Financial Services Finally Getting Big Share Of LBO Dollars

Private equity firms have been on a mission to infiltrate every nook and cranny of the investment universe. So it’s not surprising that buyout shops are now setting their sights on financial services, an industry they have historically shunned.

In fact, buyout firms invested in a record-breaking 96 financial services companies around the world last year, with a value of $30.5 billion, according to Freeman & Co., an M&A advisory and consulting firm that focuses exclusively on the financial services industry. That’s up significantly from 2004, when firms pumped just $14 billion into 67 deals.

The blistering pace has continued into this year. TA Associates announced in March it was leading an approximately $1.45 billion management buyout of asset manager firm Jupiter, a subsidiary of Commerzbank. And Advent International recently acquired an 80 percent interest in Pronto!, a leading consumer credit company in Uruguay.

That’s on top of several blockbuster deals last year, including the $7.8 billion purchase of GMAC, the financial services division of General Motors, led by Cerberus, as well as Hellman & Friedman‘s $950 million acquisition of Gartmore Investment Management, a U.K.-based asset manager.

So what’s behind this growing investment trend? For one thing, with the glut of money in the marketplace and valuations skyrocketing for traditional deals like retail and consumer goods, buyout firms are eagerly looking for new areas to put their money to work. They’ve come to the conclusion that financial services is as good a place as any—maybe even better.

“Financial services is a huge component of the economy, yet it’s still relatively underserved by private equity,” said Eric Weber, managing director at Freeman & Co. “Just think of all the things that consumers need, whether it’s a credit card, 401K plan, brokerage account, life insurance, or foreign currency translation. It’s a giant business and it spits out a lot of fees.”

Of course, there are good reasons why LBO shops have traditionally approached the sector with caution. The biggest obstacle is the highly regulated nature of the industry. Jeffrey Lovell, managing director of Lovell Minnick Partners, said there are many deals he wouldn’t touch because of stringent regulations—and his firm specializes in financial services.

“In some cases, it not just the [financial institution] that’s subject to regulatory requirements, but the owner of the institution,” said Lovell. “That oversight could even flow through to your limited partners.” These kinds of deals, which include purchasing more than 25 percent of a bank, require extremely focused specialization. Lovell said his firm aims to avoid that level of oversight. Most recently, Lovell Minnick invested $10 million of equity capital in PlanMember Financial Corp., a financial services marketing company that offers an array of retirement plan services.

Another knock against financial services is that these firms already carry a lot of debt, making them difficult to further lever. “These companies are subject to credit ratings, and the more you lever them up, the lower their ratings,” said Freeman & Co.’s Weber. “Nobody wants to buy life insurance from a company with a low rating.”

Finally, financial services is often a people-centric business, as opposed to an asset-based business. At a typical wealth management firm, for example, there might be 10 key employees. That can spell big trouble if they suddenly leave to start a competing firm. This situation is very different from, say, a restaurant chain. “If the management team decides to leave, you’re still left tangible assets and a brand name,” said David King, a senior managing director at Bear Stearns Merchant Banking. “In the case of a financial services firm, all that might be left are some desks and chairs.”

Moving In Despite The Risks

Despite the challenges, more firms—both generalists and specialists—seem willing to test the waters. Bear Stearns, for its part, has made a conscious decision to focus more of its attention on the financial services industry. Though the firm only committed about a fifth of its previous fund to the sector, financial services has quickly become a favorite, especially as prices continue to explode in sectors it formerly targeted.

“It makes a lot of sense that our focus on financial services deals has increased,” said King. “After all, we are affiliated with Bear Stearns. That’s a competitive resource we can really take advantage of.”

Bear Stearns Merchant Banking closed a $2.7 billion fund last year, and its first three deals from that fund have all been in financial services. These include Alter Moneta, an asset-based equipment finance company; Caribbean Financial Group, a regional consumer finance business; and Ironshore Inc., a global provider of property and casualty insurance.

The opportunities for private equity in financial services may be greater than at any time in the past. One reason is the move by commercial banks to divest their non-core assets. In 1998, when the Glass-Steagall Act was repealed by Congress, wide-eyed commercial banks eagerly entered investment banking. But today their visions of “synergy” and cross-selling are mostly in tatters, and they are anxious to shed these units.

“We continue to see the regurgitation of strategic acquisitions that were wrongly owned from the outset, and that do much better as independent companies,” said Allen Thorpe, a managing director at Hellman & Friedman. In particular, he points to asset management firms like Gartmore, which his firm picked up from Nationwide Mutual Life Insurance Co.; and TA Associates’s recent buyout of Jupiter from Commerzbank.

Christopher Dean, a general partner at Summit Partners, said he’s excited about financial services because the sector is experiencing higher growth rates than other parts of the economy. He also believes the industry is undergoing a wave of innovation spurred by new technologies like electronic trading and the creation of new financial products.

“The investments we make today are predicated on how technology is reshaping the industry,” Dean said. “More and more financial products are being traded electronically, which creates economies of scale.”

One of Summit Partners’s investments, for example, was a $250 million purchase of Liquidnet Holdings, Inc., an online trading system servicing buy-side institutions in the mutual fund and hedge fund industries. Its most recent deal was a $35 million investment in Focus Financial Partners, a group of wealth management firms serving individuals, families, employers, and institutions.

New opportunities in financial services are appearing everyday. The recent debacle in the subprime market, for example, has piqued the curiosity of more than one buyout firm.

“The industry might look like a big burning wreckage to the public markets, but there might be something of value here to private equity,” said Bear Stearns’s King. “Sure, there are bad subprime operators, but there are also good ones who may be able to attract the long-term capital they need.” King said he’s poking around in the subprime market, but admits it would take a bit of courage to pull the trigger.

Now that private equity has discovered financial services, it’s more than likely investors are here to stay. But one question remains: Will competition and valuations spin out of control? “Don’t kid yourself: There is no free lunch here,” said King. “Every year is more competitive than the last. It’s inevitable that the sector will feel the added burden of higher prices.” Still, the financial services industry remains one of the most promising areas to play—for now.