The Green Sheet Online Edition
May 24, 2010 • Issue 10:05:02
Capital flow in acquiring
ISOs, like cells, are known to continuously form, fuse and divide -new companies appear, others are acquired and some spring from existing ISOs to form a subsidiary or separate business. Industry analysts say shifting market conditions will bring a flurry of ISO activity in the coming months and years, to the benefit of some industry players and detriment of others.
While payments industry acquisitional activity dropped considerably during the recession, sources say we will see a shift toward increased outside investment, more buys between ISOs and a widening loan market.
Acquisitions, mergers and private equity investments will boost many established ISOs, while the strengthening of bigger players and elusiveness of capital for fledgling ISOs will create difficulties for new startups. For startup ISOs that do brave today's market conditions, turning profitable can take a while. But smart ISOs that develop a specialty and do superior work can nonetheless secure capital and see profits, sources said.
Several recent reports of either completed or potential mergers and acquisitions involving huge payment players may foretell a broader lift in acquiring sector activity.
"In the last couple years, private equity investment, and not just in this space, has slowed down," said David Konig, Senior Analyst for Robert W. Baird & Co., an investment consultancy. "With the bigger deals now happening, it seems the indication is that private equity as a whole is going to pick up.
"Some of the big private equity firms will step in and buy very big firms like First Data, but for smaller ISOs there's a lot of potential for private equity as well. ... This is a sector that probably generates above average interest because of the recurring cash flow."
On May 7, 2010, it was reported that three equity groups were looking to buy payment processor Fidelity National Information Services for more than $10 billion. If that deal happens, it would be the industry's biggest buyout since the 2007 acquisition of First Data Corp. for $29 billion by the private equity firm Kohlberg Kravis Roberts & Co.
Other noteworthy developments of late include equity firm Silver Lake's April 2010 acquisition of a 60 percent stake in Mercury Payment Systems LLC; partnerships between Total System Services Inc. and First National Bank of Omaha, as well as between Fifth Third Bancorp and Advent International; and, maybe most significantly, Visa Inc.'s recent buyout of online payment processor CyberSource Corp.
In general, capital flowing from outside the payments space tends to target larger ISOs, especially when it comes from Wall Street. Apart from a select few processors and Super ISOs, Wall Street investors have historically shown little interest in the acquiring sector.
Nonetheless, analysts say small and mid-size ISOs will also attract investment as the economy recovers, and that the industry will see an uptick in ISO acquisitions by other ISOs - a fairly common occurrence historically that came to a near halt when the recession hit.
"In recent years there was a sharp drop off [in ISOs buying other ISOs]," said David Fish, Senior Analyst for Mercator Advisory Group. "But in the last three to six months that has been picking up quite a bit."
Scott Zdanis, co-founder and co-Chief Executive Officer of Merchant Warehouse, said that, while the company hasn't historically purchased other ISOs, "it is something we're going to do more and more in the future. ... We recently became a debt free company and have extra cash to spend on that type of thing. I think it's true of a lot of companies that, as market conditions change and people are getting more optimistic about the economy, that kind of thing is going to happen more."
An early sign of potential upticks in ISO buyouts of other ISOs (as well as renewed interest in ISOs below the super ISO tier among equity providers) came in March, when the Kentucky-based ISO FrontStream Payments Inc. bought a mid-sized ISO called Fast Transact Inc. - a transaction funded with capital from New York City-based private equity firm Arsenal Capital Partners. FrontStream CEO Emmet Seibels said today's ISO market is as ripe as ever for buyers.
"Valuations have come down, and buyers can be more picky about who they acquire," he said. "More ISOs are trying to sell, portfolios are more attritive due to compressed margins and a lot of ISOs are having trouble growing."
Seibel said FrontStream would continue to seek the purchase of ISOs that have a "competitive advantage either through a niche or superior technology, a good growth rate and a quality portfolio."
He said investors in general would be attracted to "niche" ISOs with a specialty - for example, Fast Transact specialized in acquiring nonprofit companies and Internet merchants.
Difficulties for new ISOs
One category of ISO that will continue to face difficulties is the startup, many of which generate scant interest from venture capitalists and other funding sources. According to a report from Mercator, the payments industry globally received 27 percent more venture capital in 2009 than in 2008. However, of all the venture capital spent, only 8 percent went to startups in 2008, and a mere 2 percent was received by startups in 2010.
Startups also face an uphill climb in an industry increasingly geared toward long-term, deferred revenue streams that follow prolonged periods of financial struggle.
Increasingly, sellers aren't receiving upfront money for sales, as merchants have come to expect free terminals. Among those that do pay upfront money, more merchants are using software-based POS systems that cost significantly less than traditional hardware terminals.
Adding to the problem for small ISOs is that fewer merchant level salespeople now work purely on commission, with most demanding either a salary or some upfront payment for their work.
"Historically, one of the low hurdles to entry in the ISO business is it has not required much capital," said Ken Musante, who is building his own Calif.-based ISO, Eureka Payments LLC, having worked in the acquiring sector since 1992.
Musante added that, while ISOs still require less capital to launch than the average business, the task of starting one is financially strenuous and demands a lot of patience.
"Formerly, selling a merchant account would generate income right away because you'd get a lease with that account, and it made funding your business a whole lot easier," he said. "Now you're not able to recoup your money from the merchant until they begin processing, and the first time you get anything close is after the first month when you get your first residual."
It may be "months or even years down the road" before a startup ISO sees a profit, he added.
Complicating matters further is that ISOs have a harder time than most other businesses getting money from traditional loan sources, including banks and the federal government's Small Business Administration. While the recession has severely tightened the loan market for businesses generally, ISOs have been virtually shut out.
One reason for this is that banks have a harder time understanding the intricacies of the ISO business model; another is that ISOs don't have many tangible assets to use as collateral since they mainly sell a service, not a product. "Banks really don't usually fully appreciate how the ISO model works; you're really explaining it to them from scratch," Zdanis said. "They're usually reluctant to loan money to any ISO."
Loan sources closer to home
With most lacking access to traditional loan sources, ISOs commonly get off the ground with money out of the founder's pockets or from friends or family.
Musante said his company is starting with capital from two private investors whom he's "known for a very long time," and that those partners are also providing lead referrals - "which are equally valuable to the capital they're providing." Musante and others also said small and startup ISOs are increasingly in need of a specialty to compete with larger merchant service providers that lure merchants with relatively low prices on terminals and interchange.
Musante said Eureka Payments will specialize in e-merchants and mobile merchants - and especially "continuity merchants" (non-face-to-face merchants who give consumers a free or low-cost trial period on goods or services), which Musante said have "been in the crosshairs of Visa/MasterCard" and are often fined or shut down for not complying with a particularly stringent and complicated set of rules.
"By specializing in merchants that have a need for specialized knowledge, specialized service and specialized terminals, we'll be able to do a better job with those niches than larger players can," he said.
Zdanis said that, as demand grows in niche markets (like mobile payments), existing ISOs may look to create subsidiaries to service areas where traditional merchant providers lack expertise.
Analysts say companies (including start-ups) that stay on the cutting edge of new payment trends stand to thrive and can attract investors who might not otherwise show interest in the acquiring space.
"I'm hearing a ton of stuff out there [about interested investors], and there's capital out there," said Paul Martaus, President of payments industry consultancy Martaus & Associates. "The problem is they're not lending in the traditional marketplaces. They're looking for the big score."
Capital for established ISOs
Of course, getting an ISO off the ground is by far the hardest part of running one. Among ISOs that do rough the difficult early stages to build a consistent portfolio, there are capitalization options outside of equity investment.
Some can borrow money from their processor or super ISO, though many processors don't have enough capital to make loans or aren't willing to assume the risk.
Also, there are a handful of ISO lending firms that provide loans and recoup them by taking a percentage of an ISO's monthly residuals until the money is repaid. Such loans are generally only available to ISOs with an established residual history.
One such company, Super G Funding LLC, loans at a 17 to 19 percent interest rate, with the loan repaid over a period of 12, 24 or 36 months, according to Darrin Ginsberg, the company's founder. Ginsberg said the size of each loan (which range from $25,000 to $1 million.) and payback period depend on an ISO's recent residual history.
"Typically, ISOs try to get a typical business loan from the bank or SBA, which is very hard to do," Ginsberg said.
"Banks just aren't funding stuff right now. .... I'm putting capital in the hands of ISOs or agents to help produce more deals and in turn help ISOs grow. This is a way for ISOs and agents to access capital without having to sell their portfolios. I'm trying to let them keep their portfolios and grow their business."
Some companies may balk at the idea of high-interest loans, but capital of any kind can save ISOs from having to take drastic measures. The lack of adequate funding or loan sources - coupled with other challenges such as free terminals, alternative payment sources and heightened competition among ISOs - have put some ISOs out of business and forced others to conduct fire sales of their portfolios.
Sources said more ISOs will have access to loans from both their processors and ISO lending firms with the economy appearing to stabilize. Other ISOs will seek buyers, which have been hard to find in recent years. Yet, as the economy rebounds, sources say buyers looking to acquire either ISO portfolios or entire companies are proliferating.
"I think the big ISOs are definitely going to be more dominant, many will buy up other ISOs and more smaller guys will get sucked in and merged into those," Ginsberg said. "I also think there are quite a few new equity investors excited about the space, but they're excited about bigger deals, not smaller scale deals."
Indeed, for smaller ISOs planted squarely in the traditional merchant services sector, improved economic conditions may well be offset by other factors like deferred revenue streams, lack of outside capital and disparities in merchant pricing between big and small providers. Yet most agree that smaller ISOs who are savvy will remain in the game and attract much needed investment.
"I think smaller players in the space, if they have a good story to tell, will have willing ears ready to listen," Fish said.
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