Sector Spotlight: What’s Hot, Warm, Cold In Financial Services

The community banking and asset management markets look to be heading for major consolidation. A protracted lack of credit availability could put an end to the era of independent specialty finance providers. American International Group’s implosion has the insurance industry in flux, while many investors see opportunities for countercyclical plays in the mortgage market. Meantime, providers of financial technology, like architects heading to San Francisco after the 1906 earthquake, are likely to stay busy as firms call on their services to cut costs and become more nimble servants to customers.

To be sure, LBO firms looking for opportunities in the financial services sector have a lot of rubble to pick through. The LBO model typically relies on stable growth in investment targets, and “stability” and “growth” are not words synonymous with today’s financial marketplace. Rather, the market continues to be plagued by write-downs, public-market fallout, and full-blown collapses of once-mighty institutions. It’s no wonder that LBO deals in the sector have fallen on a percentage basis. At press-time, 35 of the 671 closed deals sponsored by U.S. firms in 2008, or 5.2 percent, counted as financial services deals, down from 74 of the 1,042 closed deals, or 7.1 percent, last year, according to data from Thomson Reuters, publisher of Buyouts.

But even at that depressed deal pace, buyout firms are still likely to invest at least $31 billion in the financial services sector over the next few years, led by such old hands in the sector as J.C. Flowers & Co., Lovell Minnick Partners, and Warburg Pincus. No doubt many financial services providers can use the money.

“The industry itself may need up to half a trillion dollars in new equity capital, and it’s either going to come from taxpayers or private capital sources,” said Tom Chen, a managing director and head of the financial institutions group at investment bank Piper Jaffray. Other reasons to expect a rise in financial services deal-making include falling valuations, a rise in the number of countercyclical investment opportunities, and a rush by corporations to divest non-core financial divisions.

Further, as the market comes out of its current slump, the government, committed to taking equity in financial services companies to help stabilize the economy, is expected to become stingier with its investment capital. “We can safely assume that the taxpayers are not going to be a permanent source of that capital, and eventually that capital will have to trade over to the private sector,” said Chen. “So we remain kind of bullish on private equity’s role in financial services.”

What follows is a rundown of several sectors in the financial services industry, along with our assessment of how hot that area is likely to be for deal-making in the months ahead.

Community Banks (WARM)

With valuations down and many depository institutions in need of capital but wary of the government’s bailout program, the community banking market is ripe for consolidation. In fact, some see the number of U.S. banks dropping from 8,500 to some 5,000 over the next three to four years.

“Eighteen months ago, banks were selling at 2 to 3.5 times tangible book value, and now some of those same banks are selling at book, or 80 percent of book, or 1.2 times book,” said Richard Decker, chairman & co-founder of Belvedere Capital, a firm that specializes in acquiring community banks. San Francisco-based Belvedere Capital is raising its third fund with a target of $500 million. (Belvedere Capital is structured as a bank holding company to avoid being limited to taking non-control stakes; other firms set up as bank holding companies include CapGen Financial and Castle Creek Capital.)

True, some banks are overburdened with toxic loans and deserve their depressed valuations. It’s easy to get the timing of such investments wrong. One need look no further than TPG’s $1.5 billion minority investment in Washington Mutual, which ended in a complete loss for the firm when that bank collapsed. But many banks simply have gotten caught in the downdraft of the financial services sector, Decker said. He added that the best money a buyout firm can spend in the banking industry is on good, front-end due diligence in order to get a grasp on the real value of a bank’s holdings.

Dilligence aside, it’s easy to get the timing wrong of such investments wrong. One needs look no further than TPG’s $1.5 billion minority investment in Washington Mutual, which ended in a complete loss for the firm when that bank collapsed.

Under the Trouble Assets Relief Program, or TARP, the federal government is promising inexpensive equity capital for banks that need it. The government has a $250 billion piggy bank with which it can buy non-voting, preferred stock in banks for a 5 percent dividend. That would appear to make the government’s cost of capital much lower than that of private equity’s, and the size of the government check book is much larger.

But it remains to be seen if banks that need the equity capital are willing to take it from the government. While some may be enticed with the prospect of the inexpensive assistance, others may be turned away by the potential financial stigma of taking money from Uncle Sam, and the ‘big brother’ oversight that comes with it. Unknown at this point is whether there will be a loss of customer confidence in banks that take federal money, Decker said.

Money from a private investor does not carry the same stigma that a federal bailout does. And while their capital is more expensive, buyout firms may be viewed by customers more as business partners.

Insurance (WARM)

When it comes to insurance services, the market is ripe for building investment platforms as long as you can find a unique market niche.

Retail and wholesale brokerages, both of which rely on fee income, are generally viewed as low-risk investments with recurring revenue streams. Such insurance services tend to operate in highly fragmented markets, which provides opportunities for roll-up plays, according to a 2008 report on the financial services industry by Piper Jaffray.

Consider Genstar Capital’s recent launch of an insurance brokerage platform in January called Confie Seguros. The firm’s goal is to acquire auto insurance brokerages that serve the Hispanic consumer. After two add-on acquisitions, Confie Seguros now generates annual revenues of $75 million, while most independent brokerages with the same focus generate $15 million or less. Genstar Capital would like Confie Seguros to reach $300 million in annual revenues within the next three to five years, half of which will come from auto insurance, with the remainder coming from products like homeowner’s and life insurance.

On the underwriting side of the insurance industry, all eyes are on AIG. The insurance giant’s implosion has sent shockwaves throughout the broader industry, which are translating into declining market capitalizations among other insurers, as well as competitive price wars among underwriters looking to pick up their share of new customers. How big a role will private equity play in the breakup and disposition of the crippled insurance giant?

Buyout firms have traditionally refrained from investing in insurance underwriters due to regulations that include leverage limitations, dividend restrictions, and quarterly and annual reporting requirements, according to the Piper Jaffray report. Still, Piper Jaffray’s Chen, who helped write the report, believes that there is a place for buyout firms in the AIG breakup, although generally in partnership with strategic acquirers.

Specialty Finance (COLD)

Pity the specialty finance category, which has been hurt more by the lack of credit availability than perhaps any other segment of the financial services industry. Companies in this sector range from check cashing and pawn shops on one end, to providers of consumer and corporate finance on the other.

The biggest problem facing specialty finance companies is that they depend on securitizations, warehouse facilities and bank lines of credit in order to fund their growth. And those credit markets are not expected to open back up for a long time.

FirstLight Financial is one buyout-backed specialty finance company that’s gotten hit by the credit crisis. The Old Greenwich, Conn.-based lender is a 2006 start-up owned by business development company Ares Capital Corp. and buyout firm Catterton Partners. In March, FirstLight Financial laid off 20 employees, bringing its head count down to less than 20 people from a high of more than 60 last year. The lender also shuttered its Atlanta office in an attempt to whittle itself down while it seeks new sources of financing, sources told Buyouts in August.

“In terms of investment opportunities, specialty finance is going to be a lot more challenged on a going-forward basis than we have seen in the past, and that’s purely a function of liquidity and debt capital that is available,” said Mitchell Hollin, a partner at Philadelphia-based LLR Partners. The firm, working through its $800 million third fund, invests up to $75 million in businesses in the financial services, health care services, and information technology industries.

LLR Partners already holds stakes in a number of specialty finance companies, including Healthcare Finance Group, a specialty lender to the health care industry; Peach Holdings, a specialty finance company purchasing high-credit quality consumer assets; and Tammac Holdings Corp., a specialty lender to the manufactured home industry. “If you’ve got access to financing, then you’ve got the time frame to figure out your new business model,” Hollin said. “If you don’t have access to financing then you’ve got to change direction on a dime, and that’s a very difficult thing to do.”

A likely outcome for a number of players in the specialty finance market will be a migration to more traditional banking models. Many of these players will likely merge with bank holding companies or combine with organizations that have a built-in source of funding.

Mortgage Services (WARM)

Buyout firms continue to remain active in residential mortgage services, though most of the deal-making has been by distressed-company specialists. The residential mortgage services industry encompasses mortgage refinancing, home loans, debt consolidation and other lending services related to residential real estate.

In May, turnaround artist WL Ross & Co. acquired Option One Mortgage Corp., a provider of residential mortgage loan services, from H&R Block Inc, for an estimated $1.1 billion in cash, while rival Lone Star Funds acquired certain assets of Bear Stearns Residential Mortgage Corp. and the home lending business of CIT Group Inc. for $1.5 billion in May and July, respectively.

Bets in this sector can be risky since there are so many variables that come into play when it comes to valuing home mortgage assets. “It’s a financial asset play,” Piper Jaffray’s Chen said. “It’s clearly, buy low, sell high.” Chen added that the goal for private equity players in the mortgage market is usually to generate IRRs in the mid-20s. Firms today can buy mortgage assets at 60 cents to 70 cents on the dollar, but the lack of financing still makes it difficult to hit that hurdle.

LLR Partners, for one, is looking at financing a roll-up in the mortgage origination market over the next two years. “While that will be a challenged space right now as far as performance, if you really lay in the groundwork as you come out of this cycle, I think it would become a very valuable asset over the next four- to five-year timeframe,” Hollin said.

Asset Management (COOL)

As any general partner knows, the asset management business is one characterized by recurring revenue in the form of management fees charged on assets under management. For managers of illiquid assets, this can be a particularly attractive setup in an economic downturn since the management fees will roll in regardless of other economic forces, like consumer spending or availability of debt. On the other hand, managers of liquid assets have been on a painful ride.

Bain Capital and Hellman & Friedman have led the way when it comes to investing in asset managers. In late September the two firms agreed to acquire the Neuberger Berman division of Lehman Brothers in a $2.15 billion deal that also included Lehman’s fixed income unit and a select portion of its alternative asset management businesses. Combined, those Lehman divisions manage more than $230 billion in assets. (Buyouts is reporting in this issue that Bain Capital and Hellman & Friedman also may interested in buying AIG’s investment management unit.)

Charles Burkhart Jr., founder of Rosemont Investment Partners, a private equity firm focused exclusively on asset management investments, sees a chance that more asset managers will seek refuge in a private equity fund in today’s economic climate. While some top asset managers are still able to draw checks from the debt markets, many others are feeling the credit pinch and could become more willing to take money from other sources. “Since the financing markets are hampered right now, private equity is going to have more of a window than they normally would,” Burkhart said.

That said, Burkhart remains skeptical that the category will make up a meaningful portion of financial services acquisitions over the long haul. When asset managers need capital, he said, they are more apt to turn to the debt markets and other non-equity-owning finance solutions. That way they don’t have to give up a portion of their interest in their firm.

“Asset managers would not find private equity an attractive source of capital because it typically does not bring anything else to the table besides money and structure,” Burkhart said. “It’s very difficult for private equity [firms] to make investments in asset managers without really knowing the people and the business and being able to help them in some way.”

Meantime, buyout shops have their eyes on the fast-growing financial planning market, which should benefit from an aging population of wealthy investors whose confidence in Wall Street money managers to safeguard their money isn’t what it once was.

Financial Technology (HOT)

Regardless of subsector, financial services companies have always strived to be more nimble and competitive, and that’s a trend that continues to blow at the back of the financial technology segment.

“Companies are still pretty big spenders on technology relative to their budgets, and you often get paid a premium for technology that allows those businesses to operate more efficiently,” said LLR Partners’s Hollin.

Buyout firms of every size are involved in financial technology, from last year’s $26.8 billion acquisition of electronic transaction services provider First Data Corp. by Kohlberg Kravis Roberts & Co. to this year’s acquisition of Higher One Holdings Inc., a provider of electronic financial disbursement and payment solutions, by financial services specialist Lightyear Capital, a New York firm whose equity investments typically hit $150 million on the high end.

The financial technology sector can be divided into two subcategories: back office solutions and transaction services.

LLR’s Hollin is a believer in the latter, given the continued movement away from cash to electronic payments. In September LLR Partners teamed up with FTVentures, a growth capital investor in software companies, to acquire Fleet One, a provider of electronic financial solutions to vehicle fleets throughout the United States, from Sun Trust Banks Inc. Nashville, Tenn.-based Fleet One provides fuel card services, electronic payment authorizations and billing, financial settlement, and services to companies managing fleets of vehicles, and to the merchants that serve them.