A remarkable reversal of fortune would be needed for most buyout professionals to contemplate becoming customers of such businesses. But with increasing frequency, they’ve been willing to invest in them. In the last two years, at least five LBO shops have taken control of companies that provide payday loans, check-cashing services, international wire transfers, money orders and more—what some call “alternative financial services.”
“The image that most people have of the customer base comes from the mom-and-pop end of the market, where the store might be darkly lit and the employees are behind a dirty glass window,” said Thomas “Bud” Ghegan, vice president of New York shop
The foundation of much of the business is check cashing. It’s a straightforward service in which a customer, usually someone without a bank account, pays a small fee—about 2 percent—to turn a check into spending money. The fee works out to a charge not much different than what one pays for withdrawing $100 from a generic ATM. Along with check cashing, alternative financial services provders may offer payday lending, wire transfers, sales of stamps and envelopes, utility bill payments and pre-paid debit cards that can be refilled through direct deposit. At one stop it’s possible, therefore, to cash a paycheck, wire money back home, send in payment for a credit card, pay off the monthly gas bill and walk out with a Visa card primed with several hundred dollars. Such businesses have even begun preparing tax returns.
Whatever their reputation, these businesses serve an enormous swath of the American population. The Federal Reserve estimates that some 50 million to 70 million people, or about half of the 135 million Americans considered bank customers, visit thousands of these stores at least once a year, and most likely do so much more often than that. Customers include the not-necessarily-poor “underbanked”—immigrants who can’t open a traditional bank account, those who harbor a basic mistrust of the banking system, and those whose poor credit scores once prevented them from opening a bank account. Another cohort, the “unbanked,” lack the funds, under any circumstances, to maintain a bank account. These customers tend to frequent the stores that operate as both pawn shops and payday loan shops.
It’s a big industry that’s growing at a breathtaking clip. The number of payday loan stores in America, for example, more than doubled to 22,000 between 2000 and 2004, according to the FDIC. In 2005, payday lenders provided $40 billion in loans, generating $5.4 billion in fees, according to government-backed lender Fannie Mae. Meanwhile, the number of check-cashing stores has doubled to more than 6,000 over the last six years, according to the Financial Service Centers of America, a trade group, and some estimates put the number as high as 11,000. Check-cashers process an estimated 180 million checks per year, generating $1.5 billion in fee income, according to the trade group.
Even as outlets proliferate, they’ve come under heavier government regulation, thanks in part to the anti-terror law known as the Patriot Act. Since 9/11, the government has cracked down on these services out of fear that money laundering and illegal off-shore wire transfers would put cash in the hands of terrorist organizations. That, in turn, has ratcheted up the cost of compliance, creating a nice double whammy for buyout firms. Regulation has weeded out some of the more fly-by-night elements from the industry, and the cost of compliance is great enough that it rewards scale.
The business, in other words, represents a classic buyout play. It’s a fast-growing, fragmented industry undergoing change forced by regulation, demographics and technological innovation. Ghegan goes so far as to call the industry the “last white space” in the world of consumer financial services. On the other hand, buyout firms wading into the market need to be wary of the risk to their reputations. At a time when they’re already under fire for their generous compensation packages and brass-knuckled business tactics, buyout firms can ill-afford more bad press. Yet the business of providing payday loans has already come under heavy fire from critics.
With payday loans, a customer needing a quick infusion of cash takes out a short-term loan, usually two weeks in duration, of $100 to $1,000; the customer pledges to repay the loan with a future paycheck. The payday loan shop exacts a fee of $15 to $30 for every $100 lent, which works out to an annual percentage rate of about 400 percent to 800 percent. After paying off the first loan, customers can find themselves in the same precarious financial position, leading to a second loan, a third loan and eventually what industry critics call a “cycle of debt.” Some states have capped the number of loans a customer can take out. Fourteen states have outlawed payday loans altogether. The Defense Department, calling the practice “predatory,” issued a warning to veterans to avoid payday lenders.
Charlene Davidson, senior managing director of RSM EquiCo Capital Markets, a mid-market sell-side advisory, described the sector’s companies as “outright predatory” and their services “habit-forming.” But even after declaring that she’s “not a fan of this business,” Davidson also gushed about the industry’s “blistering growth” and how “it’s extremely profitable.” Indeed, the market capitalization of Dollar Financial Corp., a model of underbanked diversification, has grown by more than 100 percent to nearly $600 million since the start of 2006; for the quarter ended Dec. 31, its year-over-year revenue from check cashing grew by 18 percent and its revenue from payday loans grew by nearly 30 percent. The company had been a a relatively sleepy regional player in 1998 when it was bought by LBO shop
Targeting The Underbanked
At least some buyout shops seem to be sidestepping the less savory aspects of the market by targeting more affluent customers looking for a one-stop source of diversified financial services.
Gene Lockhart, a senior operating partner of Diamond Castle who helped lead the CheckSmart deal, started researching the unbanked and underbanked at his former job leading Bank of America’s retail bank. Most people assume, Lockhart said, that customers of payday loan and check-cashing stores are poor, sporadically employed or from other countries. In fact, half of the customers have bachelor’s degrees and make at least $50,000 per year, he said, citing statistics from the Federal Reserve. (The Federal Reserve also recently concluded that banks and credit unions charge higher fees and interest rates on “bounced check protection” than do payday lenders for their services.)
To be sure, a considerable segment of the customer base is made up of people who barely eke out a living from one paycheck to the next and who must pawn valuables to pay the heating bill. But those aren’t the people that buyout firms say they have targeted; rather, they claim to be going mainly after underbanked customers that provide a steady stream of business. “We don’t like to bank deadbeats,” Lockhart said. “That’s not in our interest. We think there are enough of [the underbanked] out there to build a really good business. And, frankly, we think we’re helping them.”
Another company catering to the underbanked is ACE Cash Express, which New York-based firm
The same can be said of Pay-O-Matic. Founders Equity liked the company in part because it can’t, by law, offer payday loans. Rather, it provides bank-like services at 130 outlets, many of which are located in parts of the outer boroughs of New York City that mainstream banks won’t go to. “The credit ladder starts with check-cashers,” Founders Equity’s Ghegan said. “Then they move to more traditional banks.”
Indeed, one big question for Pay-O-Matic, ACE Cash Express and rivals is whether more traditional banks might try to capture these customers while they’re still lower on the ladder. A year ago Bank of America started offering credit cards to customers without social security numbers. Two years ago, Citibank began selling home mortgages to illegal immigrants. And KeyBank offers low-fee check-cashing and pre-paid credit cards. “The banks are definitely the sleeping giants,” said RSM EquiCo’s Davidson.
On the bright side, of course, buyout firms may be able to take advantage of this growing interest by traditional banks when it comes time to sell their portfolio companies, said Ryan Kelly, a Founders Equity principal who co-led the Pay-O-Matic deal. For a bank looking to enter the underbanked market, a fully scaled, regulation-compliant, streamlined Pay-O-Matic presents an attractive target. “It’s just a matter of time before they enter this market,” Kelly said. “Our thought process is to consolidate and provide an array of service offerings that would make strategic sense.”
Lockhart, the former banking executive now with Diamond Castle, is less convinced. Bank executives obviously salivate at the thought of doubling the size of their customer base, Lockhart said. But they may never open their doors to these customers because of the perceived financial and reputational risks. “Banks are torn,” Lockhart said. “They would love to have this business, but then their chief risk officer and chief reputational officers say no.”