Creditors Exercising Options for Receivables Management

Creditors seeking help managing cash flow have great flexibility choosing not only among providers of receivable management services, but also among the services themselves. Given the growth and sophistication of the accounts receivable management (ARM) industry over the past 10 years, creditors now have options that did not exist in recent memory.

So, which of these services should creditors be considering? Which of these services provides creditors with the greatest returns? What risks are associated with each of these choices?

An overview of today's ARM industry begins to answer these brief but important questions. The 6th Edition of The Kaulkin Report classifies the industry's services from the perspective of the creditor and by the stage of the collection service in the receivable's life cycle. The industry's four major markets are analyzed in turn.

Contingency Collections
Contingency collections is defined as a third party service provided by collection agencies to creditors that have delinquent or charged off receivables. The collection agency is paid on a commission basis, typically defined as a percentage of the total amount collected by the agency. Accounts, or placements, are provided to the collection agency for a finite period of time, which can range from several weeks to several months or years. Uncollected accounts are generally returned to the creditor at the end of the placement period.

Contingency contracts are negotiated either on a gross fee basis, in which creditors receive recovered cash and pay agencies in turn, or on a net fee basis, in which agencies collect cash from debtors and pay creditors in turn. Government agencies, large financial institutions and some telecommunications companies are paid on a gross fee basis, while contracts with smaller creditors tend to be structured on a net fee basis.

The provisions of contingency contracts vary widely depending on the sophistication of the creditor. Large banks, which have decades of experience contracting with contingency agencies, tend to be among the most sophisticated creditors. Conversely, local creditors such as doctors and small utilities may lack sophisticated, internal collection practices. The smaller contingency agencies that collect these accounts generally expect better terms from these creditors. For example, some smaller creditors do not recall accounts at the end of the placement period.

Creditors typically place delinquent accounts with a contingency collection agency for the first time after an internal collection effort has proven unsuccessful, generally when these accounts are between 180 days and one year past due. However, many creditors now involve contingency agencies or first party collectors earlier in the receivable's life cycle to maximize their chances of collecting delinquent accounts.

The terms of the contracts vary, but discussions tend to focus on the commission rate and the length of time the collection agency has to collect on accounts. Creditors maintain leverage in these discussions by contracting with several agencies and creating a competitive environment for new business. Creditors can also terminate contingency contracts within 30 days after the contract is signed. Collection agencies improve their leverage in negotiations with creditors by demonstrating superior performance collecting on placed accounts. Collection agencies that can handle the greatest number of accounts tend to have more leverage with creditors and receive the most new business.

While commission rates vary with the age and sector of the debt being collected, fees for the youngest receivables are often less than 10% of the amount collected. Rates for older debt that has already been placed with other agencies may be as high as 50%. Overall commission rates generally range between 15 and 35%, depending on the age of the debt, its industry sector, the amount of information available about debtors and other factors.

Debt Buyers
Debt buying is one of the fastest growing and most dynamic parts of the ARM industry. For the provider of ARM services, purchasing and collecting distressed debt can be more complicated than collecting on a contingency or flat fee basis, but it can also be much more profitable. At the same time, creditors have recently been selling receivables in recent years at historically high prices. As a result, a number of creditors are considering or have made their first sales of debt portfolios in recent years, further increasing the size and visibility of the debt buying market.

This increase in interest in debt buying can be explained most directly by the benefits that creditors receive when selling portfolios rather than contracting collection to a third party. First, the sale of debt brings immediate cash to a creditor, which may choose the certainty of upfront revenues over the uncertainty and expense associated with a protracted collection effort. Second, the sale of a debt portfolio allows a creditor to avoid investments in personnel and infrastructure that would be required to collect the debt internally or to avoid the need to manage and share margins with a third party agency that has been contracted to collect debts. Finally, a creditor may decrease its legal liability and hedge its public relations risk when it transfers the ownership of receivables to a buyer.

These benefits have increased the types of debts being sold by creditors in recent years. The debt buying market has largely been focused on non-performing debt, but more and more debt purchases are taking place earlier in the receivable's life cycle. Some creditors are selling portfolios that have never been collected on a third party basis, as well as portfolios that have been worked a number of times by collection agencies.

Purchased debt is typically classified by age as fresh, prime, secondary or tertiary. Fresh debt is typically debt that is less than six months past due. Prime debt is six to twelve months past due. Secondary and tertiary debt is generally more than one year past due. These classifications are also based on the number of collection agencies that have worked the paper before it is sold.

Pricing varies widely with the receivable's age and industry sector. The older the debt, the lower the chances of successful collection and the lower its price upon resale. Fresh debt may cost as much as nine cents or more on the dollar, while tertiary debt may be bought for a couple of pennies on the dollar or less.

First Party Collectors
First party collections take place under a creditor's name, either by the creditor itself or by collection agencies working with creditors on fixed price contracts. The primary difference between first party and contingency collections is the stage at which the service occurs: first party work takes place earlier in the receivable's life cycle, typically when a delinquent account is between 30 and 90 days past due but has not yet been charged off by the creditor. Conversely, contingency collections generally take place after a creditor has officially charged off the account.

First party collection services that are not handled internally by a creditor are provided by collection agencies servicing accounts that are between 30 and 90 days past due. In these instances, collection agencies work under a creditor's brand, supplementing clients' in-house collection efforts with trained collectors and specialized technology tools. These collection activities draw largely on the same expertise and resources as other types of customer care.

Importantly, providers of first party collection services are paid differently than providers of contingency collection services. First party services are generally conducted on a fee-for-service basis, whereas contingency collections generate revenues proportionally with the success of collection efforts. While early out collections can be conducted on a contingency basis, the fees for first party services tend to be lower than the fees for contingency collections.

Particularly among smaller collection agencies, first party collections may be undertaken as loss-leader engagements or bundled in a suite of services. In this way, first party work can be used to develop relationships with creditors, leading to contingency work at higher fees and performance-based incentives.

First party collection services offer a number of important benefits to creditors. First, first party collections take place earlier in the receivable's life cycle, when collections efforts can be most successful; the likelihood of collecting an outstanding debt decreases as accounts age. Second, first party collection efforts can be less expensive to a creditor over time than other collection services, given the lower fees associated with first party collections. Finally, first party collections are more likely to enable creditors to maintain constructive relationships with debtors who may become repeat customers, as the collection activity can reinforce brand loyalty if handled correctly.

Price is frequently the primary criteria when creditors choose between first party providers, and this benefits companies with offshore presences. Large creditors in particular look for the best value and have demonstrated flexibility over where services are provided. As a result, first party collection services are increasingly provided by large, multinational companies.

Collection Law Firms
Collection law firms constitute the smallest but fastest growing market in the accounts receivable management industry. While these firms typically seek judgments against debtors in court, they also strive to settle accounts before scheduled court actions take place. The pursuit of delinquent debt through legal channels has led to high recovery rates in recent years, contributing to this market's heightened visibility as well as its increased growth.

Whatever the many differences among the many collection law firms in the U.S., one characteristic best illustrates the competitive positioning of collection law firms in this industry: the ability to sue and exact payments from debtors through legal channels.

Collection law firms have adopted a number of revenue models as they have utilized this resource. Since collection law firms generally compete with contingency agencies for contracts with creditors, these firms typically charge creditors a contingency fee that ties the contract's revenues to the law firm's collection performance. Like contingency agencies collecting paper that has already been worked a number of times, collection law firms tend to collect debts later in the receivable's life cycle, after debts have been charged off.

However, many law firms that specialize in serving clients in the ARM industry also provide traditional legal representation to creditors, billing on an hourly basis for legal services. These law firms represent creditors on bankruptcy filings, sales of bad debt portfolios, legal actions to recover cash from debtors, litigation related to collection efforts, and a number of other legal matters that are specific to the ARM industry.

After pursuing an account using methods that are similar to those employed by collection agencies, collection law firms utilize their expertise within the legal system to collect debt on behalf of clients. Generally, these agencies first contact debtors through phone calls and written correspondence in hopes of collecting debts without involving the courts. As a contingency agency would place a debtor on a payment schedule and collect payments over time, a collection law firm would similarly work with debtors to collect delinquent accounts. When these efforts prove unsuccessful, these law firms file cases with court systems, obtain judgments in favor of creditors and enforce these judgments through ongoing asset searches and reclamations.

It Depends
Creditors considering new approaches to receivables management must weigh a number of variables, such as the industry in which the creditor is doing business, the age of its receivables, its history working with providers of receivable management services, and its balancing of risk and return. So, which of these services should creditors be considering? – at risk of stating the obvious, it depends.

Still, the sophistication and diversity of today's account receivable management industry suggests that creditors and their service providers are finding increasingly effective ways to convert receivables into cash.

As Director at Kaulkin Ginsberg, Paul oversees custom research projects and publications focusing on the ARM industry. Contact Paul at 301-907-0840 ext. 104, or at plegrady@kaulkin.com.