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January 28, 2008 • Issue 08:01:02

Sizing up merchant cash advance

By Marc Abbey, Yuriy Kostenko and Myron Schwarcz
First Annapolis Consulting

Precisely when free terminals began destabilizing POS equipment revenue in earnest for acquirers and ISOs, the merchant cash advance phenomenon began to gain substantial market momentum. Though the pricing to merchants and commissions to acquirers and ISOs for these advances are significant, cash advance revenues are still small in the scheme of the acquiring industry.

A merchant cash advance involves a cash advance provider extending funds (the funded amount) to a merchant to be repaid through the cash advance provider's diversion of a percentage of the merchant's daily credit card settlement until a higher amount (the repayment amount) is paid to the cash advance provider.

So, for example, a merchant may receive $25,000 from a provider, which would divert, say, 15% of the merchant's daily settlement until the merchant had repaid $30,000.

The percentage of daily settlement diverted would be calibrated to repay the repayment amount typically in six to nine months (though some cash advance providers are shortening the amortization period to drive up effective yields).

Some cash advance providers position the product as a loan and live within usury and other regulation of lending. A much greater proportion of providers position the product as the purchase of a future receivable, allowing them (successfully, so far) to avoid the oversight and other legal implications of lending relationships.

There is significant variation from provider to provider, but on average, providers require a minimum of $3,000 to $5,000 per month in Visa Inc./MasterCard Worldwide sales volume and have a maximum cash advance funded amount of $200,000 to $300,000. Average funded amounts generally are in the $20,000 to $25,000 range, again with substantial variation between players.

In First Annapolis' most recent research, we identified 52 cash advance providers. Fourteen of those appear to be captives of ISOs, and 38 appear to be stand alone cash advance providers, primarily distributing their products through direct marketing and distribution deals with acquirers and ISOs. Of the 38, several are resellers for other cash advance providers, though it is difficult to fully quantify. We interviewed 19 acquirers and ISOs ranging from mid-sized ISOs to the largest of acquirer-processors, representing over 60% of industry volume. We determined 58% of them do not offer a merchant cash advance product.

The 42% of acquirers that do offer merchant cash advances tend to skew more to smaller ISOs than to larger enterprises; over 60% utilize two or more merchant cash advance providers. None of these acquirers reported a merchant-base penetration of more than 10%; the average was well less than 5%.

We also asked these acquirers about the level of commissions they received from cash advance providers. There is variation in how commissions are structured (for example, based on funded or repaid amount, paid upon funding or upon repayment, and so forth), but the median commission the acquirers reported for the origination and referral of a new cash advance was 7% of the funded amount, ranging as high as 10%.

The median commission for a renewal of a cash advance the acquirer had originated previously was less than 2%, ranging as high as 8%. (AdvanceMe Inc., one of the industry's largest players, has indicated in the press perhaps as many as 70% of merchants request renewals.) We also approached nine cash advance providers themselves. They reported a median commission on the origination and referral of a new cash advance of 7% of the funded amount, ranging as high as 11%.

With a handful of heroic simplifying assumptions from this research, our best educated guess is that the size of the merchant cash advance industry is $500 million to $700 million in "outstandings." We have no direct data, but we believe outstandings to be growing rapidly and may already exceed our estimates, as the underlying research was completed through the second half of 2007.

Total volume would be higher, as the average maturity of the cash advances will be less than one year. (It's highly speculative, but our estimate of total market potential is $3 billion to $5 billion in outstandings.)

Based on prevailing commission rates, today's outstandings and volume would generate perhaps as much as $60 million in revenue for the acquiring industry, which, though it could be substantial for individual institutions, nevertheless represents perhaps 1% of industry revenue. (However, the front-end loaded nature of these revenues makes them disproportionately attractive to many acquirers.)

Revenue to cash advance providers is very high. Thinking of the product like a loan, the effective interest rate is commonly 70% or higher, depending on how quickly the repayment amount is paid. Again, our educated guess is that industry revenue may be as much as $300 million. This revenue amount is impressive, given the total estimated size of the business, but the expense structure of these cash advance providers is substantial.

Depending on the mix of renewals, a cash advance provider may be paying out as much as 15% to 20% of its revenue in commissions.

We have only a handful of anecdotes regarding loss levels at cash advance providers, but those anecdotes range from 600 to 1,000 basis points of the funded amounts and are sure to increase if the economy dips into recession (some are close to 1,500 basis points). Most cash advance players are funded with a very high cost of funds (we're guessing mid-teens, factoring in the cost of equity and high-cost debt). And finally, because most players must be extremely subscale, the operating cost per account must be high. So adding these factors up, so to speak, the economics of the cash advance business are likely marginal for most of the players despite the robust revenue model.

Putting merchant cash advances into perspective, they are still quite a modest economic factor in the acquiring business, though they have risen extraordinarily rapidly compared with other elements of acquiring. (Think of the 15 years it took for PIN debit to become material, for example.)

The number of current players relative to the size of the business, combined with what we infer about the economics of the business, makes it hard to believe the industry will ride a recession without a significant shakeout. This concept in addition to the underlying regulatory and other business risks indicate acquirers and ISOs should be quite cautious about whom they select as their cash advance providers. end of article

Marc Abbey is Managing Partner, Yuriy Kostenko is a Senior Analyst and Myron Schwarcz is a Consultant at First Annapolis, a Baltimore-based consulting and mergers and acquisitions advisory firm.

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