Merchant Cash Advances: An Asset Class for the Small Business and the Big Investor

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Merchant cash advances (MCAs): They’re a form of non-bank lending that, while a simple mechanism, can offer a big payoff for both small-business recipients and investors alike. MCAs are structured as a lump sum payment to a business in exchange for an agreed-upon percentage of future cash receipts of the business. It’s a form of financing that helps guarantee a steady cash flow to small businesses without having to go through the lengthy application and approval process of traditional bank loans when funds are needed immediately for a growth project, equipment financing, or working capital.

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MCAs offer small businesses a painless funding option in exchange for a percentage of future income. Payments are made on a short-term, often daily or weekly basis. This funding structure offers a win-win for funding recipient and lender alike: the recipient gets steady funding and with a manageable payment schedule, while the investor gets steady, dependable returns.

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Especially given the tighter bank lending requirements following the late-2000s financial crisis, MCAs have been on an upswing in recent years. It’s the economic conditions that have come in the wake of the coronavirus pandemic, however, that have cast MCAs in a whole new light. At the same time, the steady returns that MCAs offer are proving attractive to the private equity firms and other alternative asset management firms that are taking a deeper look at this re-emerging asset class.

Among those financial firms that are jumping into MCAs is LOUD Capital, an early-stage venture capital firm-slash-alternative asset manager headquartered in Columbus, Ohio. Specializing in what the firm calls “Venture for People;” that is, ensuring that entrepreneurs from all walks of life can avail of the opportunity to launch their own businesses, for LOUD, the appeal of helping young and small companies survive is particularly compelling.

Nishad Parmar, senior partner and chief investment officer at LOUD’s Chicago office, sat down and spoke with BX3 about the ins and outs of merchant cash advances, and how they can promote a lasting, symbiotic relationship between small business owners and investors alike.

How Do Merchant Cash Advances Work?

For the layperson in finance, how do these work? What is their history, and how do they help a recipient? How do they provide a return on investment in one’s portfolio?

Parmar: At their core, merchant cash advances are a type of financing specifically for small and medium businesses. We look at their future receivables, how they’re invoicing their capital, any gaps between their accounts payable and accounts receivable. The application process for merchant cash advances is similar to the process as that for loans, though the cycle time on how they fund is much shorter.

To the point, however, they provide critical working capital to the small- and medium-sized businesses that are really underserved by the traditional institutional banks. There are an estimated 28 million small businesses across the US, with many of those businesses falling short of receiving the funds they need to keep pressing forward. It’s been estimated that in early 2019, pre-coronavirus shutdown, SMEs have about $80 billion-$120 billion worth of unmet funding needs, in large part because of lengthy loan approval times.

Conversely, MCAs offer a much shorter funding cycle, often within 48-72 hours.

Something that investors find intriguing about MCAs is that the funds get collected on a daily or weekly basis. If a company that’s receiving the funds has to do a reduction in payment, they might have paid 40, 60, or 70 percent into the deal. Thing is, you’ve already collected most of your principal. In a typical loan, payments don’t get collected that frequently, so the loss could be significant. Take a wedding coordinator, for example. They’re usually small enterprises, if not one-person shops. They often need to put down thousands of dollars in deposits to vendors: venue rentals, caterers, florists, musical entertainment, you name it. Yet—especially now, with so many wedding receptions getting postponed—the payout from the customer doesn’t come until much later. An MCA can help these businesses forge the gap in the meantime.

Our cash loss rate is about half of what the industry standard is today. It comes down to our very rigorous underwriting process, which ensures we do funding deals with the right company. Our merchants are repeat customers who come back and want to fund with us again and use our services.

Why Are MCAs Particularly Intriguing?

That dovetails well into the next question: Why are MCAs particularly intriguing as a class in this economic and investment climate?

Parmar: So many of these small, private businesses are really suffering coming out of the economic shutdown and need financial support to grow and sustain their business. As we’re heading into month three of the coronavirus shutdown, we’ve come across so many startups and small businesses that are looking for funding, yet banks aren’t doing loans beyond PPP. But businesses still need to continue growing beyond payroll. That’s a great opportunity for us to support these companies and create structural deals to find ways to get them back up and running.

On the investor side, we’ve been educating on how this new alternative asset class can be a valuable part of portfolio diversification—one that, depending how we structure the deal, provides steady passive income on a monthly, quarterly, semi-annual, or annual basis.

What Advice Do You Have For Investors Considering MCAs?

Parmar: There’s definitely the educational aspect. The more we can share and talk about how it really diversifies your wealth and it’s an asset class with steady returns, the more confidence and interest there will be. A positive development on this front has been the fact that Institutions, especially private equity funds, have made major investments into MCAs as part of their return strategies.

How Has Been Investor Interest In MCAs?

Parmar: The volume of merchant cash advances provided to US small businesses has steadily grown since the industry first launched in 1998: Since their inception, the amount of funding in MCAs swelled to $10.7 billion in 2015. From there, that amount has skyrocketed. Over the following two years, that number grew to $15.3 billion in 2017 and is around the $20 billion mark today.

Since 2015, when we linked up with our partners, we’ve really ramped up our alternative investment offerings, including MCAs. As these programs have gotten off the ground and gotten more involved, we’ve been growing in lockstep at a much faster pace as well. There’s plenty of energy for lending tools as we come out of this downturn. Even government entities are looking to private lending facilities to see how they can help provide funding to small businesses. Partnerships will continue to develop and the bigger players will keep evolving, in terms of both joint ventures and M&A strategy.

Investors have various options to invest in MCAs through LOUD. The majority invest through a steady fixed rate debt offering that offers healthy returns in the high-teens. We also partner with large strategic capital investors, for whom we offer a combination of debt and equity to share the upside.

Final Takeaway For Investors On MCAs

As investors continue on the never-ending hunt for yield, alternative asset classes are often the first stop as they look for market-beating returns. Given MCAs’ regular payout and ease of issuance, they merit a second glance for the portfolio manager or high-net-worth individual looking to earn steady returns while extending a lifeline to a small business.