New Products and Strategies as an Alternative to an MCA
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The MCA/small business loan (“MCA”) product was never intended to encroach upon factors’ turf, but did so as a byproduct of an abundance of entrepreneurs and institutional capital coming into a sector with no-to-low barriers to entry. The fact that there now exists a securitization market and significant investor demand to purchase in bulk indicates not only the industry progress that has been made, but also the access to capital available. This compared to the reality that most factors live-and-die by their own bank line and have their own high fixed costs as part of ordinary course services provided to clients and general compliance.
MCAs simply ran out of merchants (pizza places, liquor stores, etc.) to lend to that fit the industry norm of the average $30k dollar daily debit loans to small merchants, and as a business strategy, came to the obvious conclusion that they are better off, not to mention safer, lending to companies with an existing lending relationship, as these companies are bigger, have more cash running through them and are presumably better credits. Better to lend $50k or even $100kto a bigger and safer company than $30k to a weaker one. This piggybacking of sorts puts factors at a disadvantage as MCAs are piggybacking off the factor’s overhead, not to mention blatantly violation factoring agreements.
Every product has its time and place and there are definitely times when an MCA is needed – timing, speed to funding and no other options, but this has to be measured and done appropriately. Until now, there have not been many options for factors whose clients need $250k+ in capital with structure meaning the amortization might not be straight line and would take into account the borrower’s capital needs. There are reasons that have precluded new alternatives, with the key ones being scale, cost of capital, and bad debt, among other things, that make it hard for a traditional credit fund to serve this market.
MCA firms need volume to account for lending small dollars that pay back ultra-rapidly and to account for their own cost of capital and bad debt. for all the negative press the industry gets for rate, the simple fact is that most large MCA companies are either profitable (e.g. On Deck) or generate a negligible profit. Rate is a misnomer when it comes to the MCA product. Lending $10,000 to a small business and charging 1.30x factor of $3,000 fee to do so over 12 implies a greater than 50% interest rate. Whatever the interest rate might be has rarely dissuaded a small business that needed money vs. the payment structure. Amortization is the ket product change that needs to be solved for in order to truly provide factors a product they will accept. Therein lies the weakness of the MCA industry.
Due solely to the need for high volume, a straight line amortization product collective via daily debit is the only effective way to manage an MCA business. Moreover, it is the only way that lenders to MCA providers can effectively track and monitor their respective underlying collateral. The loans are too small and the credits too weak to risk making a long-term loan and the underwriting is too quick to be able to really evaluate a credit. The output of 24 hours financing is a true cookie-cutter product that can fund quickly, but can’t provide a product that will help factor’s clients.
Factors welcome subordinated capital and understand the need for amortization, but when the amortization does not take into account the underlying business cycle, the it creates a tenuous situation. MCA firms have essentially clubbed up to provide merchants with large sums of capital by stacking each other and the factor that is doing all the work. These same firms also use insalubrious methods to collect circumvent factors such as confession of judgement, which prime UUC-1s.
Factoring firms are under attack, as they are too many insalubrious firms that don’t care whether they violate a factoring agreement. New strategies are necessary to not only survive, but to protect unsophisticated clients from firms who have no, or limited, ability to restructure loans or know how to work with senior lenders. One strategy would be to partner with investment or debt funds to participate in a factoring facility on a last-out basis. In simplistic terms, this would be a junior participation, but with more patient amortization and also controlled by a factor. The factor would control and manage everything, but with the help of a junior participant, would not be able to provide up to 110% if not more of availability. For avoidance of doubt, the participant would simple be purchasing the over-advance or out of formula part of the advance and not be a lender to the underlying client.
This structure enables factoring firms to quickly provide capital to their clients in a very controlled manner, as they would be controlling everything. The factor would collect and disburse funds to the participant and the participant would get a higher return, but accept the potential risk., which could include standstills or potential loss of some principal. This method is not reinventing the wheel per se, but factoring is still a fragmented industry when it comes to the lower middle market so many smaller factoring companies do not have relationships with firms who would look to provide more patient junior capital to help onboard and retain clients. Most importantly, factors are not left holding the bag by a client who does not realize that a broker is going to give them five $50k loans rather than one $250k loan when they seek additional capital.
The partnership aspect is essential for both the factor and subordinated capital provider as these firms need volume, too. It is hard to build a portfolio with one-off $250k loans, but it is very possible to build a symbiotic business with strong deal flow and market rate intercreditor agreements that proctect factors and incentive them to send deal flow to firms who will play by the rules, write sub $500k checks and provide flexibile amortization schedules.
By working in partnership with a factor and providing a payback schedule that is tailroed to a business’s cash flow needs, subordinated capital providers can help factors reclaim lost market share and provide a valuable product needed by companies across America. The short-term daily debit MCA is not going away, but when you start getting bigger capital needs, there are now real alternatives that are able to provide a customized payment and solve for the amortization inflexibilty that faces the MCA industry.