Merchant cash advance market's allure hides major risks

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The recession that began in 2008 left a mark on many industries, but one effect for payments was the growth of merchant cash advance (MCA), which became an ongoing source of alternative financing for retailers when the downturn caused banks to sharply curtail lending to small businesses.

The economy has largely rebounded, but banks have not rushed back into small-business lending because of today’s steeper organizational and regulatory requirements. Thus, MCA remains a very active area, serving an increasingly diverse range of merchants hungry for immediate capital.

MCA also has become fiercely competitive and a bit more risky these days, as small businesses face more volatility, experts say.

“MCA is a very tough business, and there’s been an excess of supply lately,” said Rick Oglesby, president of AZ Payments, noting that competition is more intense than ever among MCA lenders seeking merchants with solid credit quality, who can deliver a good profit stream with relatively low risk.

Authorities in several states, including California, this year announced plans to look at business-to-business lending as other federal and local regulatory agencies have stepped up their scrutiny of practices, which could possibly affect companies active in the MCA space, according to experts connected to the industry.

“Various state, federal and local regulators are looking closely at alternative financing to make sure it’s not subject to unfair practices, and at some point in the not-too-distant future, I expect there will be new guidelines for MCA, too, around the pricing and disclosure,” said Ryan Masters, head of strategy and business development at New York-based Certa Group, which originates loans to a broad range of borrowers, including some involved in MCA.

Though specific new regulations for MCA aren’t immediately looming, Masters said it’s not too early for industry participants to begin preparing for some potential changes. “MCA players should begin at least thinking about making sure their pricing is fair and they have a clear process for disclosing their policies and practices, to be ready for the day when they’re asked to provide proof of fair APRs and full disclosure,” he said.

Many MCA participants are pricing loans to small businesses within a reasonable range, but Masters said all operators must avoid straying into territory that could be considered usurious, declining to specify what interest rate range potential regulations might prohibit.

“There are always some lenders pricing things in a range that could be considered predatory, and it’s only a matter of time before those come under the regulatory knife, so beware,” Masters said.

Lately the credit quality among merchants seeking MCA loans also shows signs of some deterioration, Masters warned.

“Business owners seeking MCA loans seem to be facing a higher level of risk than in past years, with bankruptcy and other unexpected disruptions becoming more common, and all of this calls for more caution when extending MCA funds,” Masters said.

Despite the obvious risks, MCA continues to generate plenty of activity, because of its somewhat unique approach.

As credit and debit card payments began to account for a larger share of merchants’ overall sales, MCA lenders over the last decade or so devised a specialized way of using card payment volume to secure business-to-business loans for merchants needing anywhere from several hundred to several thousand dollars. Initially MCA appealed mostly restaurants and inventory-heavy retailers, but observers say all types of merchants now are targets for this product.

MCA lenders can look at a merchant’s credit card volume and history and get a quick snapshot of cash flow, enabling them to advance funds based on the borrower’s anticipated credit card receipts. The competitive advantage MCA lenders offer over other channels is speed—most can provide businesses with the needed funds within a day or two—and the merchant repays the loan from a set percentage that comes out of the merchant’s daily, weekly or monthly credit card receipts.

Most major card processors have evolved a relatively turnkey system for routing a percentage of a merchant’s card volume to the lender until the loan is repaid, minimizing hassles around collections, experts say. Rates vary, based on the value of the loan and borrower's risk level.

For merchants, MCA is appealing because it enables business operators to get a bundle of money quickly to buy inventory or make opportunistic investments, with minimal paperwork and without providing the extensive credit checks and verification banks typically require. And lenders get an investment that’s relatively lower-risk than other types of deals, because of the guaranteed revenue-split.

The ease of entry into MCA also means it’s constantly attracting newcomers who think the business looks fairly easy, say participants.

“There seem to be more players than ever in the MCA space, but there’s a lot of turnover because it turns out it’s a lot harder than it looks, so it’s not like it’s growing as a whole,” said Jim Fink, director of strategic partnerships for Rapid Advance, a large MCA lender based in Bethesda, Md., which entered the niche in 2005.

Rapid Advance lends directly to merchants and it also receives a lot of referrals from ISOs that don’t fund loans on their own, Fink said. Recently he’s seen a surge in the number of ISOs that are funding their own loans directly, or white-labeling MCA loans obtained from wholesalers.

“Many ISOs are comfortable doing MCA deals if they know the merchant well and they’re confident of their credit rating,” Fink said.

Anyone extending an MCA loan to an unknown business is taking on higher risks, Fink noted.

Rapid Advance has built a complex, proprietary system to evaluate prospective MCA borrowers drawing on information available from credit bureaus, bank statements, data from merchants’ credit card processors, social media and strategic analysis of business sectors, according to Fink.

“We’ve developed technology to very quickly assess whether we think a merchant can support the debt they’re proposing to take on, and we make a judgment based on what we think is reasonable, because it doesn’t do anyone any good if we deploy too much cash for their case,” Fink said.

Rapid Advance gets most of its business from partnerships it’s built with ISOs, partnerships and even banks that are starting to refer business to the company, Fink said. “There’s a lot of opportunity to work with banks who want to refer clients to MCA, because in many cases, they’d rather give their customer a lead than say ‘no.’”

Along with a seeming revolving-door of newcomers entering MCA, Rapid Advance in recent years has seen more competition coming from independent operators who are offering merchants loans where the funds are repaid not through credit card receipts via a processor, but from daily payouts from a bank account via ACH.

Paying back loans via ACH may not fall exactly under the heading of merchant “cash advance,” which generally involves a processor routing the funds instead of a bank, but Fink said both approaches are becoming more common in MCA.

“For us it’s irrelevant whether merchants agree to pay back loans through the processor or ACH, and it may depend on what’s most appropriate for the merchant,” Fink said, noting that all major processors continue to provide a broad supporting role for MCA.

What may be somewhat surprising is that high-profile online lending services, and national small-business lenders like Intuit, which offers loans through a handful of banks to its QuickBooks customers, and Square Inc., don’t seem to be cutting directly into MCA providers’ business, Fink said.

One reason may be that online lenders go after more startups, and business software companies tend to have a captive audience of their existing customers, observers say.

“We just not seeing a lot of direct competition from the likes of Intuit, maybe because they’re lending to businesses that never went looking for funds elsewhere,” Fink said.

Online lending may pose a general competitive threat, but Fink said there is still plenty of opportunity for MCA operators willing to market their services and perform due diligence on prospects for deals that make sense to both sides of the equation.

“MCA stays alive because we operate in an area banks aren’t looking at anymore, and we have a business model that works for a certain type of enterprise, if you measure your risks appropriately,” Fink said.

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