Portfolio Attrition
In the sale of residuals associated with a portfolio of merchants, sellers are usually trying to get the highest multiple they can. By “multiple” I mean the number that is used to determine the purchase price for the sale of a portfolio. The multiple is multiplied by the average monthly residuals for the portfolio to calculate the purchase price. Many buyers think that no matter what, the higher the multiple the better as they equate that with the highest overall purchase price. But that could not be further from the truth. As we will see, the overall structure of the deal can make a lower multiple a better deal.
By way of numerical examples, we will be able to show how this might be true. Assume you are selling a portfolio that averages $1,000 per month and you have been made two different offers. One buyer tells you it will pay 20 times the average monthly residuals or $20,000 all paid all up front when the purchase closes. The other offer is a 30 times multiple paid over time or a $30,000 total purchase price. The manner in which that 30 multiple offer is paid can make a huge difference as to which of the two offers is really better.
Many portfolio purchases call for an up-front payment to the seller and then additional payments over time, subject to the residuals meeting certain attrition guarantees. By way of example, assume that the 30 times offer we mentioned above was going to be paid 15 times up front ($15,000) and then a 5 multiple ($5,000) at the end of each of the first three years after the close of the transaction. As you can already see, the “higher” offer already pays less up front than the offer that looked inferior on the face of it.
Typically, the payments in the years after the close of the transaction are tied to certain attrition guarantees. By that I mean the seller guarantees that the buyer will be paid a certain monthly residual payment over the stated time period to guarantee the future portfolio purchase payments.
Continuing our example, let’s say that the buyer states the attrition can be no more than 12% per year. If the attrition is higher than that, then the seller would forfeit any of the payments due after the attrition guarantee is not met. So that means you take the $1,000 portfolio, subtract 12% or $120 and the portfolio must pay the buyer on average $880 a month during the first year after the closing in order for the seller to receive the future portfolio purchase payments. That means the buyer must collect a total of at least 12 months of $880 for a total of $10,560.00 or the seller does not get paid the next $5,000 portion of the purchase price at the end of year 1 right? Not so fast because many buyers choose to calculate attrition a bit differently.
Some buyers choose to calculate the attrition on a monthly, not annual basis. Using the 12% figure from our example the attrition would be calculated month after month with 1% attrition allowed from the previous month. The chart shows the effect of that change. So in the end the change in the way of calculating the attrition on a monthly versus annual basis means the ending number is just about the same with $886 versus $880 average that is used in the example above calculating the attrition annually right?
Using that same 12% attrition rate can yield different results if a different method of calculating the attrition is used. Some buyer do not use the formula explained in the paragraph above. Instead, some buyers calculate the attrition drop on a month by month basis measured off the prior month. So in our example, using 12% the attrition allowed would be 1% per month. So month one you take 1% of the starting $1000 or $10 and that gives you $990 for month one. But month 2 you take 1% of the previous month or $9.90 which is the allowed drop in the portfolio residuals.
As you can see under this method the amount of allowed attrition is smaller and smaller each month. The chart shows what the attrition would be allowed for the first year after the closing. If you take all those months and add them up and divide by 12 turns out that is an average per month of $937 per month. So one could argue that if you use that method, it would mean that in reality the seller is being held to a less than 7% attrition rate if you looked at it on an annual basis the way we first calculated the attrition. So arguably a 12% monthly annual attrition rate is equal to a 7% attrition rate when measured on an annual basis.
So if we go back to our original example, under the “lower” 20 times offer, the seller gets the whole $20,000 up front. If the buyer holds the seller to the month over month attrition guarantee, it seems nearly impossible that the seller will get anything but the up-front payment of $15,000. So if that is the case, the 20 times offer is superior to the offer of 30 times.
This illustrates the fact that if you are a seller, you don’t really care about what the attrition percentage is represented to be by the buyer. You need to be diligent in getting the buyer to divulge exactly how the attrition will be calculated. And the easiest way to do that is to find out from the buyer exactly how much they expect to collect in the year. Once you have that information the seller can figure out pretty quickly if the buyer is using a simple annual rate or is going to make you guarantee each and every month of the attrition.
Also, as a seller there are additional things you can do to maximize the amount you are paid to sell your portfolio. If you fail to meet the attrition guarantees, there are ways you can ask to be able to fix that. One way is to agree in the purchase agreement to pay the buyer the difference between the amount of the guaranteed payment and the actual residuals that are payable to the buyer in the event of a shortfall. That way if the attrition is close but not quite meeting the minimums, you may be able to make a nominal payment in order to be paid the later purchase price payments.
Another way to fix the issue is to add merchants to the portfolio that you have sold to allow the portfolio to meet the attrition guarantees. In the purchase agreement the seller agrees to submit additional merchants to the buyer that will allow the residuals to meet the attrition requirements. The buyer will usually want to see that the new merchants are of like kind and quality as the ones that have left the portfolio. Sometimes buyers will allow the seller to assign other residuals over from a different processor to allow the residuals to meet the requirements. The key to the seller is that it is able to add merchants to get the payments of the purchase price that are due in the years after closing. And, the buyer is happy to get its expected return on investment.
No all offers are created equal. The multiple being paid is just one part of the overall strength and potential value of the offer to the seller. The attrition guarantees and the time period over which the purchase price is paid to the seller can make a higher multiple offer a lower quality one to a seller.
The information contained herein is for informational purposes only and should not be relied upon in reaching a conclusion in a particular area. The legal principles discussed herein were accurate at the time this article was authored but are subject to change. Please consult an attorney before making a decision using only the information provided in this article.
