By Adam T. Hark
Preston Todd Advisors
Once upon a time, a merchant was a merchant was a merchant. The putative strategy in merchant acquiring was simple: board as many accounts as possible – big merchants, small merchants, low-risk merchants, high-risk merchants and even new LLCs – basically any merchant with a checking account and an "open for business" sign. The rationale was straightforward: payment processing produced real, actualizable revenue that made merchant acquiring lucrative.
Fast forward to 2017, and much has changed, not the least of which is margin compression on basic transactional processing. The merchant-is-a-merchant-is-a-merchant strategy is no longer viable. The fact that so many leading acquirers have transitioned their revenue models away from a dependency on transactional processing, and toward the delivery of technology based, value-added products and services, is a defining attribute of today's new merchant acquiring paradigm, and one that will surely last.
Beyond the product offering evolution, a second, and perhaps more consequential change in the merchant acquiring paradigm comes from the increased sophistication of merchant acquirers. Today's owner/operators are just as likely to have a background in finance as in sales. As such, the industry is bearing witness to a surge in operational expertise and business acumen among its leading management. Furthermore, this surge in operational competencies has precipitated implementation of new standards for best practices in building quality portfolio assets. One new best practice caught my eye recently during an auction, and I feel there's tremendous value in bringing it to the forefront of the industry: portfolio rationalization.
If you haven't heard the term "portfolio rationalization" in your discussions with merchant acquiring owner/operators, you will. Though the concept isn't new, the terminology is, and its relevance continues to gain import in the industry. My first exposure to this term came by way of a sophisticated operator in the space, former investment banker John Wu, Managing Partner at Anaraq Holdings LLC. While working with John on an M&A transaction, I had to explain the concept of portfolio rationalization to many of the prospective buyers. Though the concept isn't new, its increasing adoption as an effective way of increasing a firm's profitability is.
The basic premise behind portfolio rationalization is performing a cost benefit analysis on the new merchants a merchant acquirer boards, as well as those merchant identification (MID) numbers that already exist within an acquirer's portfolio. The objective of the owner/operator is the identification of low- to no-revenue (or even negative revenue) accounts: accounts that may require costly, high-touch customer service from the acquirer and/or setup and equipment costs commensurate with those required for high-revenue, highly profitable accounts.
The portfolio rationalization process essentially purges these costly accounts from an acquirer's existing book, and establishes minimum processing thresholds for new boards so that the resultant portfolio primarily comprises quality, high-revenue and high-margin accounts.Data analytics show that over the past 30 months, net static pool attrition runs on merchant portfolios consistently produce outputs for account/MID attrition that are 10 to 20 percent higher than the outputs for net processing volume attrition on the same merchant portfolios.
The takeaway from this data point is that for a majority of merchant acquirers, there has occurred a natural sloughing off of low- to no-margin accounts from their portfolios. Much of those losses have been to the likes of Square, whose payment facilitator model is better suited to accommodate low-revenue merchants. Accordingly, by implementing a portfolio rationalization initiative, whereby a merchant acquirer proactively removes these types of merchants from its book of business and creates guidance that will prevent it from boarding new ones in the future, the merchant acquirer has much to gain by way of profitability.
One drawback, albeit a temporary one, to implementing a portfolio rationalization process is when an acquirer is preparing its book of business for sale. A necessary consequence of purging accounts from an existing merchant portfolio is that the process artificially increases the rate of attrition on the book – a primary driver of merchant portfolio valuation. So it behooves all merchant acquirers to be mindful of their future objectives regarding an exit or financing event, and the timelines thereof.
If an acquirer intends to go to market in the offing, the acquirer would be well served by documenting the merchant accounts that were intentionally purged so this information can be verified by prospective buyers. This in turn would allow buyers to adjust or "normalize" the portfolio's attrition numbers.
The other option, particularly if an acquirer is working on a longer time frame for an exit or financing event, would be to effectuate the portfolio rationalization process at least 18 months before going to market, which would allow for normalized year-over-year comps when running attrition analyses, and flush out the purged accounts long before they would artificially, negatively affect the attrition numbers, and ultimately the merchant portfolio valuation.
Adam T. Hark is Managing Director of Preston Todd Advisors. With over a decade of consulting in the payments and financial technology sectors, Adam advises clients on M&A, growth strategy, exits, and business and portfolio valuations. Adam T. Hark can be reached at firstname.lastname@example.org or 617-340-8779.
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