By Adam T. Hark
Preston Todd Advisors
Mergers and acquisitions activity in payments is prodigious, and maximizing portfolio value in a sale has never been more important. Though the heavy level of deal activity in the marketplace is a fairly current phenomenon (the past 18 months or so), there's nothing particularly new about trying to maximize the value of our businesses or assets when we attempt to sell them.
In the merchant acquiring space, saleable properties are unique, and their worth is ultimately valued on the basis of primary attributes tied directly to the performance of the underlying processing portfolio: attrition, revenue concentration, and standard industry classification (SIC)/merchant category code (MCC) distribution, for starters.
However, in such an active market, where demand is high, new buyers emerge, and by virtue of their expansion of the marketplace, these new buyers bring new deal structures and the concomitant broadening of the primary attributes that drive portfolio and ISO valuations.
Year over year attrition, revenue concentration, and SIC/MCC distribution are widely recognized by the bankcard processing community (and the M&A specialists who serve as brokers to it) as primary drivers of merchant portfolio and ISO enterprise valuation. And they are.
But to assume these "usual suspects" account for 100 percent of a given property's value is folly. So much more goes into maximizing portfolio value in a sale that owner/operators need to understand, including distribution of accounts, processing volume, and residual revenue attributable to each and every downline MLS writing new business for an ISO.
And it's with the downline agent portfolios where we see a changing trend in the industry: new entrants to the marketplace – buyers of payment portfolios and ISOs – are becoming less sensitive to the risk associated with the downline MLS/agent portion of an ISO's merchant portfolio.
As such, brokerage firms are seeing more deals where the acquiring party is making offers on the gross residual received by the ISO from its portfolio, as opposed to traditional deal structures where buyers' offers were based on the net residual received by an ISO, after payouts to downline MLSs.
To illustrate these new deal structures and how the MLS's portion of an ISO's portfolio is playing into valuation, let's assume a seller has a portfolio generating $400,000 per month in processing residual, but after paying out downline agents, the seller's net is only $200,000.
Traditional portfolio-acquisition deal structures contemplate the acquisition of the seller's portion only: meaning the portfolio valuation is based on a factor/multiplier of the $200,000 in residual the seller nets each month.
What we're starting to see in the marketplace is buyers looking to acquire the entire processing revenue of the portfolio. Using this same portfolio as an example, that would mean the buyer would be looking to acquire the entire $400,000 per month. Sellers would then work out the buyouts of the downline agents' portions of the portfolio.
As a direct consequence of this, the risk associated with the agents' portions of the portfolio revenue requires much more scrutiny, particularly of an often overlooked and ignored factor in traditional portfolio acquisitions: the contractual relationship between an ISO and its MLSs.
To maximize portfolio value in a sale, owner/operators need to re-think the contracts with their downline MLSs to account for valuation variance. To understand this concept, we need to accept the following premise as true: all agent books are not worth the same. By way of example, let's imagine taking the following two MLS portfolios to market:
Assuming the primary attributes of both portfolios are the same – attrition, SIC/MCC distribution, and revenue concentration – the variance in valuation between Portfolio 1 and Portfolio 2 would be stark as a function of size (number of active merchants). The risk concentration of Portfolio 2 is much greater than Portfolio 1 as a function of its small size, resulting in Portfolio 2 necessarily trading in a lower valuation range. Thus, when contemplating a transaction where an ISO's gross residual is being purchased, the valuations of the downline MLSs' portions of the portfolio would not be equal.
If the ISO's owner assigned a standard, one-size-fits-all buyout formula to all of his or her downline agent portfolios, the ISO owner could lose out on a lot of money in the transaction. How? Remember, this is a gross residual buy, so the buyer would assign a multiplier to the gross residual amount before the ISO pays out downline agents. For the sake of this example, let's say the multiplier is 40. So if the ISO owner has to buy out all of his or her downline MLS' portions of the portfolio at 40X, the ISO owner is losing out on the valuation variance of the downline MLSs' portions of the portfolio, because many or most of those smaller, downline agent portfolios aren't worth 40X.
What does this mean? ISO owners today need to anticipate the possibility of gross residual purchases and account for that potentiality in their agent and MLS agreements. In a portfolio deal where the gross residual is being purchased, ISO owners need to have already included buyout formulas in their agent agreements addressing the inherent valuation variance in the downline portfolios.
This can be established by creating multitiered valuation ranges in the MLS agreements based on the specific portfolio attributes of each downline's book of business: number of accounts, total processing volume, etc. All ISO owners should take a close look at their agent agreements and discuss with an industry specific attorney or consultant the insertion of a framework that addresses this.
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. He can be reached at email@example.com or 617-340-8779.
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