On Wednesday, FreightWaves reported that Convoy is winding down its operations. Early in the morning, I started writing about the liquidity problems some freight brokers are having or will have. Then, the same morning, news broke that one of the most iconic freight brokers to emerge from the venture era of freight technology financing was going bankrupt.
Convoy was the victim of a violently commoditized industry facing one of the deepest recessions in decades and a sudden shift in investor appetite from risk to unit economics.
There will be a lot of articles written about Convoy in the coming weeks, but unfortunately, Convoy is not the only significant broker to suddenly shut down.
This is unusual.
After all, anyone who has worked in trucking knows that asset-based carriers frequently face impending bankruptcy. But it’s rare for freight brokers to suddenly go out of business. Compared to trucking companies, freight brokers have a much more flexible business model and can adapt to changing market conditions.
But more large freight brokers are likely to suddenly close down. The reason for this is a major change in the funding environment.
In an article earlier this week, I wrote about the growth and proliferation of the freight brokerage industry over the past decade. Freight brokers have grown from a small cottage industry to one of the most important forces in the freight industry. A large part of FreightWaves’ success is due to the growing importance of freight brokers in the industry.
After all, freight brokers are day traders in the freight market, so they need up-to-date information about the freight market.
FreightWaves was founded at a time when freight brokers were transforming from a small part of the industry to a dominant force. Much of FreightWaves’ success is due to this reality.
However, much of the securities industry’s growth has been driven by funding structures such as venture capital (VC) and asset-based lines of credit. Freight brokerage companies’ appetite for venture funding has been sluggish for more than a year, which is part of the reason Convoy failed. Venture capital investors have realized the reality that freight brokerage is not suitable for venture investment.
For brokers who didn’t take advantage of VC funding and instead funded their growth through alternative financial institutions, the story is different, but the result is the same. These alternative lenders are common across the freight market. Trucking companies use factoring companies to finance their accounts receivable on a transactional basis. The same goes for brokers. However, it is often done on a portfolio of accounts receivable rather than on a transaction-by-transaction basis.
Accounts receivable are pledged as collateral for a line of credit called an “asset-based line of credit” (ABL), allowing brokers to grow rapidly without having to wait for shippers to pay.
If the market and unit economics are expanding, it’s a very efficient way to grow. For stock market traders, this can be compared to using margin to buy stocks.
If your stock position is increasing in value, you can obtain a larger line of credit. The danger, of course, is when you use your line of credit to buy more of the same stock. If the stock crashes, your losses will only accelerate in the downward direction, and you’ll be in real trouble.
A similar thing is happening in the securities industry. Freight brokers borrowed against AR Portfolio to fuel growth, accumulating debt at cheap interest rates. When the Fed changed its cost of capital, its debt became more expensive. That in itself is not a problem.
But something else happened in the trucking market.
The average transaction size for the load has also decreased. A package that brought him $3,000 in revenue two years ago now ships for just $1,500 in revenue. Once you make enough of these trades, the size of your credit facility begins to collapse.
That’s not necessarily a problem if the broker holds capital when times are good. But problems arise when that capital is used for further growth or other purchases. For Optimus Prime, it was about fostering growth. For other brokers, this could be personal use, such as a home, car, plane, or yacht.
The capital has been used up, but the debt still remains. And financial companies, recognizing the risk of freight volatility, have sought to protect themselves by placing covenants on these lines of credit, often benchmarked to margin.
As margins compressed, rules were violated and financiers became nervous. Some of them now face the dilemma of whether to continue funding their lines of credit or call in. In Convoy’s case, the credit line appears to have been called in.
FreightWaves has been hearing from people in recent weeks that a number of mid-sized freight brokers are experiencing financial difficulties. One of the CEOs of a large brokerage firm with whom I discussed a potential deal told me that the risks are most pronounced at brokerages that generate revenues of between $50 million and $250 million.
The CEO of a major bank involved in trucking said the three major brokers in his portfolio are in dire financial shape and he expects them to close in the coming months.
These companies have used accounts receivable financing to fuel growth. However, due to a collapse in market fundamentals, they broke the terms.
The banks that financed these asset-based loans are trying to play matchmaker with some brokers, but their patience is starting to wear thin.
Unfortunately, the situation will only get worse.
The cruelest part of the cycle for freight brokers is not the soft market.
That’s when the freight market starts to recover and spot rates improve while contract rates come under pressure. This puts pressure on intermediaries’ profits.
In other words, the spread between spot and contract narrows. This will have a negative impact on the acceptance rate for the carrier.
The majority of contract rates are established during bidding season. If the conditions at the time of bidding are weak, the contract rate will decline.
Bidding season traditionally begins in mid-October and ends in February. Freight rates have been very weak throughout the year, and no improvement has been seen since the bidding season has begun.
Overcapacity in the market has kept both spot and contract rates low, with some lanes at or below 2019 levels. These developments will have a significant impact on contract rates during the 2023-2024 bidding season. Contract rates are expected to fall further as carriers realize that rates will be cheaper over time.
Spot prices are currently at a level where airlines are losing money on many miles driven, but they are unlikely to fall any further.
This compresses brokerage firms’ profits and further exacerbates the financial difficulties they may face.
Therefore, we expect to see some frenzied trading in the freight brokerage industry in the coming months as healthy players take down weak players.
I also predict that companies under significant financial stress will go bankrupt. Bankruptcies are common in the trucking industry, but it’s usually asset-based trucking companies that go bankrupt.
This cycle could be the first time we see a large number of bankruptcies impacting securities markets.
