We deal with a lot of investors and will contend that, with few exceptions, they have no idea how payments works.
Which isn’t crazy when you realize that > 99% of people who work in payments don’t know how payments work either.
Every now and then we meet an investor who’s hired a payments operator; if that operator was also founder, then there’s a fighting chance they know what the hell is actually going on.
But by and large?
Clueless.
Payments is a motherf*cking cheat code.
And this article will make clear just how obvious this should be.
For starters, interchange is not COGS.
Payment acquirers have no way to influence these numbers: they’re set by the duopolies and that’s the end of it.
If merchants get large enough they can carve out special favors from the card schemes (i.e. Amazon or Walmart can negotiate Visa’s take rate from 20 bps down to 10) and from the issuing banks (i.e. Chase has been known to reduce processing costs by eating into their rewards revenue) but it’s not some variable that’s easily within control.
For example, if you run a restaurant and your COGS are high you can switch to lower cost ingredients, shop for a different supplier, buy in bulk, etc..
Can’t do this in payments.
Interchange is interchange.
Because duopoly.
That investment analysts even consider interchange COGS is ludicrous because it implies that it’s an actual cost of business.
It’s not.
You know what the real COGS are for payments acceptance?
The cost to support the connection to the duopolies.
That’s it.
If you were building a processor from scratch, these would be non-trivial in the formative years.
But as you move further downstream, from processor to acquirer (wholesale ISO -> ISO -> agent) the connectivity COGS become zero.
That’s not to say there aren’t support costs for merchants, and this can be considered COGS depending on the financial model used, but lumping in non-negotiable interchange fees into COGS never made any sense to us.
This whole “direct third party costs” is not germane to acquiring businesses.
Next, let’s talk about funds themselves.
The whole purpose of a fund is to generate returns.
Hard stop.
For many private investors, the reality is that “value creation” is simply a cost of capital arbitrage over their portfolio companies, with price-taking measures as the icing on the cake, meaning that funds know how to wield spreadsheet models/debt better than the companies they acquire, and investors will almost always make their portfolio companies increase prices.
But even with all these morally-questionable tactics, the majority of funds don’t even meet their stated performance goals.
While this varies based on stage (funds focusing on earlier stage investments have higher return targets and higher volatility and funds focusing on later stage investments have lower return targets and lower volatility), private funds expect to return 25% IRR on a gross basis.
(Don’t compare these returns with those of public market funds [i.e. multistrat hedge funds], who deliver the returns of treasurys despite taking market risk thanks to their absurd fee structures.)
Over the past 20 years, private funds have outperformed the public markets, even net of fees:
Yet their aggregate performance is not 25% IRR.
From a combination of Pitchbook and Prequin data:
- The median IRR for private equity funds is ~13%
- Top quartile performance starts at ~19%
- No more than 10% of funds achieve 25% IRR
In other words, very few funds meet the 25% IRR that they promise their investors.
And here’s how understanding payments can take a fund from middling performer to top quartile.
Funds make returns one of three ways:
- Grow revenues
- Grow profits
- Multiple arbitrage
The first two are obvious, but the outsized returns come from the the third bucket.
For example, a fund acquires a business for 4x EBITDA then tucks-in other businesses at 4X EBITDA, and by virtue of the new, combined entity having higher revenues, it trades for 6X EBITDA even if the other pertinent financial metrics remain unchanged.
But check this out: margin expansion yields higher multiples.
Even for public companies.
As history suggests (as depicted in the screenshot from the Morgan Stanley article below, which is a recommended read), profit expansion is equally crucial as multiple expansion for the total returns of a stock over the long term. We believe that earnings expansion serves as a signal of optimism, prompting investors to incorporate higher growth expectations into the stock price, thus driving the multiple higher.
This is why larger, more sophisticated funds recognize that they actually need to do something besides wielding a spreadsheet.
To help their portfolio companies, these larger funds will employ operations teams. Some of these teams are well-renowned, like the operations team at Vista, armed with their VSOPs.
But we’d contend that even these sophisticated funds don’t understand the power of payments in achieving their financial goals.
Yes, they do go about leveraging the size of their portfolio for better terms from vendors, whether it’s healthcare or other group purchasing (and they often try this with payment acquirers only to learn that the softwares their portco’s use won’t let them change payment providers), but they miss the bigger opportunity that payments delivers.
Sometimes larger funds will hire the usual MBB consultants, and while these consultants observe many trends by keeping the elite clientele that they do, they are very rarely operators who know how to create value through execution (though we can recount some hilarious tales of consultants givings funds solid advice only for the funds to sit on their thumbs).
Let us run through an example to show how much free money a fund is leaving on the table by being payments-illiterate.
We’re going to choose a random services business, which investors have generally enjoyed owning because of their durability and adaptability: services businesses are not prone to full automation (good luck getting a robot to fix your AC) and are often easily modernized (i.e. achieve a much better margin profile) with a little bit of technological injection.
The average services business earns 8% in net profits. This varies by industry, but let’s go ahead and round this up to 10% for easy math in our example.
Let’s assume that the average cost of card acceptance is 2.5%.
Interchange is 2.2%, and we’ll assume that the acquirer isn’t totally screwing the portfolio company and has thusly capped their avarice at a meager 30 bps.
The first order of business?
Surcharge or dual price to eliminate card costs.
This move immediately drops 2.5% to the bottom line.
Yes, you can also increase the costs of your services by ~3% to cover card costs, but sometimes this makes you uncompetitive in a bidding process.
For example, a services business might quote a job in cash, making it appear that they’re lower priced than competition. At time of payment the customer can realize that lower cost if they pay with a non-card tender type. If they quote in card, especially for a large job, they might get priced out.
Furthermore, PEs love to increase prices, but a surcharge/dual price allows you to increase prices with a get-out-of-jail-free card: if the customer doesn’t want to experience the price increase, all they need to do is pay with a low cost tender type (i.e. ACH, check, cash, EFT, etc.).
Tacking 2.5% to our 10% net profit means we’ve just expanded profit 25%.
Next let’s look at labor.
What kind of employees does this portfolio services company (portco) employ?
Why don’t we assume that 30% of the portco’s expenses are labor expenses.
Of those 30%, let’s say half of those expenses (~15% of total expenditures) emanate from hourly laborers.
These employees want faster access to their paychecks. Hell, all employees want faster access to their paychecks, but let’s just focus on the hourly laborers for now.
A study from ADP showed that 62% of employees with eligible earned wage access (EWA – the ability to receive a pro-rated amount of your pay check prior to payday) will use EWA either every or every other pay period, paying an average of $3.18 to access an average payment of $106.
From the CFPB:
Even in best-model cases where the only costs are for expedited payments, fees can add up for frequent EWA users. The CFPB says that workers using these employer-sponsored products request early paycheck access an average of 27 times per year
Said another way, hourly laborers are willing to pay 300 bps to access their money during every two-week pay cycle.
This means that EWA is a default perpetual-on for every pay period.
Time to monetize the payouts.
Using some math, we could determine how much we pay these employees and add 300 bps to the bottom line since they’re perpetually paying the vig on every pay period.
3% of the 15% of total expenditures nets us another 45 bps to the bottom line.
Our net profit margin has now grown to 12.95%.
But we’re not done monetizing the payout.
Those of us in payments know that Brex and Ramp have funded their entire business models with interchange fees on card issuance.
As part of the payout, let’s go ahead and stack the payment on a debit card we issue. This will net us another 150 bps of hourly laborer spend.
Our profit margin has now grown to 13.17%.
Next we should look at COGS, or payables.
We’re going to assume that this example portco has COGS outside of labor. Well, how is the portco buying this equipment to service their customers?
Using the above math, we’re estimating COGS at 60% of revenues.
Let’s monetize payables spending.
So we’ll issue the portco a credit card.
We can expect to earn 150 bps of all spend. While not a direct deposit to the portco’s bottom line, it would hit the fund’s income statement, implying another 0.9% (60% * 150 bps) to the portco’s profit margin.
The net profit margin grows from 13.17% to 14.07%.
If the portco’s vendors surcharge, then it’s sensical to investigate the ERP that the porcto uses; as is growing in popularity, these B2B softwares are embedding payments and charging high fees to vigorously monetize their captive customer base. There’s doubtless accretion that will be had by breaking the mandated processing of the ERP, though it’s much harder to give a concrete figure here.
While lending to the portco is a real payments opportunity, the fund is already monetizing this to the full extent. Their risk models are probably shit, but it’s not relevant since they own the borrower.
If you were so inclined to pursue this line of value further, there are plenty of B2B payment opportunities where the portco is getting net 30/60 terms from their customers, or even the portco’s suppliers are offering net 30/60 terms to the portco.
This creates a working capital gap.
Companies on both sides are likely to come to a middle ground to solve that problem. The default rates are very, very low, and there could be 100 bps of margin for offering float.
In practice, this might look like a portco putting all payables on card and having a third party remit to the portco’s vendor the desirable remittance type (i.e. portco pays third card via card and the third party sends a check to the vendor).
The portco has now significantly lengthened their working capital window from net 30 (typical vendor terms) to ~90 days (at day-30 the portco paid the third party with card, and the portco has an additional ~60 days to pay off the card balance).
Depending on the operating and financing needs of the portco, the portco could stick cash on hand into a money market account or similar for the 60-pday period and earn a return.
In effect, a smart operator would straddle this dynamic to get working capital for much lower than a fund’s mezzanine rates of 12%+.
We won’t include it on our graphic below, though, because PE is already heaping mezzanine debt on the portco and earning spread off that.
Looks pretty “not terrible”, eh?
If a fund ran this playbook they’d get a massive multiple premium for their assets.
But there’s a catch.
And we want to be emphatically clear on this part:
A fund cannot achieve these results if the software used by the portco has locked them into payments.
All of the optionality and IRR we’ve discussed is predicated on the portco having control.
Once the software has determined that the merchant (i.e. portco) must use the software’s payments – usually starting with acquiring – all bets are off.
We don’t blame the software: building software is hard.
Payments are oh, so easy by comparison.
So of course the software company wants to cram their hands in the payments cookie jar as fast as they can.
But they need to earn that right by being fair, honest, and competitive.
If you want to see how over $550B of fund AUM is running this playbook with POS+ already, check it out.
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