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The Green Sheet Online Edition

September 22, 2008 • Issue 08:09:02

The residual-buying game

By Lane Gordon

One of the most interesting areas and, perhaps, one of the most profitable within the payments industry is the purchasing of residual streams. For anyone outside the industry looking in, it is hard to fathom that ISOs and merchant level salespeople (MLSs) can sell their revenue streams.

In most industries, you can't decide one day that you want to monetize your future cash flows and effectively sell them in a secondary marketplace to a buyer who is going to pay you a lump sum today.

Other than folks who sell their future lottery payments or insurance settlement payments, it is practically unheard of. Thus the merchant processing business offers yet another unique profit opportunity for savvy buyers and investors.

Two types of sellers

Generally, there are two types of residual sellers in the secondary market. At the high end of the market, there are ISOs who have built fairly substantial nonportable portfolios.

Typically these sellers have several thousand accounts and are fairly sophisticated. They expect to receive payment at the high end of the marketplace for aggregating many accounts into one book of business.

At the other end of the scale are the "small sellers" who are looking to sell $10,000 or less of monthly residuals; typically these are MLSs. Usually, these sellers are more concerned with getting a transaction done quickly than they are with the effective multiple.

Unfortunately, however, a percentage of these sellers have yet to realize that, despite the fact that their friend may have received a high multiple for a residual in excess of $200,000 a month, they are not going to come close to that multiple for a residual sale of $10,000 or less.

These small sellers inevitably will have to go through a process and confront the realities of the marketplace. At the end of the day there are little, if any, economies of scale to small residual purchases; therefore, buyers pay accordingly.

Two types of buyers

Buyers also come in several varieties. But, in general, there are two main types of buyers for residuals: strategic and financial.

Strategic buyers are usually larger ISOs with superior processing contracts. These buyers can typically purchase residuals, and as long as said residuals are on the same platforms as their current processors, they can often apply the better terms contained in their ISO agreements to their acquisitions.

This allows strategic buyers to pay more money for select, larger residuals because they can effectively re-price the merchants once they have completed the acquisition.

The other type of buyer is the financial buyer. Financial buyers are completely dispassionate about their potential acquisitions. For these buyers, everything is a spreadsheet and a net present value calculation.

These buyers are attuned to the current state of the market and what acceptable levels of risk are, and they can rapidly translate that into a discount rate to apply to their discounted cash-flow analysis.

Interestingly enough, financial buyers and strategic buyers rarely compete for the same residual streams. The reason for this is because strategic buyers typically want to look at larger residuals - above $50,000, and even $100,000 a month, whereas most of the financial buyers want to look at residuals under $30,000 a month.

For cases in which financial buyers are competing for a large residual, the residual will typically not command the same multiples that it would if several strategic buyers were competing for it.

Working assumptions

Let's look at an example of why it might make sense to buy small residuals and where you can potentially generate a fairly healthy rate of return in purchasing a residual. For purposes of this analysis, let's make the following assumptions:

Rate of return chart

For this example we are contemplating purchasing a small residual of $10,000 per month. I have assumed the residual may have a monthly rate of revenue attrition of 1.5 percent.

Some buyers, especially for larger residuals, may use historical attrition data as a basis for determining future annual attrition. However, many buyers of small residuals assume the attrition may be higher post transaction due to the seller no longer servicing the accounts or, perhaps, due to personal bonds between merchants and sellers.

I chose a discount rate of 35 percent. If you are not familiar with discounted cash flow analysis, understand that we need to discount future cash flows into today's dollars. The expression that a dollar today is worth more than a dollar tomorrow is absolutely true in the world of finance. As such, one has to assign a discount rate to these future cash flows.

The discount rate typically is calculated by starting with a risk-free rate, like the rate that would be received by long term U.S. Treasury bonds, and then adding to it premiums for risks incurred in each of the following areas:

  • Equity investment
  • Portfolio size
  • Type of industry
  • Time and effort needed to acquire and manage the purchase

You may feel the 35 percent in this example is either too high or too low, in which case you will be able to effectively pay more or less than I would be able to for the residual in the example.

My other assumptions are that the buyers will put 30 percent of their own money down and get the remaining 70 percent for the acquisition from a bank or other funding source. I have then analyzed the resulting numbers, looking at fully amortizing loans over both three and five years.

Now the numbers

The analysis is summarized in the accompanying chart "Loan amorization - three and five years."

Loan ammorization chart

The discounted cash flow analysis indicates the $10,000 monthly residual would yield $210,000 in today's dollars for a five-year period and $179,000 in today's dollars for a three-year period.

If you paid the equivalent of the discounted cash flow, you would be effectively paying 21 times (21x) monthly and 18x monthly, based on the five-year analysis and the three-year analysis, respectively.

If you are extremely conservative and believe the residual may not exist at the end of three years, then you go with the three-year analysis, and you can afford to pay around 18x, otherwise you choose to go with the five-year analysis.

Additionally, note that I opted to "offer" 80 percent of the effective gross multiple, which is why you will see a lower number given for net discounted cash flow in the analysis. Obviously, paying 80 percent of the effective discounted cash flow increases your annual return on equity.

However, even if you were to offer the full monthly gross multiple, you would still potentially see annual yields of 17 percent and 21 percent on equity, based on these assumptions, including an aggressive discount rate and an 18 percent annualized attrition schedule.

Lastly, my calculations assumed that at the end of the three or five years, residual payments would cease. But in many cases the residual continues for several years beyond the years given in my aggressive assumptions, which means the effective return on equity could be substantially higher than the table indicates. end of article

Lane Gordon is Managing Partner at MerchantPortfolios.com, a company specializing in marketing ISOs and portfolios for sale. Prior to MerchantPortfolios.com, he spent a number of years working in the payments industry. Gordon holds degrees from the Massachusetts Institute of Technology and Carnegie Mellon University. He can be reached at 866-448-1885, ext. 301; lane@merchantportfolios.com; or by fax at 508-638-6444.

The Green Sheet Inc. is now a proud affiliate of Bankcard Life, a premier community that provides industry-leading training and resources for payment professionals. Click here for more information.

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