The Green Sheet Online Edition
November 23, 2009 • Issue 09:11:02
The squeeze in merchant cash advance
The recession seems to have had a paradoxical effect on the merchant cash advance market: while interest in it has grown, the number of providers and actual use of the product have apparently shrunk.
Observers say more merchants are seeking loans from cash advance providers than they did two or more years ago, and for several reasons. One is that many business owners are struggling or in debt; two, even among those who are doing reasonably well, some are looking to restructure or refine their businesses to adapt to shifting consumer trends; three, the drying up of traditional credit lines is pushing some merchants to seek a product that's easier to obtain than bank loans.
According to industry analysts and merchant advance providers consulted for this article, however, qualifying for a merchant advance has grown increasingly difficult in just the last couple years. Whereas merchants in the past would be essentially rubber stamped for the product, they now face careful screening from more vigilant providers. Analysts say this new wariness likely owes itself to a trend of defaults when underwriting was more lax.
"When people change their underwriting and make it more difficult to get merchants approved, that's very likely because they're getting burned by the merchants who got into this system through less strict underwriting," said Scott Zdanis, co-founder and Co-Chief Executive Officer of Merchant Warehouse, an ISO whose merchant accounts include some cash advance recipients. "Initially one of the big selling points of this was that it was easy to get the money within a few days. ... That's changed quite a bit."
Growth, then constriction
Industry experts say merchant cash advances began taking hold about five years ago and then mushroomed in the following years before shrinking considerably in the last year or two.
Above all else, this contraction may have stemmed from the recession's impact on the marketplace more generally; whatever product you're selling, finding a buyer has become more difficult. Yet, advances and loans are a special case because they can be most desirable (and dangerous) when times are tough and potential clients have less money.
Problems in the merchant cash advance business may have started when the product became too available. Merchants who weren't financially positioned to pay back a merchant advance - and the relatively high interest rates such advances often carry - started receiving them on a wide scale, and providers emerged that were willing to supply the product when doing so was neither prudent nor ethical.
Part of that, sources say, was the movement in recent years of loan providers from outside the payments business into the merchant cash advance realm, which gave rise to practices that proved damaging to the reputation of the business at large.
"When the mortgage industry bombed and the economy tanked, you had all these people in the mortgage business, housing and loan officers and other people that naturally migrated over to the cash advance side," said Christian Murray, National Director of Business Development for Telecommunications for payment services provider Global eTelecom Inc. "That's what I saw from a recruiting perspective. I was training and boarding and watching new officers that had no idea about bank cards or checks, people foreign to our business.
"It caused a lot of misrepresentation and fraud and a lot of problems. I'm not saying they were all bad guys, but some people were not honest and upfront with merchants, and I think as those companies have gone belly up, the few that are out there are doing stand-up business."
Indeed, the providers of merchant cash advances often depend on the financial health of their clients; the rate at which they recoup an advance hinges, in most cases, on the client's volume of credit and debit card purchases.
Traditional loans are paid back in installments of some fixed dollar amount, but merchant advances are recouped by taking a percentage - known as a "split" - of a merchant's receivables. The process involves the automatic redirection of certain card purchases - usually Visa Inc. and MasterCard Worldwide credit and debit purchases, depending on the processor - away from the merchant and to the cash advance provider.
In most cases, the processor takes a small fee from the arrangement, courtesy of the cash provider. If the total receivables are low, the split, which can range from 3 percent to upwards of 30 percent, can take an especially long time to roll in, given a typical payback period of six months.
On the other hand, providers that take too high of a split can jeopardize both a merchant's business and their own reimbursement.
While the processing split is the most common method of recouping an advance, there are other avenues. One is known as the "lockbox" method, in which the split is done by a third-party bank (separate from the merchant's acquiring bank). The other involves the cash provider making an automated clearing house (ACH) debit from the merchant's bank account.
A merchant cash advance executive who spoke on condition of anonymity said companies usually prefer doing the processing split because it carries the smallest risk.
For example, while the split entails redirecting the money before it reaches the merchant, an ACH debit requires that the provider wait until the money arrives at a merchant's bank account - where it is liable to disappear before it's drawn.
"With the ACH option, we're subordinate to his bank account, so you could be pulling checks or maybe the things on auto-bill pay," the source said. "[With split processing] we capture it at the point of sale versus after the sale."
He noted that the complicated processing arrangements of certain merchants necessitated the ACH option and added that, with the onset of the recession and the resulting tightening of credit lines, cash advance ISOs may have a financially stronger client base that would have historically turned to bank loans.
In effect, the negative economic climate may result in a higher approval rate among merchant applicants. But another position has it that approval rates will steadily decline as merchants' financials face closer scrutiny.
"A lot of accounts [with Merchant Warehouse] do get declined now, where in the past very few of them did," Zdanis said. "I think the big companies' approval rates have dropped significantly, and we are experiencing that firsthand. ... Last month we acquired over 3300 new accounts, and I think we did 12 [advances] and ended up getting three approved."
Tightening the noose
Zdanis said the tightening of restrictions on merchant cash advances could be traced to a couple of trends. The most significant one, he said, was the recession's overarching toll on businesses, and their resulting vulnerability to bankruptcy and other outcomes compromising their ability to reimburse providers. (Zdanis added that Merchant Warehouse has yet to have a client default on an advance.)
The second trend has been the shift among consumers away from the use of credit cards and toward debit cards, which Zdanis said has had "a small negative effect." The reason is that debit card payments often don't run on the Visa-Mastercard rails and thus avoid the processing split that providers enjoy. Another reason is that debit payments tend to be smaller than credit payments.
"People spend less money per transaction on their debit card," Zdanis said. "They know they have to pay the bill right away, and generally tickets are higher as people are using credit and paying in the future. Also, debit cards have limits: you might only be able to spend $300 a day when you get it, whereas with a credit card you can spend up to the whole limit if you want."
Znadis added that "this product is driven not by the people using it but by the people selling it." He said some Merchant Warehouse sales agents simply do not introduce merchant cash advance as a possible value add, in some instances because they fear the merchant will see the offer as something predatory and choose a different merchant provider.
Such fears, sources say, have their roots in the practices of certain bad loan providers - both in and outside the payments business. In the mortgage market, for example, lenders gained a dubious reputation in recent years for providing home loans to unqualified borrowers; in merchant cash advance, a few companies became known for predatory lending practices, such as charging hidden fees and using fluctuating splits.
Mark Lorimer, Chief Marketing Officer of AdvanceMe Inc., one of the industry's largest merchant cash advance providers, said the proper use of cash advance can be a boon to merchants looking to grow or revamp their businesses.
He added that the use of a percentage, rather than a fixed dollar amount to collect advances, helps safeguard merchant borrowers against business failure, making merchant cash advance less risky than traditional loans.
"That's the beauty of merchant cash advance: the amount collected rises and flows with the amount of credit card transactions that the business is seeing," Lorimer noted.
Lorimer said most of AdvanceMe's clients are return customers. (Znadis said that was true of Merchant Warehouse as well). AdvanceMe only takes a maximum 9 percent of a merchant's card receivables - and sometimes as little as 3 percent - to protect it further from long-term harm.
The percentage, Lorimer said, depends primarily on a merchant's total sales volume, the proportion of transactions that are credit or debit card-based and the type of business.
"We have about 60 people in data systems and technology and another 15 full-time analysts that are running our adaptive learning programs, our profiling, our scorecards," Lorimer said. "We have an extensive data services division that feeds our underwriting decisions, scoring models, as well as things like the small business credit sales report."
An economic reprieve
Lorimer and others said that the manner in which merchants typically use cash advances has changed as well, further strengthening the value of the product. Cash advance companies, they agreed, have begun taking an interest in the way the forwarded money is spent to ensure merchants are using it constructively and not just paying off debt or forestalling bankruptcy.
"Before you could be any company and, if you had credit card processing, you could get a loan," where now they're digging deeper, Global eTelecom's Murray said. "They're wanting to know, you've been in business for a year? Great; do you pay your bills? They're looking closer at the credit worthiness of the merchant."
Lorimer said AdvanceMe has seen a shifting mentality among merchants, likely springing from the economic downturn. Before most advance recipients were looking to simply expand their businesses by increasing existing inventory, opening new locations and building on current ones, but now the money tends to be used for a more strategic brand of repositioning.
"It may be a retail store moving from high-end clothes to more accessories, or a high-end automotive place maybe using it to stock up inventory that's not quite so expensive," Lorimer said. "Two or three years ago people were using the money a lot more for opening new locations and expanding and buying out a partner.
"We're seeing a lot more merchants now using the money to refine their concept or change slightly to reflect what they're seeing in their local marketplace."
Indeed, it seems that the business of merchant cash advance has itself been tuned up and refined in recent years as the number of providers has shrunk and the most judicious ones have survived.
According to Zdanis, the service is likely to remain the province of a small group of providers, while other companies looking to penetrate the market will have to get creative.
"I think the product in its current form will always have some customers, but it's definitely not going to grow like people had hoped, and it'll be very rare that you'll find a company like mine really making its money or building its future around this product," he said.
"If underwriting has changed so that it's more like bank [loans], I think the product maybe has to be revamped to directly compete with banks or else take a whole different direction. And I think that'll happen - with very few strong players in the business there's opportunity out there for someone who's financially stable and creative enough."
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