Institutional interest in the private debt universe has exploded in the past ten years, with total AUM in the space quadrupling from a mere $75 billion in 2006 to a staggering $373 billion at the end of last year, according to Preqin. Nearly $200 billion of that institutional capital has been raised since January 2015 alone.
But what is “private debt,” exactly? Traditionally, the expression has referred to such things as mezzanine finance, distressed debt and what we do at Old Hill Partners – direct lending to small and medium-sized businesses. Increasingly, however, other forms of lower middle-market capital formation, such as merchant cash advances, are being thrown into the mix.
Given the confusion, which we’ve seen firsthand among both investors and managers in the private credit space, we decided to devote this month’s commentary to describing exactly what merchant cash advances (MCA) are, what they’re not, and how they fit into our world.
First, some context: Old Hill Partners first became involved in the MCA industry in 2007, when we began financing one of the largest direct participants in the space. We worked with this client prior to, during and after the financial crisis, making us one of the few lenders with hands-on experience with the institutional financing of MCA companies through a full credit cycle. We know firsthand the attractiveness of this segment from a wholesale finance perspective, and also know just how bad it can get.
In simple terms, MCA refers to the purchase of a company’s future receivables today for a specific price to be repaid over time via small daily or weekly remittances out of the company sales. As an example, a finance company might agree to buy $120,000 worth of XYZ Trucking’s future revenues in exchange for $100,000 paid today, with repayment of the $120,000 made through payments of a small percentage of daily sales. When all goes well, the company gets immediate cash, and the financer generates a healthy return on its invested capital.
As banks have pulled out of the small-company credit space, the MCA business has boomed because these transactions are typically very quick to fund and are generally both unsecured and unencumbered – the merchant is not restricted by use covenants and can buy equipment, pay suppliers, or otherwise spend the capital however they see fit.
Out of the gate, however, it is important to note that these transactions are often purchase and sales agreements, not loans per se. Future sales are bought for a discount to face value and paid for over time, which is a markedly different structure from a credit transaction. Furthermore, MCA deals are not typically secured by anything beyond a personal guaranty, so there is little recourse should the financed company go out of business. But when all goes well, these transactions can generate loss-adjusted IRRs of 30%-40% annualized, so it is perhaps unsurprising that the segment has attracted significant interest from capital sources and a lot of demand for transactions.
The flip side is that the MCA business comes with structural concerns, starting with origination. Deals are typically sourced through brokers in a similar fashion as mortgages, meaning their prime directive is to originate, not underwrite. In fact, in light of the counterparties involved, brokers of MCA transactions are chiefly concerned with feeding the proverbial machine, not extensive due diligence.
On the cost side, the MCA process is labor intensive, expensive and difficult to automate, since each merchant and deal is different. At the same time, transaction amounts are small, typically well under $100,000 and short-term in nature (3-12 months). This creates pressure in three ways; first, through high fixed costs, secondly from low deal sizes, and third, from rapidly amortizing outstanding balances, all of which translate into a constant need to generate high volume. As we saw with sub-prime mortgages during the crisis, this type of scenario can quickly lead to looser standards – a trend we’ve been seeing over the past few years.
Taken together, these concerns give us a degree of restraint in the MCA space right now. That said, it can offer attractive opportunities for Old Hill, given our expertise in wholesale financing, so we are being very picky. Our preferred situation is one where we’re working with a company that has developed a unique or cost-efficient origination platform, so acquisition costs are lower. These are companies that reach out to merchants directly, use affiliate marketing programs, etc. – some way to engage the marketplace without going through a broker.
From there, Old Hill Partners’ typical conservative discipline kicks in. For instance, we lend only to MCA companies with deep historical performance data and extensive collections experience, and we structure deals such that they will still perform even if we assume default rates and other loss statistics double during a recession. We make sure the borrower is well capitalized, and ensure a very hands-on relationship.
Furthermore, we lend using a borrowing base concept, so if an underlying merchant starts delaying or skipping their daily/weekly repayments or otherwise starts to veer off course, we dynamically reduce our exposure to that merchant by using excess collections that would have otherwise gone to our client, the MCA company. These adjustments are made at least once per month as we assess the portfolio, and we always lend at a proportionate rate. For instance, if the MCA firm provides $10,000 to a merchant, we’ll advance $8,000. Such structural elements help us create excess cushion in a portfolio that provides additional protection.
And where does it go from here? For the MCA industry itself, we think a wave of consolidation is due - there are benefits to be had with scale, such as origination and operating costs and lower funding costs. As far as the Federal Reserve is concerned, we don’t think pricing will change very much for the foreseeable future. It hasn’t moved tremendously since 2006 – not on the way up, and not on the way back down – because these transactions are already priced far in excess of traded credit yields. Investor demand might eventually lessen as interest rates reach nosebleed levels but we’re a long way from that scenario. Moreover, our wholesale transactions generally have floating rate structures with a floor, so we’re protected regardless.
Old Hill Partners’ portfolio manager Peter Faigl contributed to this commentary. Peter has more than 15 years of experience in credit-based transaction analysis, structuring, modeling and portfolio management for asset-backed lending investments. Prior to joining Old Hill in 2009, he was a director at NewStar Financial, where he helped the company develop its structured finance and asset-backed investment businesses. Beforehand, Faigl was responsible for structuring and execution of asset-backed principal transactions at UBS. He is a CFA charter holder.