Further on Alignment of Interests

In my last post I suggested that TRE modify its fee structure to eliminate distortions caused by the fixed component of the Buy-side Exchange fees. Those distortions are magnified in auctions with relatively short durations.

One auction in this week’s market activity caused me to look back at the question of distortions from a different point of view.

On Monday afternoon, a fairly seasoned TRE Seller posted an auction with pricing parameters that set a new record. The buy-out advance requested was higher than any in my memory and the buy-out monthly fee offered was the lowest in my memory.

The Seller is solid, but not gold-plated. The Debtor has an unquestioned capacity to pay and its performance in prior auctions appears to have been fine. I have bought an auction from this Seller, involving invoices due from this Debtor, and was quite satisfied with the result.

So the deal deserved a good price.

But the pricing requested in this transaction would have returned to the Buyer something closer to a CD rate than a return typically associated with receivables financing.

My first reaction was: What are they thinking?

My second was: Let’s try to actually understand what they’re thinking.

I have to admit that I have a Buy-side bias when it comes to analyzing auctions. I spend a lot of time on the subject of return to the Buyers. I really haven’t spent much time working on the cost of funds from the Seller’s point of view.

But the only way to answer the question: “What are they thinking?” is to look at the transaction from the “other side”.

I’m not going to say much about the TRE sell-side fee structure except to say that the basis of the fee is essentially the size of the auction and that the rate charged is variable depending on certain Seller characteristics. For my purposes I’m going to assume that the Seller in this case enjoys a rate at the low end of the range.

The auction under study has a probable duration that can be readily estimated. There has been a reasonable amount of past activity and actual payment experience has been quite consistent.

If we know the auction size and its pricing parameters, the duration is really the only remaining variable in the return calculation. So this particular example is a good one to use from that perspective.

It really is quite surprising how the view of the transaction changes, depending on one’s perspective!

I looked at two cases:

1) the initial buy-out pricing parameters, and

2) the actual final sale pricing parameters.

And I looked at the projected return to the Buyer in both cases and then the projected cost of money to the Seller in both cases.

Case 1: Using the initial buy-out pricing parameters, the net annualized yield to the Buyer would have been in the very low single digit range. But the net annualized cost of funds to the Seller would have been about 5 times that level!

The cost of funds would still have presented an extraordinarily attractive deal for the Seller, however --in the mid single-digits on a net annualized basis -- so there’s no mystery why the Buyers weren’t willing to play.

The point is that the gap between the return to Buyer and the cost to Seller, which is clearly a function of the fees earned by the Exchange, is a hugely distorting factor when pricing is extremely aggressive and duration is relatively short.

Case #2: Using the actual sale parameters, the distortion is much lower but it is still substantial. The return to the Buyer is just into the double-digit range while the cost to the Seller is in the high teens.

Now I don’t know how many Sellers look at their cost of funds in the same way that I have looked at it. But in this instance, while I would have been unwilling as a Buyer to accept the return generated by the deal; if I were in the Seller’s shoes I would probably have thought I was paying a pretty fair price for the money.

There’s the rub.

At this stage in its life TRE has a fairly small transaction base on which to generate fees. It’s clear that fees alone can’t cover its current expenses. It will need to grow by a significant amount to reach that point, I suspect.

On the other hand, given the need to grow substantially, the question of the impact of fee structure on growth potential is a fair one to ask.

Having gone through this exercise I have a greater sensitivity to the position of the Seller.

But my sensitivity doesn’t change my estimation of appropriate return to Buyers’ capital one bit. And it won’t change my actions at all.

[Except that the language I use when I see what appears to be an irrational Seller pricing structure might be somewhat more moderate.]

Only TRE needs to be sensitive to BOTH sides of the auction transaction. Buyers are going to look to their own interests and Sellers to theirs. That's the nature of the market. But TRE has to understand and act to ensure that both sides find the net benefits fair.

Otherwise, the growth that we all need and want is at risk of failing to materialize.

Alignment of Interests

For nearly two years now I have spent a significant part of every working day (and of many non-working days, for that matter) somehow engaged in the activity of The Receivables Exchange.

Over the course of that time I have bought nearly 400 TRE auctions; analyzed the financial condition of hundreds of TRE Sellers and their customers; had some success; made some mistakes; and thought quite a bit about what makes TRE “tick”.

And over the course of that time I’ve seen TRE make many changes in its operating practices, responding to perceived opportunities to improve on its original business model. Most of those changes have been, I think, responsive to understandable issues or concerns, and most have been motivated by a quest to add value to the benefit of all involved in the Exchange.

Ultimately, for TRE to succeed, the interests of Seller Members, Buyer Members and the Exchange itself, must be served. All three business models have to work if the Exchange is to achieve its long-term goals.

It is with that in mind that I’d like to offer a suggestion, as one with a substantial interest in the success of the Exchange.

I believe that the fee structure of TRE could be modified, in two fairly straightforward ways, to better align the interests of the parties. And, at the same time, to provide an opportunity for both increased Seller volume and increased Buyer appetite.

The basis of my suggestion is:

FIRST: the fact that Buyer and Seller interests are (primarily) reflected in distinctly different Exchange functions.

1. The primary interest of the Seller is met at the time its auctions are sold and funded, but

2. The primary interest of the Buyer is met when an auction is repaid in accordance with auction terms, and

SECOND: the fact that all three parties have a common interest in the length of time between the sale and the repayment of an auction.

It is not necessary to this discussion that we refer to the actual LEVEL of fees charged to Buyers and Sellers by TRE. It is sufficient to discuss the STRUCTURE of the fees.

The fee charged a TRE Seller, with respect to a specific auction, is (with minor exception)a function of the size of the auction. And it is earned and payable when an auction is sold.

In principle, there is little to quarrel about there. If the Seller’s primary interest in selling an auction is met in the sale and funding process, then it makes sense that that process should provide both the nexus and the basis of fee payment.

The Buyer's fee structure, however, has two components:
a) a fixed charge payable at the time of purchase and based on auction size, and
b) a variable charge payable with each remittance received, based on the Buyer’s earnings.

It could be argued that the Buyer’s primary interest has two components: the opportunity to deploy funds and the opportunity to have its capital returned with agreed-upon earnings. Under that logic, the two-part fee structure might appear reasonable.

In fact, however, there would be no desire to deploy funds without the expectation of their return. The ESSENTIAL interest of the Buyer is not in buying: it is in earning. And that essential interest is not met until an auction is closed-out.

The current TRE fee structure aligns the interests of the Exchange with those of the Seller to a greater degree that it does to the interests of the Buyer.

An equally-aligned fee structure would eliminate the fixed, size-determined portion of the Buyer's fee and provide for fee payments to TRE as and when Buyers are paid. Such a fully-variable fee might well be at a higher rate than that of the current variable portion of the Buyers’ fee. My issue here is STRUCTURE, not rate.

I can well understand how the current Buyer fee structure was conceived but, at the same time, I think it’s hard to argue with the logic that the Seller’s basic need is met at the time of sale and the Buyer’s basic need is met when an auction is closed-out.

Aligning the fees to the time when those basic needs are met has a clarity and simplicity that I find compelling.

My second suggestion, which I believe would be in the interest of all parties, is also simple in concept if perhaps a little more difficult in implementation.

It arises from the issue of duration, which I’ve written about in several prior posts. In those prior posts my point has been that the fixed portion of the Buyer fee structure disadvantages short-duration auctions. Obviously, a fixed fee based on size will dilute the Buyer’s yield on an auction that is only open for 10 days to a much greater degree than it will on an auction open for 60 days.

If the fixed portion of the Buyer’s fee is eliminated, as I suggest, this problem goes away for the Buyer. However, since the fees to the Seller are payable without respect to duration, the actual cost of funds to the Seller rises as the duration decreases.

Currently, the return to the Buyer on short-duration auctions is squeezed by the fixed fee and the cost to the Seller in a short duration auction is substantially magnified.

As matters stand, I will almost never bid on an auction when the invoices included are due in 14 days or less. (That’s not iron-clad, of course. The LIKELY payment velocity is more important than the stated due date. But the principle is the same.)

If I won’t buy the short duration auctions, I suspect that there are others who act in the same way. The counter-argument will probably be: “But those auctions DO get sold!”

Agreed! There are clearly Buyers willing to pay up for paper that might roll over every 10 days.

But that’s not really the point!

All parties in this adventure need overall TRE volume to INCREASE.

The fact that there are a few Sellers that routinely succeed in selling short-term invoices and that find a way to rationalize the all-in cost of those funds, obscures the real question, which is: how many more Sellers, whose invoices are relatively short-term, might be attracted to TRE if the short-term nature of their invoices was reflected in the fee structure?

I don’t know the answer to that question. And I recognize that incorporating a variable element in the Seller fee structure would require solving a few complicating issues.

But consider the difference between the annualized fee costs of two Sellers, both of which pay the same size-based fee for selling an auction, one of which is selling invoices with an average life of 10 days and the other selling invoices with an average life of 60 days.

I cannot believe that more Sellers of short-term invoices would not be attracted to TRE if it made a fee accommodation for the shorter-term paper. Such an accommodation might be accomplished simply by providing a fee credit for payments received earlier than a specified number of days.

And I cannot believe that more Buyers would be not willing to consider shorter-term paper if the returns were not so diminished by the fixed fee element.

Fee structure is fundamental to the TRE business model and no consideration of a change so fundamental will be easy. But we’re in the third year of actual TRE operations and we’re in a rather prolonged period of flattish volume.

At this point I believe that all elements of the business model have to be open to further analysis.

The question of fee structure should not be ignored.

In the Way of St. Augustine

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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