Recent high profile acquisitions made by some of the payment industry’s key players, such as Heartland Payment Systems, First Data, and Vantiv, point to a recurring theme—traditional merchant businesses are making the shift into integrated technologies. 

Transactions like these are changing the typical profiles of historical acquisition targets by combining payments acceptance with business applications to penetrate new market verticals, defend value propositions, and gain sustainability. For the smaller buyers (i.e, traditional ISOs and sales offices) without the means to invest in more transformational plays, it’s about gaining access to additional sales channels, continuing to build a book of business with hopes for higher premiums later, and capitalizing on annuity generating portfolios.

Rapid introduction of new technologies and software are strong catalysts to lowering the barriers of entry and payment processing costs; creating disruptions within the traditional payments facilitation business model (e.g., software POS solutions, NFC, in-app payments, mPOS, eWallets/mWallets, virtual currencies, cloud computing).  According to a recent report from McKinsey, the majority of merchant payments’ revenue growth over the next five years will be acquired through software solutions. 

Newcomers such as Ziosk, Starbucks, Dwolla, Square, Intuit, and others are creating challenges for the traditional payment facilitators and service providers.  To compete, ISOs need to continue to make aggressive acquisitions of essential technologies in strong growth areas. 

Forward thinking payment companies recognize that technology drives value creation and customer stickiness. In the hunt for game-changing, transformational plays, Independent Software Vendors (ISVs) are a magnet for the larger players.  Vantiv’s 2014 acquisition of Mercury Payments Systems’ integrated payment solutions is helping it win at differentiation by customizing solutions to meet the needs of merchants across small and large segments.  Heartland’s POS buys are helping it grow its portfolio of merchants and offer unique integrated commerce capabilities.

In addition to expanding by acquiring differentiated technology and software solutions, ISOs are targeting industry verticals with hyper-growth potential to capture more share at sustainable margins (e.g., B2B, eCommerce, Education, Healthcare).  Vertical market diversification was the aim of Global Payments Inc.’s 2014 $420 million acquisition of Payment Processing Inc. (PayPros), which has helped it expand its B2B processing business by gaining access to PayPros’ complimentary vertical markets under the rebranded name OpenEdge.  And by snatching up companies such as Element and its leading-edge payments technology in point-to-point encryption (P2PE) and tokenization, buyers like Vantiv are building broader, more defensive value propositions by growing their integrated payments channels.

Smaller businesses are not shielded from the widespread slowdown in growth and diminishing margins; in fact, this segment stands to face greater compression compared with its larger counterparts. 

An emerging core strategy is to partner with technology companies to benefit from lower attrition and incremental revenue streams.  

Given the fast-changing dynamics in the payments business, it is prudent to challenge traditional valuation assumptions. There are two key questions you need to answer when conducting your due diligence. What is your return on investment? And how long will it last?  Using a discounted cash flow method is still a common and acceptable valuation practice in the due diligence process; however, buyers may need to adjust certain key assumptions in the model that may have changed over time (e.g., closure rates, attrition rates, same store sales rates).  When determining the right bid range, at least 24 months of historical data should be considered for the discounted cash flow (DCF) model with weight placed on the most recent 6 months’ trend. 

At the highest level, industry experts claim that the two most important drivers of value undoubtedly are attrition and revenue.  Though conducting an in-depth analysis of other key factors such as portfolio concentration, account origination, channel dynamics, and processing platforms are critical to the valuation process. 

Attrition history is the most important driver of value.  Prospects should review attrition trends of at least the most recent 6 months and compare attrition rates to asset peer groups. 

Revenue is the other top driver of value.  There are several factors to consider when analyzing the revenue opportunity, including the size of the asset, pricing structure (e.g., bundle vs unbundled), average revenue per account, basis points spread, and same store sales.  For growth assets, re-pricing potential, the number of expected new adds, and the pricing structure of new business can also influence the multiples buyers are willing to pay.  For the smaller traditional ISOs looking at buyouts to access additional channels, secure margins, and capitalize on annuity, these buyers should pay close focus to the basis points on the accounts.  

Concentration and risk profile of the asset are necessary factors in the due diligence process and will affect the internal rate of return.  Analysis of average volume per account over the past 6 months, residual ratio, industry concentration (e.g., certain industry verticals carry lower attrition risk and are typically insensitive to price), accounts concentration (e.g., a single owner with a great number of locations may overweight the valuation).

Origination of the asset or sales approach used to acquire the merchant is very important to determine the expected longevity and support services requirements.  People often place higher valuation on niche assets because the merchant tends to be stickier, which contributes to lower attrition risks-- where attrition rates are typically in the single digits compared to high teens-low 20s for the average merchant. 

Channel dynamics, if not fully understood can create significant pains for the buyer post acquisition.  In addition to understanding the sales origination of the book, knowing how residuals are distributed is critical to the deal.  As part of its standard practice, iPayment usually makes a point to speak to the top agents of an ISO when exploring a potential prospect.  For those larger size deals, the economics can take the spotlight, creating oversight or less attention given to the legal terms and conditions to ensure the residuals are free of any encumbrances or security positions of third parties that could interrupt revenue streams.  One way to keep the downstream happy and producing new business, is to ensure agent incentives are part of the deal.

Processor Platforms can pose potential opportunities and risks, depending on the buyer’s and seller’s situation.  As an example, smaller buyers of residual/agent book assets may only be able to purchase the cash flow, particularly if the seller does not have platform portability.  Another issue for smaller buyers is limited access to transaction data if not a registered ISO with the current processor. 

On the flip side, larger players find foreign platforms to be an opportunity by adding exclusivity requirements to gain future business from the seller.  Additionally, most large ISOs and super ISOs usually have platform portability and can benefit from synergies by reducing back-office functions and expenses.  In cases, where the large ISO does not have portability or if the originating processor is second tier, the collection risk of the residuals rises.  And if the deal involves migrating merchants from one platform to another, this will contribute to higher attrition.    

Like in any M&A wave, as valuations rise, both opportunities and risks also increase. While traditional valuation methods haven’t changed a whole lot, some rejiggering of inputs into the models can ensure pricing reflects the current and future growth prospects of the underlying asset.

Avoid rushing due diligence to scoop up the next book or new technology. When reviewing tech companies, ISOs, and agents, look for high growth and strong historical performance.  Net revenues, margins, and the maturity of the portfolio must be analyzed in the context of current multiples and forecasted continued margin compression.  One of the best pieces of advice offered in our common pitfall section is to ensure the legal certainty around the payments of residuals being purchased and keep the seller close to the deal over the longer term.  It behooves the buyer to get familiar with the reputation of prospects by interviewing top sales agents and partners.

Sherry Seetram is president of ePay Consulting Services.