Why Small Merchant Processing Portfolios & Residuals Trade At Lower Multiples Than Larger Ones (Part I)
Merchant processing portfolios and residuals typically trade in 2 different multiple ranges, a higher and lower one. The primary attribute of a merchant portfolio or residual that determines which multiple range it trades in is the portfolio’s size. It may be a tad bit counter intuitive, but when I say “size” I am NOT speaking of the amount of revenue (residual) the portfolio is throwing off. The metric I’m using to determine a portfolio’s size is the number of merchant accounts that make it up.
So why does a small merchant processing portfolio trade in the lower multiple range? Well, reason #1 is discussed below: specifically, the relationship between small merchant portfolio size and attrition.
As I’ve previously written about ad nauseum, and will undoubtedly write more about in the future, one of the most heavily weighted attributes of a merchant portfolio which determines it’s valuation is its attrition. As you should be aware, attrition is basically a calculation of loss over time. In the merchant processing world, attrition can be the loss of accounts, number of transactions, sales volume, or revenue. Regardless, attrition is always stated as a percentage (example: account attrition is 19% annually). What we’re actually doing when we calculate attrition is performing a statistical analysis on a particular population of merchants. Mathematically, we know (or should know) through the law of large numbers, that as a general rule, the greater the population size (sample size), the more accurate an inference we can draw from our statistical analysis. Therefore, the greater the number of merchants in the portfolio, the more accurate an inference we can draw regarding the merchant portfolio’s attrition.
To illustrate this point better, let’s imagine we’re looking at a 2 merchant portfolios, 1 with 10 merchant accounts and 1 with 1,000 merchant accounts. Intuitively we know that the attrition calculation we derive from the larger portfolio is much more precise, and therefore more meaningful, than that which we can derive from the smaller portfolio, with it’s very small sample/population size (number of merchants).
This inability to derive any meaningful inference from the smaller merchant portfolio we used in our example above creates uncertainty, uncertainty creates risk, and risk translates into a downward pressure on valuation. Therefore, the smaller sized portfolio will trade in the lower multiple range.
That (hopefully) explains one of the main reasons why a merchant portfolio or residual with a small number of merchants has an inherent valuation less than a larger merchant portfolio, but it also begs another question: how many merchants are required for a portfolio to be considered ‘small’ or ‘large’? This is a great question for which (unfortunately) I don’t have a great answer. As a general rule, if the merchant portfolio has more than 400 merchant accounts, it would fall into the large category, and below 150 merchant accounts, it would fall into the small category. Obviously this leaves a kind of “no man’s land” in between. For merchant portfolios with a number of merchant accounts fewer than 400 and greater than 150, look to other portfolio attributes to determine whether it will trade in the higher or lower multiple range.