Report

Private Equity’s New Path to Payoff in Payments

Private equity has feasted on the payments business, but the opportunity is changing amid rapid innovation.

By Hugh MacArthur, Justin Miller, Tim Cochrane, Mike Cashman, and Glen Williams

Published on 二月 24, 2020
min read


This article is Section 2.3 of Bain’s 2020 Global Private Equity Report. Think about the last time you bought something in a store or online. If the payment process wasn’t quick and painless, you probably got more than a little annoyed. Never mind that what’s going on behind the scenes is a miracle of software, encryption and networking technology. You’ve gotten used to a seamless customer experience, and you chafe at anything less. The magic behind the curtain is largely invisible to the buying public. But private equity has taken a fervent interest in the fast-evolving ecosystem of companies responsible for it. The so-called payments sector has become a prime hunting ground for buyout firms. The number of deals involving payments companies in North America and Europe has grown 7% annually in the current cycle, compared with a 0.1% annual decline in deal count for the industry overall during the same period (see Figure 2.13). Payments deal value in 2019 was five times higher than it was in 2006, while the industry’s total deal value remains below its 2006–07 peak. Figure 2.13 Payments deal count has grown 7% annually in the current cycle, compared with zero growth in deal count for the industry overall The attraction is growth and superior returns: Since the global financial crisis, buyouts involving payments companies have generated a gross pooled multiple of invested capital of 2.7x, outpacing tech, financial services and even the fintech sector generally (see Figure 2.14). Figure 2.14 Returns from buyouts involving payments companies have outpaced those in tech, financial services and fintech Several megadeals have supercharged the growth in transaction value over the last several years, including the $6.4 billion buyout of Denmark’s Nets and a pair of $4 billion deals for Paysafe and Travelport, which has a payments unit called eNett. Strategic buyers, meanwhile, have been increasingly active. In 2019, Fidelity National Information Services bought Worldpay for $43 billion, and Global Payments took over Total System Services for $21.5 billion. KKR produced a major (if partial) exit in the sector last year when Fiserv paid $39 billion for First Data, cutting KKR’s stake from 39% to 16%. As attractive as the payments ecosystem has been for private equity investors, several disruptive trends are opening up a new set of opportunities to back innovative, high-growth companies. At the most basic level, payments is the business of authorizing the movement of money from a paying customer to a recipient through a secure channel and network, like Visa or Mastercard. But in the era of connectivity and e-commerce—when food trucks would rather take credit than cash and an Uber driver can pick you up a bottle of shampoo—that traditional chain of relationships isn’t robust enough. Making payments work across an ever-shifting array of devices, platforms and use cases, all with minimal losses or security breaches, has become the focus of innovation for companies that straddle the financial and software industries. The marriage of digital technology and connectivity is breaking down barriers to entry and changing business models as companies seek to bend a massive, inflexible system to the evolving needs of consumers and businesses. Even by tech-industry standards, payments is an arcane, complicated business. Knowing where to play and how to win requires a specialized understanding of a broad and turbulent ecosystem of companies at various stages of development. To get a handle on what’s shaping opportunity for investors, it helps to break the payment process into its constituent parts: merchant services (acquiring), buyer services (issuing) and networks. Private equity investors over the past decade have focused on merchant services, helping legacy companies build scale. But innovation across the industry is shifting attention to other areas of opportunity, especially in the historically underserved B2B payments sphere. Merchant services: Moving past commodity economics The payment process has always started with the infrastructure that enables a business to pull electronic payments from a buyer through a secure (now encrypted) channel. Traditionally, that has involved payments companies processing transactions through the relatively dumb point-of-sale (POS) terminals that take payments when the card is physically present. The explosion in e-commerce and mobility has forced the development of sophisticated new gateways to process “card not present” transactions. The companies that provide these merchant services—known in the industry as merchant acquirers—are the critical gatekeepers to the electronic payment networks. They underwrite a guarantee that merchants will honor their side of the transaction and behave according to network rules. That service generates steady streams of fee revenue, but the business has become commoditized over time. In response, private equity has played a major role in helping to build scale players, often by carving out acquiring divisions from large banks, especially in Europe. Investors like Advent and Bain Capital have repeatedly bought legacy platforms like Vantiv (from Fifth Third Bank), Worldpay (from RBS) and Nets (from a consortium of Danish and Norwegian banks). That cycle is still playing out as select opportunities to build scale in less consolidated geographies present themselves. But as the commoditization of basic payments processing continues, a new generation of innovators is spawning high-growth business models that integrate plain-vanilla payments services with software to help merchants in specific verticals run their businesses more effectively (see Figure 2.15). Figure 2.15 Merchants are switching from simple countertop point-of-sale terminals to systems integrated with business software or tied to mobile devices The power of integrated payments An increasingly common business model, integrated payments turns the commodity conundrum on its head. From the customer’s standpoint, payment processing becomes just one part of a mission-critical integrated software package, not the main attraction. The selling point is to offer small to midsize (SME) companies a full range of tools and services that work in unison, so the company doesn’t have to stitch together a bunch of unrelated products from different vendors, each requiring an investment in training and maintenance. The payments component is critical to the software vendor because it creates a separate, recurring revenue stream—a small percentage of every transaction. That helps fund development of the other software offerings in the bundle and makes the overall package more affordable for the SME market. Building payments into a well-rounded SaaS-based subscription model also allows the vendor to get paid straight from a client’s revenues, transaction by transaction, rather than billing and collecting in arrears. The resulting efficiency and revenue predictability makes it much more attractive to sell and service software to small businesses. For some of these companies, payments revenue is replacing software subscriptions as the dominant revenue stream. Toast, for example, started as a payments application for restaurants in 2011 but has since blossomed into a full restaurant management platform that ties together solutions for the front of the house, kitchen and back office. For a typical restaurant account, some 80% of Toast’s revenues are linked to payments as opposed to software or equipment leases. While the hub of the network is a POS system that processes payments for a standard fee, it also links to a variety of devices throughout the restaurant to manage everything from order taking to payroll. Orders taken on a handheld device, for instance, can be sent to the kitchen and integrated with takeout orders coming in from third-party apps like DoorDash, Grubhub and Uber Eats. Toast also offers apps for back-office tasks like inventory management and staffing across locations, plus a robust reporting and analytics app that captures and analyzes the steady stream of data flowing through the system. The company has developed many of the tools in-house, but it has rapidly expanded the number of solutions available to client restaurants by creating a partner ecosystem of more than 70 third-party apps that can be plugged into the POS system—products like Davo to automate sales-tax management or BevSpot to manage bar inventory. Toast recently acquired StratEx, a leading provider of human resources and payroll software for restaurants. Toast’s formula has attracted avid attention from investors. After posting revenue growth of 148% in 2018, the company raised $250 million in March 2019 in a deal led by TCV and Tiger Global Management. That transaction valued Toast at $2.7 billion, a 50% increase from the valuation of $1.4 billion set just nine months earlier. Mindbody, another payments/management hybrid aimed at the health and wellness sector, has followed a similar trajectory. The company was taken private by Vista Equity Partners in February 2019 at $1.9 billion, a 68% premium to its public trading price. Moving from cash to credit While restaurants and spas have long taken both cash and credit cards, vast numbers of small businesses haven’t. Historically, professionals like general contractors, HVAC specialists, plumbers, therapists and accountants have accepted cash and checks only. That’s changing, however, as methods to automate payments and put them online have become more affordable and easy to implement. New tools are fundamentally changing the way these businesses operate. Consider recurring payments. The ability to take a client’s credit card and set up a recurring service plan changes a once-episodic, call-as-needed relationship into a steady revenue stream. That increases stickiness and allows the professional to schedule and plan much more effectively. The integrated model that has worked so well for Toast and Mindbody also works in this arena. Private equity has viewed it as an opportunity to create a scale player by finding a company offering a unique value proposition and rapidly expanding its capabilities or offerings through a buy-and-build strategy. A good example is Providence Equity’s $115 million investment in a payments company called PaySimple. Based in Denver, the company started out targeting service professionals with solutions like online payments and apps to manage appointments and scheduling. Providence invested through its growth equity fund in 2016 and, over the next three years, encouraged PaySimple to embark on an acquisition and partnership strategy to broaden its suite of products. The company, rebranded as EverCommerce, bought 35 SaaS providers in areas like e-invoicing, cash-flow reporting, hyperlocal marketing, customer relationship management (CRM) and website design. By aiming the expanding suite of cloud-based subscription solutions at businesses like accountants, general contractors, child-care providers and psychologists, the company grew to more than 200,000 customers by July 2019 and was expected to generate over $100 million in EBITDA on more than $500 million in revenues for the year. Looking to fund more growth, EverCommerce sold a minority stake to Silver Lake that valued the total equity at $2 billion. Providence remains the majority shareholder. Even churches and other nonprofits can benefit from integrated payments solutions. Ministry Brands is a SaaS-based provider of solutions to digitize collections, manage financial accounting, build websites and organize sermon content. Started in 2012 in Knoxville, Tennessee, the company has grown rapidly through acquisitions or partnerships with competitors. It currently has a portfolio of 32 brands that combine payment processing with products to help manage everything from communications and leadership development to creating mobile apps. One of its brands, easyTithe, helps Christian organizations turn year-end gifts into recurring contributions. The company was backed by Genstar Capital and Providence Equity until 2016, when Insight Venture Partners bought out Providence in a deal the Wall Street Journal said was valued at north of $1 billion. Genstar retained a minority stake. Buyer services: Transforming B2B payments On the opposite side of the payment network from the merchant sits the card issuer, historically a bank. Its job is to guarantee settlement for an authorized transaction. For credit cards, this involves providing a significant float between when the payment was settled (overnight) and when the credit card customer is billed (a month later, if not longer). Funding this float equates to issuing a massive volume of unsecured credit, which historically gave large banks a major cost-of-capital advantage, leaving limited opportunity for nonbank card competitors. Visa and Mastercard eventually created a new profit pool by introducing debit cards and prepaid cards and then raising interchange fees to be nearly on par with credit cards. Because these cards no longer required a fat balance sheet to be competitive, their introduction led to some innovation. But the issuer side was still dominated by the legacy players who could take advantage of their existing infrastructure. The game changed in 2010, amid a merchant outcry in the US that debit and prepaid card interchange fees were unfair given that they didn’t burden issuers with the same balance-sheet risk. In response, Congress passed the Durbin amendment to the Dodd-Frank financial reforms, which directed the Federal Reserve to cap interchange fees “at cost” for banks with more than $10 billion in assets. The net effect was that the larger issuers pulled back from the debit and prepaid market, clearing the way for start-up fintech companies. These innovators, sponsored by smaller banks, could build a business without getting squashed by the legacy players. Going virtual. The biggest beneficiaries of that innovation have been companies that never felt comfortable using credit cards for business transactions. In most industries, the B2B payment process looks much as it has for decades: A vendor sends an invoice, the customer runs it through its payables system and eventually cuts a paper check that the vendor then has to process. This paper-based system is slow, inefficient and prone to errors. Corporate credit cards ease transactional friction for relatively small transactions like a business lunch. But finance departments generally dread the idea of employees running around with approval authority for large-scale payments in their wallet. Procurement cards and fuel cards have emerged over time in response, but they are inflexible and difficult to use outside of a few limited situations. Enter virtual card technology. A new generation of start-ups recognized that what business users really wanted was the ability to authorize payments in real time to address specific needs. Virtual cards are single-use card numbers that can be issued on the fly. They offer a business an almost endless number of ways to customize a payment system to meet its specific needs. The issuer can define when the card can be activated, when it expires, how much the user can spend and the exact set of merchants where the card can be used. Cards can be created instantly, and many can be pushed directly to digital wallets, including Apple Pay and Google Pay. Single-use issuing reduces fraud and avoids FX fees on international transactions. The transactions are easy to reconcile and enjoy wide acceptance through deals with Visa and Mastercard. Virtual cards are creating new business models for private equity–backed payments providers like VPay and Zelis in healthcare, eNett and WEX in the transportation business, and AvidXchange, Nvoicepay and CSI in automated accounts payable solutions. Virtual cards will also be a future source of growth for Bill.com, which in December 2019 raised $216 million in an IPO that valued the company at roughly $1.6 billion. Virtual cards required new issuing technology capabilities that the large legacy issuers did not have (and had no incentive to build once the Durbin amendment capped their fees). An early leader in developing a modern issuer system was Marqeta, an Oakland, California–based company that raised $260 million in May 2019 in a deal led by Coatue Management, which valued the company at around $2 billion. Marqeta developed an open API that companies can use to develop their own virtual card and real-time funding use cases. Instacart, for instance, uses Marqeta’s real-time funding to power its legion of personal shoppers. Once an order from a customer comes in, the company authorizes payment for a specific item at a specific store, giving the shopper the ability to fulfill the order—and nothing else. Using the same technology, Affirm, a consumer lending company, gives merchants the flexibility to offer instant financing to customers as they are checking out. It creates a virtual card that allows the merchant to complete the loan at the point of sale like any normal transaction. Square, which makes integrated POS hardware and software solutions, uses real-time capabilities to fund merchants faster than it could using the traditional ACH bank settlement system. When news broke that Siris Capital and Evergreen Coast Capital were taking Travelport private for $4.4 billion in December 2018, virtual issuing technology was at the center of the value proposition. eNett, a unit of Travelport, had developed its own platform for issuing virtual cards and was using it to transform the travel industry. The company’s technology addresses the considerable expense and friction travel companies face when transacting business overseas. Foreign exchange fees charged by the big banks can be onerous, and buying travel services in far-flung locations is inefficient. Transactions are often processed manually, and there are high levels of fraud and supplier default. To combat these issues, eNett issues virtual card numbers to let travel agents pay for flight, hotel and cruise bookings in 58 currencies worldwide. For each individual transaction, eNett generates a unique 16-digit number that allows the agent to make purchases for a specific amount wherever Mastercard is accepted. This increases security, is system agnostic and streamlines processing. It also avoids the credit card network’s FX fees by issuing the virtual card in the travel service provider’s domestic market. eNett sweetens the deal by giving cash rebates on every transaction, funded by rich commercial card interchange rates. Networks: Closing the loop For all this innovation, Visa and Mastercard still occupy a position of power at the center of the payments system. They control the central authorization and clearing mechanism between buyers and issuers. Diners Club, Discover, multiple generations of mobile wallets, PayPal at POS—many have tried to pierce their armor, and many have failed. Building open networks at scale is hard work, and the existing players are relatively efficient, even if their fees rankle merchants. For years, the only real alternative has been companies that build smaller, closed-loop networks—like EFS, which provides fuel cards to fleet managers. Warburg helped fund the company’s growth and sold EFS to WEX in 2016 for $1.1 billion and 4 million shares of common stock. Increasingly, however, innovators are attracting private capital by creating high-growth businesses that integrate a closed-loop network with infrastructure that makes it easier for companies to do business. In healthcare, for instance, Bain Capital and Parthenon Capital are backing Zelis and RedCard, which in August 2019 announced a merger to create a new platform. The goal was to simplify and digitize the notoriously byzantine payment process between insurers, healthcare providers and patients. Under the current system, a doctor submits a claim to the insurance company and the patient doles out a copay. The insurance company adjusts the claim a dozen different ways before sending back payment for about a third of the doctor’s rate. The patient sees only a blizzard of diagnosis codes and may or may not owe an additional balance. The doctor sees a steady stream of revenue but no easy reckoning of what payment links to which procedure. Together with RedCard, Zelis provides technology solutions to over 700 payers and 600,000 providers that help price claims, pay claims and explain claims. It has developed a network that sits between the insurance companies and the providers and contracts with both parties. It charges providers around 150 basis points to process payments. (The all-in cost for accepting virtual cards can be 400–500 basis points for small companies.) It also adds value by, among other things, linking the payment directly to remittance information like invoice number or purchase order number, which helps providers see the connection between payments and specific services, along with the adjustments the insurance company has made. That kind of clarity makes it much easier for providers to close their books on received payments. Finding the right deal Private equity’s investments in the payments sector over the past decade have created scale leaders in specific domains of merchant services, from country-based leaders in card-present acquiring to specialists in e-commerce acquiring like Worldpay, Stripe and Adyen. The coming decade will see a shift: Activity will likely be dominated by deals involving companies offering tailored, value-added, integrated payment solutions in all three segments of the business: acquiring, issuing and closed-loop networks. For investors, the key will be identifying the targets that best monetize payments by bundling those services with sticky solutions that truly enhance how a company manages its business. That starts with several important considerations: Does the target payments company own the relationship with the end customer? Or is it at risk of being displaced by a technology vendor that is helping customers operate more effectively while making or taking a payment? How is the company moving beyond commodity payment processing by providing value-added services that a customer can use to be more competitive? This may include integration with management tools like CRM or scheduling software. Or it may be a matter of providing vertical-specific information to help automate payment reconciliation or transaction aggregation and netting to reduce FX costs. Payments companies can offer supplier financing, credit enhancements, recurring billing and outsourced collections. The question is, what is the payments provider doing to retain clients and generate recurring revenue? How does the target’s strategy for integrating payments with the customer’s broader technology fundamentally improve the efficiency of that customer’s day-to-day operations? Better yet, does it open up an opportunity for a customer to transform its business model—for instance, by shifting from an “invoice and collect” cash cycle to a “credit card on file” model, where the client is billed and pays immediately as services are provided? Does the company have the people, architectures and technology to make good on its strategy? Can it scale sufficiently to support the investment thesis? If that’s not the case, what will it take in terms of technology investment during the next cycle to get there? While private equity investors have made a lot of money in the payments sector to date, the challenge is increasing as multiples rise and the industry becomes more dynamic. Average returns are impressive, but they don’t come without heightened risk. The firms that are tapping into the magic behind the curtain are as differentiated as their targets. They have acquired a specialized understanding of how to underwrite these complex opportunities, and they have built the capabilities to help rapidly growing companies stay ahead of the technology curve. Read the Next Section Harnessing Pricing Power to Create Lasting Value Explore the report More from our 2020 Private Equity Report Letter from Hugh MacArthur Private Equity in 2019: Strong Deal Activity Despite Worsening Macro Conditions Technology: Bubble or Opportunity for Private Equity Investors? Investing with Impact: Today’s ESG Mandate in Private Equity Private Equity’s New Path to Payoff in Payments Harnessing Pricing Power to Create Lasting Value How to Assess Disruption in Due Diligence Public vs. Private Equity Returns: Is PE Losing Its Advantage? Private Equity Report This article is part of our 2020 Global Private Equity Report. Download the 2020 Report (PDF) Explore our latest report

This article is Section 2.3 of Bain’s 2020 Global Private Equity Report.

Think about the last time you bought something in a store or online. If the payment process wasn’t quick and painless, you probably got more than a little annoyed. Never mind that what’s going on behind the scenes is a miracle of software, encryption and networking technology. You’ve gotten used to a seamless customer experience, and you chafe at anything less.

The magic behind the curtain is largely invisible to the buying public. But private equity has taken a fervent interest in the fast-evolving ecosystem of companies responsible for it. The so-called payments sector has become a prime hunting ground for buyout firms. The number of deals involving payments companies in North America and Europe has grown 7% annually in the current cycle, compared with a 0.1% annual decline in deal count for the industry overall during the same period (see Figure 2.13). Payments deal value in 2019 was five times higher than it was in 2006, while the industry’s total deal value remains below its 2006–07 peak.

Payments deal count has grown 7% annually in the current cycle, compared with zero growth in deal count for the industry overall

The attraction is growth and superior returns: Since the global financial crisis, buyouts involving payments companies have generated a gross pooled multiple of invested capital of 2.7x, outpacing tech, financial services and even the fintech sector generally (see Figure 2.14).

Returns from buyouts involving payments companies have outpaced those in tech, financial services and fintech

Several megadeals have supercharged the growth in transaction value over the last several years, including the $6.4 billion buyout of Denmark’s Nets and a pair of $4 billion deals for Paysafe and Travelport, which has a payments unit called eNett. Strategic buyers, meanwhile, have been increasingly active. In 2019, Fidelity National Information Services bought Worldpay for $43 billion, and Global Payments took over Total System Services for $21.5 billion. KKR produced a major (if partial) exit in the sector last year when Fiserv paid $39 billion for First Data, cutting KKR’s stake from 39% to 16%.

As attractive as the payments ecosystem has been for private equity investors, several disruptive trends are opening up a new set of opportunities to back innovative, high-growth companies. At the most basic level, payments is the business of authorizing the movement of money from a paying customer to a recipient through a secure channel and network, like Visa or Mastercard. But in the era of connectivity and e-commerce—when food trucks would rather take credit than cash and an Uber driver can pick you up a bottle of shampoo—that traditional chain of relationships isn’t robust enough.

Making payments work across an ever-shifting array of devices, platforms and use cases, all with minimal losses or security breaches, has become the focus of innovation for companies that straddle the financial and software industries. The marriage of digital technology and connectivity is breaking down barriers to entry and changing business models as companies seek to bend a massive, inflexible system to the evolving needs of consumers and businesses.

Even by tech-industry standards, payments is an arcane, complicated business. Knowing where to play and how to win requires a specialized understanding of a broad and turbulent ecosystem of companies at various stages of development. To get a handle on what’s shaping opportunity for investors, it helps to break the payment process into its constituent parts: merchant services (acquiring), buyer services (issuing) and networks.

Private equity investors over the past decade have focused on merchant services, helping legacy companies build scale. But innovation across the industry is shifting attention to other areas of opportunity, especially in the historically underserved B2B payments sphere.

Merchant services: Moving past commodity economics

The payment process has always started with the infrastructure that enables a business to pull electronic payments from a buyer through a secure (now encrypted) channel. Traditionally, that has involved payments companies processing transactions through the relatively dumb point-of-sale (POS) terminals that take payments when the card is physically present.

The explosion in e-commerce and mobility has forced the development of sophisticated new gateways to process “card not present” transactions. The companies that provide these merchant services—known in the industry as merchant acquirers—are the critical gatekeepers to the electronic payment networks. They underwrite a guarantee that merchants will honor their side of the transaction and behave according to network rules. That service generates steady streams of fee revenue, but the business has become commoditized over time.

In response, private equity has played a major role in helping to build scale players, often by carving out acquiring divisions from large banks, especially in Europe. Investors like Advent and Bain Capital have repeatedly bought legacy platforms like Vantiv (from Fifth Third Bank), Worldpay (from RBS) and Nets (from a consortium of Danish and Norwegian banks). That cycle is still playing out as select opportunities to build scale in less consolidated geographies present themselves. But as the commoditization of basic payments processing continues, a new generation of innovators is spawning high-growth business models that integrate plain-vanilla payments services with software to help merchants in specific verticals run their businesses more effectively (see Figure 2.15).

Merchants are switching from simple countertop point-of-sale terminals to systems integrated with business software or tied to mobile devices

The power of integrated payments

An increasingly common business model, integrated payments turns the commodity conundrum on its head. From the customer’s standpoint, payment processing becomes just one part of a mission-critical integrated software package, not the main attraction. The selling point is to offer small to midsize (SME) companies a full range of tools and services that work in unison, so the company doesn’t have to stitch together a bunch of unrelated products from different vendors, each requiring an investment in training and maintenance.

The payments component is critical to the software vendor because it creates a separate, recurring revenue stream—a small percentage of every transaction. That helps fund development of the other software offerings in the bundle and makes the overall package more affordable for the SME market. Building payments into a well-rounded SaaS-based subscription model also allows the vendor to get paid straight from a client’s revenues, transaction by transaction, rather than billing and collecting in arrears. The resulting efficiency and revenue predictability makes it much more attractive to sell and service software to small businesses. For some of these companies, payments revenue is replacing software subscriptions as the dominant revenue stream.

Toast, for example, started as a payments application for restaurants in 2011 but has since blossomed into a full restaurant management platform that ties together solutions for the front of the house, kitchen and back office. For a typical restaurant account, some 80% of Toast’s revenues are linked to payments as opposed to software or equipment leases. While the hub of the network is a POS system that processes payments for a standard fee, it also links to a variety of devices throughout the restaurant to manage everything from order taking to payroll. Orders taken on a handheld device, for instance, can be sent to the kitchen and integrated with takeout orders coming in from third-party apps like DoorDash, Grubhub and Uber Eats.

Toast also offers apps for back-office tasks like inventory management and staffing across locations, plus a robust reporting and analytics app that captures and analyzes the steady stream of data flowing through the system. The company has developed many of the tools in-house, but it has rapidly expanded the number of solutions available to client restaurants by creating a partner ecosystem of more than 70 third-party apps that can be plugged into the POS system—products like Davo to automate sales-tax management or BevSpot to manage bar inventory. Toast recently acquired StratEx, a leading provider of human resources and payroll software for restaurants.

Toast’s formula has attracted avid attention from investors. After posting revenue growth of 148% in 2018, the company raised $250 million in March 2019 in a deal led by TCV and Tiger Global Management. That transaction valued Toast at $2.7 billion, a 50% increase from the valuation of $1.4 billion set just nine months earlier.

Mindbody, another payments/management hybrid aimed at the health and wellness sector, has followed a similar trajectory. The company was taken private by Vista Equity Partners in February 2019 at $1.9 billion, a 68% premium to its public trading price.

Moving from cash to credit

While restaurants and spas have long taken both cash and credit cards, vast numbers of small businesses haven’t. Historically, professionals like general contractors, HVAC specialists, plumbers, therapists and accountants have accepted cash and checks only. That’s changing, however, as methods to automate payments and put them online have become more affordable and easy to implement. New tools are fundamentally changing the way these businesses operate.

Consider recurring payments. The ability to take a client’s credit card and set up a recurring service plan changes a once-episodic, call-as-needed relationship into a steady revenue stream. That increases stickiness and allows the professional to schedule and plan much more effectively.

The integrated model that has worked so well for Toast and Mindbody also works in this arena. Private equity has viewed it as an opportunity to create a scale player by finding a company offering a unique value proposition and rapidly expanding its capabilities or offerings through a buy-and-build strategy.

A good example is Providence Equity’s $115 million investment in a payments company called PaySimple. Based in Denver, the company started out targeting service professionals with solutions like online payments and apps to manage appointments and scheduling. Providence invested through its growth equity fund in 2016 and, over the next three years, encouraged PaySimple to embark on an acquisition and partnership strategy to broaden its suite of products. The company, rebranded as EverCommerce, bought 35 SaaS providers in areas like e-invoicing, cash-flow reporting, hyperlocal marketing, customer relationship management (CRM) and website design.

By aiming the expanding suite of cloud-based subscription solutions at businesses like accountants, general contractors, child-care providers and psychologists, the company grew to more than 200,000 customers by July 2019 and was expected to generate over $100 million in EBITDA on more than $500 million in revenues for the year. Looking to fund more growth, EverCommerce sold a minority stake to Silver Lake that valued the total equity at $2 billion. Providence remains the majority shareholder.

Even churches and other nonprofits can benefit from integrated payments solutions. Ministry Brands is a SaaS-based provider of solutions to digitize collections, manage financial accounting, build websites and organize sermon content. Started in 2012 in Knoxville, Tennessee, the company has grown rapidly through acquisitions or partnerships with competitors. It currently has a portfolio of 32 brands that combine payment processing with products to help manage everything from communications and leadership development to creating mobile apps. One of its brands, easyTithe, helps Christian organizations turn year-end gifts into recurring contributions.

The company was backed by Genstar Capital and Providence Equity until 2016, when Insight Venture Partners bought out Providence in a deal the Wall Street Journal said was valued at north of $1 billion. Genstar retained a minority stake.

Buyer services: Transforming B2B payments

On the opposite side of the payment network from the merchant sits the card issuer, historically a bank. Its job is to guarantee settlement for an authorized transaction. For credit cards, this involves providing a significant float between when the payment was settled (overnight) and when the credit card customer is billed (a month later, if not longer).

Funding this float equates to issuing a massive volume of unsecured credit, which historically gave large banks a major cost-of-capital advantage, leaving limited opportunity for nonbank card competitors. Visa and Mastercard eventually created a new profit pool by introducing debit cards and prepaid cards and then raising interchange fees to be nearly on par with credit cards. Because these cards no longer required a fat balance sheet to be competitive, their introduction led to some innovation. But the issuer side was still dominated by the legacy players who could take advantage of their existing infrastructure.

The game changed in 2010, amid a merchant outcry in the US that debit and prepaid card interchange fees were unfair given that they didn’t burden issuers with the same balance-sheet risk. In response, Congress passed the Durbin amendment to the Dodd-Frank financial reforms, which directed the Federal Reserve to cap interchange fees “at cost” for banks with more than $10 billion in assets. The net effect was that the larger issuers pulled back from the debit and prepaid market, clearing the way for start-up fintech companies. These innovators, sponsored by smaller banks, could build a business without getting squashed by the legacy players.

Going virtual. The biggest beneficiaries of that innovation have been companies that never felt comfortable using credit cards for business transactions. In most industries, the B2B payment process looks much as it has for decades: A vendor sends an invoice, the customer runs it through its payables system and eventually cuts a paper check that the vendor then has to process. This paper-based system is slow, inefficient and prone to errors. Corporate credit cards ease transactional friction for relatively small transactions like a business lunch. But finance departments generally dread the idea of employees running around with approval authority for large-scale payments in their wallet. Procurement cards and fuel cards have emerged over time in response, but they are inflexible and difficult to use outside of a few limited situations.

Enter virtual card technology. A new generation of start-ups recognized that what business users really wanted was the ability to authorize payments in real time to address specific needs. Virtual cards are single-use card numbers that can be issued on the fly. They offer a business an almost endless number of ways to customize a payment system to meet its specific needs. The issuer can define when the card can be activated, when it expires, how much the user can spend and the exact set of merchants where the card can be used. Cards can be created instantly, and many can be pushed directly to digital wallets, including Apple Pay and Google Pay. Single-use issuing reduces fraud and avoids FX fees on international transactions. The transactions are easy to reconcile and enjoy wide acceptance through deals with Visa and Mastercard.

Virtual cards are creating new business models for private equity–backed payments providers like VPay and Zelis in healthcare, eNett and WEX in the transportation business, and AvidXchange, Nvoicepay and CSI in automated accounts payable solutions. Virtual cards will also be a future source of growth for Bill.com, which in December 2019 raised $216 million in an IPO that valued the company at roughly $1.6 billion.

Virtual cards required new issuing technology capabilities that the large legacy issuers did not have (and had no incentive to build once the Durbin amendment capped their fees). An early leader in developing a modern issuer system was Marqeta, an Oakland, California–based company that raised $260 million in May 2019 in a deal led by Coatue Management, which valued the company at around $2 billion. Marqeta developed an open API that companies can use to develop their own virtual card and real-time funding use cases.

Instacart, for instance, uses Marqeta’s real-time funding to power its legion of personal shoppers. Once an order from a customer comes in, the company authorizes payment for a specific item at a specific store, giving the shopper the ability to fulfill the order—and nothing else. Using the same technology, Affirm, a consumer lending company, gives merchants the flexibility to offer instant financing to customers as they are checking out. It creates a virtual card that allows the merchant to complete the loan at the point of sale like any normal transaction. Square, which makes integrated POS hardware and software solutions, uses real-time capabilities to fund merchants faster than it could using the traditional ACH bank settlement system.

When news broke that Siris Capital and Evergreen Coast Capital were taking Travelport private for $4.4 billion in December 2018, virtual issuing technology was at the center of the value proposition. eNett, a unit of Travelport, had developed its own platform for issuing virtual cards and was using it to transform the travel industry. The company’s technology addresses the considerable expense and friction travel companies face when transacting business overseas. Foreign exchange fees charged by the big banks can be onerous, and buying travel services in far-flung locations is inefficient. Transactions are often processed manually, and there are high levels of fraud and supplier default.

To combat these issues, eNett issues virtual card numbers to let travel agents pay for flight, hotel and cruise bookings in 58 currencies worldwide. For each individual transaction, eNett generates a unique 16-digit number that allows the agent to make purchases for a specific amount wherever Mastercard is accepted. This increases security, is system agnostic and streamlines processing. It also avoids the credit card network’s FX fees by issuing the virtual card in the travel service provider’s domestic market. eNett sweetens the deal by giving cash rebates on every transaction, funded by rich commercial card interchange rates.

Networks: Closing the loop

For all this innovation, Visa and Mastercard still occupy a position of power at the center of the payments system. They control the central authorization and clearing mechanism between buyers and issuers. Diners Club, Discover, multiple generations of mobile wallets, PayPal at POS—many have tried to pierce their armor, and many have failed. Building open networks at scale is hard work, and the existing players are relatively efficient, even if their fees rankle merchants.

For years, the only real alternative has been companies that build smaller, closed-loop networks—like EFS, which provides fuel cards to fleet managers. Warburg helped fund the company’s growth and sold EFS to WEX in 2016 for $1.1 billion and 4 million shares of common stock.

Increasingly, however, innovators are attracting private capital by creating high-growth businesses that integrate a closed-loop network with infrastructure that makes it easier for companies to do business. In healthcare, for instance, Bain Capital and Parthenon Capital are backing Zelis and RedCard, which in August 2019 announced a merger to create a new platform. The goal was to simplify and digitize the notoriously byzantine payment process between insurers, healthcare providers and patients.

Under the current system, a doctor submits a claim to the insurance company and the patient doles out a copay. The insurance company adjusts the claim a dozen different ways before sending back payment for about a third of the doctor’s rate. The patient sees only a blizzard of diagnosis codes and may or may not owe an additional balance. The doctor sees a steady stream of revenue but no easy reckoning of what payment links to which procedure.

Together with RedCard, Zelis provides technology solutions to over 700 payers and 600,000 providers that help price claims, pay claims and explain claims. It has developed a network that sits between the insurance companies and the providers and contracts with both parties. It charges providers around 150 basis points to process payments. (The all-in cost for accepting virtual cards can be 400–500 basis points for small companies.) It also adds value by, among other things, linking the payment directly to remittance information like invoice number or purchase order number, which helps providers see the connection between payments and specific services, along with the adjustments the insurance company has made. That kind of clarity makes it much easier for providers to close their books on received payments.

Finding the right deal

Private equity’s investments in the payments sector over the past decade have created scale leaders in specific domains of merchant services, from country-based leaders in card-present acquiring to specialists in e-commerce acquiring like Worldpay, Stripe and Adyen. The coming decade will see a shift: Activity will likely be dominated by deals involving companies offering tailored, value-added, integrated payment solutions in all three segments of the business: acquiring, issuing and closed-loop networks.

For investors, the key will be identifying the targets that best monetize payments by bundling those services with sticky solutions that truly enhance how a company manages its business. That starts with several important considerations:

Does the target payments company own the relationship with the end customer? Or is it at risk of being displaced by a technology vendor that is helping customers operate more effectively while making or taking a payment?
How is the company moving beyond commodity payment processing by providing value-added services that a customer can use to be more competitive? This may include integration with management tools like CRM or scheduling software. Or it may be a matter of providing vertical-specific information to help automate payment reconciliation or transaction aggregation and netting to reduce FX costs. Payments companies can offer supplier financing, credit enhancements, recurring billing and outsourced collections. The question is, what is the payments provider doing to retain clients and generate recurring revenue?
How does the target’s strategy for integrating payments with the customer’s broader technology fundamentally improve the efficiency of that customer’s day-to-day operations?
Better yet, does it open up an opportunity for a customer to transform its business model—for instance, by shifting from an “invoice and collect” cash cycle to a “credit card on file” model, where the client is billed and pays immediately as services are provided?
Does the company have the people, architectures and technology to make good on its strategy? Can it scale sufficiently to support the investment thesis? If that’s not the case, what will it take in terms of technology investment during the next cycle to get there?

While private equity investors have made a lot of money in the payments sector to date, the challenge is increasing as multiples rise and the industry becomes more dynamic. Average returns are impressive, but they don’t come without heightened risk. The firms that are tapping into the magic behind the curtain are as differentiated as their targets. They have acquired a specialized understanding of how to underwrite these complex opportunities, and they have built the capabilities to help rapidly growing companies stay ahead of the technology curve.

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