In the immediate aftermath of the global financial crisis, opinion on investment opportunities in the financial services sector remains divided. A few private equity practitioners are of the belief that businesses are in this space are struggling and any investments made in them are unlikely to generate returns for limited partners.
On the other hand, there are others who believe that in a crisis lie the best opportunities, and this adage is most apt for investments in the financial services sector. For after all, companies in this space have been hit hard and are likely struggling or distressed, resulting in opportunities to buy fundamentally strong companies at cheap valuations.
Fund managers in Asia, however, suggest that while a crisis brings forth exciting opportunities to invest, opportunities need to be thoroughly vetted because finding the right companies to invest in remains the primary challenge.
In fact, the financial services sector has been the hardest hit by fraud in the aftermath of the crisis, according to the Kroll Annual Global Fraud Report published by global risk consulting company Kroll. According to the study, 51 percent of respondents globally in the financial services sector noted that the financial crisis had increased levels of fraud at their companies, more than in any other sector.
Internal financial fraud, management conflict of interest and money laundering are fraud issues firms in the financial services sector are confronted with.
Besides the prospects of fraud afflicting potential companies, there are other challenges to owning risk management businesses at this time. Tim Sims, founder and managing director at Australian private equity firm Pacific Equity Partners, says it is a challenging time to own a risk management business and to be a provider of risk products in either the insurance or the lending space. “These businesses rely on predictable patterns of risk and return which have been radically disrupted by recent events,” he says.
Consequently, a popular sentiment is that if there are distressed risk management companies, now is probably a good time to buy them. Taking into account the long tail of most risk management businesses, such businesses might be weakened enough and selling at deep discounts.
However, Sims points out that such a proposition would require careful due diligence to ensure there isn’t sufficient risk in the business in whatever regulatory environment it is operating in that could put the health and survival of the business at risk. Either that, or the risk has to be sufficiently well understood so that the buyer is genuinely buying that portfolio of risk at a discount, he says.
Mark Thornton, a partner at London-listed private equity firm 3i, offers a similar view. He says while financial services is a big sector characterised by high growth, it is not one for generalists. “You need to have specific domain knowledge and expertise to be able to operate within the financial services segment,” he says.
Financial services across Asia
Considering Asia’s size and diversity, the attributes of the financial services sector across the region are remarkably diverse.
“The most obvious difference is that the regulatory environments are different. Inevitably, the expectations and rules related to investments in the financial services sector vary by market,” says Sunil Kaul, a managing director focused on investments in the financial services sector across Asia at The Carlyle Group. These differences affect factors such as the ownership stake firms are able to take, the investment’s pace of expansion, the choice of partners and return expectations.
As Asian economies are at widely varying stages of development, financial services companies in some countries are more fragmented than others. This leads to contrasting competitive structures, which affects rates of returns across different marketplaces, says Kaul.
Industry practitioners agree that while Asian growth giants China and India are attractive due to their growing middle classes and concentration of high net worth individuals, it is more difficult for firms to acquire significant stakes in Chinese and Indian financial institutions due to regulatory restrictions.
And while more mature markets such as Australia, Korean and Taiwan are better penetrated, opportunities are still available whether driven by a need for capital, the exit of larger players, or consolidation.
In October, for instance, a consortium comprising Primus Financial Holdings and China Strategic Holdings acquired a 97.57 percent stake in Taiwanese insurance company Nan Shan Life Insurance for $2.15 billion from US insurance giant AIG, beating off competition from other buyout majors such as The Carlyle Group, Bain Capital and MBK Partners. The deal is Asia’s largest private equity transaction to date this year.
Investing in the financial services sector also requires more sensitivity as compared to other sectors.
“You have to be able to demonstrate that you bring both capital and an appreciation of the sensitivities that go with accepting deposits, selling insurance, providing financial advice or assuming market or credit risks that can have implications beyond just one institution,” says Carlyle’s Kaul.
Since the sector plays a vital role within a community as well as within an economy, it is inevitably highly regulated. And as private equity investments in this space tend to be large, they are also heavily scrutinised.
Overall, financial services represent somewhere between 10 percent and 20 percent of the gross domestic product of the Asian economy and in some hubs like Singapore and HK, it’s a more meaningful pillar of the economy, says 3i’s Thornton.
“Whether you have majority control of the investee company or not, very often you end up working in partnership with the original owners or some local partners. That’s a good thing in our view. They can leverage our regional and international experience and we can benefit from their local and organisational knowledge,” says Kaul.
Ultimately, the sector at large is poised for further growth in Asia. The region’s banks are getting bigger in keeping with the growing stature of the region’s economies.
As Carlyle’s Kaul puts it: “The financial services sector, in many ways, is a proxy for the economy as a whole and to the extent one believes Asian economies are well positioned for growth, you have to be optimistic about the sector in this region.”
Private equity firms investing in the financial services sector in Asia have had mixed experiences. While some deals have been highly profitable, there are others that have stalled due to regulatory factors.
One of the most successful private equity deals involved the purchase of Japan’s Shinsei Bank. In 2000, US private equity firms JC Flowers and Ripplewood Holdings led a consortium to acquire the bank for $1.2 billion. After a restructuring programme, the firms sold their stakes in tranches. Flowers and Ripplewood made about ¥2.2 billion ($24 million) in advisory fees immediately after the transaction, $2.1 billion in profits from the bank’s IPO, and later earned $2.8 billion when they sold a one third stake in the bank, to reduce their voting rights to 2.56 percent. In November 2007, Flowers invested in Shinsei for a second time and acquired a stake of 32.6 percent for $1.8 billion. Although the deal left an unfavourable legacy in Japan, it was extremely lucrative for the firms involved.
Also lucrative was the Tokyo Star Bank deal transacted by Texan buyout major Lone Star Group in 2001. The firm acquired the bank for ¥40.4 billion ($450 million), listing a third of it four years later on the Tokyo Stock Exchange. Lone Star made ¥230 billion from the sale.
However, Lone Star’s experiences with the Asian financial services sector have not always been particularly smooth-sailing. A $6.3 billion deal to divest its 51.02 percent stake in Korea Exchange Bank (KEB) last year and a prior $7.3 billion agreement to sell to Korean bank Kookmin Bank in 2007 both fell through due to ongoing investigations over its 2003 purchase of KEB for KRW1.38 trillion ($1.2 billion).
Despite this chequered history, private equity firms have continued to ply the financial services industry for deals and 2009 has seen several transactions complete.
Seoul-based Vogo Fund has invested KRW194.4 billion ($166 million) for a 30.7 percent stake in BC Card, the country’s largest credit card company this September and intends to acquire a controlling stake in the company by the end of this year.
In July, Norwest Venture Partners announced an INR1.2 billion ($26 million) investment in Indian retail finance company Shriram City Union Finance.
In the same month, Kohlberg Kravis Roberts, investment bank China International Capital Corporation and sovereign wealth fund Government of Singapore Investment Corporation acquired a 30 percent stake in Chinese financial lease holding business International Far Eastern Leasing Company for $160 million.
Says Mark Thornton, a partner at London-listed private equity firm 3: “If you are a private equity player, it’s not a sector that you can ignore as it has historically been over a fifth of the industry.”
The Big Three
The term ‘financial services’ encompasses a wide range of businesses including banks, credit card companies, insurance companies and stock brokerages. However, there are three broad categories can be identified within the sector.
Risk management businesses
Risk management businesses, the most common example of which are banks, require highly specialised skill sets, practitioners spoken to for this article say. “Success demands specialised risk assessment skills and often specialised conflict management structures to ensure that the correct balance of corporate and customer interest is maintained in the normal pursuit of profit,” says Tim Sims, founder and managing director at Australian private equity firm Pacific Equity Partners (PEP). In order to compete, the business needs scale as well as a large balance sheet.
An example of private equity deal in this sector is Carlyle’s $40 million investment into KorAm Bank, a Korean commercial bank, in 2000. The firm later partnered with JP Morgan Corsair, an affiliate of the US investment bank, to invest another $395 million in KorAm. Four years later, Caryle sold its stake in KorAm to Citigroup for $2.73 billion.
These include information management businesses such as share registry, credit scoring and credit informational businesses. “Often, they are businesses which are under-managed and under-loved among the larger and more glamorous risk management style businesses because they tend to be caretaker businesses with a strong focus on day-to-day repetition,” says PEP’s Sims.
In Sims’ view, LBO activity is more common in this space as such companies can handle some financial risk, compared to risk management businesses, which are frequently already geared and exposed to other forms of risks
3i’s Thornton says that financial infrastructure and financial technology will have “huge applications” as the financial services industry grows in Asia and globally as well.
In a way, information management companies in the financial services sector work well with private equity. Being the back office of a large organisation, they typically have traditional and inert cultures, so that when they move to a more service oriented organisation, the asset class can usually achieve substantial performance improvement.
One example of private equity interest in this segment is an investment made in Itz Cash Card, an Indian prepaid company. In July, Lightspeed Venture Partners led an INR500 million investment in the company along with returning investors Matrix Partners India and Intel Capital, who had provided the company with $10 million in funding two years earlier.
Itz Cash Card is a multi-purpose prepaid cash card company offering cashless payment solutions across physical, internet and mobile channels, providing a payment instrument for the under-banked population of India.
Third party players
Increasingly, financial products are being sold and distributed by third parties fostering a healthy degree of competition. Examples of such businesses include broker organisations, which allow customers to shop across the suppliers of various financial products.
“This space carries its own unique challenges around achieving competitive product supply on the one hand and on the other, managing large numbers of entrepreneurial commission-based sales people,” says Sims.
As an example of such a deal, PEP invested just under A$7 million for a 75 percent stake in Oasis Asset Management, a Sydney-based investment platform specialist provider, in 2000. In 2006, the firm exited Oasis for approximately A$36 million, representing a nearly 6x return on the deal.