Merchant cash advance has emerged as an attractive alternative financing option for small businesses in recent years. With high approval rates and quick funding, merchant cash advances allow businesses to access capital fast. However, investors need to carefully evaluate the risks and returns before investing in merchant cash advance companies. This article provides a comprehensive review of investing in merchant cash advances to help investors make informed decisions. We will analyze the pros and cons, expected returns, risks, and tips for succeeding in this niche. By understanding the merchant cash advance industry dynamics, investors can position themselves to earn steady returns from this growing asset class.
High interest rates lead to double-digit returns
The biggest appeal of investing in merchant cash advances is the high interest rates charged to borrowers. Merchant cash advance companies provide financing by purchasing a percentage of the businesses’ future credit card sales. The money is repaid as a fixed percentage of daily credit card receipts until the advance is settled. The fixed daily repayment structure means the advances can have an annualized interest rate of 30-300%. For investors, this translates to double-digit returns from 10-20% per year. However, higher defaults can diminish actual realized returns. Investors should aim for an average target return of 12-15% when investing in merchant cash advance funds.
Defaults and prepayments are key risks to manage
While merchant cash advances offer high interest rates, they also come with a higher risk of default as the borrowers are small businesses with variable cash flows. Typical default rates range from 5-15% of advances made. Investors should look for merchant cash advance firms with disciplined underwriting and active collections practices to minimize defaults. Portfolio diversification across many merchants can also reduce default risk. Another risk is prepayments, where merchants repay early to reduce interest costs. This shortens the advance duration, reducing the total interest earned. Overall, investors should be prepared for returns to be lowered by 2-3% due to defaults and early repayments.
Short durations provide liquidity but limit upside
A key feature of merchant cash advances is their short duration of 3-9 months on average. This provides good liquidity to investors as the funds are quickly reinvested in new advances. However, the short tenors also limit the upside as total interest earned is capped. For good returns, the portfolio has to keep turning over new advances continuously. Any disruptions in new origination would quickly impact investor returns. Furthermore, merchant cash advance firms have high sales and marketing costs to continually source new deals. This reduces profit margins unless they can achieve scale efficiencies.
Specialized underwriting skill is challenging to replicate
The underwriting process for merchant cash advances requires deep expertise in evaluating retail businesses’ sales patterns and cash flows. Data from bank statements, credit card processors and point-of-sale systems is analyzed to forecast the repayment capacity and default risk of each merchant. Replicating this specialized underwriting skill is difficult for individual investors. Hence, investing through a fund structure with experienced merchant cash advance specialists is advisable. Investors should conduct thorough due diligence on the underwriting criteria and risk management practices of the fund manager.
Diversification and short lock-up periods can manage risks
While merchant cash advance investments carry risks like defaults and prepayments, prudent portfolio construction can mitigate the risks. Investors should seek diversification across geography, industry verticals, credit qualities, and merchants. A portfolio of advances with an average duration of 6 months and diversified across over 50 merchants can smoothen out individual underperformance events. Investors can also consider a fund structure with monthly or quarterly liquidity rather than multi-year lock-ups. This provides better risk management though overall returns may be marginally lower.
Merchant cash advances offer yields far exceeding conventional fixed income. However, investors need robust underwriting and diversification to manage the higher risks. By partnering with specialized fund managers and constructing diversified portfolios, merchant cash advances can earn annual returns of 12-15% and provide good diversification to investment portfolios.