looking diligently for alternative approaches and alternative vehicles.

The thesis of Bill Siegel’s piece on Friday was that the troubles being faced by CIT might ultimately provide a boost to the business of The Receivables Exchange.

I suspect that he is correct.

But I also think that, more importantly than the impact of any single entity or event, the business of investing in accounts receivable and the vehicle provided by The Receivables Exchange are likely beneficiaries of the re-evaluation of larger, foundational concepts in the business of finance.

An Inconvenient Essential--Part Two

In our last post we identified the invoice verification process as a potential source of “friction” in TRE operations; potentially a threat to both its speed of growth and even to its scale.

We discussed the steps taken by TRE to mitigate the friction and concluded that there appears to be a reasonable balance between: a) the risks posed by forgoing certain typical verification requirements, and b) the risk-mitigation elements in the TRE process.

But the issue cannot be left there. The fact that there are procedural protections that mitigate the apparent risk does not address the question raised by the fact that TRE, itself, verifies the receivables proposed for sale.

Given TRE’s rapid growth goal and the potential for the verification process to impede that growth, there is a potential conflict of interest that has to be acknowledged.

According to the materials available on the TRE website, it was initially expected that the verification process would be outsourced. The idea that a reputable third-party would be handling the verification process was expected, I assume, to give Buyers comfort that there was no potential conflict.

In fact, however, the process in place does not include an independent verification agent.

I do not know what caused the change in direction so my comments here have to be understood as no more than my own speculation.

If I were going to identify a list of candidates for the job of verification agent I would probably start with the big accounting firms: well-known, respected and knowledgeable; the names you find on public companies’ audit reports. They also employ hordes of relatively inexpensive, entry-level professionals.

The second group that I’d reach out to would be the credit rating firms with high name recognition i.e. D&B, Experian, Equifax, etc. These firms also employ large numbers of relatively inexpensive information gatherers.

From the perspective of an accounts payable person in a Debtor’s office it would probably not seem unusual to get a request to verify information from either a well known accounting firm or from a credit reporting agency.

From there, though, I begin to scratch my head. I’m not sure what other type of firm would have the capacity, the name-recognition, the staff resources and a willingness to consider the job, at a pricing level that would make sense.

If a well-established accounting firm or credit reporting agency were to consider the assignment, what would be the likely outcome? My guess is that they would quickly get tied-up in problems of definition, procedure, authority, work product and potential liability.

What level of authority must the individual providing verification possess? How is that authority ascertained? What reason can the verification agent give for wanting the information? After all, the Debtor isn’t told the invoice has been sold. What is the minimum evidence of acceptable confirmation? What specific assertions are required? How does the verification agent assure TRE that it has actually obtained the information if it is obtained only orally? Would it be feasible to obtain any written verification and, if so, at what cost in terms of transaction speed? What level of liability, if any, would the verification agent assume for the accuracy of its information? If no liability is assumed, what is the quality-control leverage?

You get the point!

The IDEA of an independent verification agent is unquestionably an appropriate one. The difficulties in implementing the idea are just as obvious.

The question now becomes: given that there IS an apparent potential for conflict, how real is the likely risk to a buyer?

In order for TRE to grow as it wants to grow, it needs more than anything else to establish credibility early. Better to lose potential business through excessive caution than to subject Buyers to losses through lax underwriting.

There is also meaningful value to TRE, I suspect, in doing the job itself (at least for a time), since the experience it gains will help it better fashion an effective relationship with a third-party should it attempt that in the future.

My own view is that, while the potential for conflict is obvious, the current risk is minimal. The stakes for TRE are too high at this point to jeopardize its long term goal by taking shortcuts this early in its development.

However, as the exchange ages a bit and the time approaches to actually meet the growth goals on which its establishment and financing were based, the level of risk could well rise.

As one who wishes success to the TRE enterprise, I hope that its management plans to ultimately establish the independent verification process that was apparently contemplated in its initial conception of the exchange.

An Inconvenient Essential--Part One

Among the essential numerical values that we learn in high school physics is the number that defines the speed of light. If we go on to other, non-scientific pursuits in our lives, it is likely that we’ll forget an important qualification in that definition. The number we learned represents the speed of light in a vacuum. In the presence of any source of friction, that speed cannot be reached.

In our last post we noted the desire of The Receivables Exchange to become a very large-volume platform. Growing from an initial transaction in late 2008 to a targeted $1 billion in volume in 2010 might not challenge the speed of light in literal terms but it comes close in financial terms. An essential element in its success must be the elimination of as much friction as possible.

We’ve already identified a few of the sources of friction usually encountered in purchasing individual invoices and the ways that TRE has devised to lessen their impact.

Now we need to address another major one: the issue of invoice verification. The buyer of a receivable needs to verify that the receivable is valid.

Most buyers of individual invoices will want assurances that: the Account Debtor acknowledges that it contracted to purchase the goods or services; that the goods or services have actually been provided; that they meet the criteria established in the contract; that the invoice being purchased states the correct amount due and the correct terms of payment; and, that the invoice is scheduled to be paid.

That’s a lot of friction! It’s often difficult or impossible to find anyone in a Debtor’s organization willing to sign-off on such assurances.

After the initial qualification of a client, the invoice verification process represents the major impediment to the speed of invoice purchase transactions. Given the need for TRE to minimize such impediments, it’s clear that this issue has had to be a focus of their operational design.

TRE has to have a process that provides appropriate comfort on the verification issue without causing so much friction in the system that it is impossible to meet their speed-of-growth and scale objectives.

The procedural solution is a compromise. Many of the typical elements of “full verification” are sacrificed, but the loss of those assurances is balanced by other elements of the TRE system.

What are the assurances that are sacrificed?

1) Neither TRE nor the Buyer has a direct relationship with the Account Debtor; so the Debtor does not provide either TRE or the Buyer with a direct assurance of the existence of a contract or purchase order.

2) The Debtor does not provide a direct assurance of the receipt of the goods or services.

3) The Debtor does not provide a direct assurance that the goods or services meet the requirements of the contract.

4) The Debtor does not provide a direct assurance that payment will be made.

In what ways is the sacrifice of those assurances balanced?

1) Prior to approving the invoices of a Debtor for posting on the exchange, TRE will investigate the history of transactions between the Seller and the Debtor to determine that a relationship does exist.

2) The history of the relationship between the Seller and Debtor will be examined to provide context for the analysis of invoices proposed for future sale.

3) The agreement of the Debtor to make all future payments to the TRE lock-box provides additional evidence of the validity of the relationship.

4) TRE will independently acquire contact information allowing it to access appropriate individuals within the Debtor organization who can verify that an invoice is “in the system for payment”.

5) TRE employs experienced fraud investigators to help it to detect any potentially fraudulent relationships or transactions.

The only piece of directly-sourced information regarding a specific invoice is that it is “in the Debtor’s accounts payable system”. That might seem to provide much less security than typically required by single-invoice buyers.

However, by the time a TRE Buyer sees that invoice posted for sale, the invoice will have been analyzed within the context of a great deal of previously-verified information about the relationship and the historical transactions between the Seller and the Debtor.

It’s certainly possible that, from time to time, specific invoices will prove problematic; and it is possible that the TRE verification process will have failed to uncover those problems in advance.

On the other hand, if such a problem occurs:

a) Within a verified pattern of transactions between the Seller and the Debtor,
b) In the presence of a continuing payment-direction agreement,
c) In the context of a security system that provides meaningful recourse, and
d) In an environment of a robust fraud-detection effort,

it is likely that a solution to an isolated problem can be found.

There is no guarantee that no losses will occur, but losses can occur when buyers obtain ALL of the typical assurances. Stuff happens!

There is a good argument to be made, I think, that the sacrifices made in the TRE verification system, for the sake of reducing friction and accommodating scale, are reasonable and that the apparent additional risks are balanced within the operational system of the exchange.

An important question remains, however, that will be addressed in our next post.

TRE itself, with its very aggressive growth goals, acts as its own verification agent. The question of potential conflict between growth goals and transaction quality goals has to be addressed.

The Financial Statement Assurance Continuum

When a company sells a receivable on The Receivables Exchange, the Seller agrees to repurchase the receivable if the Account Debtor (the Seller’s customer) does not pay it.

The Seller’s commitment to repurchase is the Buyer’s initial line of defense against loss.

The strength of that defense is a function of the Seller’s ability to fulfill its commitment.

If the Seller’s customer doesn’t pay, how likely is it that the Seller will be able to pay as required?

The bulk of the information available to help answer that question will come from the Sellers themselves, principally in the form of financial statements. (Even if a Buyer obtains supplementary credit information from an independent provider, much of the information will have been sourced from the company itself.)

Two threshold questions always have to be asked: a) does it appear from the information provided that the Seller has the capacity to fulfill its commitment, and b) what level of confidence should we have in the information provided?

Each Buyer will look at financial statements somewhat differently but any analysis is only as good as the information available to analyze. So we’ll focus here on the question of confidence.

There are four generally-recognized types of financial statements produced by corporate entities: 1) audited, 2) reviewed, 3) compiled, and 4) internally-generated.

In the first three cases, an independent accountant or accounting firm has had some degree of involvement in the preparation of the statements. Statements that are internally-generated have no third-party whose name and reputation is associated with the data provided.

There are important procedural, technical and legal distinctions that have to be made to accurately distinguish among the first three types of statements. For our purposes, however, I think we can use a convenient “shorthand” distinction that appeared in a paper published in March 2008 by the Reliability Task Force of the American Institute of CPAs.

That paper presents an “Assurance Continuum” that positions each of the three types of financial statements on a line that proceeds from the highest level of assurance that the information is reliable to the lowest level of assurance.

In the language of that Task Force Report:

An audited financial statement has a “High Assurance” of reliability.
A reviewed financial statement has a “Limited Assurance” of reliability.
A compiled financial statement has “No Assurance” of reliability.

It follows, I think, that an internally prepared statement, which has had no independent accountant’s review, would also fall in the “no assurance” category.

Now, the fact that an accountant has not certified the accuracy of the data presented in a financial statement doesn’t mean the data is NOT accurate. And we’re all aware of cases in which apparently diligent audits have proven inaccurate.

We also have to acknowledge that the staff of The Receivables Exchange does spend time and effort vetting potential Sellers.

All that said, however: it is still only reasonable to acknowledge that there is a higher level of reliability in the financial statements of a company whose books have been audited by a third-party professional than there is in the books of a firm that internally generates its own statements.

The level of risk in a Buyer’s analysis does, without question, vary with the reliability of the financial data.

All else equal, the lower the level of assurance that the Seller's financial data is reliable, the higher the appropriate Buyer’s risk premium.

Liability: It's Not Personal.

Most firms that buy individual invoices routinely obtain a personal guarantee of the seller’s obligations from one or more individuals associated with the seller.

If the transaction goes bad, the personal guarantee can become critical in ultimately recovering the money advanced for the invoice purchased. One of the reasons is that, if litigation is required, the litigation process can take so long that other pledged security, such as other receivables and other financial assets, can be long gone by the time there is actually a judgment for the buyer to attempt to enforce.

The Receivables Exchange does not obtain personal guarantees from its Sellers. So the Buyers’ avenues of recourse in the event payments are not properly received are more limited.

Why would personal guarantees not be obtained by TRE and what are the implications?

I think there are a few pretty obvious answers to the first question.

1) TRE aims to become a very large-volume marketplace. As a practical matter, scaling up gross transaction volume requires two components: a) more Sellers, and b) larger average transaction sizes.

2) Larger average transaction size implies larger Sellers and the larger and more substantial the Seller the less likely its principals will be willing to provide personal guarantees.

3) In order for a personal guarantee to affect a Buyer’s assessment of risk, the substance of the guarantee would have to be known to the Buyer. Few individuals, especially owners or principals of more substantial Sellers, would be willing to have their personal financial information made broadly available to Buyers with whom they have no direct relationship and over whose use of the information they would have little effective control.

As to the implications, again, I think there are a few.

1) Analysis of the Seller’s financial condition and capacity becomes more critical. If a payment is not received for a purchased receivable, does the Seller have the ability to make good the Buyer’s loss?

2) Analysis of the validity of the receivable proposed for sale, which is always critical of course, becomes even more so.

3) Analysis of the Account Debtor’s capacity to pay and likelihood of paying the invoice likewise becomes more critical.

4) In short, when one source of security is removed, all of those that remain become more important.

I think it’s quite understandable that TRE does not obtain personal guarantees from its Sellers. But that doesn’t mean that there is no impact on risk assessment. And if there is an impact on risk assessment there should be an impact on pricing.

It does mean that analysis of the Seller’s financial condition, the validity of the invoices posted for sale and the ability and likelihood of the Account Debtors to pay those invoices, all take on heightened importance.

If analysis of the Sellers' financial condition becomes more important, reliability of the financial information provided (or otherwise available to Buyers) is key.

In our next post we’ll discuss the issue of the level of assurance that can be attributed to information in various types of Seller financial statements.

"Does this dress make me look fat?"

Wisdom from a good friend, older and wiser than I…

1. If you are asked: “Does this dress make me look fat?” and the questioner is your significant other, the appropriate answer is always “No!”. Honesty is neither virtuous (nor necessarily safe).

2. If that same person has a piece of parsley stuck in her teeth, on the other hand, you’ve just got to point it out.

I am a friend of The Receivables Exchange. I am a Buyer on TRE, so I am committed to it, and in my last several posts I’ve expressed very positive opinions on several major aspects of TRE structure, concept and operations.

But in my first post (scroll down or select the May 28 post from the sidebar) I did write:

“TRE is new and it is far from perfect. It will inevitably be required to make adjustments as experience teaches its operators and its users some valuable (and some potentially expensive) lessons. All beginnings are hard.”

So, in the next few posts I’m going to be discussing some aspects of TRE operations that I think are analogous to parsley in the teeth. You’re no less a friend for pointing it out; arguably you’re a better one; but it's less comfortable than delivering a compliment.

The issues to be discussed all bear on the assessment and pricing of risk.

More to follow.