While Richard Decker sits perusing a
It is shortly before noon on 9 October, and the Dow Jones Industrial Average is in the midst of the worst seven-day period in its 112-year history.
The day before, the Dow had closed down 189 points on fears that turbulence in the world's credit markets would persist, and that US and European government intervention would ultimately be unable to mitigate the crisis spilling over into the general economy. By the time Decker had returned to his New York hotel room later that night, the Dow had slid another 679 points.
For Decker, chairman and cofounder of San Francisco-based Belvedere Capital Partners, which currently counts seven banks in its most recent fund's portfolio, the roundtable discussion he is about to participate in could not be more timely.
WHAT JUST HAPPENED?
Decker folds the newspaper as members of the
All file into a conference room and, after settling in their seats and introducing themselves, naturally begin speaking of the unthinkable succession of events of the past few weeks and the ultimate impact it will have on private equity activity in the financial services space.
The consensus is clear – the financial services industry has been completely recast, and opportunities for private equity abounds. But is there too much uncertainty to act just yet?
The roundtable kicked off with the deliberately broad question of how the turmoil of the last few months has affected the investment landscape for private equity firms eyeing the financial services sector, hoping to stimulate as broad and far-reaching a conversation on the topic as possible.
The question was greeted with a collective sigh from around the table, each looking to the other to see who would be first to tackle such an obviously massive topic. Finally, Decker offered the first response.
“From the credit side, let's pick a time,”he said. “Eighteen months or two years ago, many banks were selling for 2.4, three, four times tangible book. Now you're seeing many of those same companies selling for book or 80 percent of book or 1.2 of book. There's been a whole downdraft in financial services, and we've all seen that.” Decker continued that from Belvedere's perspective, whether a bank is being punished fairly or unfairly by the current financial meltdown, the field is rife with opportunity. “So that's given people like us who look for ways that we can invest and be partners in these banks opportunities to come in at a much lower price, even though the key of course is doing your due diligence.”
Reconsidering the question, Edwards contrasted his own firm's interest in financial services now compared with the heyday of the buyout boom, when valuations of deposit-taking institutions were sky high.
“Valuations had historic highs across whatever parameters you could look at – earnings, book value, it didn't matter – and you had historic highs in loan production in every area as well. But that's been flipped on its head now, and now banks with overexposed balance sheets have been exposed as too risky, losses are being taken and there's more to come. Now you've got valuations at book value but the problem is today no-one knows what book value is. That's why it's still today very difficult to invest.”
Chulack noted that although the financial services investment climate was indeed highly uncertain, especially with regard to banks, many attractive acquisition opportunities were going to be available as the credit world reshapes.
“The financial services landscape as we know it is being re-cut almost on a daily basis, and so it is a highly uncertain time,”he said. “Whatever you decide to do from an investment point of view, you have to tread carefully. But there are also new opportunities emerging as a result, both in terms of valuations coming back down to earth, but also in terms of new business models being developed. There are a lot of lending and other businesses that have been severely damaged by the market change and that is creating opportunities for existing management teams to rebuild their businesses and for established management teams to launch new businesses to address market needs.”
Decker, shaking his head, wryly reflected on the events of the past year. “Who would have thought if we had gotten together 18 months ago, and we said as a group, you know what's going to happen? We're going to have half the investment banks we have on the street. And let's pick Goldman Sachs and Morgan Stanley as survivors, and over a weekend they're going to become bank holding companies. If Don and Alex and I had said that to you you'd say we were smoking something.”
Although opportunity abounds in the near future, the uncertainty prevalent in most of the financial services industry today makes immediate investments very touch-and-go, and has made certain industries in which private equity invested in past cycles basically off limits. “Non-depository lenders were a significant area of opportunity for private equity,”said Edwards. “Consumer lenders, student loan companies, companies where you could lend to a specific segment of the population, and fund those loans with asset-backed securities. That market is all but shut down today. All of the non-bank lenders that provided opportunities for private equity today are not viable business models, but something will emerge from that.”
“I don't necessarily subscribe to the idea you read in the papers that these PE guys are coming into financial services and will make a lot of money now. It's going to be a very difficult time to make PE-like returns in financial services, especially in those lending businesses.”
Outside banks and non-depository lenders, however, certain financial services businesses are thriving. Buoyed by unprecedented activity and volatility in the public markets and elsewhere, many companies engaged purely in trading or other volume-intensive activities are catching a lucrative windfall.
“A lot of businesses are actually seeing their best performance to date, on the back of the volatility and uncer tainty impact ing capi tal markets,”said Chulack, whose employer holds a stake in the New York Stock Exchange. “A great many businesses will actually do better going forward than they had done before because a greater degree of transparency will be forced on the market, and some people will benefit from it and some people will not.”
Said Decker: “Private equity can invest in insurance, specialty finance, payment systems, foreign exchange, they're going to be limited on the depository side because the Fed is still going to hold true to its ownership limits. It's a new paradigm. One thing you have to give America credit for is it addresses its balance sheet as a country immediately. These are unprecedented times, but if you take a look at the Japanese it probably would have taken them three decades to do what we've been doing.”
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Much of the current discussion on financial services investing typically revolves around distressed and sinking assets, whether a book of automotive loans or mortgages or collateralised debt obligations. But much of the roundtable conversation was focused on evaluating viable and emerging business models.
“We are fundamentally not asset purchasers,”said Chulack. “We have never been in that business, that's not our focus and is unlikely to be. Our focus is on building companies. Do I think this market presents opportunities where both companies and assets are under-priced? Absolutely. But that's not our focus and it is not typically a private equity firm's focus.”
“For us there's a hybrid opportunity there,”said Edwards. “As operators, the opportunity to both acquire loans and potentially service them where you own the servicing company and you can buy the loans at historically high returns, that is an opportunity that we are looking at constantly.”
Decker took issue with distressed assets as the flavour of the month. “The interesting part in buying assets is determining the value. What are you going to do with them when you buy them? You have to service them, manage them, collect them. Fundamentally, this rush to buy assets is flawed because you have to be able to support it with operations.”
THE FED, PIPES, AND OTHER TIGHTROPES
Much of the explanation for why TPG's Washington Mutual (WaMu) investment flopped centred on the lack of control the private equity giant could effectively exercise over the saving and loan's beleaguered management. When TPG took its $2 billion stake in WaMu, private equity firms not registered as bank holding companies were restricted to no more than 9.9 percent ownership in US banks, relegating TPG to only one board seat – albeit one occupied by David Bonderman.
Since then, the Federal Reserve has relaxed those regulations, hoping to encourage an infusion of private equity capital into distressed bank coffers. But will the additional equity shares and board seats be enough for generalist private equity firms not registered as bank holding companies to influence the direction of the banks?
“TPG only had one board seat out of 13 with WaMu,”said Decker. “Those are very smart people, we know them well and look at things together. The thing that we like about being a bank holding company is that you can put two, three, four board seats on, and that allows you to hold higher ownership stakes, which allow you to exercise control and work with the regulations as appropriate.”
Chulack was similarly sceptical of the scope of the Fed's reforms. “I view it as a clarification rather than a seismic shift. Fundamentally these businesses are highly regulated. Your ability to have impact at that level is still highly constrained, so you just have to be very, very careful in backing the right management teams and situations right now.”
Edwards cited the difficulty of doing any deal with a large, publicly-listed deposit-taking institution.
“I think that the fundamental issue for large PIPE investments for financial services in balance sheet-intensive businesses in these falling knife environments is did you get access to the loan portfolio to do the deep dive due diligence that takes probably months and months to do on large institutions, and sometimes is impossible to do?
“Did you have the access, did you have the time, and do you have the expertise to do all that with a public company? If you don't have that time and access, you're essentially investing more as a public company investor.”
Decker noted that the complexity involved in major bank deals is all the more reason the mid- market is attractive.
“This is why we have always focussed as a firm on mid-cap and small-cap financial services. That due diligence is simpler, it's not as complex and esoteric. The bigger, the more complex, is tough to know. Remember people are usually moving quickly, they're moving within a weekend or two weekends. There's a lot of pressure to make decisions, so there's a lot of unknowns that you're having to work through.”
ASSUAGING THE PORTFOLIO
It's always exciting to talk about potential deals, especially in an investment environment with this much uncertainty. But with the credit markets contracting at a perilous rate and the macro-economic outlook decidedly grim, how are financial services investors steering their portfolios through such turbulent waters? within financial services are nonbalance sheet-driven,”said Chulack. “Over the last five or six years we've been a heavy investor in global capital markets around the world. As long as the products and services a company provides continue to be useful, they're going to be fine. We're taking a somewhat defensive posture in a number of instances because you can't tell where the world is going, and try to position the businesses for what's on the other side of this.”
Edwards observed that private equity-owned insurance companies with a significant exposure to mortgage-backed investments would obviously face challenges, but that Flexpoint's portfolio has largely avoided those pitfalls.
“We didn't have any lenders in our Fund I, for either lucky or smart reasons or somewhere in between. We do have three insurance companies, four if you count a healthcare insurance company. Some have been doing phenomenally well, some less so.
“There is an unprecedented level of disruption in AAA or AA corporate bonds, which is affecting even small insurers,”he continued. “We didn't have that problem, but now for insurance companies in general in private equity portfolios, that's something to be worried about.”
Everyone was interested to know how Belvedere's portfolio was faring, considering it consists almost entirely of deposit-taking institutions.
“We have 10 portfolio companies in our second fund, seven of them are banks, and generally they're all doing very well,”said Decker. “That 's amazing,”chimed in Edwards.
“And the reason is they're very boring,”continued Decker. “They're mostly commercial and industrial lending, which come with great deposits. They are a microcosm of their community, so are they down a little bit in some areas? Of course. But generally they're doing very well. We're actually taking some business – generally deposits and loans – away from elephants that are now having trouble.”
WHAT AN LP NEEDS TO KNOW
Despite a general downturn in fundraising, limited partner appetite for funds with dedicated financial services strategies has been relatively strong, as evidenced by Flexpoint Ford's roughly $1.3 billion fund close. However, with many generalist private equity houses increasingly eying the sector, institutional investors of all stripes must know which firms to trust with their capital.
When asked what one question limited partners should ask general partners who want to invest in banks or financial services, Edwards, fresh from his road show, responded immediately: “How much experience do you have evaluating a book of loans?”
“Financial services is a specialised field,”added Chulack. “Unless you've looked at it for a period of time and have seen it go through more than one cycle – and this one is unlike any other that anyone can remember – getting into it is risky, especially in large dollars.”
So far, at least according to Decker, limited partners have been on the ball.
“I've been very impressed with LPs. They've been very thoughtful and are asking the right questions. They understand, they've seen it in the papers where they've seem some missteps, so they have to understand.”
AROUND THE TABLE: OUR THREE PUNDITS