This, and my other posts are long and tedious because I like thinking about CCP in that way, and I have the time to poke about and synthesise my thoughts in writing. As a long-term holder with limited need to sell my CCP holding, or funds to buy more shares, I have no short-term agenda to push the SP up or down, but I know if I publish my thoughts, vanity disallows me from thinking carelessly about the long-term issues. Avoiding sloppy thinking and bias, and getting feedback, is important to me.
My recent post that mentioned the Alan Kohler interview, and others that look to the past, are examples of trying to figure what history tells us may happen in future, and why. I'll now shift to material and thoughts that look at the present to get a feel for the whats and the whys that may inform us of the future. When reading what Encore and others state, one needs to know what lies behind some of the accounting terminology used, so I'll attach what I wrote on fair-value accounting model for PDLs. This accounting model is based on the model for trading in bonds, but the problem is that bonds have an active market, and hence there are market values that constrain managerial optimism. PDLs do not have that constraint, much to the joy of scoundrels, which is why it is well worth investors taking the effort to understand the accounting.
Encore's Reports give Insight to what CCP doesIf one reads Encore Capital's June 2020 report at
https://encorecapital.gcs-web.com/static-files/807c011e-02b9-49cb-9c2a-35c694ec418f, one could plagiarise the gist of it to apply to CCP, and it may help to understand what the thinking is at CCP that suggested boosting funds available. I'll not spoonfeed the issues to readers, they can read the original Encore material themselves.
Fair-Value Accounting Model (this is the tedious bit)
Encore, and similar overseas companies, frequently refer to ERC (the sum of all undiscounted
expected remaining collections from acquired portfolios). ERC is information, not a balance sheet item like PDL Carrying Value. If $1m face value costs $200k to buy, but $530k is expected to be collected, then at the time of purchase, the face value is $1m, the ERC is $530k and the Carrying Value $200k. The missing $330 is future revenue to be brought to account over time as collections occur, or adjustments are made. In the flow of time, debt collections happen, and they reduce the ERC. Managements expectations also change for other reasons, which introduces a personality factor (optimism or pessimism) that is not constrained by an active market like the bond market.
In concept, if 45% of collections were amortised, then as the money rolls in, the balance sheet value (the Carrying Value) declines by that amount. That is the accounting model that the sector historically used, with an occasional adjustment to reconcile to reality. If PDLs were written off over six years, it was not material that in any accounting year, individual PDLs were a little out, because the total PDL book would tend to have had off-setting variances, and anyhow, over six years the slate was wiped clean for a PDL. A high percentage of collections amortisation ratio, as used by CCP, would have tended to move profit recognition to a later period, and undervalued the PDL carrying value of fresh PDLs, and for other debt buying companies, the reverse would have been the case.
The current fair-value accounting model does away with the concept of amortisation, and it requires the ERC to be continually reassessed, and discounted to present value (the Carrying Value) at the original effective rate of interest. It is now the dog (the updated ERC, and hence the updated Carrying Value) that wags the tail (revenue recognition). Effective amortisation is now merely important information that CCP reports to allow historical comparison, which is why I used the adjective 'effective".
The effective rate of interest is the interest rate that when applied to the expected collection streams, derives what was paid for a PDL. In a world of perfect knowledge, during the life of a PDL, the carrying value would reduce to zero without correcting accounting adjustments. Because of the continual revaluation of the ERC (and hence Carrying Value) in the fair-value accounting model, profit adjustments can move in any direction to reflect the latest Carrying Value. This means management pessimism may show less profit early, and more profit later, whereas optimism effects the reverse of that.
Optimistic managers can keep up the facade of success as long as they continue buying fresh PDLs, and more so if PDL acquisitions accelerate. Consequently, management focus tends to shift to buying PDLs, rather than collecting on them. Therein lies the time bomb that destroys so many debt buyers, and nearly wiped out CCP a dozen years ago. Had CCP been destroyed in this way then, you can be sure the GFC would have been blamed. If you read about auditors having trouble with the accounts of the likes of CLH and PNC, the nub of the issue would always be about the Carrying Value of PDLs, and if Carrying Values are too high, it means that profit recognition in the past (including the year being audited) has been too optimistic.
In the fair-value accounting model, using the earlier sample metrics mooted, CCP would examine a $1m face value PDL offered for sale, and develop an expected collections model to derive the $530k ERC mooted earlier, and a time-series pattern of when collections are expected to occur. The company calculates the effective rate of interest that, when applied to the expected timing of the $530k collections, gets a present value (PV) equal to the earlier mooted $200k buying price. CCP normally works in reverse – it starts with a target effective interest rate, and applies it to the expected income stream to derive the PV it is prepared to pay. It may for tactical reasons accept a buying price that delivers a lower effective rate of return to break into new relationships with PDL vendors, but it would aim to normalise the buying process in future. Because relationships with PDL vendors is so important, CCP avoids planning to pay too little for PDLs.
For each accounting period, which could be each month, or more frequently, CCP adjusts the ERC in the light of its expectations, and reduces it to PV (a new Carrying Value) via the original effective interest rate. The new Carrying Value adjustment causes a contra posting (usually a debit) to revenue, and that is the effective amortisation, which may be called an “adjustment”. This is offset by the collections received, a credit (the contra debit is to Cash Account) to give Revenue. While CCP reports are periodic in the sense of half years, CCP can for internal use have the metrics changing continually, so the effective interest rate could be applied on a daily basis to keep the accounts continually up to date.
From the foregoing, one can see that if debtors offer unexpected one-off repayments, the current recording period shows an increase in collections received, but that means future periods are going to collect less, so the ERC changes to reflect that, and hence the Carrying Value changes.
If you look at Intrum's Q1Y20 report, it shows an “adjustment” that reflected its expected Covid-19 induced change to ERC, discounted to Carrying Value. In Q2, this value was virtually reversed because of an unexpected flood of one-off collections. Because what was paid early means that what was expected later is not going to happen, so Intrum made a new adjustment of carrying value in Q2 that was about 40% of its Q1 adjustment (a Covid-19 impairment of about 2% or 3%). Intrum would continually make adjustments to reflect what is repaid each period, and what is expected in future, discounted by the effective rate of interest to give a new Carrying Value. From this you can understand that CCP cannot hide the reality of what is repaid, but it can view what remains of its Covid-19 impairment more pessimistically than Intrum does, so it would take longer for CCP's statutory profits to normalise.
(20min delay)