Getting the Best Price When Selling Your Portfolio

W hen many of the industry veterans began in this industry in the early to mid-1980s, we had no concept of the value or liquidity of the portfolios we would be building. Portfolios had been traded between different banks and public companies for years, but there were no significant non-bank portfolios to buy or sell in those days.

Rich Roberts and Greg Daily changed all of that when they took PMT Services public in 1994. Rich and Greg were aggressive in buying small and large ISO portfolios. In the early days, PMT telephoned ISOs and offered 20 to 24 times monthly residuals to purchase a portfolio. As PMT grew, its acquisition approaches became more sophisticated and the multiples skyrocketed.

PMT did quite well for itself, increasing its market cap to about $1.2 billion before merging with the equally valued NOVA in the fall of 1998 to create a new NOVA with a market cap of about $2.4 billion. The course for portfolio purchases had been set - temporarily.

Almost two years later, NOVA disclosed certain facts (well-known by then within our industry) about the actual results of the PMT merger. NOVA disclosed that the attrition of PMT merchants was enormous, that some portfolio purchase prices had been inflated and that merchant losses were running high.

This disclosure dropped the market cap of the new NOVA back to its pre-merger valuation of about $1.2 billion, wiping out all of the value that went to pay for those ISO portfolios. (NOVA was able to recover some of that value back, however, and was acquired by US Bank for about $2.1 billion last year.)

I think it is fair to say that PMT changed the bankcard-acquiring world in several ways.

First, it is almost impossible for many of my friends to fall asleep at night without wondering how much their portfolio is worth. The fact is that portfolios have become valuable and liquid properties. (But you might have trouble convincing a lender of that!)

Second, the PMT-NOVA merger also taught many buyers in the industry that consequences can be severe if portfolio transactions are not valued accurately and transitioned carefully after the purchase.

To define my words, when I discuss "portfolio" in this article, I mean a set of merchant contracts that the seller has the right to sell in the clear without claims made by former salespeople, sub-ISOs or others. I assume that the business and the salespeople who originated those contracts are not part of the sale. To sell an ISO business is different from selling an ISO portfolio. This article is about the value of a portfolio absent the rest of the ISO's business enterprise. Some industry experts call this a "static pool portfolio."

Obviously, selling an ongoing business is going to bring a different value than selling a "static pool" of merchant contracts. Many ISO businesses have been sold with huge benefits to both buyer and seller. Look back to the acquisition of Card Payment Systems by Concord EFS in January 2000 to see how best to model selling your ISO business. It helps to have two guys as smart as Larry Stone and Ed Labry negotiating a merger of two great businesses to maximize returns for all parties.

Another transaction that helped all parties tremendously was the sale of the First Union portfolio to the pre-IPO NOVA in 1995. First Union converted its entire portfolio and a contract for future bank leads to pre-IPO NOVA stock and benefited in the hundreds of millions of dollars upon the IPO of NOVA. Clearly, First Union and NOVA knew how to craft a merger that benefited all parties.

On the other hand, some other sales of ISO businesses have been nightmares for the buyers. Many of you are familiar with one well-known ISO who sold his business for a huge multiple without an adequate non-compete and had 50% of his business back in less than two years - good for the seller, but a very bad transaction for the buyer. I doubt too many ISO businesses will be sold profitably without protective non-compete agreements in the near future.

In deciding to sell a "static pool," one of the first decisions is whether to sell to a financial buyer or a strategic buyer. I have been involved in both kinds of transactions. A financial buyer is one who will be focused on the value of the revenue stream alone. I have seen financial buyers pay anywhere from nine to 58 times monthly revenues. Obviously, there is a huge difference in these valuations. I will try to explain some of the variables below.

A strategic buyer is one in our industry who will move the merchant contracts to its own processing platform in the belief that the earnings from merchants processed on one's own platform will be higher than by leaving the merchants on a foreign platform. Strategic buyers are looking at all of the same factors important to financial buyers, but their approach to valuation adds the complication of portfolio conversion and the opportunity for lower processing and servicing costs.

Also, strategic buyers are focused on Net Revenue as opposed to the existing revenue stream. Net Revenue = Gross Fees charged to merchants (exclusive of leases, rentals, supplies, chargeback fees and other miscellaneous items) less the interchange, dues and assessments paid to the issuing banks, Visa, MasterCard and Diners Club.

I have seen transactions to strategic buyers in the range of 15 to 26 times Net Revenue. This variance is narrower than for financial buyers, but strategic buyers normally only look at larger portfolios that can be moved profitably to their platforms.

In order to sell a revenue stream and/or merchant contracts, buyers almost always will require such things as releases from the current processors, contractual rights to assign the contracts and/or to move the merchant to the buyer's platform and non-competes from the seller. These and other factors are part of almost every portfolio transaction and, for the purposes of this discussion, I will assume they are part of any transaction.

The three key words in portfolio valuation for financial buyers are IRR, Attrition, and Risk. For strategic buyers, add the additional key words of Conversion and Size.

IRR (Internal Rate of Return) Every buyer of a portfolio has ideas about the desired return on an investment relative to the risk of that investment. I think it is safe to say that there aren't too many buyers out there looking for any size of a portfolio with goals of less than a 20% return. Many are looking for more than 20%, and many are looking in the 30%-35% range.

To calculate the IRR, you need to know the purchase price, the cost of money, the cost of conversion, the monthly revenue stream, the cost of maintaining that revenue stream, the attrition rate and the anticipated losses. If you have all of this information, you can use the IRR function in your Excel spreadsheet to play with these variables to calculate the value of your portfolio based upon different IRR factors.

My experience is that the buyer always is looking for a much higher IRR than he is willing to disclose to the seller! Bottom line - calculate the IRR for yourself! Figures don't lie, but ?

Attrition The PMT-NOVA merger demonstrated that high attrition can destroy the value of an acquired portfolio. If you want to sell your portfolio at the highest price, you will want to offer some type of attrition guarantee to the buyer, either in the form of replacing lost merchants in excess of the attrition target or in the form of a holdback of part of the purchase price. Obviously, buyers would prefer a non-recourse transaction. Those are certainly available, but they do not provide the best price to the buyer. The highest values are received by sellers who are willing to protect the attrition of the buyer.

Risk I believe the average losses in portfolios in the U.S. today run in the range of one basis point. Buyers are going to look carefully at the historical losses in your portfolio and calculate an anticipated loss ratio. The more card-not-present business and high-risk business in your portfolio, the less you will be offered.

Buyers will look at the chargeback and credit percentages of your portfolio. The higher these percentages, the lower your valuation will be. To maximize the value of your portfolio, you might consider offering to pay any losses over a certain threshold during a fixed period of time after the sale - perhaps one or two years. It is almost certain that the seller will believe the portfolio is less risky than the buyer will believe.

Other risk factors include top-heavy portfolios with a high percentage of large merchants. If losing a few of the largest most-profitable merchants would seriously impact the revenue stream, the buyer will haircut the valuation.

Also, heavy concentrations in certain kinds of cyclical industries (such as travel business and furniture stores) will hurt the valuation. Again, the best way to maximize value is to protect the buyer in advance with a holdback or a guarantee to replace excessive lost revenues.

Since many ISOs have no risk on their existing portfolios, they do not understand merchant losses except on a philosophical level. A formerly well-known ISO financial institution - one of the best-known institutions in the country a few years ago - took such large losses on its portfolio that it was taken over without receiving any money for its portfolio.

Merchant losses are real to buyers of portfolios. If you have experienced no losses in the past, to get top dollar you will need to protect the buyer from losses in the future. If you do not have hard facts about the loss experience in your portfolio or the chargeback and credit history of your portfolio, you will lose the benefit of the doubt because the buyer will assume that the history is not good.

Size of Portfolio The larger your portfolio, the more prospective buyers exist. If your portfolio has fewer than 1,000 merchants or less than $100 million in annual volume, it may be difficult for you to find a strategic buyer, but there are always financial buyers who will buy any portfolio if the price is low enough.

The best advice is to get professional help in selling your portfolio. If you have a large portfolio, you will want to work with an investment bank or consultant who has done this many times before. If you have a small portfolio, your options are more limited. A few of the seven companies listed in the Resource Guide of The Green Sheet under "ISOs/Banks Purchasing Merchant Portfolios" are interested in buying portfolios in any size range. A suggestion for the owner of a small portfolio would be to get bids from the folks listed here.

If you have a larger portfolio, there are a significant number of additional prospective buyers. The larger your portfolio, the better valuation you will receive. It is always best to build a bigger, well-diversified portfolio with low attrition and low losses than to sell a small portfolio with poor attrition and loss profiles.

Conversion to Buyer's Platform Strategic buyers of portfolios want the merchants processing on one of their platforms, and that means a conversion. The merchants will be moved to the buyer's BIN and back-end settlement platform. Often the merchant also will need to be moved to a different front-end processor.

Moving merchants is ALWAYS a huge problem. There rarely is an incentive for a merchant to move. The merchant must learn new procedures or call different people for help or have a different monthly statement or billing method. A portfolio sale is always a negative for a merchant, and notification that a merchant's contract has been sold is often reason for a merchant to look for a better deal with another processor.

To maximize the price of your portfolio, you should offer to move it to the buyer's platform at your cost. If you do not do this, the buyer will build in a huge haircut in value (as much as 25%) under the assumption that a high percentage of the purchased merchants will not convert to the buyer's platform or stay very long after the conversion. In addition to the perceived attrition that will occur, the buyer also will have costs of conversions that will be subtracted from the price you are offered.

In summary, the best buyer is the one who has the most to gain from an acquisition.

Here are three transactions that appear to have been huge winners for all of the parties involved.

- First Union found a company that was ready to go public and converted portfolio to stock that made a fantastic return for the First Union stockholders in the early days of NOVA's post-IPO valuation.

- Concord EFS was looking for a management team and found Larry Stone, who could fulfill that need as well as anyone in our industry.

- NPC was looking to expand into the regional account marketplace, and SalomonSmithBarney found NPC to help Heartland's management team raise the funds to buy out its bank partner. If your portfolio is too small to have significant impact to a potential buyer, you are not going to get great valuations. But you can maximize your valuation if you will protect the buyer from the unknowns with a recourse sale. If you want to take your money and not look back, you will take a significant haircut on valuation, but you will be able to find a buyer unless your merchant base is loaded with risky merchant types.

One of the experts on valuation of merchant portfolios is Marc Abbey of First Annapolis Consulting (410-855-8521). Marc and his associates have made presentations on portfolio valuation at industry meetings throughout the country. If I wanted to sell a small, midsize or large portfolio, I would call Marc and ask him to sell it for me. He knows the buyers, and he knows what they are looking for. Another expert focused on very large portfolios (billion dollars plus) is Robert Hyer of SalomonSmithBarney (212-816-8703).

There are a lot of experts, but these are two I can recommend based upon first-hand experience. If you are looking to sell a portfolio for the first time, I promise you one thing: You will be a lot more knowledgeable about a lot of things after the process is completed than when you started. Good luck maximizing the value of your portfolio!

Bob Carr spent the first half of his career as a software developer, as a provider of data-processing services, as Director of Computer Services for the Bank of Illinois and for Parkland College in Champaign, Ill., and as a college-level instructor of mathematics and computer science.

In 1987, he started CCSS, which developed custom software and created a portfolio of merchants in excess of $400 million. In 1997, he started Heartland Card Services in a 50-50 partnership with Heartland Bank of St. Louis. In 2000, Heartland bought out the interest of Heartland Bank.

Since 1997, HPS has grown from a small ISO with less than $500 million of process volume to become the ninth-largest acquirer in the U.S. with a portfolio approaching $14 billion and more than 50,000 merchants, mostly restaurants. Bob served as Vice President of the Bankcard Services Association (now the ETA) from 1988-1990.

Bob's goal is to turn HPS into a public company and one of the top five acquirers in the industry before he retires.