INSIGHTS: Unlocking Overlooked Opportunities: A Deep Dive into Merchant Cash Advance

[Bobby] In today's investment world, which has become increasingly efficient and saturated, it's difficult to find opportunities that have the enviable combination of an uncrowded space, strong competitive moats, high and consistent return potential, coupled with low volatility and drawdowns. Oftentimes, these rare opportunities are overlooked or misunderstood, which, in essence, sometimes creates the opportunity.

Today, I am talking with a leading player in the strategy – Merchant Cash Advance – that I believe, if done correctly, checks all of those enviable boxes. This will be the first of several conversations on the topic, and hopefully, we'll be able to provide some insights into the strategy and address some of the questions that I initially had when I was introduced to the strategy and that many investors have.

I am joined by Jason Myers, Managing Partner at PMF Asset Management, one of the largest, if not the largest, and most institutional firms in the Merchant Cash Advance industry.

So to start off, for the benefit of those in the overlooked or undiscovered camp – what is Merchant Cash Advance?

[Jason] In a nutshell, it's short-term financing for small businesses looking for additional capital. We purchase a portion of a business's future receivables or revenues, providing them with a quick and convenient source of capital that they can use for operating purposes or growth.

[Bobby] Merchant Cash Advance can be more expensive than other forms of financing. Why would merchants choose this potentially more expensive form of financing versus other options that may be available to them that are less expensive?

[Jason] Many businesses already have other forms of more traditional bank financing or SBA government-sponsored loans where they've pledged collateral, whether it be real estate, assets, or anything else a bank would typically require for a loan. However, we provide unsecured capital based on the cash flows of the business. So, if a business is growing and generating increasing cash flows, but the collateral a bank requires is not growing, they are limited in where they can access additional funding. Sometimes, a business's growth outpaces the restrictive lending standards of a bank.

The cost for banks to process a small loan versus a large loan is about the same. It’s a fixed cost. So, from a margin standpoint, banks prefer to focus on larger loans. It costs the bank just as much to underwrite a $250,000 loan as it does a $50 million loan. Larger loans are typically seen as less risky compared to smaller loans, all else being equal. The third factor, which is often overlooked, is cross-selling opportunities.

A larger company likely has more banking needs, such as demand deposits, cash management, or foreign exchange (FX) services, which banks can profit from. Small businesses, on the other hand, do not offer as many cross-selling opportunities, making them less attractive to banks. As a result, banks have moved away from this segment of the market. It’s not that small businesses have deteriorated in credit quality, but rather that they have fewer resources and limited options to fund their operations.

These are not loans; this is financing provided based on future revenues. I think when a bank looks at it, they’re getting paid back. However, in MCA, the ability to be successful is based on collecting future revenues, which only happens if the business generates future revenues.

[Bobby] Talk a little bit about the duration of this financing. This is something unique to this strategy, and makes it difficult to compare apples to apples when talking about different financing opportunities and underwriting standards. How does the underwriting process of Merchant Cash Advance differ from a traditional bank loan?

[Jason] The duration or term of these deals is much shorter than traditional bank loans. We’re talking about weeks or months, not years. So, our underwriting focuses on the cash flows of the business.

Have the merchants historically had consistent cash flows? Have the cash flows been growing? Will those continue to grow? Will they continue to be steady? We are selective in this sense because some small businesses have choppy or seasonal cash flows. There are many different ways to run a business, but we look for that consistency in cash flows.

Banks, on the other hand, focus on collateral. If something goes wrong, banks look at what they can take to be made whole, or at least partially whole. They’re looking at it from a collateral standpoint, and we look at it from a cash flow standpoint. In contrast, we look at businesses over a 12-month or shorter period, while banks typically looks at businesses over a multi-year period.

[Bobby] One of the first questions many investors ask – given the relatively high factor rates (which can be 1.4 or more); is this is really desperation capital for lower-quality merchants for the most part?

[Jason] I know it can be seen as desperation capital due to the high factor rates in this space. However, the reality is that small businesses today have far fewer funding opportunities than they did pre-2008, or that people assume existed. If a small business already has a bank loan with collateral and still needs additional funding, what are the options? It’s not going to be an IPO or bond issuance. You could get a cash advance on a credit card, but that is typically not going to be enough for whatever the business needs, as it is based on personal credit scores and finances.

Most small businesses are either too small for private equity; you’re running into a situation where you sold equity in your business, which could be in perpetuity. So, maybe you need $200,000 to purchase the building next to you, or hire a few office assistants – that just seems more expensive. Whereas, we’re not taking equity – we’re giving you cash now, and our belief is that the revenues in the future will be able to pay us back. So, private equity is a very expensive form of capital – the most expensive form of capital for some. Merchant Cash Advance is a very convenient and easy source for these small businesses, without giving up equity in a very successful endeavour. 

[Bobby] Switching gears, can you talk a little bit about the current landscape of the Merchant Cash Advance industry and provide a high-level overview of the different types of players?

[Jason] Sure. There are a couple of dozen players out there; there are really two types of groups – the direct groups, and the platform groups.

We fall into the direct origination camp. What that means is, we have originators communicating directly with business owners. We are communicating with them, developing a rapport with them, and getting to understand their business. As we go through the process, even after funding, we remain in direct contact with those business owners. We do that consistently, and they are able to reach out and contact us. We have about 600 originators that are talking to U.S.-based business owners on a daily basis.

I would say the next closest group would be about 10-20 people, maybe 25. They are both originators and underwriters.

The other one is the platforms – the indirect groups. These can be groups that are also small, but there are groups that can be quite large, so they are getting deals from direct origination groups like us.

So a part of our business, in addition to funding deals, is brokering out deals that we choose not to fund internally – to these platforms. We do not take a deep dive from an underwriting perspective with them, because they are not a fit for us at first glance – so we broker them out. Whether or not they get a full underwriting review from the platform groups, depends on the platform.

[Bobby] Given that you've been in the Merchant Cash Advance space for over a decade, first in brokerage and now in asset management, you’ve probably learned a lot and seen a lot. What do you think are some of the keys to success in delivering a Merchant Cash Advance strategy well? What should investors avoid when looking at this space?

[Jason] From an asset management and strategy perspective, our biggest advantage is deal flow. Like I mentioned, we have 600 originators calling into 32.5 million U.S. businesses. Not all of them are worth funding, and many of them are brokered out. So we can be very selective in what we choose to fund – the deal flow provides us with that luxury.

Whereas if we didn’t have that level of deal flow (as a much smaller group), we would be forced to be less choosy – meaning that you’re going to have a situation where if you stick to your underwriting standards, you might have to pass on deals, but then you might not see enough deals that fit your underwriting standards. So, now you have a cash drag, which affects performance, or you compromise your underwriting standards to avoid a cash drag – which you obviously shouldn’t do, because default levels will go up. Like a bad gambler placing a bad bet to make up for a bad bet, you get into trouble very quickly.

So, our focus is on high quality deal flow and high quality underwriting – those two have a symbiotic relationship.