Call it the ISO’s lament. Forced to squabble over a shrinking pool of customers in a price-oriented marketplace, merchant-service providers say they are slashing margins and scrambling for ways to differentiate their offerings.
Still, investors are rejecting views that dark days are ahead. Indeed, the industry glows with promise in the eyes of financiers, according to Tim Munto, group executive of sales and client relationships for acquiring at Total System Services Inc., or TSYS, a Columbus, Ga.-based payments processor.
“There is more equity capacity in play in our industry at the current moment than at any time in the past,” Munto quotes a colleague as saying at a conference.
That capital is fueling consolidation among ISOs and processors, which creates synergies and economies of scale that benefit behemoths but squeeze smaller players investors might ignore, observers say. Whatever mix of positive and negative effects emerges, few say they expect the interest among investors to cool anytime soon.
Investors want a piece of the acquiring business because the industry fared relatively well during the recession and positioned itself to take advantage of the recovery, says Munto. Meanwhile, growth seems assured as electronic payments continue to take market share from checks and cash, he notes.
“Private equity looks at these businesses and sees recurring cash flow, good growth and the opportunity for leverage,” agrees
David Koning, a senior research analyst for Milwaukee-based Robert W. Baird Co. Inc. If one processor buys another, the combined entity can achieve cost synergies by shutting down one platform or eliminating redundant jobs, he says.
With an influx of capital in March 2009, Advent International, a Boston-based global buyout firm, bought a 51% stake in Fifth Third Bancorp’s processing business, with Cincinnati-based Fifth Third Bank retaining a 49% share. The deal created a new company, Fifth Third Processing Solutions LLC, the companies valued at $2.35 billion.
Four months later, Fifth Third Processing
Solutions purchased Town North Bank’s TNB Card Services. TNB specialized in processing cards for credit unions in 27 states.
In August, Advent teamed with Bain Capital LLC to acquire an 80.01% interest in RBS WorldPay, the processing unit of The Royal Bank of Scotland Group PLC, for a approximately $3 billion. RBS
retained a 19.99% stake in the processing business.
The following month, Fifth Third Processing Solutions bought Louisville, Ky.-based National Processing Co. as part of a strategy to grow through complementary acquisitions and to create one of the largest merchant-acquiring businesses in the United States, according to Fifth Third. The company says it intends to focus on processing for small and midsize businesses.
In another September acquisition, Fifth Third Processing Solutions bought Springbok Services, a Colorado-based firm with a reloadable prepaid card-processing platform.
Still, Fifth Third did not manage to grab every headline. TSYS launched a processing joint venture with First National Bank of Omaha in April by
acquiring a 51% interest in First National’s
merchant-acquiring business for approximately $150.5 million. First National retained a 49% interest in the newly formed company, First National Merchant Solutions LLC.
In April, Silver Lake Partners, a Menlo Park, Calif.-based technology-investment firm, bought
a 60% stake in Mercury Payment Systems. The
Durango, Colo.-based processor retained a 40% share in the business.
As mergers and acquisitions were sweeping the
processor landscape, investors also were acquiring ISO portfolios or were buying entire ISO businesses, including their sales organizations, Koning says.
It was all part of a flurry of investment that
occurred despite pressures the recession was bringing to bear on the marketplace, says Koning. In fact, the acquisitions began and continued while processors were lowering the fees they charge ISOs for transactions, he says.
The downward trend for fees became apparent by September 2008 and continued for two years, as processors were lowering the fees to entice ISOs to switch to their companies, Koning notes. With more ISOs on the roster, processors could increase transaction volume and boost revenue even with depressed margins, he says.
The lowest teaser rates, about 5 cents per transaction for the largest retailers before the recession, declined to 2 cents per transaction during the economic slowdown, Koning says. “ISOs were getting increasingly good deals,” he notes.
But nothing lasts forever, and fees have been rebounding in recent months, Koning says. “We started to hear some say, ‘No we’re not going to match our competitor’s price. It’s too low. We just won’t do it,’” he says.
The large ISOs were enjoying what nearly amounted to a “fee holiday,” but small ISOs still faced relatively high transactions fees besides fixed assessments for processing services, Koning says.
For smaller ISOs, rates per transaction varied during the period from
4 cents to 10 cents, according to Kelly King, vice president, operations, and owner of KBO Payment Processing LLC, a small Atlanta-based ISO.
Processing fees have been high enough to force some small ISOs to seek shelter under the wing of bigger ISOs, King says. As sub-ISOs, they benefit from lower transaction fees that accrue because of higher volume, she says.
Besides benefiting from those lower transaction costs, sub-ISOs reduce expenses and avoid hassles by tapping into the support services of “parent” ISOs, says King. “The sub-ISO would just be out there doing deals and not doing administrative tasks,” she says. Such support might include sending statements or answering merchant support calls.
The price competition among processors was one of several trends that have brought uncertainty to the marketplace but have failed to dull investors’ penchant for acquiring ISOs and processors,
The shopping spree is occurring despite uncertainties surrounding stronger new federal regulation of cards, says Mike Passilla, president and CEO of Atlanta-based Elavon Global Payments Solutions. He points to the questions raised by the Durbin amendment to the Dodd-Frank Wall Street Reform and Consumer Protection Act, which
President Obama signed into law in July.
“The government now has the ability to regulate debit (card) interchange prices,” Passilla says. How that power would affect the industry remained in doubt at press time, but many expected the ramifications to become clearer by the end of 2010, by which time observers expected the Federal Reserve Board to issue proposed guidelines.
“It will have operational, financial and personnel implications associated with the [merchant-
services provider] community,” Passilla says of the potential fallout from the Durbin amendment. The changes will unsettle the merchant-acquiring
community for years to come, he predicts.
For example, the new law could obligate ISOs to teach merchants how to navigate its intricacies, such as a newly granted right to offer discounts on debit card fees, Passilla says. In ways still undetermined, ISOs and merchants also will change their financial reporting to accommodate the law, he points out.
How other aspects of the law will play out also remains unclear, according to TSYS’s Munto. “Anytime you have government intervention, there’s always that concern that you’ll be dealing with
unintended consequences,” he says.
Though the uncertainty troubles many
observers, others are contemplating an opportunity the legislation may create, says Munto. The law likely will lower debit card interchange rates, but ISOs and processors might not have to pass the
entire price reduction along to consumers, and that would increase the industry’s margins, he says.
“From where we sit, the prevailing thought is it does represent an opportunity for a margin
expansion play,” Munto says. “That’s creating some excitement.”
Meanwhile, another legislative tide is rippling through the industry, Passilla says. The Housing and
Economic Recovery Act of 2008 requires “merchant acquiring entities” to report the gross amount of merchant customers’ electronic payments to the Internal Revenue Service, beginning in January, he says.
If an acquirer reports figures that do not match a retailer’s filings, the IRS can instruct the acquirer to withhold funds–up to 28% of the estimated total–until the discrepancies are reconciled, Passilla says.
Some observers see an opportunity for the acquiring industry to impose fees on merchants
for providing that expanded IRS reporting, but Passilla views the new mandate in a different light.
“It is an opportunity to further deepen the trust and partnership that a company like us has with their respective ISOs because at the end of the day the acquirer and the ISO together are jointly having to abide by this on behalf of the merchant base and on behalf of the federal government,” Passilla says. “We are both in the middle.”
In ISO-processor relationships already in jeopardy, the reporting requirement could drive a wedge between the two businesses, he predicts.
While Passilla makes the best of the regulatory situation, investors are continuing to enter the
industry despite the changes their presence could bring, observers say.
The infusion of capital into ISOs naturally tends to increase their size and power, Koning notes. Larger ISOs can reach the critical mass that enables them to make the massive capital outlay required to start their own processing units and assume the accompanying risk of breaches, says Koning. Launching a processing business can cost at $20 million to $50 million, he estimates.
That movement of ISOs into processing can threaten the market’s 10 or 15 major processors with a loss of business, Koning says. But some of the big processors have become so well established that they have ways to cling to market share, says TSYS’s Munto.
ISOs that perform their own processing may still rely on TSYS for some of their processing work because TSYS has become certified for acceptance at so many merchants and has built the necessary infrastructure, Munto says. “It’s not something you can do in a matter of months,” he says.
Processors sometimes work together, but ISOs and processors almost always do, says Bruce Dragt, senior vice president and division manager at First Data Corp. The Atlanta-based processor, for example, provides ISOs with individualized processing and marketing support, he says.
Established ISOs have developed their own ways to sell and prefer an automated, behind-the-scenes approach to processing, Dragt says, noting newer ISOs want to put their brand on Web-based templates that First Data provides. Older ISOs can handle the risk of new accounts on their own, while fledgling ISOs may require First Data’s help in handling technology that deals with risk, Dragt says.
Processors also help ISOs understand and distribute value-added products and services “so you don’t become a one-trick pony showing up with just credit and debit on a single point-of-sale”
offering, says Passilla. His company helps ISOs set themselves apart from competitors by supporting them with gift cards, bill pay and a high level of reporting detail, he says.
ISOs used to limit their offerings to Visa Inc. and MasterCard Worldwide transactions but in the past two years have begun to provide more products and services, such as Discover Financial Services and American Express Co. transactions and prepaid products, says Dragt. In the past six months, ISOs also have begun offering data encryption and tokenization. “No longer is it just about core acquiring,” he says.
Reporting and analytics, both based on payments information, are becoming more important to merchants and hence more important to ISOs, says Dragt.
A merchant might ask, “What does it mean that I’m taking more AmEx today or more PIN debit versus signature debit?” ISOs and acquirers, with the right tools, can help provide answers to those questions, Dragt says.
Interest in such sophisticated approaches seems destined to grow, Dragt says.
“It’s becoming a more strategic part of a merchant’s life, and correspondingly we need to give them more tools to help them strategically understand what’s going on with their payments versus just taking as something that comes through their system,” he says.
Someone in the processing business, it appears, has heard the ISO’s lament.