The economic and political environment that we find ourselves living in today is fertile ground for increased government oversight and ever more assertive regulators. Our economy’s anemic recovery has resulted in many debtors continuing to struggle in making payments on their financial obligations. As the Chief of Analytics at Flock Specialty Finance, I have the opportunity to review and evaluate many portfolios across nearly all asset classes. The most important key to success in evaluating portfolios and partners is Knowledge. The more knowledge that I have about our potential partner and the portfolio, the better decisions I am able to make.
As a child I was very inquisitive. I was always asking questions, looking in drawers, and touching everything. As a direct result, my mother’s words echo in my mind to this day. “Don’t touch that, you don’t know where it’s been.” This phrase captures the essence of parents and children as a child tries to learn about a larger world. It also applies to our business as well.
In my role at Flock, knowing our partners, the sellers, and the history of the accounts being sold is critical. Long past are the days of midnight exchanges of disks or USB drives with accounts on them, passed from seller to buyer, handed over in dark parking lots. To mitigate the increasing risks of our industry, we have to “Know”. We have to know if our partners or the seller have faced regulatory scrutiny from the CFPB in the past. We find that far from being a negative, the online CFPB database offers a wealth of information about companies and their past practices. The database in the hands of a savy user can provide essential insights into sellers, buyers, asset classes and portfolios. It is easy to determine if the seller is pushing off accounts that may create exposure or if a potential buying partner has the tendency to be less than compliant. These insights are critical, however, a deeper dive is often required. An excellent example presented itself recently when a client brought files for our review. During our due diligence process, we discovered that the seller had an identical corporate structure and identical officers with a company currently under investigation by a regulatory agency. Taking that extra time to get to know the seller helps us avoid exposure that could put our partners and our investors at unnecessary risk.
Partners
As part of our review process, we seek to insure our partners and their sellers are strong. We conduct a financial review of our partners. Why? A company with a solid financial foundation may find it prudent to leverage its returns to accelerate growth. However, a company in a weak financial condition may find itself under pressure to perform, and in so doing affect the collections culture on its floor. This may push its collectors to excessive aggressiveness and trigger enforcement actions. As a result, a wise investor will seek to partner with companies on a sound financial footing and have the financial strength to withstand changes and adapt to them.
The same must also apply to our selling partners. Any debt purchaser must know the relative financial strength of the seller. Larger financial institutions should be reviewed through open sources such as the SEC and news searches to see if the company is under strain. This provides critical evaluation data as well as may provide intel on the portfolio itself. This same thing can be done for smaller sellers as well, and can save a debt buyer considerable time and avoid loss risks in the future. A debt buyer might spend weeks negotiating with a health care provider to begin selling accounts for the first time and be entirely focused on the deal at hand. But in being so focused on a deal they fail to investigate the seller’s condition. Lacking actionable intelligence on the condition of the company, the debt buyer might be unaware that the seller was on the brink of bankruptcy or sale to another provider. In such a case, the debt buyer might spend those precious resources working to achieve a purchase only to see the seller walk away at the last minute. The putative seller was sold off to another company, having effectively used the debt buyer as a “mark to market valuation” source.
Similar circumstances can impact the sale well after the transaction. A financially impaired seller might fail to remit direct payments to a debt buyer. Challenged sellers have been known to offer post sale settlements and keep the funds or attempt to buyback paying accounts. In many cases these flaws are uncovered too late as the buyer accumulates unrecoverable losses. As in the case of bankruptcy, the debt buyer finds itself an unsecured creditor, standing far back in line hoping there might be some funds left for distribution. Knowing your partners and keeping close to them is key when investing in the purchase of accounts.
Accounting statements, BBB reports, regulatory and complaint databased can only carry us so far. We recommend that debt buyers take stock of the reputation of their partners as well. Warren Buffett once said “It takes 20 years to build a reputation and five minutes to ruin it.” Debt Buyers must check up on the reputations of their business partners. A new client of ours, and relatively inexperienced in debt buying, was pursuing a particular product from a seller. We had direct experience with the product and its bidding process. The seller made repeated assurances to the debt buyer but the reputation could be summed up simply: “No one who has purchased those accounts buys them twice.” Having that experience, we were able to guide our investment partner. If you lack direct experience, it’s important to partner with an entity who does have the experience. This likewise goes for any partners, joint investors, funding sources, or subsequent buyers. If a partner has a reputation for dishonorable behavior or taking advantage of partners when difficulties arise then a debt buyer has only itself to blame later.
A score at the end is just a score. Knowing how to interpret that score is a must, and the ability to spot data issues will help avoid risk.
As joint investors, we find it valuable to know our partner’s reputation. We carefully review a variety of sources in doing so. In any joint venture, you should verify your partner’s standing with certified industry leading associations, like the DBA International, ACA and the Better Business Bureau. We regularly make a practice of checking the CFPB’s complaint database – that real time monitoring of consumer complaints, the offending company and a description of the issue. Generic online company searches can provide additional background information or alert you to ongoing or current issues impacting your partner.
Recently, I was researching a potential partner in connection with the sale of a hospital’s non-performing accounts. Through these methods, we discovered that the hospital was in poor financial condition. Additionally, this hospital was experiencing conflict between its upper management as the CEO and CFO seemed to be publicly debating short term and long term strategy. We uncovered this risk through a simple search and a read of the local small town paper. This wasn’t difficult, but if overlooked can pose material risks to a buyer post acquisition. In this case we were able to help our partner craft the purchase and sale agreement in such a way as to mitigate the risks.
Data
Buyers of consumer receivables must understand their data and have a solid background in data analysis, spotting trends, and identifying inconsistent data elements. Smaller buyers may lack in house expertise and in doing so should partner with those who have analytical resources and talent. Purchased generic risk scores are great tools for evaluating portfolio risk, however, they can be one dimensional. If the data is corrupt, incomplete or flawed in some manner, then the score generated will not yield the intended results. It’s not sufficient to outsource the process through purchasing a score. A deeper more thorough look at the data and trends is critical to making an informed evaluation of a portfolio. Analytics within your team or partnership are also better suited to your company’s method of working accounts. Ideally the entity providing this aid will be aligned with the debt buyers’ interests.
Identification of key variables is a fundamental part of the process but it’s not enough to know the variables. Context is critical and understanding how to identify when variables don’t make sense. A debt buyer will likely examine the rate of first pay defaults, but understanding what that rate means in the context of the product type matters. A high first pay default rate on auto deficiencies might indicate data quality issues or file quality issues pointing towards adverse selection of the accounts being sold. A similar rate might not be out of the ordinary for high interest personal loans. A file indicating no payments to date on the consumer obligation portion of healthcare files might tell a different story entirely. In all three cases, the single data element has a very different impact on the potential liquidations.
Many debt buyers might only look at charge off date without questioning other data variables and their relationships. In a file where the seller discloses that the charge off policy is 180 days post delinquency, we would of course then look to the date of last payment. Recently I reviewed a file with one of our clients with a considerable, as in years, difference between the charge off date and the date of last payment. In the process of follow on inquiry, I determined for the client that 1/3 of the file had a charge off date of a single date. When the seller was asked about the anomaly it was discovered that they had a systems conversion and apparently simply block dated many accounts. This means that the charge off date in the file, arguably one of the most key variables for compliance, was questionable.
Debt buyers are also well advised to truly understand the balance. When a file arrives with a column heading simply stating “sale balance”, what precisely does that entail? Pre and post charge off interest? Fees? Other items? This can also be a pointer to the consumer treatment prior to sale and its attendant effects on your recoveries.
Debt Buyers should either have a basic understanding of, or partner with someone who does, basic statistical concepts. When your analyst tells you the average is X, is that the weighted average or the Mean? How far from the Mean is the Median, the middle point? I have recently seen a file, that when plotted as a histogram looks like a two humped camel. The file consisted of approximately half overdraft protection accounts and the other half HELOCs. It was sold as a personal loan file. Having the ability to spot data inconsistencies will lead you to deeper questions, allowing you to maximize returns, but also to avoid pitfalls that put your capital at risk and can affect the balance sheet of your company.
From this perspective, buyers should not get trapped into examining just quantifiable information. Seller surveys and disclosures help a great deal. I also find it important that your company’s “quants” have an understanding of the direct collections business and an ability to relate to the consumer and collector. When I built a predictive model for a specialized asset class a few years ago, my first stop wasn’t my computer and a whiteboard. I began by doing a survey of the people already collecting the asset in our company. What did they see as predictive, and where? Were there relationships they thought they knew already? Doing so allowed me to set up testing more quickly and test relationships. By interviewing people directly connected to the portfolio, I was able to better understand the asset and build a better model. In many cases the relationships were right, but now quantified. In others, the relationship was correct but only with other variables present, and a minority were disproved. But by working with people who knew the data and were in contact with the debtors day to day, we produced a better product.
A score at the end is just a score. Knowing how to interpret that score is a must, and the ability to spot data issues will help avoid capital loss risk. Partners who take their fees on the front end have little to lose from mistaken valuation. Having a partner who is aligned with their long term interests as a co-investor whose returns are tied to long term realization of value is a necessity.
Assertive company managers may choose to take risks in order to grow and thrive. But the key is that take educated risks. A savvy manager will begin with identifying expertise that is needed and set about partnering with those able to aid in developing the knowledge needed and understanding it. Knowing your partners; whether sellers, other debt buyers, collections companies, or co-investors as well as knowing the accounts you are purchasing will enable you as a debt buyer to take educated risks and maximize your returns.
About the Author
Damon W. Edmondson, with 19 years of experience in the receivables management industry, is Chief of Analytics for FLOCK Specialty Finance, providing underwriting support for new lending, borrower evaluation, business intelligence, assisting clients with portfolio pricing, and valuation for M&A projects. Damon earned his BA from The Citadel, and currently resides in Roswell, GA with his wife and 3 sons.
About FLOCK Specialty Finance:
FLOCK Specialty Finance is dedicated to alternative funding in a variety of specialty finance segments. FLOCK’s mission is to provide clients with capital and expertise for the purchase of both charged off debt portfolios as well as for the financing of subprime consumer obligations. FLOCK has funded over 600 portfolios since 2013.
FLOCK believes its funding is “More Than a Transaction”. FLOCK’s proprietary financing structure provides growth-minded clients with a competitive advantage in multiple asset classes. Founded in 2007, FLOCK is headquartered in Atlanta, GA. For additional information, please call: 770-644-0850 or contact us today.