For debt purchasers, such as Cabot, Arrow Global and 1st Credit, the relationship between purchases of portfolios and the revenue which arises from them is subject to time lags and variations depending on quality of debt, collections environment, regulations and other factors. This makes debt purchase a complex industry for outsiders to analyse and adds a layer of risk to the process of forming conclusions based on such analysis. This complexity is one of the reasons why we at Apex Insight have covered the debt purchase market over the last six years.
Under applicable UK and international accounting standards, we are not sure that the financial reports of the UK’s debt purchasers always help investors and others to deal with this complexity. We believe that this may have been one factor explaining the reported doubts over the value of Cabot Credit Management when it tried to float last November. One credit hedge fund manager was quoted in the Financial Times as saying: “It takes a while to get your head around these businesses – they’re not easy to understand – so you have to be careful about the price at which you get in”.
Purchased debt portfolios are recorded initially at purchase cost. That is inherently a conservative measure. Like any negotiated price, it is somewhere between the value to the seller and the value to the buyer.
Debt purchasers may review the value of the purchased portfolio, but they tend not to rush to do so. Cabot states it will not revalue a portfolio above its purchase price until sufficient collections experience is obtained, typically 12 months from purchase. Even then, auditors will always challenge any upward revisions (which result in the creation of ‘goodwill’ in the accounts) so conservatism seems to be an inherent part of the accounting system which may not be entirely helpful in this context. Firms may, for example, may limit the number of years over which they will consider future collections.
The value of the portfolio is then amortised (reduced) each year. Oddly perhaps, this is based not on actual collections, but on an accounting methodology that is possibly more relevant to the original lenders of credit rather than secondary purchasers of debts. It works on the principle that the return on investment is constant over the years that debt purchasers expect to recover their investment, even though in reality collections are likely to be ‘front-ended’ i.e. higher in the earlier years.
In summary, values of purchased portfolios are likely to be low when first recorded; values are likely to be slow to be adjusted upwards; values may still be conservative when they are adjusted upwards; and revenues are slow to be recognised. It all points to the accounts presenting a rather downbeat view of the value of the industry.
This situation doesn’t last forever. Whatever the methodology and estimates made, all the value of portfolios will eventually be recognised in the accounts. In a steady-state market, the accounting rules wouldn’t matter too much. But the growing UK market makes studying the small print of the notes to the accounts essential for anyone wanting to understand the financial information they are being given.
Most firms refer to ‘uncertainties’ in the valuation their portfolios. In plainer terms, Motormile Finance noted in its 2016 accounts that “Trade debtors represents the amortised cost of debt book purchases. This method of accounting is significantly below the potential earnings of the debt book”.
If the financial accounts are so complicated, are there simpler alternative measures of debt purchasers’ size and performance? Expected Remaining Collections (ERCs) are reported by leading firms, but the methodologies behind these vary. In addition, ERCs are a gross estimate and do not allow for the time value of money.
Frank Proud, Apex Insight, Director
For our recent report on the market: UK Consumer Debt Collection and Debt Purchase: Market Insight Report 2018, we present a range of measures of the size and performance of firms. Perhaps the most useful measure of firms’ relative size is a simple one: cash collections on owned debt portfolios in the UK together with accounting revenue for debt collection activities. Unfortunately, that is often not an easy number to figure out from firms’ financial reports. Being able to measure and compare the size of leading firms may only a small part of understanding this industry, but we think it is a good place to start.
Apex Insight has produced a white paper report on Debt Purchase of which a preview can be viewed here.