By Marc Abbey and Ray Carter
First Annapolis Consulting
Across the United States, the "R" word has inched into press accounts of economists' deliberations. This is because the current expansion continues to age, and recession risk factors such as oil prices and subprime mortgages (the housing sector in general) continue to be troubling.
The acquiring world is a different place now than it was not so many years ago when the economy went through its last downturn. It is our thesis that credit exposure has been building in acquiring, begging a thoughtful response.
The acquiring business has never been particularly cyclical. In every recession since the early 1980s, the secular growth in card based payments more than offset declining retail sales, which accompanies recession.
Of course, business failure always spikes in a downturn, impacting acquiring losses and attrition. But it was not until the 2001 recession that acquiring growth began to show strong tracking with the macro-economy.
In the mid 1990s, for example, co-branding was emerging, and issuers were for the first time literally paying consumers to transact with credit cards. Now issuing has matured substantially, and acquiring volume has as well.
The issuing side of the business may have more inherent risk than some believe, since the availability of home equity dollars to pay off card balances has declined.
So, there is every reason to expect that volume growth in general will track with the macro-economy in the next recession (though some merchant categories are more impacted than others, and some are actually countercyclical).
At the same time, certain risk factors have continued to build since the last recession. It is our contention that the average acquirer faces significantly more risk than in the last downturn.
E-commerce - and card not present transactions in general - have continued to grow at much faster rates than the system average. They now represent a much higher proportion of industry and individual acquirer volume.
Competition has driven acquirers to a certain level of risk tolerance: Even conservative banks are approving merchants they would have looked twice at not that many years ago. Aggregation models have flourished and often have ambiguous risk characteristics untested in a general recession.
The Payment Card Industry Data Security Standard and other compliance requirements have become greatly increased sources of financial risk for most acquirers. In the 1990s, the truly substantial fine exposures tended to be limited explicitly to high-risk acquirers.
Some sectors have attributes that greatly raise acquirer risk. The restaurant industry is an interesting, albeit narrow, case study.
Restaurants have long been prone to business failure. In fact, restaurant failure rates are more sensitive than average to recessions. However, historically, restaurants have not represented significant exposure for acquirers because they lack a delayed deliver profile that would create chargeback risk.
Nevertheless, we believe both the exposure and likelihood of default in the restaurant sector is on the rise.
First, the incidence of proprietary gift cards in restaurants has boomed. In recently updated First Annapolis research, the number of U.S. and Canadian restaurants with total sales under $10 million with a proprietary gift card offering increased from 6% in 2003 to 55% in 2007.
This phenomenon is important because it creates a delayed delivery risk where one did not exist before. So, some portion of the proprietary gift cards will be purchased on a credit card. And if the restaurant fails with gift cards outstanding, the cardholders will have chargeback rights.
The gift cards themselves represent the delayed delivery. Because gift cards have much greater penetration than paper gift certificates, this risk is incremental, in part, to the current gift certificate related risk.
This phenomenon has not generated significant losses yet, in no small measure because consumers have not yet realized they have a chargeback right, but we consider this an inevitability.
Second, at the same time, the merchant cash advance product has emerged. Restaurants, which are generally not bankable, were the primary early target.
In a cash advance, the lender will provide a merchant credit (say $7,500) and divert presettlement funds from the merchant's daily credit card receivables until the merchant has repaid a larger amount (say, $10,000).
Commonly, these advances are calibrated at 70% to 90% of monthly credit card receipts, and the cash advance provider diverts 15% to 20% of daily settlement. This corresponds to something like a six- to nine-month effective maturity.
The 25% discount on these cash advances is highly sensitive to the amount of time it takes for the merchant to repay the advance. But, for example, over nine months a 25% discount corresponds to an effective interest rate approaching 75%.
Merchant cash advances very likely make a segment of the merchants more economically fragile, as the cash advances likely divert on the order of 10% of the merchants' cash flow. For restaurants, this represents 60% of their gross margin.
Additionally, cash advance providers report as much as a 70% renewal rate, which may indicate merchants have trouble avoiding such forms of credit once they have begun to use them.
The commissions that cash advance providers pay are very high and offset potential losses from this increased fragility. The problem arises when the party bearing the acquiring risk is not the same party receiving the cash advance commission.
So, if an acquirer's sales agents are referring merchants on the side and receiving commissions, or if the downstream "no-liability" ISOs of an ISO aggregator or BIN bank have their own deal with a cash advance provider, there is a bit of a chump-factor for the party accepting the acquiring risk.
This is because the increased acquiring risk will not be offset by commissions.
In this example, a confluence of industry factors has made restaurants, on the margin, both more risky and more fragile (though still lower risk, in the scheme of things).
First Annapolis believes these factors are an argument for a re-analysis of exposure, credit policy and process at most acquirers.
The focus should be on compliance strategies and process, credit and fraud process, credit enhancement, and portfolio mix.
Ray Carter is a Senior Manager responsible for the Commercial Risk practice at First Annapolis Consulting. Marc Abbey is Managing Partner at the Baltimore-based management consulting and mergers and acquisitions advisory firm.
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