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TABLE OF CONTENTS
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P R I VAT E E Q U I T Y I N S I G H T S
O P P O R T U N I T I E S F O R P R I VAT E E Q U I T Y
IN FINANCIAL SERVICES
2 0 0 8 U P D AT E
2008 Update
TABLE OF CONTENTS
Executive Summary...................................................................................... 2
Part I: Financial Services Market Update
Valuation............................................................................................. 6
How Did We Get Here? ....................................................................... 7
Current Outlook.................................................................................. 8
Part II: Financial Services Defined
Large and Broad .................................................................................. 9
Sizing the Market............................................................................... 10
Embedded Opportunities ................................................................... 11
Part III: Financial Services M&A
Recent Activity .................................................................................. 12
Strategic-to-Strategic Dealmaking ...................................................... 13
Private Equity Involvement ................................................................ 14
Deal Terminations and Revisions....................................................... 15
Part IV: The Investment Thesis
Overview ........................................................................................... 18
Private Equity’s Misperceptions ......................................................... 18
Focus on Intrinsic Risk....................................................................... 20
The Cycle .......................................................................................... 20
Relative Value.................................................................................... 21
What About Cashflow and EBITDA? ................................................. 22
An Undifferentiated Commodity ........................................................ 23
Value Creation Relative to Earnings Growth...................................... 24
Value Creation Relative to Book Value .............................................. 25
Impact of De-Leveraging.................................................................... 26
Keys to Success .................................................................................. 27
Part V: Summary Sub-Sector Overviews
Overview ........................................................................................... 29
Profitability and Growth.................................................................... 29
Specialty Finance ............................................................................... 30
Insurance ........................................................................................... 36
Financial Technology and Services ..................................................... 40
Depository Institutions....................................................................... 42
S&L Crisis Case Study ....................................................................... 47
Next Steps.................................................................................................. 52
Appendices: Precedent Transactions in Financial Institutions
Private Equity Buyouts....................................................................... 53
Private Equity Minority Transactions................................................. 58
Terminated Private Equity Buyouts .................................................... 60
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
1
2008 Update
EXECUTIVE SUMMARY
This paper is updated annually as part of our ongoing effort to provide thought
leadership on the subject of private equity investing in financial services. Since our
publication last summer, the financial services sector has been in what may be the
severest and broadest crisis ever. Looking forward, substantial uncertainty and
risks remain.
This, the Credit Crisis of 2007-2009, has had significant implications for private
equity and financial services companies, including:
•
unprecedented terminations of announced private equity deals;
•
negative valuation multiple variances of up to 5-sigma. Note, a 5-sigma
event is a 1 in 33,544-year occurrence;
•
a systemwide capital call to replenish asset write-downs and loss
provisions of approximately $500 billion (thus far);1 and
•
sizeable private equity investments in both public and private financial
institutions in need of capital.
Notwithstanding this crisis, the opportunities for private equity in financial services
remain compelling, requiring a firm commitment on the part of private equity
sponsors to (1) have in-house competencies to underwrite and price both financial
asset values as well as enterprise values; (2) develop an investment thesis that
recognizes the inherent cycles that exist across all sectors of financial services; and
(3) work closely with the important external constituencies that provide capital and
regulatory oversight to this evolving industry.
State of the Market
Since August 2007, financial institutions have written balance sheet values down by
approximately $500 billion. These losses and the corresponding diminution in
equity capital have, thus far, been efficiently plugged by new equity capital raises
totaling $350 billion, or roughly the after-tax amount of the losses. The sources of
this new capital have been both public (65%) and private (35%) equity investors.1
With total systemwide loss estimates ranging from $1 trillion to $2 trillion, it is
highly likely that more losses and write-downs will by taken by financial
institutions.2 More capital will need to be raised and private equity is a logical and
significant source, albeit on highly dilutive terms to existing stakeholders. Patient,
diligent and value-seeking private equity investors will be presented with a
tremendous, if not once-in-a-lifetime, investment opportunity.
Guides for the Credit Crisis
of 2007-2009
1
2
1.
Reversion to the Mean
Depository institutions, for example, are trading at a 5-sigma negative variance
from their mean price/book multiples. This is equivalent to a 1 in 33,544-year
event. Common sense, however, would suggest it is more likely that the
historical valuation environment – used to calculate the mean – was more the
outlier than the norm. Underwriting exit valuations based on historical
“normal” valuation metrics may prove to be a perilous assumption.
Source: Bloomberg LP; data as of July 31, 2008
Source: International Monetary Fund and New York University Professor Nouriel Roubini, August 2008
2 ⏐ PIPER JAFFRAY
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
2.
Work from Left to Right
Balance sheets theoretically provide a snapshot of a financial institution’s
intrinsic value. Given the uncertainty and volatility prevalent across nearly all
financial asset classes, it is impossible to rely on GAAP accounting measures to
ascertain true economic values. Asset valuation by mark-to-market analysis
must be established at the most granular level possible. It is paramount that
the economic value of the “left-hand side” of the balance sheet be established
before either capitalization levels or valuations can be determined.
3.
Permanent De-Leveraging
The de-levered state of financial institutions is likely to persist for some time.
On the one hand, the most plain vanilla of credit markets are temporarily
frozen. On the other, extinction has likely occurred for most of the esoteric
and highly structured financing products. The use of unlimited leverage is no
longer available to enhance an institution’s ROE.
Recent issuance statistics across various classes of asset-backed securities most
visibly illustrates this phenomenon.
Exhibit 1
Asset–Backed Security Issuance Down Across All Classes
(Asset–Backed Security Issuance 2006 – 2008)
($ in billions)
Home Equity
Other
Student Loans
Auto
Credit Cards
2006
$287
723
62
94
$68
$1,234
2007
$117
490
38
46
$77
$768
Annualized 2008
$1
58
21
31
$65
$175
YOY Change
(99%)
(88)
(46)
(34)
(15)
(77%)
Source: Bloomberg LP, as of July 31, 2008
4.
Calling the Bottom
Of the 14 significant equity investments in publicly traded U.S. financial
institutions announced in late 2007 and 2008, 86% are currently trading below
the price on the date of initial investment and 21% are trading down 50% or
greater.3 Volatile declines in many key financial asset classes (e.g., housing)
have created negative “feedback loops” into other financial asset classes (e.g.,
credit cards, student loans, commercial loans). Calling the bottom simply
based on an investment thesis predicated on mean reversion trends has and will
continue to be a perilous exercise.
At $19.7 trillion, the U.S. residential housing market represents the largest and
therefore most important financial asset class.4 In a sonar-like manner, home
price trends can provide an indicator of how far we are from the bottom. With
peak-to-trough estimates of national average home price depreciation ranging
from 25% to 35%, it appears that we are halfway through the Credit Crisis of
2007-2009, given the 16% decline in home prices the U.S. has already
experienced.5 On this basis, the bottom may not form until mid-2010.
3
4
5
Source: Bloomberg LP; data as of July 31, 2008
Source: Federal Reserve Board; data as of March 31, 2008
Source: S&P/Case Shiller Index
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
3
2008 Update
5.
The 3 C’s and Strategic M&A Activity
U.S. financial services M&A has historically been driven by strategic acquirors
that possessed the “3 C’s” – Capacity, Confidence and Capability. Today,
these attributes are scarce, if not non-existent, among strategic acquirors.
There has been a marked slowdown in strategic M&A activity due to lack of
capital, weak-kneed acquiror confidence and acquirors incapable of managing
their own issues, let alone successfully integrating acquisitions. Financial
services M&A volumes have declined from $214 billion in 2006 to $180 billion
in 2007. Financial services M&A continues to decline as the volume of
announced and completed transactions in the first half of 2008 stands at $65
billion against $126 billion in the first half of 2007.6
The Role of Private Equity
Since 2006, U.S. private equity funds have raised nearly $480 billion in capital.
Approximately $222 billion has been invested.7 As a result, private equity funds
have un-levered equity capacity of $258 billion of equity capital to invest. Financial
services companies and their various constituencies – regulators, lenders,
shareholders, boards of directors and management – are beginning to recognize the
value-added source of smart capital that private equity represents. Private equity
now has a seat at the table with strategic buyers when sellers embark on M&A
transactions or capital raising exercises. Capital is the “cost of goods sold” and,
more importantly, the lifeblood for most financial institutions.
New Topics
This paper contains several new topics from the 2007 version, including:
6
7
•
a review of the Credit Crisis of 2007-2009 – what caused it, its implications for
private equity and when the bottom will form;
•
a discussion of deal terminations and re-negotiations and the implications for
private equity going forward;
•
a case study of the S&L crisis and the corresponding activities of the Resolution
Trust Corporation and private equity;
•
an update on the various control-friendly structures available to private equity
in depository acquisitions; and
•
an updated list of private equity transactions in the financial services sector
since 2002, including minority investments and terminated transactions.
Source: SNL Financial, Thomson Financial and Piper Jaffray
Source: S&P, LCD, Buyouts, Private Equity Analysis and The Daily Deal
4 ⏐ PIPER JAFFRAY
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
If you would like to discuss in greater detail the role and opportunities for private
equity in financial services, we would welcome you to contact any of the following
members of the Piper Jaffray Financial Institutions Group or Financial Sponsors
Group:
Contacts
Financial
Institutions
Group
Financial
Sponsors
Group
Thomas S. Chen
Managing Director, Group Head
212 284-9585
[email protected]
Robert P. Rinek
Managing Director, Chairman
612 303-6306
[email protected]
Michael J. Gebo
Managing Director, Head of Insurance
212 284-9581
[email protected]
Nicholas N. Golding
Managing Director, Head of Financial
Technology & Services
212 284-9584
[email protected]
John M. Butler
Principal
212 284-9580
[email protected]
Valentine A. Schnell
Principal
212 284-9444
[email protected]
Jana M. Ernakovich
Principal
212 284-9597
[email protected]
Pam S. Nightingale
Principal
612 303-6753
[email protected]
Elizabeth Karger
Principal
415 277-1563
[email protected]
All information presented herein has been sourced from both proprietary Piper
Jaffray databases as well as public information sources. Additionally, all marketbased information, unless otherwise noted, is presented as of July 31, 2008.
Tom Chen, Andrew Atkins, Narendra Chokshi, David Endo and Nevin Vages from
Piper Jaffray contributed to this paper. Additionally, we would like to thank
Latham & Watkins LLP and Sidley Austin LLP for their insights and assistance.
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
5
2008 Update
PART I: FINANCIAL SERVICES MARKET UPDATE
Now entering its second year of upheaval, the financial services sector has been
caught in what may turn out to be one of the deepest, broadest and most prolonged
downturns ever. While its causes are highly circular – declining financial asset
values and the evaporation of low-cost capital and leverage to support these values
– its impact on the financial services sector has been severe and presents significant
opportunity for patient and committed private equity investors.
During this Credit Crisis of 2007-2009, financial firms have written down the
carrying value of financial assets by approximately $500 billion. These losses, and
the corresponding book value evaporation, have, thus far, been efficiently
replenished by new capital raises totaling $350 billion, or roughly the after-tax
amount of these losses. The sources of new equity capital have come from both
public (65%) and private (35%) equity investors.8
Market valuations across all sectors of financial services have significantly declined
as a result of the balance sheet write-downs, dilutive capital raises and uncertainty
over future profitability. Banks’ and thrifts’ price/book multiples are currently
trading at a five standard deviation negative variance from their historical averages.
This represents a 1 in 33,544-year statistical probability. While this environment is
certainly unprecedented, it also begs the question of whether our historical frame of
reference for expected ranges of valuation multiples is itself statistically aberrant.
Valuation
Exhibit 2
Current Price / Book Multiples vs Five Year Averages by
Sector
Price / Book Multiples
Financial Sector
Depository Institutions
5 Year Weekly Statistics
Mean
Max
Min
1 STD
2.29x
2.76x
1.55x
0.24x
Today
P / BV
σ
1.08x
-5σ
Statistical
Likelihood (1:)
33,544 years
Broker / Dealers
1.80
2.22
1.36
0.31
1.13
-2σ
5 months
P&C Insurance
1.44
1.75
1.08
0.14
1.12
-2σ
5 months
Life & Health Insurance
1.22
1.44
0.91
0.12
1.07
-1σ
22 days
Consumer Finance
2.26
3.47
0.93
0.46
1.63
-1σ
22 days
Commercial Finance
1.47
1.85
0.80
0.25
1.12
-1σ
22 days
Note: Depository institutions include the 50 largest public U.S. banks and thrifts as measured by
market capitalization. All other sub-sectors include all public U.S. companies in each of the years
between 2003 and 2007. Standard deviation is calculated based on normal distribution.
8
Source: Bloomberg LP; data as of July 31, 2008
6 ⏐ PIPER JAFFRAY
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
How Did We Get Here?
The beginnings of the Credit Crisis of 2007-2009 can be traced back to the
monetary policies adopted by the Federal Reserve in 2001 to revive the U.S.
economy from recession and the bust of the dot-com bubble. The Federal Reserve
rapidly reduced the fed funds rate from its then peak of 6.5% in May 2000, to 1% in
June 2003, a reduction of 550 bps. Declining interest rates and the increase in
liquidity, inflated prices of financial assets in turn, driving down asset yields.
On the financing front, credit spreads declined significantly, making it easier to
borrow and achieve high leverage levels, even for risky investments. With low asset
yields and the availability of cheap credit, market participants used leverage and
unwieldy structured financing vehicles to enhance returns.
An unsustainable vicious credit cycle was created as the use of leverage drove asset
valuations even higher as excess capital was chasing too few assets. This depressed
yields further and, thus, the cycle began again. At the same time, the
macroeconomic environment was strong, with low core inflation, strong GDP
growth and low unemployment levels.
Exhibit 3
2001 – 2004 Asset Inflation Cycle
Fed Rate Cuts 2001-2004
Date
2001:
Fed Funds
Jan 3
Jan 31
Mar 20
Apr 18
May 15
Jun 27
Aug 21
Sep 17
Oct 2
Nov 6
Dec 11
2002: Nov 6
2003: Jun 25
2004: Jun 30
6.00%
5.50%
5.00%
4.50%
4.00%
3.75%
3.50%
3.00%
2.50%
2.00%
1.75%
1.25%
1.00%
1.25%
Delay
33 wks
4 wks
8 wks
4 wks
4 wks
6 wks
8 wks
4 wks
2 wks
5 wks
5 wks
47 wks
33 wks
53 wks
DECLINING
RISK
PREMIA
RISING
ASSET
PRICES
LEVER
UP!!
• Low Core Inflation
• Strong Growth
• Low Unemployment
REACH
FOR MORE
YIELD
GREATER
RISK
TAKING
The impact of this cycle was evident in both institutional and consumer financial
asset classes. For example, corporate leveraged buyout volume peaked at $189
billion in 2007, and aggressive mortgage products, such as Alt-A loans and Pay
Option ARMs, allowed individual consumers to lever up as well.9
9
Source: S&P Leveraged Buyout Review
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
7
2008 Update
Current Outlook
In short, the current credit environment, characterized by massive de-leveraging, is
the perfect mirror image of the 2001-2004 asset inflation cycle. Monetary policy,
asset valuations and the macroeconomic environment are again undergoing a
cyclical spin, only this time in the opposite direction.
Exhibit 4
Reversal Into Asset Deflation Cycle
Fed Rate Increases 2004-2007
8 ⏐ PIPER JAFFRAY
Date
Fed Funds
2004: Aug 10
Sep 21
Nov 10
Dec 14
2005: Feb 2
Mar 22
May 3
Jun 30
Aug 9
Sep 20
Nov 1
Dec 13
2006: Jan 31
Mar 28
May 10
Jun 29
2007: Sep 18
1.50%
1.75%
2.00%
2.25%
2.50%
2.75%
3.00%
3.25%
3.50%
3.75%
4.00%
4.25%
4.50%
4.75%
5.00%
5.25%
4.25%
Delay
6 wks
6 wks
7 wks
5 wks
7 wks
7 wks
6 wks
8 wks
6 wks
6 wks
6 wks
6 wks
7 wks
8 wks
7 wks
7 wks
64 wks
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
DECLINING
ASSET
PRICES
LEVERAGE
REDUCED!!
• Large Write-Downs
• Declining Growth
INCREASING • Higher Unemployment FLIGHT
TO
RISK
SAFETY
PREMIA
NEED
FOR
LIQUIDITY
AND CAPITAL
2008 Update
PART II: FINANCIAL SERVICES DEFINED
Large and Broad
Financial services is a large and broad sector, with total U.S. and global market
capitalizations of approximately $2.8 trillion and $17.7 trillion, respectively.
Financial services is among the largest industry sectors within the S&P 500,
representing 17.3% of the index, behind technology (17.8%) and energy and power
(17.4%). In 2007, public U.S. financial services companies accounted for
approximately $181 billion of annual after-tax earnings, or 24% of total U.S.
corporate earnings.10
Financial services companies range from highly capital-intensive businesses to
transaction-focused service providers and can be segmented into six key sub-sectors
as shown below:
Exhibit 5
Financial Services Sub-Sector Spectrum
Capital-Intensive:
• Spread Income
• Credit-Sensitive
• Ratings/Capital
Dependent
Specialty
Finance
• Consumer
Finance
• Banks
• Thrifts
• Mortgage
Banking
• Credit Cards
• Commercial
Finance
• Leasing
• Debt
Collections
• Underbanked
10
Depository
Institutions
• Industrial
Loan
Companies
(ILCs)
• Special
Purpose
Credit Card
Banks
Transaction-Focused:
• Fee Income
• Recurring Revenues
• Highly Leverageable
Insurance
Broker-Dealers
Asset
& Trading
Management
Services
• Property &
Casualty
• Brokerage
• Health
• Stock
Exchanges
• Investment
Banks
• Life & Annuity
• Brokerage
• Third-Party
Administrators
• Commodities
Exchanges
• Trading
Support &
Services
Financial
Technology
• Mutual Fund
Managers
• Payment
Processing
• Institutional
Managers
• Financial
Transaction
Processing &
Outsourcing
• Alternative
Investment
Managers
• Wealth
Advisors
• Private
Banking
• Financial
Software &
Infrastructure
• Securities
Processing &
Technology
• Exchanges and
Trading
Services
Source: FactSet, Capital IQ and Piper Jaffray
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
9
2008 Update
Sizing the Market
Framing the financial services private equity investment thesis begins with an
understanding of both the number and size of companies involved.
Exhibit 6
Sizing the U.S. Financial Services Sector: Public
Companies
(Total Market Capitalization and Number of Public Companies)
($ in billions)
Market Capitalization
July 31, 2007
July 31, 2008
Percentage
Change
Specialty Finance
$278
$126
(55%)
Depository Institutions
1,445
1,004
Insurance
1,167
Broker-Dealers & Trading Services
Current
Mean
Number of
Market Cap. Companies
$1.1
112
(31)
0.7
1,371
867
(26)
4.6
188
370
288
(22)
4.5
63
Asset Management
133
159
19
4.9
32
Financial Technology
234
299
28
3.0
101
$3,628
$2,743
$1.5
1,867
Total
(24%)
Source: SNL Financial and Piper Jaffray
Over the past year, the aggregate market capitalization of U.S. financial services
companies has declined by $874 billion, a 24% decrease.
While the depository and insurance sub-sectors have lost 31% and 26% of their
market capitalization respectively, the specialty finance sector has suffered the
most, with a loss of 55% of its market capitalization.
The financial technology sub-sector’s market capitalization is higher as a result of
the IPO of Visa Inc. Adjusting for the Visa IPO, the total market capitalization of
the financial technology sub-sector is down 2% year-to-date.
10 ⏐ PIPER JAFFRAY
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
The private financial services sector is also robust and largely represents early-stage
companies. The exhibit below summarizes our estimates of the size of various
financial services sub-sectors.
Exhibit 7
Sizing the U.S. Financial Services Sector: Private
Companies
(Number of Private Companies)
Number of
Private Companies
Sub-Sector
7,091
Depository Institutions
Specialty Finance
~ 1,200
Insurance
~ 3,000
Financial Technology
~ 2,000
Source: Federal Deposit Insurance Corporation, National Association of Insurance Commissioners and
Piper Jaffray
Embedded Opportunities
It is worth noting the presence of financial services subsidiaries or divisions within
other industry sectors, such as manufacturing and retailing. These embedded
opportunities provide a potential source of financial services deal flow. Examples
include:
Exhibit 8
Financial Services Embedded Opportunities
Retailing
Manufacturing
•
Captive Finance
•
Captive Finance
•
Leasing
•
Sales Finance
•
Commercial Finance
•
Credit Cards
•
Auto Finance
•
Mortgage
•
Inventory / Floorplan Finance
•
Life Insurance
•
Warranty
•
Warranty
•
Depository (ILCs)
•
Depository (ILCs)
Recent and notable private equity acquisitions of embedded financial services
businesses include:
•
the sale of AMR Corp.’s asset management unit, American Beacon Advisors, to
Pharos Capital and TPG Capital for $480 million in April 2008;
•
the partial sale of General Motors’ finance arm, General Motors Acceptance
Corp. to Cerberus Capital Management for $7.4 billion in April 2006; and
•
the sale of Ford Motor Company’s Triad Financial to a consortium including
GTCR Golder Rauner and Goldman Sachs & Co. in December 2004.
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
11
2008 Update
PART III: FINANCIAL SERVICES M&A
Recent Activity
Consistent with its massive size, financial services has been one of the most active
sectors in the M&A deal economy, comprising 12% of overall announced U.S. deal
volume in 2007.
Exhibit 9
2007 U.S. M&A Activity
(Aggregate Deal Value of Announced Transactions by Sector and Financial Services Sub-Sector)
Financial Services
Sub-Sector
Depository Institutions
Financial Technology
Specialty Finance
Asset Management
Broker-Dealers
Insurance
Materials
9%
Industrials
7%
Technology
11%
Real Estate
9%
Financials
12%
Consumer
16%
Media and
Entertainment
Telecom
9%
4%
Healthcare
10%
2007
Volume
Number of
($ billions)
Transactions
$67
377
41
43
3
189
29
265
13
105
26
382
Totals
Energy and Power
13%
$180
1,361
Total M&A Volume
$1.42 Trillion
Source: SNL Financial, Thomson Financial and Piper Jaffray
Note: Excludes all terminated and asset transactions.
Exhibit 10
U.S. Financial Services M&A
(Aggregate Deal Value and Number of Announced Transactions)
2,000
$250
$176
$181
$186
1,271
$121
1,006
889
885
793
1,600
$180
1,400
$150
$100
1,800
$214
$200
1,361
1,200
1,000
1,065
800
798
$65
$61
278
200
0
$0
2000
2001
2002
2003
2004
2005
Source: SNL Financial, Thomson Financial and Piper Jaffray
Note: Excludes all terminated and asset transactions.
12 ⏐ PIPER JAFFRAY
600
400
$50
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2006
2007
1H 2008
Number of Transactions
Aggregate Deal Value ($ in billons)
$221
2008 Update
Strategic-to-Strategic
Dealmaking
Until recently, financial services M&A has been almost exclusively the domain of
“strategic-to-strategic” deals. The four key factors that have historically driven
strategic M&A activity are currently in a polar state, suggesting very limited M&A
activity levels.
Four Key Drivers of Strategic M&A
Then (Active)
1.
The U.S. depository sub-sector is
fragmented as a result of historical
regulatory barriers and in-market regional
biases. There are currently more than 8,400
banks and thrifts in the U.S., down from
11,462 in 1992.11
2.
Technological Improvement and
Innovation
Technology has enabled financial services
companies to operate more efficiently.
Consequently, the quest for economies of
scale and scope has been a significant driver
of M&A and consolidation.
11
12
Under Capacity
While the U.S. continues to be one of the
most fragmented banking markets in the
world, strategic buyers no longer have the
capacity to acquire other depositories or
other financial institutions due to lack of
their own financial capacity and
wherewithal.
2.
Re-Regulation
A likely outcome of the Credit Crisis of 20072009 will be a reversal of deregulation trends.
This stems from policy shifts to provide
additional protections to consumers and
borrowers such as the Federal Housing
Finance Regulatory Reform Act of 2008.
Institutional changes are also likely as
governmental support and bailouts to
historically non-protected sectors will likely
require future regulation and oversight.
Broker-dealers, which recently were granted
emergency access to the Fed discount
window, will likely be regulated in a fashion
similar to their brethren depository
institutions.
Globalization – Strategic Deals
Cross-border M&A in financial services
increased from 7% of announced deal
volume in 1995 to 17% in 2007.12 European
institutions in particular are looking to the
U.S. for growth, product competencies and
new distribution channels.
4.
1.
Deregulation
Deregulation only began in earnest in the
mid-1990s. The Gramm-Leach-Bliley Act of
1999 (repeal of Glass Steagall) enabled
combinations of depository institutions with
insurance and securities companies. The
Riegle-Neal Act of 1994 enabled interstate
banking, prior to which depositories were
highly restricted from operating multi-state
branches.
3.
Now (Dormant)
Excess Capacity
3.
Globalization – Bailout Deals
Asian and Middle-Eastern sovereign wealth
funds have played an active role in providing
capital to U.S. financial institutions in the
current credit crisis. The sovereign wealth
funds are seeking sizeable investments in
brand-name companies in the U.S. financial
sector at significant discounts. We currently
estimate that sovereign wealth funds have
approximately $3 trillion in capital.
4.
Simplicity in Financial Products
There has been a marked reversal in the use
of complex financial products in the financial
markets as market participants move toward
adopting simpler financial products that are
easier to understand and value and have
relatively liquid markets.
Source: Federal Deposit Insurance Corporation
Source: Thomson Financial
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
13
2008 Update
Private Equity Involvement
As shown in Exhibit 11, of the $388 billion of announced private equity buyout
volume in 2007, $50 billion, or 13%, involved financial services companies.
Exhibit 11
2007 Aggregate U.S. Private Equity Deal Volume by
Sector
(All Announced Transactions)
Media and
Entertainment
Healthcare 11%
Energy and Power
8%
1%
Real Estate
2%
Telecom.
12%
Consumer
25%
Asset
Management
16%
Financial Services
12%
13%
High Technology
12%
Materials
7%
Industrials
10%
Depository
Institutions
1%
Specialty Finance
5%
Insurance
12%
Total PE Buyout Volume:
Total PE FIG Buyout Volume:
$388 billion
$50 billion
Source: SNL Financial, Thomson Financial and Piper Jaffray
Note: Excludes all terminated and asset transactions.
14 ⏐ PIPER JAFFRAY
Financial
Technology
66%
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
Exhibit 12
M&A Involvement by Private Equity
(Comparative Announced Deal Volume)
$500
Financial Services Private Equity Deal Volume
All Private Equity Deal Volume
$450
$433
All Financial Services M&A
$388
Aggregate Deal Value ($ in billions)
$400
$350
$300
$250
$221
$214
$200
$122
$95
$100
$0
$180
$144
$150
$50
$186
$181
$175
$50
$26
$2
$0
2000
2001
$61
$44
$5
$1
2002
$50
$45
$22
$4
2003
2004
$21
2005
$65
$47
$19
2006
2007
1H 2008
Financial Services PE as % of:
All Private Equity Deals
4.9%
2.0%
2.9%
10.1%
4.1%
15.0%
4.8%
12.9%
40.4%
All Financial Services M&A
1.1%
0.0%
2.1%
2.6%
2.2%
11.6%
9.7%
27.8%
29.2%
Source: Thomson Financial and Piper Jaffray
Deal Terminations and
Revisions
The collapse of the credit markets in the latter half of 2007 and deteriorating
market and business conditions for financial services companies left many private
equity acquirors renegotiating, restructuring or terminating pending acquisitions.
Private equity acquirors asserted that a “material adverse change” had occurred and
utilized that provision as the basis for renegotiation or termination. In other
situations, acquirors used reverse termination fee provisions to simply walk away
from deals where no MAC was claimed.
These front-page war stories and the continued volatile market conditions have
heightened the attention of sellers and their boards to the meanings of these and
related provisions in merger agreements. Further, the re-emergence of adverse
market change provisions for the benefit of financing providers, also known as
“Market MACs,” created additional uncertainty for transactions requiring
significant external financing. Given the ongoing market dislocation, changing
market dynamics and evolving regulatory developments within financial services,
private equity acquirors are well served to aggressively negotiate and structure
MACs and other similar provisions, with specific risks – on a company-specific
basis – clearly accounted for.
MAC clauses are intended to provide a backstop that protects a buyer against the
occurrence of unknown events prior to closing that would substantially threaten the
earnings and economic potential of the target. The specific provisions within a
MAC clause allocate the risk of general or specific adverse events during the period
from agreement to transaction closing between the acquiror and the target. With
the increased focus on these provisions, the specific risks (e.g., market, industry,
regulatory and closing) that are excluded from MAC clauses and the definition of
the magnitude of adverse event required to trigger a MAC (for example,
“disproportionate” versus “materially disproportionate” industry changes in the
Sallie Mae transaction) are important negotiating and drafting points.
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
15
2008 Update
Given the limited case law on MACs, it is not possible to solely rely on MAC
provisions to provide for a specific economic outcome. Rather, MACs provide a
qualitative test that, when asserted may result in either the renegotiation or
termination of the transaction, depending on buyer and seller interests and relative
negotiating strengths. In recent financial services deals, the assertion or threat of
assertion of a MAC has more often resulted in the outright termination of the
transaction. This is more likely due to the severity of declines in company
performance and profitability than an indictment of the effectiveness of MACs.
Recent financial services transactions where a MAC claim was made are detailed in
the following exhibit.
Exhibit 13
Private Equity/Financial Services Transactions With a
MAC Asserted
(MAC Related Transactions)
Date
Closed
Original
Deal Value
($ in millions)
Issue and
Resolution
Target
Acquiror(s)
Accredited
Home
Lenders
Lone Star Funds
$400
Subprime mortgage, leveraged
loan and high yield credit
markets deteriorate. Acquiror
seeks to terminate the deal.
Accredited files lawsuit
against acquiror seeking to
have the merger agreement
enforced. Both parties settle
with acquiror agreeing to pay
$311 million.
Terminated Acxiom
Corp.
Silver Lake Partners,
ValueAct Capital
Management
2,200
Acxiom reports a net loss for
Q2 2007. Parties enter into
discussions to break off the
buyout and settle. Acquiror
settles and pays $65 million, or
half the reverse termination
fee. Other half paid by the
financing banks.
Terminated SLM Corp.
(“Sallie
Mae”)
JC Flowers & Co.,
Friedman Fleischer &
Lowe, Bank of
America Corp.,
JPMorgan Chase &
Co.
25,537
Private equity consortium
proposes to renegotiate the
deal due to pending
legislation. SLM Corp. sues to
terminate and collect the $900
million reverse termination
fee. Consortium files
counterclaim seeking
declaratory judgment.
Litigation eventually
abandoned by SLM Corp.
10/2007
Source: SNL Financial, Thomson Financial and Piper Jaffray
Another increasingly exercised contract provision is a reverse termination fee that
permits acquirors to pay a lump sum to walk away from the transaction regardless
of the existence of a MAC. If structured properly, reverse termination fee provisions
can provide private equity buyers with what is effectively an option to terminate the
transaction. The inclusion of reverse termination fees in transaction structures can
be beneficial to both buyer and seller. For buyers, the reverse termination fee sets an
upper bound for the maximum damages that a prospective acquiror is exposed to
and can mitigate the risk of nonperformance due to something less significant than a
16 ⏐ PIPER JAFFRAY
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
MAC. For sellers, a reverse termination fee can provide more expedient and certain
recourse than litigation in the event of buyer nonperformance.
Reverse termination fee claims are typically made in concert with the exercise of a
MAC provision. In the recent cases detailed above, the payment of a reverse
termination fee was the ultimate outcome of those MAC claims that ultimately led
to the termination of the deal. In other cases, private equity firms have exercised
walk-away rights and asserted a MAC claim to avoid payment of the reverse
termination fee altogether. The assertion of a MAC can also provide acquirors with
extra time to assess the changing dynamics of the transaction before ultimately
renegotiating or terminating the deal. Certain recent transactions have included a
two-tier structure for reverse termination fees, with a lower percentage of the
transaction value if the buyer walks away as a result of certain conditions, such as
the inability to secure financing, and a higher percentage of the transaction value for
terminating the deal without specific cause.
Exhibit 14 highlights recent financial services transactions in which the acquirors
terminated the transaction by paying a reverse termination fee.
Exhibit 14
Terminated Private Equity/Financial Services
Transactions With a Reverse Termination Fee Claimed
(Financing/Regulatory Related Transactions)
Date
Announced
Target
Acquiror(s)
Original
Deal Value
($ in millions)
Issue and
Resolution
3/2007
PHH Corp.
GE Capital Solutions,
The Blackstone
Group
$434
Banks unwilling to provide
financing under originally
agreed terms. Acquiror settles
and pays PHH Corp. a $50
million reverse termination fee.
5/2007
Alliance Data
Systems Corp.
The Blackstone
Group
6,755
Acquiror cites onerous
regulatory conditions placed
on it. Alliance Data Systems
terminates the merger
agreements and litigates for the
$170 million termination fee.
Source: SNL Financial, Thomson Financial and Piper Jaffray
Going forward, MAC clauses and reverse termination fees are likely to continue to
be utilized as complementary bailout provisions. Consequently, the structure of
both provisions in deal agreements will be more closely scrutinized, heavily
negotiated, and tightly drafted with clear definitions and exclusions. Buyers and
their counsel should exercise caution to ensure that reverse termination provisions
do not conflict with other provisions, such as specific performance or equitable relief
provisions. MAC clauses, while difficult to enforce, will continue to provide value
for acquirors for as long as significant market, industry and regulatory uncertainty
and volatility persist. The optionality provided by reverse termination fees,
particularly those that are broadly constructed, provides valuable additional deal
insurance for situations where adverse events do not rise to the level of a MAC.
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
17
2008 Update
PART IV: THE INVESTMENT THESIS
Overview
There are no special, secret or particularly complex strategies to developing a
successful financial services investment thesis. Growth and profitability are very
simply the two key drivers of value between acquisition and exit.
The fundamental tenets to a successful financial services investment strategy are
very similar to that of any other sector.
Exhibit 15
Common Investment Tenets
Private Equity’s
Misperceptions
1.
Find, incentivize and retain experienced management.
2.
“Over-study” the sub-sector and understand the near-term trends in the context
of historical cycles and expected macro trends.
3.
Buy “right” and do not buy into growth alone.
4.
Have a clear vision before investing of what and when the exit will be.
5.
Do not rely upon leverage alone – run scenarios on an unlevered return basis to
understand the sources of value creation.
6.
Work outside the box by being creative in structuring, pricing, financing and
exiting the investment.
Why have private equity sponsors avoided such a large opportunity as financial
services? Many funds have simply enjoyed robust deal opportunities in traditional
buyout sectors, such as manufacturing and retail, and have underinvested in
developing the requisite competencies and, consequently, deal flow in financial
services.
Financial services is uniquely esoteric and complex, given its regulated and capitalintensive nature. Multiple governmental and self-regulatory bodies as well as
multiple legal jurisdictions add to the regulatory complexity. Sector-specific
accounting practices compound the specialization required to invest in financial
services, particularly with respect to specialty finance and insurance companies.
Also, as many financial institutions are inherently highly levered, traditional LBO
structures simply may not work. Thus, returns from financial engineering may be
limited or non-existent. While there are indeed impediments to investing in
financial services (as there are with all industry sectors), many such impediments
are merely misperceptions or require a deeper understanding of evolving industry
and regulatory trends.
18 ⏐ PIPER JAFFRAY
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
Exhibit 16 highlights four of the most common misperceptions:
Exhibit 16
Four Misperceptions and Realities
Misperceptions
Realities
1.
Prohibitively
Regulated
It Just Takes Some Thought and Creativity
•
The regulatory environment is evolving, facilitating the
possibility of private equity ownership of depository
institutions. Some of the most innovative acquisitions of
depository institutions have been by private equity firms.
•
Specialty finance, insurance, asset management, brokerdealers and exchanges generally all have regulatory
elements that require careful attention but are not
prohibitive.
2.
Inability to
Use Financial
Leverage
Acquisition Leverage Not a Prerequisite for Returns
•
Most financial institutions are already highly levered, with
existing leverage ranging from 4:1 to 10:1 and higher.
Traditional leveraged buyouts are consequently difficult.
•
IRRs in the 20% to 30%+ range can be generated in
financial services without traditional buyout acquisition
leverage.
3.
Too Much
Capital Is
Required
Manage Growth Judiciously
•
Growing a business in financial services must be balanced
against liquidity and capital generation. Marginal ROE
contribution and capital formation rates need to be
carefully factored into deal modeling.
•
Most of the spectacular failures in financial services have
resulted from mismanaging the balance among growth,
liquidity, credit quality and capital.
4.
Can’t Win
Against
Strategics
Strategics Are Your Best Friend
•
With the collapse of the credit markets and the resultant
decline in asset values, strategics are consumed by capitalraising efforts to strengthen their financial position and
restructure their own struggling operations in order to
survive the crisis.
•
Consequently, strategics are too pre-occupied to compete
with private equity players in purchasing attractive
financial services businesses. Further, this situation is
likely to prevail for at least another 12 to 18 months as
strategics continue their house cleaning.
•
In fact, strategics are more likely to be net sellers of
businesses in this environment, creating an even better
buying environment for private equity players in the
financial services space.
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
19
2008 Update
Focus on Intrinsic Risk
Financial services companies are unique, as secondary markets exist for many of the
financial risks that are processed through their businesses. From time to time, these
secondary markets become dislocated, causing temporary volatility in a financial
institution’s assets or liabilities or both. Earnings consequently become impacted
and going-concern values are potentially impaired. Significant opportunities for
private equity exist in these dislocation situations, as sponsors can bring the
necessary patience, capital and management expertise.
Exhibit 17
Intrinsic Risks
(Examples in Financial Institutions and Secondary Markets)
Financial Risk Types
•
Credit
The Cycle
20 ⏐ PIPER JAFFRAY
Examples
Commercial, consumer and
counterparty
Secondary Markets
Credit default and structured
finance markets
•
Liquidity
Mismatch between assets
and liabilities
Whole loan, asset and
portfolio transactions
•
Interest Rate
Yield, duration, convexity
and asset/liability impact
Interest rate derivatives,
swaps and caps
•
Market Value
Long/short, basis (relative
values) and collateral
Commodity, currency, and
equity derivatives and futures
•
Underwriting
Catastrophe, casualty,
mortality and credit
Reinsurance
•
Operational
Scale, efficiency and quality
Sub-servicing and
outsourcing relationships
Cyclicality in financial services provides periodic buying and selling opportunities
for private equity and occurs at the intrinsic financial risk level. Thus, the challenge
for private equity is to understand the timing of such cycles and how such
cyclicality manifests itself at the enterprise value level so that buy and sell decisions
may be made. A good example of this cyclicality is in the P&C insurance sector in
terms of pricing and profitability.
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
Exhibit 18
P&C Insurance Cycle
(Premium Growth and Underwriting Margin)
16%
35%
Premium Growth
14%
30%
Underwriting Margin
25%
10%
20%
8%
15%
6%
10%
4%
Underwriting Margin
Premium Growth
12%
5%
2%
0%
0%
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Source: A.M. Best and Piper Jaffray
Note: The underwriting margin is based on calendar year statutory combined ratio for all U.S. P&C
insurance companies.
Relative Value
From a valuation perspective, examining historical price-to-book multiple trends
can highlight the theoretical min/max boundaries under “normal” market
conditions. However, due to the Credit Crisis of 2007–2009, certain financial
services sectors are currently trading at large standard deviations from historical
price-to-book multiples. Depository institutions are trading at valuations that are
“5-sigma” from their recent 5-year historical mean. Potential investors should
question the relevance of recent history and the likelihood that market valuations
will return to these historical ranges in the foreseeable future.
Exhibit 19 illustrates the observed price-to-book peak and trough multiples based
upon a 1σ to 2σ range (a 95% confidence interval) around the mean for the past
five years.
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
21
2008 Update
Exhibit 19
Range of Historical Multiples
(Distribution of 5-Year Weekly Historic Price-to-Book Multiples)
-2σ -1σ
_
x +1σ +2σ
68%
95%
Current Price/Book
Multiple
+/- 2σ Price / Book Dispersion
1.8x 2.1x 2.3x 2.5x 2.8x
1.1x
Depository Institutions
1.4x
1.8x
Consumer Finance
1.0x 1.2x 1.5x
2.3x
2.7x
3.2x
1.6x
1.7x 2.0x
1.1x
Commercial Finance
1.2x 1.3x 1.4x 1.6x 1.7x
1.1x
P&C Insurance
1.0x1.1x1.2x1.3x1.5x
Life & Health Insurance
1.1x
Source: SNL Financial, Capital IQ and Piper Jaffray
Note: Depository Institutions includes the 50 largest public U.S. banks and thrifts as measured by
market capitalization. All other sub-sectors include all public U.S. companies in each of the years
between 2003 and 2007.
What About Cashflow and
EBITDA?
Financial services sub-sectors such as asset management and financial technology fit
neatly into traditional LBO frameworks given their free cashflow generation and
capital-light balance sheets. Other sub-sectors are much more capital-intensive,
including depository institutions, specialty finance companies and insurance
companies. In these instances, traditional EBITDA metrics and free cashflow to
firm concepts become less relevant, if not completely meaningless. Rather, it is
more meaningful to analyze free cashflow to equity after setting aside cashflow to
fund growth. Despite financial services firms being regular dividend payers,
observing cashflow available for dividends is more meaningful than observing
actual dividends paid. This distinction becomes evidently clear in the current
market environment where financial services firms continue to pay dividends
despite shortages of capital.
Capital and interest expense are essentially a financial institution’s cost of goods
sold, considering that cash is the primary raw material. Consequently, cashflows
generated by a financial institution are not always “free” and must be recycled to
create the next vintage of products, assets and earnings. Financial institutions
generate very little unlevered free cashflow available to support either upfront
acquisition leverage or dividends for future leveraged recapitalizations. The bulk of
a financial institution’s cashflows are never truly “free” until the accumulated
cashflow balances (book equity) are monetized through a sale or liquidated in a
run-off.13
13 Note that accumulated cashflows and GAAP book value are typically divergent, as many accounting principles – namely, revenue recognition and matching – can create significant
differences between a financial institution’s cash (economic) and GAAP performance.
22 ⏐ PIPER JAFFRAY
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
As financial institutions grow – assets are increasing – capital must be retained to
meet leverage limitations set forth by regulators, rating agencies and lenders.
Consequently, unless a target is overcapitalized it would be difficult to put
meaningful acquisition leverage on top of existing operating leverage, and dividends
supportable by free cashflow would be limited or even negative.
Exhibit 20 illustrates the value creation cycle in financial services buyouts.
Exhibit 20
Financial Services Value Creation Cycle
(Capital Is Recycled to Support Growth)
YEAR 3
EXIT
YEAR 5
$
$
$
RETURN ON
INVESTMENT
$
CUSTOMER
(BORROWER/
INSURED)
YEAR 4
YEAR 2
Some Dividend Capacity:
• Availability dependent
upon target capital
levels and future
growth needs
REINVESTMENT/
GROWTH
PROFIT
IPO / SALE
INITIAL INVESTMENT
YEA
R1
Source: Piper Jaffray
In certain limited instances, private equity can look to the structured finance
markets to borrow against unencumbered financial assets such as mortgage whole
loans, student loan pools, lease receivables and servicing rights.
An Undifferentiated
Commodity
Generally speaking, financial engineering is an undifferentiated commodity “skill”
in private equity deals. Financial services buyouts will require private equity
sponsors to look beyond return opportunities created solely by leverage. Since
acquisition leverage cannot typically drive returns when investing in financials,
careful attention must be paid to other drivers of value, including:
•
the upfront acquisition multiple paid;
•
implementation of operational efficiencies or product enhancement initiatives
to accelerate growth and capital formation rates (i.e., ROE acceleration into
book value accretion); and
•
a higher exit multiple derived from operational and managerial improvements
and/or any cycle arbitrage that may exist due to changing perceptions and
market conditions from the time of acquisition to the time of exit.
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
23
2008 Update
Exhibit 21 illustrates the potential unlevered return opportunities (IRR basis) with
these value drivers in mind:
Exhibit 21
5-Year Unlevered IRRs
(IRRs Generated by Book Multiple Expansion and ROE)
VALUE CREATION
Improve Efficiency and Growth in Operations
Return on Equity
Buy Right,
Time the
Cycle, and
Increase
Profitability
and Growth
Price/Book
Multiple
Expansion
(Over Entrance
Multiple)
12%
14%
16%
18%
20%
0%
12%
14%
16%
18%
20%
20%
16%
18%
20%
22%
24%
40%
20%
22%
24%
26%
28%
60%
23%
25%
27%
30%
32%
80%
26%
28%
30%
33%
35%
100%
29%
31%
33%
36%
38%
Note: Return on equity shown as a constant return.
Note that these returns compare to top-quartile buyout returns of 17% to 20% for
seasoned funds.14
Value Creation Relative to
Earnings Growth
We examined the earnings growth characteristics of financial services companies on
three bases: (1) implied perpetuity growth rate, (2) actual historical growth and (3)
Wall Street analyst projected 5-year growth. The perpetuity growth rate is the
perpetual growth rate implied by a company’s price-to-earnings ratio and its cost of
equity (Ke). Exhibit 22 establishes that growth rates – both on a 5-year historical
and an analyst-projected basis – exceed the market-implied perpetuity growth
estimates. Financial services may be viewed as a “growth” sector when the price-toearnings ratio paid upfront supports growth premiums.
Exhibit 22
Three Formulations of Earnings Growth Expectations
(Perpetuity Growth Rates, Historical Earnings Growth and Estimated Growth Rates)
Ke
A
Implied
Perp.
Growth
Rate
Depository Institutions
13.9%
7%
11%
8%
4%
1%
Consumer Finance
14.3%
6%
16%
15%
10%
9%
Commercial Finance
11.6%
4%
6%
15%
2%
11%
P&C Insurance
10.0%
2%
10%
11%
8%
9%
Life & Health Insurance
11.4%
3%
11%
12%
8%
9%
Financial Technology
10.2%
5%
9%
15%
4%
10%
B
5-Year Growth Rate
B–A
Actual
First Call
Growth Premium
Historical
Estimated
Historical
Estimated
Source: Thomson Financial and Piper Jaffray
Note: Perpetuity growth rate is calculated using the perpetual growth model: Perpetuity Growth Rate =
Ke – (1 / P/E) with a mean current cost of equity and forward price-to-earnings ratio for each sub-sector.
Estimated 5-Year Growth Rate is the current analyst-estimated growth rate as provided by First Call.
14
Source: Venture Economics
24 ⏐ PIPER JAFFRAY
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
The resulting price/earnings to growth (PEG) ratios illustrate the relative value vs.
growth propositions across various financial services sub-sectors.
Exhibit 23
Relative PEG Ratios
8.0x
Perpetuity Growth Rate
Historical Growth Rate
Estimated Growth Rate
7.0x
6.1x
6.0x
5.0x
4.1x
3.7x
4.0x
3.2x
3.0x
1.0x
2.1x
2.0x
2.0x
1.1x 1.0x
1.2x
P&C Insurance Life & Health
Insurance
Financial
Technology
0.9x
1.1x
2.1x
1.8x
2.0x
1.3x
0.9x
0.8x 0.8x
0.0x
Commercial
Finance
Depository
Institutions
Consumer
Finance
Source: Thomson Financial and Piper Jaffray
Note: Calculated based on the mean price-to-earnings multiple on a forward 12-month basis.
Value Creation Relative to
Book Value
Price-to-book multiples represent the ratio of the present value of future profits
relative to current book value (accumulated historical profits). The expected future
profits can be measured by the expected ROE and the growth rate of earnings. This
relationship between profitability and growth forms the crux of the investment
thesis for valuing capital-intensive financial services companies. Investment
opportunities arise when either: (1) current valuations are attractive relative to
future profitability and growth, or (2) additional profitability and growth can be
generated above the market expected rates.
Exhibit 24 illustrates this relationship between growth and profitability for
depository institutions. At a Ke of 13.9%, a depository institution with an ROE of
approximately 14% and a perpetuity earnings growth rate of 4% (or any other such
combinations along the blue line) would theoretically be fairly valued at book
value. If the objective was to acquire the company at book value and achieve an
exit valuation of 2.5x book value (or achieve 2.5 times the initial investment), ROE
would have to increase to almost 28% and the perpetuity growth rate would have
to rise to 4.5%, assuming no change in the cost of equity. Of course, infinite
combinations exist along each of the price-to-book lines and this chart simply
illustrates one “Value Vector.” We believe that some form of this methodology and
logic should be integrated into all private equity investment analyses in financial
services.
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
25
2008 Update
Exhibit 24
Growth and Profitability Value Vectors
(Return on Equity, Cost of Equity and Earnings Growth Rate Relationship)
P/B = (ROE – g) / (Ke – g)
Illustrative Depository Institutions Value Creation
35%
Value
Vector
At Ke = 13.9%
Sell
P/B = 2.5x
25%
P/B = 2.0x
Profitability
Return on Equity
30%
20%
P/B = 1.5x
P/B = 1.0x
15%
Buy
Growth
10%
5%
3.0%
3.5%
4.0%
4.5%
5.0%
Perpetual Growth Rate
Source: Piper Jaffray
Impact of De-Leveraging
In the current market environment, the financial services sector is experiencing
systemic de-leveraging with the possibility in certain sectors of a permanent deleveraging. This de-leveraging, coupled with higher cost of equity (due to increased
volatility of returns) and slower earnings growth, is largely responsible for the
significant decline in the valuation of financial services companies.
Exhibit 25 illustrates the impact of de-leveraging using a typical finance company’s
market attributes. Unable to obtain leverage and with a significantly higher cost of
equity, it is no surprise that many financial institutions are trading at such steep
discounts to book value.
26 ⏐ PIPER JAFFRAY
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
Exhibit 25
The Mathematics of De-Leveraging
P/B = (ROE – g) / (Ke – g)
Today's Finance Co. Impacted by:
Yesterday's
Finance Co.
Debt / Equity
De-Leverage
Only
4:1
10 : 1
Cost of Equity (Ke)
Perpetuity Growth (g)
ROE
(1)
De-Leverage, Higher
Ke and Lower Growth
4:1
(1)
15.00%
15.00%
20.00%
5.00%
5.00%
3.00%
20.00%
11.57%
11.57%
P / B = 1.50x
P / B = 0.66x
P / B = 0.50x
Source: Piper Jaffray
(1) Assumes pre-tax cost of debt of 7% and tax rate of 35%
Keys to Success
McKinsey & Company found that the primary sources of value creation by leading
private equity firms were company out performance (63%), market/sector
appreciation and financial leverage (32%), and arbitrage (5%). Based on their
survey, five leading edge practices were found to deliver “company out
performance” in traditional buyouts.15
Exhibit 26
Leading-Edge Practices
1.
Seek out expertise and secure “privileged” knowledge.
2.
Institute substantial and focused performance incentives for management.
3.
Be skeptical of and challenge management’s plan. Continually review,
challenge and revise it.
4.
Devote more time to the initial stages of a deal. Meet daily with management
to reach consensus on strategic priorities, build relationships and detail
personal responsibilities.
5.
Change management and strengthen the management team before closing if
necessary. Later in a deal’s life, use external support to complement existing
management.
Source: McKinsey & Company
15
The McKinsey Quarterly, 2005 Number 1, “Why Some Private Equity Funds Do Better Than Others,” Joachim Heel and Conor Kehoe.
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
27
2008 Update
Exhibit 27 shows an adaptation of these performance practices for financial services
investing.
Exhibit 27
Adapted Practices for Financial Services
28 ⏐ PIPER JAFFRAY
1.
To fully capitalize on the opportunities available, private equity funds will need
to first invest in intellectual capital. Few funds today have specialized industry
expertise dedicated to financial services. Most funds will generally assign a
partner or managing director to cover financial services as part of a portfolio of
several industries. This organizational structure does not provide the specific
intellectual capital required to source, structure, monitor and exit financial
services investments.
2.
Leverage the vast network of management talent and information that exists as
part of a consolidating and regulated industry. There are many good
management teams that have been merged out of a job and are available to
private equity sponsors.
3.
Don’t set management incentive compensation simply around traditional
metrics such as earnings or earnings growth. Risk-adjusted margins, static pool
performance and capital-normalized earnings are examples of performance
metrics that more directly correlate to value creation.
4.
In upfront modeling and due diligence, focus beyond the going-concern
numbers. Again, the intrinsic value of the financial services company’s
financial risk must be understood and valued.
5.
Double the typical upfront due diligence effort in financial services
acquisitions. Often, the majority of the value is the current book of business,
represented by tangible book value. A thorough mark-to-market of the balance
sheet, with the appropriate stress tests, needs to be performed to confirm book
value. Accounting complexities are likely to cause significant GAAP-versuscash differences, which will materially impact economic value.
6.
Change and strengthen the management team before closing if necessary. Later
in a deal’s life, use external support – including the board of directors, advisors,
consultants and bankers – to continue to refine and shape the company’s
strategic and financial priorities.
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
PART V: SUMMARY SUB-SECTOR OVERVIEWS
Overview
Profitability and Growth
In this section, we examine the specific value drivers and market dynamics for
private equity in the following four sub-sectors:
•
Specialty Finance
•
Insurance
•
Financial Technology and Services
•
Depository Institutions
The profitability and growth dynamics are very different across sub-sectors.
Exhibit 28 highlights the key value drivers.
Exhibit 28
Comparison of Value Drivers
Value Drivers
Profitability
Specialty Finance
•
•
•
•
•
•
Insurance
•
•
•
•
•
Financial
Technology and
Services
•
•
•
Growth
Capital Efficiency
Credit Performance
Asset Yields
Operating Efficiency
Fee Income
Servicing Efficiency
•
Underwriting Acumen
Loss Mitigation
Operating Efficiency
Investment Return
Risk Retention
•
Fee Income
Recurring Revenue
Operating Efficiency
•
•
•
•
•
•
•
•
Depository
Institutions
•
•
•
•
•
Asset Yields
Credit Performance
Operating Efficiency
Fee Income
Capital Efficiency
•
•
•
•
Product Innovation
Market Share (balanced
by capital and liquidity
management)
Selective Market
Expansion
Market Expansion and
Penetration
Customer Retention
(Renewals)
Pricing Power
Risk Cession
Product Innovation and
Adoption
Market Expansion and
Penetration
Customer Acquisition
and Retention
New Customer
Acquisition
Customer Retention and
Cross-Sell
Footprint Expansion
New Products
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
29
2008 Update
Specialty finance has been one of the most active areas in financial services for
private equity. The breadth of specialty finance companies range from fee-based
models, such as companies serving the underbanked market (i.e., check cashing and
pawn shops), to capital-intensive leasing and consumer finance businesses.
Specialty Finance
Exhibit 29
Specialty Finance Primary Market Segments
Consumer Focus
Mortgage Banking
•
Credit Cards
•
Student Lending
•
Auto Finance
•
Subprime Lending
•
Debt Collections
•
Underbanked
•
Attractive
Attributes
30 ⏐ PIPER JAFFRAY
Commercial Focus
Asset-Backed Lending
•
Equipment Leasing
•
Business Development Companies
•
Registered Investment Companies
•
Finance Real Estate Investment Trusts
•
Specialty finance companies generally offer the following attractive attributes for
private equity:
•
Growth
Specialty finance products often are not fully mature and are in
their growth phase of their lifecycle. For more fully mature
products, such as prime mortgages and credit cards, the growth
investment thesis can be challenging.
•
Higher
Margins
Given the unique and non-commoditized nature of specialty
finance products, as well as the demand/need for them by
consumers, specialty finance assets tend to command higher
yields and fees than more traditional banking products. On a
risk-adjusted basis, these higher margins are somewhat, but not
completely, offset by higher credit or operating costs.
•
Leverage
Highly developed structured finance markets exist for many
asset classes within specialty finance. This may enable
incremental leverage for acquisition financing; however, as
stated before, financial leverage should not be relied upon as a
meaningful driver of buyout returns.
•
Regulatory
Flexibility
Most of the regulatory focus in specialty finance (e.g.,
disclosures, rates and fees) is designed to protect the consumer.
Unlike depositories, there are relatively few issues with regard to
leverage, ownership or change of control. Given the everchanging social priorities of lawmakers, however, it is critical to
carefully monitor legislative changes that may impact a specialty
finance company’s business.
•
Scalability
Specialty finance businesses are highly scalable given the large
markets that they tend to serve. Massive balance sheets can very
quickly be built with an attractive profitability stream. Care
must be taken that both balance sheet and earnings growth are
achieved within the constraints of prudent credit underwriting,
strong financial leverage and, most importantly, ample liquidity.
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
A primary reason that specialty finance companies fail is the lack of adequate
liquidity. Liquidity failures result from the capital/credit markets’ unwillingness to
renew existing facilities and/or provide financing for new growth. These financing
markets have tended to shut down on specialty finance companies when:
Current Trends Within
Specialty Finance
•
aggressive underwriting leads to severe credit deterioration and losses;
•
competition becomes too severe such that products and credit are mispriced;
•
asset growth outpaces internal capital generation; and
•
dislocation occurs in the structured finance markets due to exogenous “shocks.”
As shown in Exhibit 30, market valuations of specialty finance segments are
currently at up to a three standard deviation negative variance from their historical
averages.
Exhibit 30
Valuation Snapshot
(Relative Valuation of Specialty Finance Segments)
Price / Book Multiples
Mean
5 Year Weekly Statistics
Max
Min
Today
1 STD
P/B
σ
Consumer Finance
Auto Finance
1.80x
2.56x
0.69x
0.46x
0.84x
-2.1 σ
Student Lenders
3.83
5.84
1.14
1.16
1.20
-2.3 σ
-3.0 σ
Mortgage REITs
1.32
1.82
0.71
0.20
0.72
Credit Cards & Other Consumer
2.03
2.85
1.16
0.35
1.29
-2.1 σ
Commercial Finance
1.47
1.85
0.80
0.25
1.12
-1.4 σ
Aircraft Leasing
1.89
3.23
0.78
0.65
0.92
-1.5 σ
Container Leasing
2.13
4.26
1.52
0.61
2.10
0.0 σ
Leasing
Debt Collections
2.67
4.18
1.37
0.67
1.55
-1.7 σ
Business Development Co.
1.44
2.34
0.79
0.31
0.85
-1.9 σ
Underbanked
2.72
3.99
1.40
0.64
2.55
-0.3 σ
Source: SNL Financial, Capital IQ
Consumer Finance
Auto Finance
•
Auto space most influenced by unemployment levels and used car values.
•
Credit quality deterioration due to weak economic backdrop and high oil
prices.
•
Near-term positive impact of the government’s economic stimulus package.
•
Trading 53% below historical price/book average.16
Student Lenders
•
Government steps to ensure available funding for students this coming
academic year enables FFELP lenders to remain active in the industry.
•
Private loans have seen some deterioration in credit quality over the past year,
largely confined to the non-traditional schools.
16
Source: Capital IQ
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
31
2008 Update
•
•
A Democratic victory in the White House may not portend well for the sector
with the potential introduction of policies that do not appear favorable to the
FFELP program.
Trading 69% below historical price/book average.17
Mortgage Real Estate Investment Trusts (REITs)
•
Serious delinquencies on residential portfolios of mortgage REITs.
•
Market continues to discount credit-related mortgage stocks fairly aggressively.
•
Sector is down approximately 58% YTD.17
Credit Cards
•
Rising unemployment, higher inflation and falling home prices create a difficult
consumer finance environment.
•
Bankruptcy trends underscore credit deterioration.
•
High debt-service burden of consumers highlights the risks of possible credit
losses as defaults rise.
Commercial Finance
•
Activity hampered by reduced leverage and liquidity.
•
Disappearance of structured finance vehicles has eliminated a key source of
permanent capital for commercial lenders.
•
Expected continued weakening of business fundamentals in the commercial
finance space.
•
Trading at 0.9x price/book as against historical average of 1.35x (33% below
average).17
Leasing
Aircraft Leasing
•
Tepid growth in U.S. passenger traffic to be offset by strength in the
international markets.
•
Expansion in low-cost carriers around the world is a positive for this sector, as
low-cost carriers have a greater tendency to lease rather than purchase aircraft.
•
Trading 51% below historical price/book average.17
Container Leasing
•
Performance tied to global trade, the shipping industry and steel prices.
•
Rising steel prices lead to modest increases in lease rates on new leases and an
increase in customers, as they prefer to lease rather than purchase containers.
•
Sole specialty finance sector with positive YTD total return (17%).17
Debt Collections
•
Prices for charged-off debt remain higher than they were prior to 2004, but
appear to be declining due to increased supply and decreased competition from
non-traditional buyers.
17
Source: Capital IQ
32 ⏐ PIPER JAFFRAY
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
•
•
Lower prices may partly reflect a weaker economic backdrop and lower
expected collections.
Trading 42% below historical price/book average.17
Business Development Companies
•
Must mark to market investments each quarter using fair value accounting
leading to volatile GAAP EPS.
•
Not particularly leveraged – a positive in this environment.
•
However, constrained in ability to raise equity in down cycles when investment
opportunities are greatest (require shareholder approval to issue stock below
NAV).
•
High dividend yields based on paying out 90% of net operating income –
though gains can be carried forward to smooth dividends.
•
Different business development companies have different degrees of exposure
to cyclical industries.
•
Most companies are trading below NAV today.
Underbanked
•
Low-end consumers caught between a higher cost of living and slower wage
growth, leading to strong growth in the pawn lending businesses.
•
Pawn lending businesses benefit from strong gold prices which provide better
economics.
•
Payday legislation under consideration could adversely affect the business in
those states.
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
33
2008 Update
Accounting
Implications
Another important aspect to investing in specialty finance companies is to look
beyond GAAP. GAAP often creates misleading differences between a specialty
finance company’s reported financial performance and its underlying economic
performance. Accounting principles affect the reported financial performance of
specialty finance companies in significant areas such as revenue and expense
recognition, asset and liability valuation, and the capitalization of transferred or
serviced financial assets. The key regulatory accounting pronouncements that
impact specialty finance companies include:
•
Accounting for
Financial Assets
•
•
•
SFAS No. 140 determines whether secured
financing arrangements qualify for on- or offbalance sheet treatment and the recognition of
gain on sale income.
SFAS No. 91 relates to the recognition of income
and expenses associated with the origination of
financial assets.
SFAS No. 156 provides guidance on the
recognition and measurement of separately
recognized servicing assets and liabilities.
•
Loan Impairments
•
SFAS No. 114 provides guidance on the
determination of loan impairments and reserves
for credit losses based on collectibility or fair
value.
•
Fair Value
•
SFAS No. 157 establishes a framework for
measuring the fair value of financial assets and
liabilities without active markets and also
expands disclosure requirements for fair value
measurement.
SFAS No. 159 provides companies with an option
to report selected financial assets and liabilities at
fair value.
•
•
Derivatives
•
SFAS No. 133 requires recognition of derivatives
as either assets or liabilities in the balance sheet.
The Financial Accounting Standards Board (FASB) is in advanced stages of issuing
revisions to the current consolidation rules covered by SFAS No. 140. Under the
current consolidation rules, Qualified Special Purpose Entities (QSPEs), which are
generally used in securitization structures and conduit financings, are not
consolidated with the financial statements of the sponsoring institutions.
The proposed revisions to the standard are likely to require QSPEs to come onto the
balance sheet of the sponsoring institutions. This is likely to have a material impact
on the balance sheet size, leverage ratios and, to a lesser extent, on regulatory
capital requirements of the institutions. FASB’s goal is to issue final standards
amending its consolidation standard and eliminating the concept of QSPEs with an
effective date in 2010.
34 ⏐ PIPER JAFFRAY
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
Notably, several of the largest private equity buyouts in financial services have
recently occurred in the specialty finance sector.
Exhibit 31
Specialty Finance Private Equity Investments
(Five Largest Acquisitions Since 2002)
Date
Announced
Target
Acquiror(s)
Deal Value
($ in millions)
3/2006
General Motors
Acceptance Corp.
Cerberus Capital Management,
Citigroup, Aozora Bank, PNC
Financial
6/2008
CIT – Home Lending
Business
Lone Star Funds
1,500
8/2005
GMAC Commercial
Holding Corp.
Kohlberg Kravis Roberts & Co., Five
Mile Capital Partners, Goldman Sachs
Capital Partners
1,500
3/2008
Option One Mortgage
(Servicing Operations)
W.L. Ross & Co.
7/2006
NCO Group
One Equity Partners
$7,853
1,100(1)
916
Source: Thomson Financial and Piper Jaffray
(1) Disclosed deal value for Option One Mortgage Servicing Operations of $1.1 billion represents the
enterprise value of the transaction.
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
35
2008 Update
Within the insurance sub-sector are a variety of business models with unique risk
exposures, liability durations and market dynamics.
Insurance
Exhibit 32
Insurance-Market Segments
P&C Insurance
•
•
•
•
Life & Health Insurance
•
•
•
•
Insurance
Services
Capital-Intensive
Personal Lines (e.g.,
auto, home)
Commercial Lines
(e.g., D&O, workers’
compensation)
Specialty Lines (e.g.,
financial guaranty,
E&S)
Reinsurance
Life Insurance
Health Insurance
Managed Care
Reinsurance
•
•
•
•
•
•
Transaction-Focused
Personal Brokerage
Commercial
Brokerage
Wholesale Brokerage
Third-Party
Administration
Life & Health
Brokerage
Third-Party
Administration
With certain notable exceptions, such as Bermuda reinsurance capacity “plays,”
private equity firms have traditionally focused on investment opportunities
involving non-risk-bearing insurance services firms. Insurance services firms include
third-party administrators and insurance distribution firms, which includes P&C
and employee benefits brokers, retail and wholesale brokers, and reinsurance
brokers.
Insurance services firms are generally perceived to be relatively low-risk vehicles to
invest in within the enormous insurance industry. As opposed to solvency-focused
insurance underwriters, insurance services firms are generally not capital-intensive
businesses and are typically able to take on more financial leverage as a result of
stable and recurring revenues. Additionally, the insurance services sub-sectors are
generally highly fragmented, which provides an opportunity to consolidate a subsector via a “roll-up.”
Insurance
Underwriters:
Investment
Challenges
With a few notable exceptions, private equity has traditionally refrained from
investing in insurance underwriters due to the restrictions imposed upon
underwriters by insurance regulators, which limit the operational and financial
flexibility of U.S. insurance companies. The burdens imposed on insurance
companies by a complex and multi-faceted regulatory scheme are substantial and
include the following:
•
•
•
•
36 ⏐ PIPER JAFFRAY
Financial leverage limitations, which A.M. Best effectively imposes on rated
companies.
Operational leverage, which state law caps and A.M. Best further limits for
rated companies.
Premium rates and forms filings, which limit an insurer’s ability to price most
insurance products and modify the terms and conditions of policies.
State “dividending” restrictions, which limit the amount of capital an insurer
can dividend to a holding company to service debt.
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
•
•
•
•
•
•
•
•
Insurance
Underwriters:
Investment
Opportunities
Form A filing, which is required when acquiring more than 10% of any insurer
and provides states with the ability to prevent specific insurance acquisitions.
Quarterly and annual reporting requirements with the relevant state
department of insurance.
Mandatory adherence to a unique set of accounting principles (i.e., statutory
accounting).
Exiting a state or line of business entails a negotiation with state departments
of insurance and is not always permitted.
Faltering insurance companies are susceptible to takeover by a state
department of insurance even if the impairment is temporary.
Private company transparency, which thrusts potentially proprietary
information into the public domain.
State-by-state regulation, which is a time-consuming administrative challenge.
Political considerations, which must be constantly evaluated given the
politicized nature of insurance regulatory oversight and the perception that
insurers are quasi-governmental entities.
While the insurance regulatory environment in the U.S. is reasonably daunting, the
insurance sector is nonetheless a rich repository of relatively low-beta investment
opportunities. P&C insurance, in particular, possesses several attractive investment
characteristics, including the following:
•
Huge and Highly
Fragmented
Industry
Smaller insurers focused on a narrow niche can generate
outsized returns over the full P&C insurance cycle.
•
Cyclical Pricing
and Valuation
The cyclical nature of P&C insurance premium pricing
and valuation provides relatively predictable entry and
exit points for investors.
•
Recurring
Revenue
While they vary over time and among markets and
insurers, as a general matter customer/policy retention
rates are quite high relative to other industries.
•
Independent
Agency System
There is a well-developed wholesale and retail distribution
system that enables new entrants to grow revenue rapidly
and without requiring investment in massive distribution
infrastructure.
•
Supply and
Demand
Imbalance
Periodic and highly predictable “capacity crunches” drive
pricing and generate outsized returns until stasis is again
achieved (e.g., the “Bermuda Thesis”).
•
Regulatory
Scheme
While competing in a heavily regulated industry is a
challenge, it also provides a significant barrier to entry for
new competitors.
•
Insurers as
Leveraged Bond
Portfolios
There is a play to acquire insurers with mature balance
sheets (i.e., with investment leverage) in a rising interest
rate environment when market valuations based on priceto-book multiples decline in-line with bond valuations
(the vast majority of an insurer’s assets) but when
investment income is likely to spike going forward.
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
37
2008 Update
Insurance
Underwriters:
Recent Trends
As a result of some modest innovations, investing in private insurance companies
has become more attractive in the last several years. Most notably, the
development of the insurance pooled trust preferred market provided smaller
insurance companies with significantly more financial flexibility by providing
efficient access to reasonably priced debt financing as an alternative to costly quota
share reinsurance. As a result, smaller insurers can now enjoy the traditional
benefits of debt financing (i.e., leveraged returns and tax-deductible interest) plus
an additional benefit as debt is treated as a form of equity by the regulators and
ratings agencies (up to 25% of pro forma statutory capital).
However, as a result of the breakdown of the asset-backed securities market in
2008, the pooled insurance trust preferred market is now effectively dormant.
Because of fortuitous timing, the disruption in the pooled trust preferred market has
had minimal impact on underwriters. Several years of record profits have resulted
in an industry swollen with excess capital and minimal use for additional capital in
any form.
In addition, the following recent trends bolster the case for allocating capital to
P&C insurance investment opportunities:
38 ⏐ PIPER JAFFRAY
•
Increased
Specialization
The entire insurance market has become more specialized
and granular as risk analysis has become more
sophisticated. As a result, there is a secular trend toward
specialty admitted / E&S business, which is not as tightly
regulated as commoditized insurance products and can
generate outsized returns.
•
Leveraging
Technology to
Evaluate Risk
The leading-edge insurers use sophisticated data analysis
powered by technology to evaluate and price the risks they
are underwriting.
•
Insurance as a
“Gateway”
Product
Another trend is using insurance distribution channels to
sell non-insurance products such as premium finance and
even unrelated products such as phone cards.
•
Spitzer Reforms
Former New York Attorney General Spitzer’s
investigations into insurance brokerage practices limited
the market power of retail brokers, which benefits
insurers and other intermediaries such as managing
general agents and wholesale brokers.
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
Exhibit 33
Insurance Private Equity Investments
(Five Largest Acquisitions Since 2002)
Date
Announced
Target
Acquiror(s)
Deal Value
($ in millions)
8/2003
Financial Guaranty
Insurance Co.
PMI Group Inc., Bank of America Corp.,
The Blackstone Group, Cypress Group
$1,900
9/2005
UICI
The Blackstone Group, Goldman Sachs
Capital Partners, DLJ Merchant Banking
Partners
1,719
2/2007
HUB International
Morgan Stanley, Apax Partners
1,677
1/2007
USI Holdings
Goldman Sachs Capital Partners
1,400
3/2004
Safeco Life and
Investments
Berkshire Hathaway Inc., White Mountains
Insurance Group, Caxton Associates,
Highfields Capital Management, Och-Ziff
Capital Management, Vestar Capital
Partners, DLJ Merchant Banking Partners,
CAI Capital Partners, Fairholme Capital
Management, Prospector Partners
1,350
(Largest Private Equity Sponsored Start-Ups Since 2002)
Date
Announced
Target
Acquiror(s)
Deal Value
($ in millions)
12/2005
Ariel Holdings
Bain Capital, Eton Park Capital
Management, Oak Hill Capital Partners,
Olympus Partners, SAB Capital
Management, The Blackstone Group,
Thomas H. Lee Partners
$1,000
12/2005
Validus Holdings
Aquiline Capital Partners, Goldman Sachs
Capital Partners, Merrill Lynch Global
Private Equity, New Mountain Capital,
Vestar Capital Partners
1,000
1/2007
Ironshore, Inc.
Bear Stearns Merchant Banking, Calera
Capital, Greenhill Capital Partners, Lazard
Capital Partners, The Beekman Group,
TowerBrook Capital Partners
1,000
12/2005
Flagstone Reinsurance
Holdings
Lehman Brothers Merchant Banking,
Lightyear Capital
715
6/2002
Aspen Insurance Holdings
3i Group, Candover Investments, Catlin
Underwriting Limited, CSFB Private Equity,
DLJ Merchant Banking Partners, Montpelier
Re Holdings, Olympus Partners, The
Blackstone Group, Phoenix Equity Group
654
Source: SNL Financial, Thomson Financial and Piper Jaffray
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
39
2008 Update
Financial Technology and
Services
The financial technology and services sub-sector continues to be a very active area
for private equity. The sub-sector is large, growing and diverse, with thousands of
players and dozens of specialized segments, each with its own unique characteristics
and drivers. Well-established growth drivers and compelling investment attributes
make for an attractive risk/reward equation for private equity. Attractive
investment opportunities can be found in virtually all financial technology
categories and significant private capital has flowed into the sector in recent years.
Exhibit 34
Financial Technology and Services Primary Market
Segments
•
•
•
Payment Processing
Other Financial Transaction
Processing
Financial Outsourcing
•
•
•
Financial Software and
Infrastructure
Securities Processing and
Technology
Exchanges and Trading Services
Growth Drivers
Financial institutions have a voracious appetite for technology and outsourced
services, spending more in this area than any other industry. This spending allows
financial institutions to stay nimble, efficient and competitive, and is nondiscretionary in today’s world. In a sense, financial institutions have become
technology companies. At the same time, the global payments system, for both
consumers and businesses, continues to migrate steadily toward electronic methods
of payment and away from paper. These powerful, ongoing trends will continue to
drive strong, steady growth across the financial technology sub-sector, providing a
very attractive private investment backdrop.
Investment
Attributes
While each of the many segments in financial technology has its own industry
nuances and investment dynamics, several attractive common threads are shared
across the sub-sector.
40 ⏐ PIPER JAFFRAY
•
Recurring
Revenue
Financial technology and services companies tend to have
revenue models that are recurring in nature. Revenue is
typically generated on a per-transaction or per-account
basis and is usually associated with long-term contracts
and/or sticky customer relationships. As a result, financial
performance tends to be highly visible and predictable.
•
Operating
Leverage
Financial technology and services companies typically have
scalable businesses with large fixed cost bases that result in
expanding profit margins as revenue grows.
•
Limited Capital
Requirements
Financial models tend to be asset-light and capital-efficient.
Mature businesses tend to be self-funding, and business
models frequently have negative working capital.
•
No Credit /
Underwriting
Risk
The vast majority of financial technology business models
carry zero or de minimis credit and/or underwriting
exposure.
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
Current
Investment
Climate
•
Limited
Regulation
As vendors, processors and service providers to the
financial services sub-sector, navigating applicable industry
regulations is an inherent aspect of the business. But most
financial technology firms provide services on a B2B basis
with no material direct regulation themselves. B2C-focused
companies are typically subject only to very limited
regulations.
•
Fragmented
Markets
Despite ongoing consolidation across financial technology,
many segments remain highly fragmented and served by
numerous small providers. Many players are highly
specialized, focusing on a specific function or sub-vertical.
These characteristics provide compelling opportunities for
private equity investors to make platform investments that
can be expanded organically and through acquisitions.
Deal activity has fallen appreciably from heights reached at the peak of the LBO
boom in 2007. Weak financing markets have cooled valuations and slowed the
overall pace of deal activity in 2008. At the same time, significant pools of
uninvested private capital must be put to work, and competition for good
transactions remains intense. As a result, high quality companies continue to
attract strong valuations. In this environment, private equity investors must seek
ways to differentiate themselves in the market and uncover transactions in niche
segments that are out of the mainstream.
Exhibit 35
Financial Technology and Services Private Equity
Investments
(Five Largest Acquisitions Since 2002)
Date
Announced
Target
Acquiror(s)
Deal Value
($ in millions)
4/2007
First Data Corp.
Kohlberg Kravis Roberts & Co.
$26,792
3/2005
SunGard Data Systems
Inc.
Bain Capital Partners, The Blackstone
Group, Goldman Sachs Capital Partners,
Kohlberg Kravis Roberts & Co., Providence
Equity Partners, Silver Lake Partners, Texas
Pacific Group
11,043
5/2007
Ceridian Corp.
Thomas H. Lee Partners, Fidelity National
Financial
5,318
7/2005
Cendant Corp. Marketing Services
Division
Apollo Management
1,825
10/2006
Open Solutions
Providence Equity Partners, Carlyle Group
1,390
Source: SNL Financial, Thomson Financial and Piper Jaffray
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
41
2008 Update
Depository Institutions
Depository institutions provide an untapped opportunity for private equity.
Creative, patient and smart private equity investors can work within the regulatory
frameworks and be richly rewarded.
The three key regulatory issues for private equity in considering depository
institution acquisitions are:
•
control and the implications of bank or thrift holding company status;
•
capital requirements and the ability to layer-on acquisition leverage; and
•
ongoing regulatory monitoring, reporting and oversight.
The Federal Reserve and Office of Thrift Supervision (OTS), which regulate the
holding companies of banks and thrifts, have as their primary objective the
protection of the depository institutions controlled by such holding companies.
The Federal Reserve and OTS pursue this objective at the holding company level by
(1) setting conservatively low thresholds defining “control” of an institution; (2)
carefully scrutinizing any entity that proposes to acquire control of an institution;
and (3) imposing various restrictions and requirements on entities that control such
institutions.
Control
Thresholds
42 ⏐ PIPER JAFFRAY
The most significant regulatory challenge facing private equity is the control
threshold that determines bank or thrift holding company status. Although the
control rules are slightly different for banks and thrifts, holding company status
generally results from (1) the acquisition of 25% or more of a class of voting
securities; (2) the ability to elect a majority of the board of directors; or (3) the
exercise of a controlling influence over a bank, thrift or company that directly or
indirectly controls either. Furthermore, a rebuttable presumption of control arises
from the acquisition of 10% to 25% of a class of voting securities. Finally, if the
acquiring parties act in concert (e.g., via a shareholder agreement), the shares of
each are attributed to the other for determining control.
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
Exhibit 36
Control Thresholds
(Regulatory Determinations of Control of Depository Institutions)
Threshold
5%
10%
Applies to:
Banks and Bank Holding
Companies
•
A transaction in which a
regulated depository
institution (banks and Bank
Holding Companies)
acquires 5% or greater
control of another
depository institution.
Any Non-Bank Entity (e.g., a
private equity acquirer)
•
Any transaction involving a
non-bank entity acquiring
10% or greater control of a
depository institution.
Implications
•
The minority investor is
deemed by the Fed to
“control” the target, and the
target is consolidated with the
minority investor for
regulatory reviews and
statutory purposes.
•
Regulatory notification and
approvals are required. Such
processes can be lengthy and
may require extensive
information disclosure about
the financial position of the
investor and its principals.
Bank Holding Company
status is not triggered.
•
25%
Control
Consequences
Permissible
Activities
Any Non-Bank Entity (e.g., a
private equity acquiror)
•
Any transaction involving a
non-bank entity acquiring
25% or greater control.
•
Acquiring entity would be
classified as a Bank Holding
Company and subject to all
associated regulatory
limitations, statutory reviews
and capital requirements.
Significant burdens and limitations may be created for a private equity fund if it is
deemed to have “control.” Furthermore, a control acquisition generally extends
beyond the primary investor and applies throughout the investor’s ownership
structure to its ultimate parent entities and limited partner investors. Any private
equity investor that subjects itself to the Bank Holding Company Act would be
required to satisfy the capital and managerial requirements necessary and would be
subject (along with its affiliates) to:
•
supervision and examination by the Fed;
•
limitations on non-banking activities and investments;
•
risk-based capital adequacy requirements and limitations on leverage; and
•
requirement of the ultimate Bank Holding Company to stand as a “source
of strength” in support of its subsidiary operating banks.
Bank and thrift holding companies are very limited in their ability to conduct nonbank activities. Consequently, most U.S. Bank Holding Companies have elected to
become Financial Holding Companies. This designation gives a Bank Holding
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
43
2008 Update
Company additional non-banking powers and requires satisfaction of certain
capital, management and other criteria.
Financial Holding Companies and thrift holding companies are generally prohibited
from engaging in non-banking activities that are not “financial in nature” or
incidental or complementary thereto, as determined by the regulators. Importantly,
Bank Holding Companies (including Financial Holding Companies) are subject to
minimum capital requirements. Thrift holding companies are assessed for capital
adequacy, too, but are not subject to specific minimums. These limitations on
certain activities, capital requirements and general regulatory scrutiny and
examination can be, and have been, of significant concern for private equity firms.
Structural
Alternatives
Minority investments offer one avenue for private equity investments in depository
institutions without becoming subject to the control provisions or regulatory review
process. If properly structured, one obvious structural work-around is to simply
acquire no more than 9.9% of a class of voting securities, so that the investment
does not create a presumption of control. However, the investment must be passive
or non-controlling (e.g., no board or management control).
The banking regulators have a conservative view regarding the meaning of “nonvoting,” which often is at odds with a business understanding of this term. In some
cases, an investor may be required to make additional assurances through standstill
agreements or “passivity commitments” that they will not make attempts to
increase their voting interest beyond the threshold limit. With this approach,
additional non-voting shares can be purchased, up to a total equity investment of
24.9%, but this requires the investor to rebut the presumption of control (which,
among other things, limits its ability to select directors).
Unique transaction mechanisms may also be utilized to acquire more significant
stakes in depository institutions without triggering the Bank Holding Company
provisions. For example, it may be possible to establish a single-purpose limited
partnership that acquires more than 25% of a class of voting stock of a bank or
thrift. In this type of arrangement, the investment in a depository institution would
be held by the limited partners in such a manner that each investor remains below
the 10% regulatory threshold (or even below the 5% level) for presumed control.
The general partner (which will be deemed to control the partnership and, thus, the
target depository institution) should be an individual person, rather than a
company.
The objective of the arrangement would be to have only the limited partnership
itself and the individual person acquire control of the bank. In other words, the
limited partnership would become a bank or thrift holding company, but not the
underlying investors. Also, because the holding company rules apply only to
entities and not individuals, the general partner will not become a bank or thrift
holding company. In this arrangement, the general partner may be compensated as
a private equity firm typically would be compensated.
44 ⏐ PIPER JAFFRAY
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
Exhibit 37
Private Equity Depository Control Structure
(Acquiring Control of a Bank or Thrift )
No Presumptive Control
“Deemed Control”
General Partner
(an Individual Person)
> 10%
Limited Partner
Limited Partner
Limited Partner
< 10%
< 10%
< 10%
Single-Purpose
Limited Partnership
(Becomes a BHC)
> 25% Voting Stock
Target Depository
Institution
Of course, this type of structure involves a great deal of nuance from a bank
regulatory perspective and needs to be pursued with great care. With thoughtful
consideration given to the nature of the relationship between the private equity
sponsor and its limited partners, as well as the form of its economic incentives in
the transaction, this arrangement does offer the prospect of a meaningful solution
to the 25% threshold.
A more recent structure has been for private equity sponsors to form a specially
purposed bank acquisition fund that itself will become a Bank Holding Company.
As the Bank Holding Company Act does not apply to individuals, the individual
control persons of the special fund’s general partner are not subject to the control
restrictions. Since the individuals are not subjected to the Bank Holding Company
Act, their other private equity investments and activities also are not as well. This
separation of the bank fund from the non-bank private equity activities is carefully
reviewed by the Fed as part of its efforts to ensure economic separation through:
•
no shared investments among the funds;
•
no cross-investments (or lending) among the funds;
•
no asset transfers among the funds; and
•
no economic relationships among the funds, including requirements for
distinct management and performance fee calculations.
Depository institutions remain fertile ground for private equity investment
opportunities but will require firms to invest in the requisite regulatory and
structural knowledge to do so.
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
45
2008 Update
Exhibit 38
Depository Institutions Private Equity Acquisitions
(Largest Acquisitions Since 2002)
Date
Announced
Target
Acquiror(s)
Deal Value
($ in millions)
5/2007
Doral Financial
Bear Stearns Merchant Banking,
Canyon Capital Advisors, D.E. Shaw,
Eton Park, GE Asset Management,
Goldman Sachs & Co., Marathon
Asset Management, Perry Capital,
Tennenbaum Capital
$610
1/2007
BankFirst
Castle Creek Capital
250
3/2004
Centennial Bank Holding
Inc.
Castle Creek Capital led investor group
155
9/2007
FC Holdings
JLL Partners
75
Source: SNL Financial, Thomson Financial and Piper Jaffray
Exhibit 39
Depository Institutions Private Equity Minority
Investments
(Largest Minority Investments Since 2002)
Date
Announced
Target
Investor(s)
4/2008
National City
Corsair Capital led investor group
4/2008
Washington Mutual
TPG Capital
11/2007
PrivateBancorp
GTCR Golder Rauner
7/2008
Boston Private Financial
Holding Inc.
Carlyle Group
Source: SNL Financial, Thomson Financial and Piper Jaffray
46 ⏐ PIPER JAFFRAY
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
Deal Value
($ in millions)
$7,000
2,000
100
75
2008 Update
Causes
The S&L crisis of the late 1980s and early 1990s dramatically affected the global
financial markets. During this period, more than 700 S&Ls with assets in excess of
$400 billion failed. The responses of U.S. legislative and regulatory bodies and the
involvement of private equity then, are instructive today, as a case study for
evaluating potential outcomes and solutions.
The environment leading up to the S&L crisis was characterized by:
•
high and volatile interest rates in the late 1970s and 1980s, exposing S&Ls to
significant interest-rate risk;
•
elimination in the early 1980s of the Federal Reserve’s Regulation Q, which put
a limit on the interest rates – including a zero rate on checking accounts – that
banks could pay, increasing the costs of liabilities compared to fixed-rate assets
and adversely affecting profitability and capital;
•
state and federal deregulation, which allowed S&Ls to take on additional risk
by making commercial loans, issuing credit cards and taking ownership
positions in real estate and other projects to which they made loans (prior to
which they were allowed only to make a limited range of loans);
•
reduced capital requirements; and
•
adverse local economic conditions due to overbuilding of residential and
commercial real estate properties in many cities, falling oil prices, which
affected states such as Texas, Louisiana and Oklahoma, and a general
weakness in the mining and agricultural sectors of the economy.
Exhibit 40
Banks and S&L Failures
(Number of Failures from 1980 through 1997)
1200
1000
800
# of Failures
S&L Crisis Case Study
600
400
200
0
1980-1982
Saving Association Failures
Bank Failures
Total Bank & Thrift Failures
115
62
177
1983-1985
1986-1988
1989-1991
1992-1994
Savings Association Failures
Bank Failures
135
246
381
309
626
935
687
499
1186
69
176
245
1995-1997
3
11
14
Source: Federal Deposit Insurance Corporation
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
47
2008 Update
Formation of the
Resolution Trust
Corporation
The Federal Savings and Loan Insurance Corporation (FSLIC) was created as part
of the National Housing Act of 1934 to insure depositor monies in S&Ls. As the
S&L crisis progressed, a sharp increase in bank failures reduced consumer
confidence, lowered asset values and caused additional bank failures. Congress
passed legislation to recapitalize FSLIC with taxpayer money several times,
including $15 billion in 1986 and $10.8 billion in 1987. By mid-1988, FSLIC’s
deposit insurance fund’s ability to support depositor claims was reported to be
running at a negative $75 billion.18 The General Accounting Office reported that
the eventual costs of restoring the S&L industry's financial health were likely to
exceed the funds that FSLIC had available. FSLIC was deemed too insolvent to
save and was abolished.
In response to the failure of FSLIC, Congress quickly passed the Financial
Institutions Reform, Recovery, and Enforcement Act (FIRREA), which created the
Resolution Trust Corporation (RTC). The RTC, which existed from August 1989
to December 1995, acted as a temporary federal agency charged with liquidating
assets from S&Ls declared insolvent by the OTS. Furthermore, the RTC was
responsible for managing and resolving all failed depository institutions previously
insured by FSLIC, acting as both a conservator and receiver for failed S&L assets.
Additionally, the RTC had the responsibility of ensuring minimal disruption to
local real estate markets and the broader financial markets as additional S&L
failures were announced.
18
19
20
Role Played by
the RTC
In its role as a conservator and receiver, the RTC, during its 6-year lifespan,
divested assets totaling $403 billion for 747 insolvent thrifts. Private equity
sponsors played a large role in the RTC dispositions, as few strategic acquirors had
the wherewithal to step in. In dealing with S&L failures, the RTC relied on a
number of asset disposition structures. One was “purchase and assumption”
transactions, where the acquiror purchased some or all of the assets and some of the
liabilities. Another structure was “deposit payoffs” where the RTC would pay
depositors of the failed institution the amount of their insured deposits either
directly (straight deposit payoff) or through a healthy institution that acted as the
RTC’s agent (insured deposit transfer). Depositors with uninsured funds and other
general creditors of the failed institution were given receivership certificates
entitling them to a share of the net proceeds from the sale of the failed institution’s
assets. As the crisis worsened, the RTC employed additional methods, such as
direct financial assistance and private/public partnerships to address the growing
problems.
Private Sector
Involvement
Early into the S&L crisis, private equity firms noticed the opportunity to get
involved by taking advantage of distressed asset sales. For example, Sam Zell
started the Zell-Merrill I Real Estate Fund and raised $409 million. Goldman Sachs
started the Whitehall I Fund in 1991 with $166 million and Whitehall II Fund with
$790 million in 1992.19 The initial success of these funds initiated further private
equity fund raising by Apollo, Blackstone and others.
Securitization
By the mid-1990s, the RTC was estimated to be holding a mortgage loan inventory
of more than $34 billion.20 Accordingly, the RTC saw an opportunity to securitize
a portion of these assets. In fact, the RTC ended up securitizing a large portion of
its underperforming mortgages, and many of these securities came onto the market
at levels much cheaper than their true intrinsic value.
Source: FDIC Banking Review
Source: Zell/Lurie Real Estate Center
Source: Federal Deposit Insurance Corporation
48 ⏐ PIPER JAFFRAY
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
Because the size of its nonconforming loan portfolio was so large, the RTC
instituted its own private securitization program in December 1990. The loans in
this program had characteristics that detracted from their marketability on a whole
loan basis, such as documentation inaccuracies, servicing problems and late
payments. Although the RTC securitization program initially included residential
mortgage loans, it was expanded to include other types of loans such as commercial
mortgages, multi-family properties and consumer loans.
Put Options
Initially the RTC required that an acquiror purchase most of the failing S&L’s
assets, whereas most acquirors wanted to cherry-pick balance sheets. To help clear
the market, acquirors were given a put option by the RTC that would require the
RTC to repurchase unwanted assets at a later date at a pre-specified (often formulabased) price. In the first year the put option structure was offered, the RTC sold
approximately $40 billion of assets subject to put options. This approach for
disposing of S&L assets failed because more than $20 billion (50%) of those assets
ended up being returned to the RTC.21
A major issue identified by the RTC was the limited time acquirors had to evaluate
the assets. Initially, acquirors returned a large portion of the assets because the 30to 90-day period before the expiry of the put option did not provide enough time
for acquirors to comprehensively review the assets purchased. Seeing this as a
major issue for acquirors, the RTC changed the expiration date on many puts,
extending them to 18 months.
That policy, however, exacerbated the existing problems with the initial put option
policy. In some cases, assets were not being properly serviced before being put back
to the RTC. In other cases, acquirors cherry picked the assets and kept those they
could sell at a profit while putting the rest back to the RTC. Additionally,
acquirors put in lower bids due to the limited amount of due diligence they could
perform prior to bidding. Ultimately, the problems led to substantial delays in the
final sale and ultimate resolution of those assets.
Equity
Partnerships
The RTC recognized that many assets being sold were undervalued and investors
were enjoying abnormally large returns from these acquisitions. Eventually, the
RTC began selling assets through an equity partnership program that allowed it to
share in the value enhancement.
While the program used a number of different structures, all of the equity
partnerships involved a private sector partner acquiring a partial interest in a pool
of assets, controlling the management and sale of the assets in the pool, creating
value from those assets, and making distributions to the RTC. The equity
partnerships aligned the interests of both parties as it provided RTC with private
capital and asset management expertise and provided investors with a passive
equity partner and bond holder. The RTC, as a passive investor, used its share of
these equity partnerships to ensure better execution and to lower overhead costs.
Although the equity partnership concept was developed early in the S&L crisis, the
RTC did not engage in its first successful partnership until the fall of 1992.
21
Source: Federal Deposit Insurance Corporation
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
49
2008 Update
Exhibit 41 summarizes the equity partnerships formed by the RTC.
Exhibit 41
RTC Partnership Programs: Summary Characteristics
Partnership
N Series
Trusts
•
•
•
•
•
Multiple
Investor
Funds (MIF)
Series
•
•
•
•
•
Land Funds
Book Value
($ in millions)
Characteristics
•
•
•
•
•
•
Six N Series trusts targeting large investors.
RTC held a 51% limited partnership interest in the trust.
Investors held a 49% general partnership interest in the trust.
The trust issued bonds to third-party institutional investors and used
the proceeds to purchase the assets from the RTC.
The cashflow characteristics permitted the bonds to be retired early;
selling bonds on the open market was not considered effective.
$2,782
Two MIF partnerships targeting large institutional investors.
Designed to sell a large volume of assets in a single transaction.
Partnerships had an absolute “kick-out right” to require the RTC to
repurchase, within a specified period of time, assets unacceptable to
the general partner (GP) up to 10% of the partnership’s assets.
The RTC held a 25% to 50% limited partnership interest and a bondequivalent note.
The GP held a 50% to 75% interest.
2,034
Three offerings spawning 12 partnerships targeting small investors.
The partnership bore the cost of developing the land and deducted
expenses before distributing proceeds to the partners.
The GP was usually an asset manager and developer.
GPs chose to contribute 25% to 40%of equity.
The RTC was a limited partner (LP) and assumed the balance interest.
After the original investments were recouped, additional proceeds
were split 50-50 between the GP and the LP.
2,218
1,019
S Series
Trusts
•
•
•
•
Nine S Series transactions were completed targeting small investors.
Smaller pools of assets were created and grouped geographically.
Structurally largely similar to N Series Trusts.
The trusts issued bonds, which were held by the RTC.
Judgments,
Deficiencies,
and ChargeOffs
(JDC)
•
•
•
30 partnerships set up targeting investors with collection experience.
Contributed assets were either legally impaired or of poor quality.
First 10% of collections placed in a reserve account to cover qualified
expenses.
Remaining collections distributed with 80% going to the LP and 20%
to the GP for small balance assets and split 50-50 for JDC assets.
If, at the end of the partnership, the RTC had not recouped its initial
investment, it received 99% of the balance in the reserve account.
If the RTC had recovered its original investment, the reserve account
after qualified expenses was split 50-50 between the LP and the GP.
•
•
•
SN Series
•
•
•
•
•
NP Series
•
•
•
•
Five partnerships set up.
Targeted to large and small investors which were allowed to bid either
on certain pools or on all of the pools as a whole, with the RTC
accepting combinations of bids that resulted in the highest recovery.
The RTC held a 51% limited partnership interest in the trust.
Investors held a 49% general partnership interest in the trust.
The trust issued bonds which typically represented 60% of the assets.
440
Eight partnerships set up, among the smallest of the partnerships.
NP Series transactions were the hardest-to-sell assets in the RTC’s
portfolio because they were the true nonperforming loans.
Private-sector bidders were given the option to bid at 20% to 50%
levels of equity ownership in the trust.
The trusts issued bonds, which were held by the RTC.
537
Total Book Value
Source: Federal Deposit Insurance Corporation
50 ⏐ PIPER JAFFRAY
12,418
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
$21,448
2008 Update
Lessons Learned
The period between 1988 and 1994 was one of turbulent change for the banking
industry, which saw record numbers of bank and S&L failures, and the creation
and dissolution of the RTC. In the short time span of its existence, the RTC was
able to help resolve many of the S&L failures through a series of actions, such as
private sector involvement, securitization, put options and equity partnerships. The
era also provided private equity firms opportunities to earn excess returns from
investments in RTC assets. The attractive returns realized by private equity
through these various structures created a political backlash that may have
implications for the structure and involvement of government and regulators in the
current Credit Crisis of 2007-2009.
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
51
2008 Update
Next Steps
The first step in further examining opportunities in financial services is to challenge
the assumptions and perspectives set forth in this paper. If all seems reasonable,
then a determination should be made as to whether the various investment theses
specific to financial services fit within the investment parameters and goals of your
particular fund.
The second step involves committing time and resources toward building
intellectual capital. Numerous services providers in the investment banking, legal,
consulting and accounting professions are able and willing to help develop the
financial services expertise required. A very logical outcome of this phase is for a
fund to initially narrow its focus to one sub-sector. Prioritization of what that first
sub-sector is should involve an assessment of (1) timing within the valuation cycles;
(2) availability of management talent; (3) feasibility and lead time required to
source deal opportunities; (4) regulatory complexity; and (5) visibility of the exit.
The third step is to build the network. Networking can involve a serious
commitment of time and resources but is critical to deal sourcing, transaction
financing and optimizing the investment exit. This networking time should be
focused upon (1) meeting management teams; (2) interviewing customers/clients; (3)
talking with regulators and legislators; (4) establishing (or deepening) relationships
with the capital markets and credit providers (particularly in structured finance); (5)
establishing contacts with the M&A-oriented strategics in the sub-sector; and (6)
building relationships with other private equity investors who may be looking for
transaction partners.
Beyond this third step lies the traditional private equity toil of deal sourcing,
structuring, acquisition, restructuring and exit. In this regard, the Piper Jaffray
Financial Institutions Group and Financial Sponsors Group are committed and
ready to assist our clients in further exploring opportunities in financial services.
We look forward to discussing with you our thoughts and views presented in this
paper.
52 ⏐ PIPER JAFFRAY
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
2008 Update
APPENDICES: PRECEDENT TRANSACTIONS
Private Equity Buyouts of
Financial Institutions Since
2002
The following includes U.S. financial services transactions with publicly disclosed
deal values of greater than $50 million, excluding asset deals and terminated deals
previously announced. Transactions in italics are pending.
Date
Announced
Target
Target
Sub-Sector
Acquiror(s)
Deal Value
($ in millions)
7/2008
PMSI
Insurance
Broker
H.I.G. Capital
$50
7/2008
Fiserv
Insurance
Solutions
Insurance
Stone Point Capital
541
6/2008
CIT Group Home Lending
Business
Specialty
Finance
Lone Star Funds
4/2008
American
Beacon
Advisors, Inc.
Asset
Management
Pharos Capital Group, TPG
Capital
480
4/2008
Clayton
Holdings, Inc.
Financial
Technology
Greenfield Partners
133
3/2008
Option One
Mortgage
(Servicing
Operations)
Specialty
Finance
WL Ross & Co.
2/2008
MoneyGram
International,
Inc.
Financial
Technology
Goldman Sachs and Thomas
H. Lee Partners
9/2007
FC Holdings
Depository
Institution
JLL Partners
6/2007
Nuveen
Investments
Inc.
Asset
Management
Madison Dearborn Partners,
Merrill Lynch Global Private
Equity, Wachovia Capital
Partners, Citigroup,
Deutsche Bank Investment
Partners
6/2007
James River
Group
Insurance
DE Shaw and Company
575
6/2007
Accredited
Home Lenders
Specialty
Finance
Lone Star Funds
386
6/2007
Alliant
Insurance
Services Inc.
Insurance
The Blackstone Group
1,100
5/2007
Ceridian Corp.
Financial
Technology
Thomas H. Lee Partners,
Fidelity National Financial
5,318
5/2007
TransFirst Inc.
Financial
Technology
Welsh Carson Anderson &
Stowe
683
1,500
1,100
710
75
6,250
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
53
2008 Update
Date
Announced
54 ⏐ PIPER JAFFRAY
Target
Target
Sub-Sector
Acquiror(s)
Deal Value
($ in millions)
5/2007
Doral
Financial
Depository
Institution
Bear Stearns Merchant
Banking, Canyon Capital
Advisors, D.E. Shaw, Eton
Park, GE Asset
Management, Goldman
Sachs & Co., Marathon
Asset Management, Perry
Capital, Tennenbaum
Capital
4/2007
First Data
Corp.
Financial
Technology
Kohlberg Kravis Roberts &
Co.
4/2007
Alea Group
Insurance
Fortress Investment Group
3/2007
Direct Capital
Corp.
Specialty
Finance
Allied Capital Corp.
2/2007
HUB
International
Insurance
Morgan Stanley and Apax
Partners
2/2007
USA
Commercial
Mortgage
Specialty
Finance
Compass Partners
67
1/2007
BankFIRST
Depository
Institution
Castle Creek Capital
81
1/2007
USI Holdings
Insurance
Goldman Sachs Capital
Partners
12/2006
Direct General
Corp.
Insurance
Elara Holdings Inc., a unit of
Texas Pacific Group,
Fremont Partners
10/2006
Universal
American
Financial
Corp.
Insurance
Management-led investor
group, Capital Z Partners,
Lee Equity Partners, Perry
Capital, Welsh Carson
Anderson & Stowe
1,107
10/2006
Open Solutions Financial
Inc.
Technology
Providence Equity Partners,
Carlyle Group
1,390
10/2006
Genatt
Associates Inc.
Insurance
Northaven Partners, CCP
Equity Partners
9/2006
Personnel
Insurance
Service
Insurance
Celerity Partners
250
9/2006
Peach
Holdings Inc.
Specialty
Finance
DLJ Merchant Banking
Partners, LLR Equity
Partners, Greenhill Capital
Partners
765
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
$610
26,792
324
75
1,677
1,400
434
65
2008 Update
Date
Announced
Target
Target
Sub-Sector
Specialty
Finance
Acquiror(s)
Deal Value
($ in millions)
8/2006
California
Check
Cashing
Golden Gate Capital
$115
8/2006
Munder
Asset
Capital
Management
Management
Management-led investor group,
Crestview Partners, Grail
Partners
312
7/2006
NCO Group
Inc.
Financial
Technology
One Equity Partners
916
6/2006
Aon
Warranty
Group Inc.
Insurance
Onex Partners
717
6/2006
Bank of New Broker-Dealer
York Execution
Services
GTCR Golder Rauner, Eze
Castle Software, Bank of New
York
441
6/2006
Bankruptcy
Financial
Management Technology
Solutions
Inc.
Charlesbank Capital Partners,
Ocwen Financial Corp.
385
6/2006
Ace Cash
Express Inc.
Specialty
Finance
Management-led investor group,
JLL Partners
453
5/2006
Thesco
Benefits
Insurance
Broker
Olympus Partners
4/2006
Sirius
America
Insurance
Co.
Insurance
Lightyear Capital, Lehman
Brothers Merchant Banking,
AlpInvest Partners
139
3/2006
Centex
Home
Equity
Specialty
Finance
Fortress Investment Group
575
3/2006
General
Motors
Acceptance
Corp.
Specialty
Finance
Cerberus, Citigroup, Aozora
Bank, PNC Financial
2/2006
ADP Claims
Services
Group
Financial
Technology
GTCR Golder Rauner
975
12/2005
York
Insurance
Services
Group Inc.
Insurance
Odyssey Investment Partners
105
12/2005
Sedgwick
CMS
Holdings
Inc.
Financial
Technology
Fidelity National Financial Inc,
Thomas H. Lee Partners,
Evercore Capital Partners
635
12/2005
Collect
America
Asset
Management
KRG Capital Partners
350
61
7,853
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
55
2008 Update
Date
Announced
56 ⏐ PIPER JAFFRAY
Target
Target
Sub-Sector
Acquiror(s)
Deal Value
($ in millions)
9/2005
UICI
Insurance
The Blackstone Group, Goldman
Sachs Capital Partners, DLJ
Merchant Banking Partners
9/2005
CCC
Information
Services
Financial
Technology
Investcorp International Inc.
8/2005
GMAC
Commercial
Holding
Corp.
Specialty
Finance
Kohlberg Kravis Roberts & Co.,
Five Mile Capital Partners,
Goldman Sachs Capital Partners
1,500
7/2005
Cendant
Corp. Marketing
Services
Division
Financial
Technology
Apollo Management
1,825
7/2005
SS&C Technologies Inc.
Financial
Technology
Carlyle Group
6/2005
Cargill
Investor
Services Global
Brokerage
Services
Broker-Dealer, Thomas H. Lee Partners
Market
Exchange
400
4/2005
Instinet
Broker-Dealer, Silver Lake Partners
Market
Exchange
208
4/2005
Pitney
Bowes Inc. Capital
Services
Financing
Unit
Specialty
Finance
Cerberus Capital Management
745
3/2005
Medical
Services Co.
Inc.
Insurance
An investor group led by
Monitor Clipper Partners
322
3/2005
SunGard
Data
Systems Inc.
Financial
Technology
Bain Capital Partners, The
Blackstone Group, Goldman
Sachs Capital Partners, Kohlberg
Kravis Roberts & Co.,
Providence Equity Partners,
Silver Lake Partners, Texas
Pacific Group
2/2005
Insurance
Auto
Auctions
Inc.
Financial
Technology
Kelso & Companies Inc.
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
$1,719
656
947
11,043
364
2008 Update
Date
Announced
Target
Target
Sub-Sector
Acquiror(s)
Deal Value
($ in millions)
8/2004
Beecher Carlson
Insurance
Austin Ventures
$89
7/2004
Retriever
Payment Systems
Financial
Technology
GTCR Golder Rauner
250
6/2004
Financial Pacific
Co.
Specialty
Finance
Allied Capital Corp.
6/2004
Refco Group
BrokerDealer
Thomas H. Lee Partners
5/2004
Global Cash
Access
Financial
Technology
An investor group,
including Summit Partners,
Tudor Ventures
316
4/2004
Long Term Care
Group Inc.
Insurance
Management-led investor
group, Advent
International Corp.,
Conning Capital Partners
130
3/2004
Safeco Life and
Investments
Insurance
Berkshire Hathaway Inc,
White Mountains
Insurance Group, Caxton
Associates, Highfields
Capital Management, OchZiff Capital Management,
Vestar Capital Partners,
DLJ Growth Capital
Partners, CAI Capital
Partners and Company III,
Fairholme Capital
Management, Prospector
Partners
3/2004
Centennial Bank
Holding Inc.
Depository
Institution
An investor group led by
Castle Creek Capital
8/2003
Financial
Guaranty
Insurance Co.
Insurance
Bank of America Corp,
The Blackstone Group,
Cypress Group
5/2003
Republic
Underwriters
Insurance Co.
Insurance
Wand Partners Inc, Bank
of America Capital
Investors, Greenhill
Capital Partners, Brazos
Private Equity Partners,
21st Century Group,
Northwest Equity Partners
127
3/2003
United National
Group
Insurance
Fox Paine & Co.
240
12/2002
Conseco Finance
Corp.
Specialty
Finance
JC Flowers, Fortress
Investment Group,
Cerberus Capital
Management
850
6/2002
2-10 Home
Buyers Warranty
Insurance
Brera Capital Partners
200
94
1,463
1,350
155
1,900
Source: SNL Financial, Thomson Financial, Bloomberg and Piper Jaffray
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
57
2008 Update
Private Equity Minority
Transactions in Financial
Institutions Since 2002
The following list includes U.S. financial services minority transactions with publicly
disclosed deal values of $50 million or greater. Transactions in italics are pending.
Date
Announced
58 ⏐ PIPER JAFFRAY
Target
Target
Sub-Sector
Acquiror(s)
Deal Value
($ in millions)
7/2008
Boston Private
Financial
Holding Inc.
Depository
Institution
Carlyle Group
$75
6/2008
Global BPO
Services Corp.
Asset
Management
Ares Management
150
5/2008
MF Global
Brokerage
JC Flowers & Co.
300
4/2008
National City
Depository
Institution
Investor group led by
Corsair Capital
4/2008
Thornburg
Mortgage Inc.
Specialty
Finance
MatlinPatterson Global
4/2008
Washington
Mutual
Depository
Institution
TPG Capital
2,000
2/2008
Assured
Guaranty
Insurance
WL Ross & Co.
1,000
1/2008
Legg Mason
Inc.
Asset
Management
Kohlberg Kravis Roberts &
Co.
1,250
12/2007
MBIA Inc.
Insurance
Warburg Pincus
1,143
11/2007
E*TRADE
Financial
Brokerage
Citadel Investment Group,
The Blackrock Group
1,750
11/2007
PrivateBancorp
Inc.
Depository
Institution
GTCR Golder Rauner
201
9/2007
Kessler
Financial
Services
Asset
Management
JC Flowers & Co.
100
7/2007
Safe-Guard
Products Intl
Inc.
Insurance
H.I.G. Capital
50
7/2007
Presidio Excess
Ins Scvs Inc.
Insurance
FTVentures
50
6/2007
Velocity
Financial
Group Inc.
Specialty
Finance
American Capital Strategies
125
4/2007
Metavante
Financial
Technology
Warburg Pincus
625
6/2006
FBR Capital
Markets Corp.
Brokerage
Crestview Partners
100
2/2006
NYMEX
Holdings Inc.
Brokerage
General Atlantic
160
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
7,000
696
2008 Update
Date
Announced
Target
Target
Sub-Sector
Acquiror(s)
Deal Value
($ in millions)
9/2005
NY Mercantile
Exchange
Brokerage
General Atlantic
$135
8/2005
Coast Asset
Management
Asset
Management
Summit Partners
126
7/2005
FleetCor Inc.
Financial
Technology
Bain Capital
75
6/2005
Creditex Inc.
Brokerage
TA Associates
50
3/2005
Cardtronics
Inc.
Financial
Technology
TA Associates
75
7/2004
American
Capital Access
Holdings
Insurance
Bear Stearns Merchant
Banking Partners
1/2004
OptionsXpress
Holdings Inc.
Brokerage
Summit Partners
11/2003
Archipelago
Holdings Inc.
Brokerage
General Atlantic Partners
3/2003
Vigo
Remittance
Corp.
Financial
Technology
Great Hill Partners
50
5/2002
Gulf Insurance
Group
Insurance
Stone Point Capital
125
4/2002
First American
Payment
Systems
Financial
Technology
Lindsay Goldberg &
Bessemer
70
1/2002
Clinton Group
Inc.
Asset
Management
TA Associates
140
90
125
110
Source: SNL Financial, Thomson Financial, Bloomberg and Piper Jaffray
PIPER JAFFRAY OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES ⏐
59
2008 Update
Terminated Private Equity
Buyouts of Financial
Institutions Since 2002
The following list includes terminated U.S. majority only financial services
transactions with publicly disclosed announced deal values that are greater than $50
million.
Date
Announced
Target
Target
Sub-Sector
Intended Acquiror
11/2007
Delta
Financial
Corp.
Specialty
Finance
Angelo, Gordon & Co.
$100
7/2007
United
Rentals, Inc.
Specialty
Finance
Cerberus Capital Management
4,000
5/2007
Alliance
Data
Systems
Corp.
Financial
Technology
The Blackstone Group
6,755
4/2007
Option One
Mortgage
Corp.
Specialty
Finance
Cerberus Capital Management
1,270
4/2007
SLM Corp.
Specialty
Finance
JC Flowers & Co., Friedman
Fleischer & Lowe, Bank of
America Corp., JPMorgan Chase
& Co.
3/2007
PHH Corp.
Specialty
Finance
GE Capital Solutions, The
Blackstone Group
434
2/2006
FirstBank
NW Corp.
Thrift
Crescent Capital
116
10/2005
Refco
Futures
Brokerage
Business
BrokerDealer
JC Flowers & Co.
768
4/2005
Universal
Underwriters
Insurance
Insurance
Hellman & Friedman
6/2003
American
Stock
Exchange
BrokerDealer
GTCR Golder Gauner
2/2003
AG Services
of America
Specialty
Finance
American Securities Capital
Partners
Source: SNL Financial, Thomson Financial, Bloomberg and Piper Jaffray
60 ⏐ PIPER JAFFRAY
Deal Value
($ in millions)
OPPORTUNITIES FOR PRIVATE EQUITY IN FINANCIAL SERVICES
25,537
1,100
110
70
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