By Anthony Malatesta
Wellesly Hills Financial
Merger and acquisition activity for payment processors, merchant acquirers, ISOs and large merchant level salesperson/agent offices is picking up after the extraordinary business challenges of this past year. For the select few whose business models cater to higher risk and online merchants, the uptick in M&A activity is a continuation of the past year.
However, for the majority of merchant acquirers catering to brick-and-mortar merchants, business fundamentals have substantially improved and are once again attracting the attention of investors. Private equity investors are seeking larger platforms, and a wide-spectrum of strategics are seeking smaller ISOs for cross-selling opportunities and growth through high-output sales channels.
Along with the uptick in M&A activity come the inevitable questions surrounding ISO valuations. What's the floor? Where's the ceiling? Are merchant acquirers trading on multiples of EBITDA or multiples of merchant portfolio residual income?
These are all relevant inquiries, and fortunately, the healthy numbers of transactions being closed provide insight into the current thought processes of investors. However, lest we forget the extraordinary pandemic year behind us, the better questions to ask have much more to do with the specific drivers of valuations than the valuations themselves.
Historically, past attrition has provided meaningful guidance for projecting future attrition within a portfolio. But what do attrition key performance indicators tell us today? The answer is, not much. Year-over-year analysis of merchant portfolio accounts, transactions, volume and residuals suffer from the base-effect created by a year-long, paradigm shifting event.
Just as March 2019 over March 2020 attrition numbers were meaningless, so are March 2020 over March 2021 numbers. In both instances, attrition, which has historically reflected the performance and quality of an ISO, now reflects no such thing. Merchant acquirer business performance was directly impacted by lockdowns, shutdowns and every other negative consequence precipitated by the virus. Though attrition was once a primary driver of merchant processor valuation, at this point in time, it's a secondary or tertiary factor at best.
Pre-pandemic, the geographic location of an ISO's merchant base was at best a valuation side-note. With the exception of very specific instances—like a strategic looking to acquire a merchant base in a specific area for servicing reasons or expansion— geography has played a minor role in influencing merchant acquirer valuations.
That has now changed. There has been, and continues to be, a correlation between warmer climates and an earlier and broader reopening of the economy. This is likely due to a combination of political and scientific reasons, and it creates a positive bias for merchant acquirers with a merchant base in the southern United States. Alternatively, there exists a negative bias towards payment processors whose merchant base is primarily in the northern United States.
The takeaway ought to be that geography—at least for now— is a top-tier driver of ISO valuation. As vaccinations continue, I'd expect geography to once again diminish in importance. But, if we fail to reach herd immunity before next fall, and pockets of the country continue to struggle with containing the virus, geography will remain very much in play.
Remember the game King of the Mountain? If attrition was King of the Mountain before the pandemic—in terms of determining merchant acquirer valuations—then merchant industry type is King of the Mountain now. The pandemic crushed brick-and-mortar businesses, leaving consumers no choice but to purchase online.
For the same reason, ISOs whose merchant base was predominantly brick-and-mortar fared poorly, and their competitors who catered to online merchants received a benefit. However, as the economy reopens and momentum shifts back toward brick-and-mortar businesses, the merchant acquirers who serve them will profit by extension. This dynamic puts an ISO's merchant base, in regards to its industry composition, front-and-center as a top driver of valuation.
There's no way to escape industry type's importance right now as ISO valuations work to anticipate future growth.
The only thing an investor loves more than a target with double-digit growth is finding a target that is about to experience double-digit growth unbeknownst to its own management team. In these cases, professional investors spend a lot of time talking down a businesses' recent performance in hopes of negotiating a better multiple for themselves.
However, before allowing an investor to peg a multiple to a portfolio's performance over the past year, it's important to consider the portfolio's performance pre-pandemic. As counter-intuitive as it may seem, if a portfolio's merchants are near a historic low in processing volume but anticipate a rebound in the near term, the portfolio should command a higher multiple. The reason being, the investor has already benefited from applying a multiple to a lower (and growing) residual base.
Valuations by nature are always forward looking, so valuations today must consider how the merchant acquirer will grow into its multiple as businesses reopen over the next several months.
All of this is to say that what goes around, comes around. While demand is highest for geographic segments and industries that have already rebounded, merchant portfolio owners must be cautious of selling at the bottom or allowing investors to sneak across discounted multiples.
As you can see, the extraordinary consequences of the pandemic have changed the historical valuation paradigm for merchant acquirers, ISOs and payments processors. The good news is that there are definitive signs of greater market liquidity, which in turn is driving increased M&A activity.
Because of this, merchant acquirers need to get back to anticipating investor interest for their companies. Better yet, ISO owners ought to avail themselves of the valuation insights discussed above. When owners understand what's driving valuation, they put themselves on better footing to negotiate with interested investors and are able to better defend the value of the companies they have built and kept alive through the past year of challenges. 
Anthony Malatesta is director at Wellesly Hills Financial, covering the payments processing and financial technology sectors. He also manages MerchantPortfolios.com, providing consulting services to ISO/MSP owners. He can be reached at a.malatesta@wellesleyhillsfinancial.com.
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