Merchant Cash Advances and Other Early Warning Signs: Spotting Credit Trouble Before It’s Too Late

Early warning systems are an essential tool for lenders navigating an uncertain credit environment. Veteran workout leader Jason Alpert discusses the risks posed by merchant cash advances, how banks can identify emerging borrower stress before problems escalate, the role of AI in credit monitoring, and why proactive risk management creates both protection and opportunity.

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TRANSCRIPT:

Frank Devlin: This is the ProSight Banking Strategies Podcast. We’re here to inform you on the top trends, challenges, and opportunities in banking today. ProSight is a leading non-lobbying connector of people and information, with deep expertise in risk, fraud, compliance, and retail and commercial banking. Our purpose is to empower financial services leaders to strengthen and advance our industry through training and insights, as well as tools and resources like this podcast.

Hello and welcome to this ProSight Banking Strategies Podcast. I’m Frank Devlin, a senior editor at ProSight. By many measures, today’s credit environment remains relatively healthy. Asset quality is generally strong, unemployment remains low, and many financial institutions continue to report stable loan performance. But experienced lenders know that the seeds of tomorrow’s credit problems are often planted during periods of optimism. History has shown that credit conditions can change quickly. Interest rate volatility, economic uncertainty, industry-specific stress, and borrower cash flow challenges can all emerge with little warning. That’s why strong lenders don’t wait for problems to become obvious. They focus on early warning signs that could lead to losses and maintaining the skills and processes needed to respond effectively.

In today’s episode, we’re joined by a credit risk expert to discuss how banks and credit unions can stay ahead of emerging threats. We’ll explore the economic factors that could reshape the credit landscape, examine why the growing use of merchant cash advances has become a major concern for lenders, and discuss practical ways to identify borrower distress earlier. Joining me is Jason Alpert, a veteran loan workout leader and now managing partner at Castlebar Holdings, specializing in asset resolution solutions and working directly with distressed borrowers. Let’s get started. Welcome, Jason.

Jason Alpert: Thank you, Frank. Always great to help ProSight and talk about what we’re seeing in the world.

Devlin: Yeah. We’re so glad to have you, and someone with your expertise in particular. Can we start big picture by discussing the credit cycle, why it’s always important, as I noted upfront, to focus on what could go wrong in a loan portfolio, even when the credit environment is, as we’re seeing, maybe generally stable right now?

Alpert: Well, generally stable is one way to view it. Depends on who you might be asking or what industry you might be looking at. But it’s always, in a very competitive environment, which is what our economic system is based on. There’s always going to be dynamic changes that businesses have to adapt to and the lenders that provide financing to those borrowers are going to need to understand. The last 20-some-odd years, we’ve been in a relatively benign credit cycle. When I was in business school, they were very clear that there is an ongoing business cycle that ebbs and flows. Over the last 20 years with maybe the exception of COVID, it has been relatively benign. But there’s always risks that are lurking, and it’s the ones that maybe we don’t think about on a day-to-day basis that can harm our borrowers and impact our loan portfolios.

Devlin: Right. So as we’re thinking about some things that could make a change and make creditworthiness drop a bit, obviously interest rates, and you’ve mentioned this to me in the past, are something even if they just tick up a little bit, that’s enough maybe on the margin for someone who’s a little bit shaky as a borrower to have even more stress. You mentioned how we now seem to be in a higher for longer environment, and we just had another first Fed increase in a bit. What kind of stress can this add to borrowers?

Alpert: Certainly, interest rates are going to be on top of everyone’s mind, but I wouldn’t say that they’re higher for longer. They’ve more gone to their historical average. An environment where we all live quarter to quarter, easy to forget that the historical interest rate for prime or what have you would be somewhere around the 5% to 7% range. So now that we’re seeing those type of rates in this cycle, and a little bit higher, a lot of us, present company included, have not seen what this normalized interest rate environment looks like. And it’s a training exercise and it’s relearning for a lot of our borrowers that have never gone through it or have started businesses that have been used to ultra-low interest rate environments that the cost of money is essentially the cost of time, and it is not necessarily cheap by any means.

And even if you are the gold standard in credit worthiness, U.S. Treasuries being the risk-free instrument even though our country’s debt is seeing an increase in interest rate exposure. For a lot of our borrowers that are highly leveraged, obviously the higher interest rates go, the less cash flow that they will have that drops to the bottom line, and the more stress is going to be put on those borrowers in a sense for the bank’s portfolios overall. So I would say that is the big elephant in the room, and unfortunately, it doesn’t look like we’re going to be seeing any type of relief from that given that inflation has been stubbornly persistent, and it probably will be given that oil and especially diesel prices have continued to climb and don’t seem to be coming down anytime soon. Maybe this will be obsolete by the time it gets published, but right now diesel’s running somewhere just south of $7 a gallon, and everything we buy as U.S. consumers are touched by diesel in one way, shape or form, so that will translate into more inflationary pressures, which is going to not relieve the U.S. government from being able to keep interest rates at a more benign kind of level.

Devlin: That’s an interesting point that you made. So it’s not so much that rates are high now, it’s that folks perhaps got used to a historic and unusually low interest rate regime that lasted for quite a few years. And then now when things are perhaps normalizing in a way when it comes to history, they’re not used to paying at that level.

Alpert: For those of us that have come into the market after the Great Recession, you’ve not seen an interest rate environment where the borrowing cost was getting closer to double digits instead of to zero. And that’s a learning curve for both the businesses as well as the lenders in that environment. A lot of those lenders weren’t sensitizing those interest rates and the interest rate risk. Maybe when they were originating those loans, interest rates stayed relatively flat and were low for years and years on end, including what would have been several business cycles if we’re thinking about a seven-year credit cycle that was the expectation, we’re almost through three of those without seeing a major interest rate contraction. But all that being said, with all the uncertainty in the market, it’s probably not going to take much to push our economy into a recession. And if we go into a recession and demand drops, the Fed’s one tool that they use to combat that will be to lower interest rates, and maybe that will bring us down. We’ve opened a new parade of horribles, aggregate demand dropping and not just interest rate pressure.

Devlin: You’ve said this in the past, of course in any environment, even if we’re not seeing the signals that we’re seeing from interest rates and geopolitical risks that are affecting oil prices and that sort of thing. You need to be on guard for early warning signals – there’s the saying, that the worst loans are made in the best of times. So I wanted to start off by talking about one of those warning signs and maybe it’s more of an alarm that’s not so subtle than it is a warning sign, and that is merchant cash advances. For folks who may not be super well-informed on this, can you explain what a merchant cash advance is and why it’s pretty bad sign?

Alpert: Well, a merchant cash advance for those of us that aren’t well versed in what they are, think of them, they’re basically a corporate payday loan. Just like consumer payday loans are very pernicious and expensive and it’s a trap, very difficult to dig your way out of. So is corporate payday loan in the form of a merchant cash advance, which position themselves as an advance on future receivables. So they claim to not be a loan, which gets them around usury laws and allows them to charge basically an effective rate of anywhere between 60% to 150% effective interest. And they’re really, really tempting because it doesn’t take much to get approved for an MCA loan. They can fill out an application, you submit some documents and we’ve heard stories within 24 hours, maybe even shorter, where you can get six-figure to seven-figure sum deposited in your account, which certainly will fix whatever short-term cash flow problem that you may have.

The problem is that form of financing, in addition to being extremely expensive, immediately starts repaying itself from the borrower’s debit account essentially the next day. So the MCA is pulling cash, usually is the bank’s cash collateral, the operating account, pulling cash on a daily or weekly basis, effectively repaying back their full amount, including the interest expense within a very, very short period of time, anywhere from six to nine to 12 to 18 months, depending on the term. And it’s a fully amortizing “Facility.” And when one comes due, most of the time the borrower has found themselves not getting whatever gold pot at the end of the rainbow they were expecting. So they need to find … And usually they will take out a new MCA to pay off the old MCA and thus this cycle will start to continue where they’ve stacked. When we’ve seen deals that have had six MCAs in the four to $5 million range on some of these businesses, and these would be businesses that most banks would consider middle market companies, businesses with revenues of 20 to 30 to $50 million, and they’re taking out these sizable facilities.

It’s not just for your small business borrowers that are looking for $100,000 to buy a piece of critical machinery or get some inventory in. This is really, really short-term working capital that borrowers are taking out. And by the time that the bank has figured out the borrower has taken it out, it might be way too far gone for that borrower to dig themselves out. And the bank has not only a watchlist credit, but probably a nonaccrual in credit and probably a credit that probably has a very high risk of bankruptcy within the next six to 24 months.

Devlin: Bad for the lender, bad for the borrower if we’re talking an effective interest rate that can go past 100%, yet they are becoming more common, these merchant cash advances from all the statistics. The total’s been growing rapidly. It’s about $21 billion today and numbers expected to grow again to about 27 billion apparently by the end of the decade. These are not priced well for the borrowers. Why are they becoming more common? Do you have any insight into that?

Alpert: Well, it’s a couple of factors. A lot of these MCAs are fintech solutions. All of our bankers on the call or listening to the podcast will be very familiar with the impact and disruption that fintechs have provided. This is just another extension of that. But also they really got accelerated coming out of COVID. They were around before COVID, but maybe not as prevalent as we’re seeing today. They were around, businesses were taking them out, they were somewhat growing. And when COVID happened, you had a bunch of borrowers take these things out, but then PPP money came in, the stimulus money came in, revenues exploded. We saw what the economy was doing coming back out of it. And all those MCAs, they had very, very low losses. They showed very, very high returns. And anytime you do that, there’s money to be made. You’re going to have a flood of capital come in, which is what has added fuel to that fire. A race towards the bottom as we lenders would know. Same thing in this industry. Credit standards have more or less evaporated and people are putting money to work.

The way that these things are structured, the best way I can get my head around it as a former banker is think about when these loans are done and they’re booked on the MCA’s books, think of it that they basically know that these borrowers are highly financial distressed, future principal and interest payments may be impaired, which would be a nonaccrual definition. And by any nonaccrual definition, you are taking principal and paying down the book balance to that loan with every payment, assuming they even kept the full book balance on there, didn’t charge a portion of that off that they didn’t think that they were going to get repaid on. Essentially, they’ve been repaid back their principal in a very short amount of time and everything they get over and above that is gravy. We only got a 30% return and we were supposed to get 60 APR. We only got half of our return, but that’s still probably 50%, 100% better than any private lender would be getting on their return. It’s still a very, very profitable solution, especially when you look at it across a broad portfolio.

And the way they set themselves up really gives them a lot of leverage over our borrowers. They get confessions of judgments. Their “loan documents” are established in jurisdictions that are very favorable to them. They get confessions of judgment. So it doesn’t take a default for that to be recorded. They also will file UCC liens that they shouldn’t be doing because technically, again, there’s no collateral, there’s no receivables, there’s no assets to record. They will call the borrower’s customers and say, “We are the lender of record. Here’s our UCC lien, go pay us.” And that again is the bank’s cash collateral. The senior secured lender has that UCC. A lot of customers wouldn’t know who to pay it to. They just know, “All right, well, I’m going to settle my debt by paying this.”

Devlin: So it sounds like it’s a mess when this happens. What should a lender do the second they discover a borrower has taken out an MCA? What are some quick things that they’re going to have to take a look at?

Alpert: They’ve identified it. I mean, we set it up as like a four-step frame. You want to identify, triage, treat, and resolve. If you’ve identified that there is an MCA, either because you got financial statements and there’s a new current liability sitting on the balance sheet that looks like a loan, smells like a loan, talks like a loan, it’s definitely a loan, that’s never good. That’s a violation of most times of a bank’s loan agreement and promissory note that no additional indebtedness will be incurred without prior written approval of the lender. You triage it. So what are the terms of this MCA loan? How much cash are they pulling out? What’s the debt service looking like net us and the MCA? Are they going to be profitable? Do they have enough cash to even service both? And then start treating that problem and working hand in glove with your borrower to figure out a way to extricate themselves out of that situation, which would require for most financial institutions to send that to a specialist in the workout department.

If you do have a dedicated workout group, if you do discover an MCA, I think it’s a do not pass go, do not collect $200 situation. You send it to workout and until that MCA is resolved somehow, it remains in workout. You would want to make sure that we’re perfecting our collateral, that the bank gets control back over its cash collateral, that it has dominion on the cash that is supporting the loan, that they do make sure that all the customers are aware that the bank is a senior secured lender. But again, the bank needs to be very careful on how they’re working with their borrower to make sure they don’t trip any lender liability issues and to get their arms around it and then resolve it. Probably going to need a forbearance agreement, going to need to work with that customer to get a plan in place that’s going to retire that MCA or they can negotiate with that MCA for some type of resolution and maybe there’s a deal to be had there. Always keep in mind that the borrower made this business decision, the bank must do what it can to protect its asset, but you definitely don’t want to go in there and start doing anything that could have a whiff of lender liability claim.

Devlin: Right. I was thinking, is there a way that lenders could message this more explicitly. “Hey, whatever you do, don’t take out a merchant cash advance.” Like you’re saying, this is all stipulated prior to a loan. They know that they’re not supposed to be taking out other indebtedness in addition to their bank loans. They’re doing this as full knowledge that they’re breaking their agreement. Is there a way that that can be just stressed more or they’re just going to do that?

Alpert: In my experience, you have really good lenders, you have lenders that maybe aren’t as strong and sometimes the conditions of that loan aren’t really discussed and explained to that borrower to where they understand that no, there is this provision of a no additional indebtedness and you cannot take out another loan without our prior written consent. Some bankers will have that discussion, others might not. So the borrower might not even know that’s in there. Their attorney might because they review the documents. We all know that a lot of banks use standard forms. They’re very rarely negotiated. If you do have larger credits, those will be documented with outside counsel and those will be negotiated, but there’s going to be conditions that the bank’s not going to waive. And usually a no additional indebtedness is the cost is a condition that most credit officers aren’t going to sit there and waive without a really, really good reason.

So it goes back to the education piece at that closing table, especially if this is a deal that is tight, like it’s graded as maybe your poorest pass-rated deal where one or two things are wrong, it’s very thinly collateralized or has a very thin cash flow profile or thin liquidity or something like that, that you would want to have those discussions. Hey, if you have a hiccup, give me a call. Can’t take out any other loans, there’s these things called MCAs. They will call you. They will be on the internet. It looks like easy money. It looks like it’s no big deal, but these things are a death trap and they are very, very difficult. And please let me know if there’s a cash flow issue that you need to address and I will work with you on this. The bank will work with you through that solution. We may not be happy about it, but we will work with you. But if you take out an MCA, you’re going to take the decision out of my hands and it’s going to go to our workout group because of the losses we’ve experienced on this before.

And I would also say AI is spectacular. It can do a lot of things. I know a lot of institutions are investing a lot of money. If I was running a bank, I would be very, very clear that we need to have an AI solution that looks at our deposit accounts or looks at our loan applications or does servicing where they can identify these type of issues when they occur. One of the early warning signs we talk about with MCAs is if you have the operating account and let’s say you have a C&I loan, and usually you will have the operating account as a condition of that borrowing base. If you have that operating account and you see a giant distribution from so-and-so funding, it’s a round number $1 million, and then you see the next day a $10,000 debit going back out to so-and-so funding, then that’s probably an MCA. Definitely ask your borrower. “Hey, this looks like an unusual transaction. What was the nature of this?” “Oh, well, we ran into this issue and we needed to take out this amount of money and we’ll be able to pay it back in nine months. I promise.” That’s where you want to have those discussions right away.

But I would say utilizing AI to be a surveillance tool that can run in the background that can identify these type of things would be incredibly helpful as well as maybe even putting a new covenant in there, no additional indebtedness, including not limited, but including merchant cash advances, something along those lines.

Devlin: Right. So it doesn’t hurt to restate it or say it three times maybe just so that you’re sure that the message gets across. And it sounds like communication is so important. It sounds like it can be really beneficial.

Alpert: This is an area where the banks need education. We go around the country and we speak to banks and we speak to ProSight chapters and turnaround management chapters and the number of financial institutions and people within those financial institutions that haven’t even heard of it is pretty shocking given that every bankruptcy attorney, every bankruptcy judge I talk to, debtors or creditors attorney in bankruptcy will say for most of middle market borrowers or below, they have an MCA. That seems to be the common denominator for why they’re finding themselves in a Subchapter 5 or a Chapter 11 or a Chapter 7.

Devlin: So in our remaining time, can you talk a little bit about early warning signals in general, apart from merchant cash advances? I know that you say there are three categories of them, and maybe if you could provide an example for each.

Alpert: I think the article that we wrote that was published maybe four or five years ago, Frank, touched on early warning signs and I put it into three buckets. You had your contractual early warning signs, which would be something like covenant breaches, missed or late financial reporting, insurance lapses, failure to pay real estate taxes, maturity defaults, those type of things would be early warning signs. I wouldn’t say a maturity default is. I think the cat’s out of the bag there. And then you have your financial early warning signs. This is where the numbers are telling a story that is showing that the borrower has some type of distress. You’re seeing accounts payable, trade being stretched by a borrower using their trade as additional leverage, AR and inventory that’s not turning as fast as it should or as fast as it was underwritten. Obviously declines in revenue and EBITDA would be typical early warning signs.

And then you have your relational or behavioral ones, which I don’t think will be ever replaced by AI or at least not in the near term future. But this is where a good old-fashioned relationship and having a good relationship and a strong relationship with your borrower will help identify those things such as they’re not taking my phone calls anymore or they stop communicating with the bank. They’re being very cagey on disclosures where they used to be very open and transparent on what was going on and something along those lines of I would call the five Ds in distress, which I know a lot of ProSight folks have heard me say nonstop, but death, drugs, divorce, disability, disagreements. Anytime you’re single key person that’s really the beating heart of an organization has one of those things occur to them is probably a sign of distress that needs to be alerted to it. You wouldn’t get without knowing the individual and knowing that customer.

Devlin: You mentioned earlier about a way that you could deploy AI and that would be detecting some of these cash movements that speak to an MCA that the borrower has. Before we move on to the next question, what are some other ways now just about early warning signals in general that you were talking about previously that you maybe can see being enhanced by AI?

Alpert: Certainly the merchant cash advances, like I previously mentioned, utilizing your AI tools to instantaneously like, hey, the lender got the financial statements, you send it in for spreading, you’re waiting for those spreads to come back. AI will be able to do that eventually within minutes. But it can also look back whatever record of financial statements you have going back and give you good trend analysis and things that were outside of certain standard deviations and all sorts of really complex statistical analysis that may have not been available, warranted smaller deals because of the cost and time from a human doing it that can be done in seconds by a bot that never gets tired. So giving that kind of a higher level overview, doing some more of that heavier math, but what it’s not going to replace is human judgment, understanding the customer, understanding the impacts of all these various changes in the environment and in their local industry competitive sphere. That’ll be the domain of expert judgment, hopefully for this foreseeable future.

But those are ways that I would be employing AI to give me that really fast … Like, wait a minute, average AR days, not just for the last three years, but for the 40 years we had this relationship have been at 20 terms per year. Now it’s down to five. What is causing that? Maybe we could find some early trends that may have not been very apparent to the human eye.

Devlin: That human eye, human factor, that’s going to be my last question I want to ask you about that. But one question before that, and if you could talk a little bit about the kind of advantages, opportunities it is to have this information as quickly as possible, whether that means weeks, months, what can be salvaged or achieved that might not be otherwise if you don’t get that information until quite a bit later?

Alpert: I use the analogy a lot of times that when a workout is similar to working in an emergency room, time is not necessarily your friend. The more timely you get information and the more timely you can understand and act on that information, the better results you’re probably going to have. Like having a lab on site that can quickly do a blood scan to tell you what’s going on rather than shipping it and waiting a week or so to get the answers back. Similar to this, you see there’s an early warning sign, especially something like an MCA that’s pulling out cash on a daily basis to get your arms around it and maybe stop that bleeding or at least pause that bleeding can maybe help salvage something with that borrower or maybe there’s a solution that could be done to get the staunch of bleeding, put them in a triage position and help nurse them back to recovery. Doesn’t mean there’s not a ton of work, but can help fix that problem while there’s still options and let’s make arrangements, i.e. Send it to our bankruptcy counsel or collections.

Devlin: Final question, and this is getting back to that human factor and talent. So a lot of veteran credit people and the regulators have said this too, I think it’s been in the OCC’s Semiannual Risk Perspective, have expressed concern that a lot of talent in the industry has not been through maybe what did you call a real recession? We had the one that was briefed during COVID, but then it was quickly reversed by the spending that was spread throughout the economy. So these people might lack skills to proactively detect these warning signals and then work out loans if needed. Do you share this concern as a veteran workout person? And if so, what might banks and credit unions do to shore up these types of skills while we’re still in this period where things aren’t perfect with the economy, but we are not in a recession at the moment?

Alpert: I definitely share those concerns. I’m unique in the fact that I started my career basically just before the Great Recession and I fell into workout during that. I just never left because I love the problem-solving aspect of it and I love the different vibe within workout. But it is the best form of credit training that there is in my mind because when you see a deal collapse, especially one that was … All my banking partners do really good underwriting. They’re not cowboy lenders out here just throwing money on the streets hoping for the best. They are making would be sound business decisions and taking risks that they know and understand. And until you see how that deal falls apart and then how you maybe put it back together. There’s no amount of case studies or I can do 50 workout seminars and it’s not going to give you the same amount of impact of actually sitting across the table from a borrower that’s in real distress, that does not know how they’re going to make payroll, that this is their life and trying to work with them to find the best solution that one, you can sell to your institution, two, that protects your shareholders, and three, helps your customer get through what might be the hardest that they’ve had in running their business, will have a real impact on their family.

That’s something that you just can’t get without that experience. And I think if God forbid, we do go through another recession, any talent that a bank wants to keep, I would be really pushing them to do a stint in workout even if they don’t want to, compensate them appropriately if a home run producer, but they may not be doing that much new originations anyway just because in a bad times credit box really gets tight and that might be the best use of their time and they will come out of that experience in six to 12, 18 months being a phenomenal banker and being somebody that will eventually be president of the bank because they understand and can ask those questions on the front end because as we started this conversation, most distressed loans are made in the best of times. And so asking those questions and understanding, all right, what are your contingencies if this, this and this happens?

What happens if this customer concentration doesn’t work out or if this competitor comes in or what happens when this IP expires? All these things that you can ask and understand and work around on the front end you might not have otherwise got until you realize, well, I thought we had this security interest and now we don’t. We expected this to happen, but these assumptions never held and why was that? Those things you don’t get until you’re looking at how you put Humpty Dumpty back together again.

Devlin: That’s very interesting that the skills learned in workout are applicable to any type of economy and any type of credit, it sounds like.

Alpert: I will add, workout is not where … We’re not three-eyed ogres. We don’t wear a black hat. We don’t enjoy getting into heavy negotiations or getting yelled at. It’s a place where you can help customers get through the hardest time within their business and professional career. Maybe besides the fact when they started the company, if they grew it from scratch. There’s a lot to be said and there’s a lot of hard negotiation. There’s a lot of legal training that is done that you might not otherwise get. You’ll come out of it a much better person. But I always like to dispel the notion that, hey, we’re just here to kick people in the shins and tell them what stupid business decisions they made and to tell the lender, how did you make this deal? That’s never the approach I took and that’s not the approach of every workout professional I’ve talked to.

It’s usually very collaborative. We want to do right by the shareholders. We try and find win-win solutions with our customers so we can keep them as our customers, but in the event that they don’t, it’s time to move on, we can do that with aplomb and professionalism that keeps the name and reputation of our institution as high as it can be.

Devlin: It’s a great foundation for whatever you end up doing in your career, whether it’s continuing in workout or branching out as you’re doing now. So thanks so much, Jason, for sharing your perspectives with our ProSight Banking Strategies podcast audience today. To our listeners, thanks for spending your valuable time with us. If you liked it, please spread the word. I’m Frank Devlin.

The views expressed by the speakers are the speakers’ own and do not reflect the views of ProSight Financial Association, BAI, or RMA. The views expressed and information shared are of a general nature and are not intended to address the circumstances of any particular individual or entity. No one should act upon any such views or information shared during this podcast without appropriate professional advice after a thorough examination of the particular situation.