Will private equity get you?

Bank CEO, does your share price lag behind that of your competitors? Are your earnings per share or return on equity shameful compared with those of your peers? Does your institution trade at price-earnings (p/e) ratios that are embarrassing? Does your business contain individual jewels that are overshadowed and undervalued amid the rest of your business mix? Is your management team old and tired? Are your shareholders disgruntled?

If the answer to any of these questions is yes, you had better beware, because hedge funds and private equity firms could be sizing up your business to see if it could perform better if it is broken up or sold on.

Investor activism, such as that by hedge fund The Children’s Institute (TCI), which forced ABN AMRO into play in March this year, may be opportunistic and rare, but it underscores the fact that financial institutions of every size and persuasion are beginning to fall under the steely gaze of financial sponsors. And that even august institutions the size of ABN AMRO can fall victim to the most bold and cheeky plays.

Outside of non-performing loans and banks on the brink of bankruptcy, financial institutions (FIs) and their assets have not historically been the favoured destination for private equity or hedge fund money. Compared with the corporate sector, FIs are too highly regulated, already highly leveraged and too sensitive to capital-based calculations, such as credit ratings, for the traditional private equity modus operandi to be profitable (enough).

All that is about to change. What began as a trickle of activity in distressed assets – such as Ripplewood’s resurrection of Shinsei Bank, Cerberus’s investment in Aozora Bank in Japan, and buyout firm MBK Partner’s 58.4% stake in South Korea’s HK Mutual Savings Bank – is threatening to turn into a flood of mainstream interest that is increasingly focused on prime assets.

“Globalisation is driving the growth of large financial conglomerates at the same time that an increasing focus on shareholder return is driving a contradictory trend towards specialisation. This bifurcation is one of the dynamics that is creating a lot of opportunities for private equity in the financial institutions sector,” says Ravi Sinha, head of US private equity house JC Flowers’ European business.

Deals galore

In the past two years, the deal list includes JC Flowers’ acquisition of the broking operation of insurance company Marsh & Mclennan in 2005; in the same year, it led a consortium to buy Dutch merchant bank NIB Capital; it followed that with an historic deal in 2006 to acquire the first private equity-led stake in a publicly owned Landesbank in Germany, HSH Nordbank, and joined with employees of Fox-Pitt, Kelton to acquire the New York-based investment bank, which specialises in financial institutions, from Swiss Re. In November 2005, Cerberus acquired a controlling stake in Bank Leumi in Israel (its bid was 16% higher than the bank’s market price; and to get around US regulation, which prevents hedge funds from owning US banks, Bank Leumi has had to sell its subsidiary bank in the US); Ripplewood and hedge fund Eton Park Capital Management acquired a chunk of Egypt’s Commercial International Bank; Blackstone is buying the prime retail mortgage originator, PHH Mortgage, from GE Capital, which is buying parent PHH.

Only last month it was revealed that JC Flowers and Friedman Fleisher & Lowe will take a 50.2% stake in Sallie Mae, the US’s largest lender to college students, in a deal worth $25bn – a 50% premium on its stock price before rumours about the deal began. JPMorgan and Bank of America will split the rest of the stock. The deal has prompted investors to look at other US FIs, such as the International Lease Finance Corporation, American General Finance and real estate financier iStar Financial, as potential private equity targets. Shares of CIT and Countrywide Financial immediately rose by 5% and 7%, respectively. Has a new era in finance company takeovers arrived?

Other hedge funds are also targeting financial firms. Prudential is being circled by the UK’s Toscafund, fuelling speculation that Tosca will use its shareholding to force the break-up of the British insurer. Leslie Apple, a US attorney who finds legal chinks in company armour that investors can exploit, and is best-known for shaking up and forcing mergers on small US banks such as Adirondack Financial Services and Cohoes Bancorp, is in the process of raising an activist investment fund, Montana Capital Partners, that will focus on small, underperforming financial institutions.

Growing hordes of FI specialists

If the number of bankers who have shrugged off the constraints of investment bank relationships to embrace the more freewheeling world of private equity or hedge funds is anything to go by, the community of FI specialists with their eyes peeled for opportunities in the sector is growing by the day.

Only last month, Luqman Arnold, former head of Abbey National (who led its sale to Santander) and previously CEO of UBS and a senior executive at Paribas and Credit Suisse First Boston (as was), closed the first fund for his new investment vehicle, Olivant. The firm will focus on financial institutions in any geography, any sub-sector and anywhere along the business value chain.

Mr Arnold (who told The Banker in 2005: “A new factor is the power of activist investors, who intervene if [the bank] is making too many acquisitions or is paying too much for an acquisition. It is scary for chairmen and chief executives.”) is well armed with a team of formidable financial specialists, including co-founders of Olivant, Alan Morgan, who helped to build McKinsey’s FI practice in several jurisdictions, and Kirk Stephenson, a former SG Warburg and Morgan Stanley banker.

Olivant swells the ranks of an industry that already includes such heavyweights as Mr Sinha, a former mergers and acquisitions banker at Goldman Sachs (where the firm’s founder also originated), Benoit d’Angelin, managing director at alternative investment house Centaurus (which is said to be one of the investors supporting TCI’s action at ABN AMRO) and former head of European investment banking for Lehman Brothers; Bruce Carnegie-Brown, former head of debt capital markets at JPMorgan, who, after a stint as CEO of insurer Marsh, the UK arm of Marsh & McLennan, joined 3i in January 2007 to form a specialist investment group. Lennie Fischer, a former head of investment banking at Dresdner Bank and most recently head of EMEA at Credit Suisse (where he led the sale of insurance unit Winterthur to rival AXA), has just joined Tim Collins, founder of Ripplewood, as co-CEO of RHJ International, Ripplewood’s listed private equity investment vehicle.

The right skills for the job

“People are seeing that deals can be done, and more people [are moving into private equity who] have the specific skills required for financial institutions business. Private equity used to be about leveraged buyouts and that is difficult to do in a balance sheet business. Now there are people with an understanding of regulatory capital and the importance of ratings and how to deal with the regulatory hoops,” says Mr Sinha.

The ramifications of such recent high-level defection to the financial sponsor space – and the knowledge and relationships they bring to the table – may already be evident. Last year, former Credit Lyonnais trader Martin Hughes, who is now CEO of Toscafund, appointed the venerable Sir George Mathewson, former chairman of Royal Bank of Scotland Group (RBS) and still an adviser to the bank, as chairman of the hedge fund. RBS’s former finance director, Fred Watt, followed him to Toscafund shortly thereafter. Toscafund is already reportedly involved as one of the investors supporting TCI’s argument that ABN AMRO should be sold or broken up.

What are they looking for?

So what do private equity firms or hedge funds look for? Their analysis is dispassionate: it dissects fundamentals and compares metrics such as return on equity (RoE) and caps ratios; it looks at the relative value of a business’s component parts and whether greater growth or synergies can be generated by carving out a business or by leveraging its capital position.

ABN AMRO, as a topical case in point, was vulnerable because earnings per share have been flat relative to peers and cumulative share price return was zero compared with about 44% for its peer group.

Management teams and strategy also come under close scrutiny. Those seen to be falling short of promises, lavishing too much money on acquisitions that do little to boost total returns but prevent companies from giving money back to investors are seen as prime targets for replacement in the event of a buyout, or as the ammunition that will rouse disaffected investors to call for change.

Here, ABN was again exposed. Its various restructurings have failed to accelerate earnings growth significantly (ironically, its most recent figures are much improved, although this has been overtaken by events), while Banca Antonveneta was seen as expensive and has failed to deliver the promised shareholder value, say agitators. Its global business – including LaSalle Bank in the US and Banco Real in Brazil – is seen as patchy and lacking in synergies. To proponents of ABN’s break-up, however, those constituent parts are valuable.

Ironically, the management team was hung by its own petard: it has consistently asked to be judged by total shareholder return, which was lacklustre. If it had used RoE as a benchmark instead, then the bank would have fared much better: it has consistently produced an RoE of 20% and above, compared with about 16% at BNP Paribas and 18% at RBS, according to the adjusted figures from independent research firm CreditSights.

RBS has thrown its hat into the ring in the fight for ABN AMRO in a joint bid with Banco Santander and Fortis (a strategy that echoes the club bids of many large private equity deals). For many in the alternative investment world, it is the caps ratios and the potential to unlock greater value in business lines that are badly run, lack scale or are neglected because they are not core to the franchise that make financial institutions interesting.

The next frontier

The managing director of one hedge fund that manages more than $3bn in assets believes that the FI space may be the “next frontier” for hedge funds and private equity because many firms are fundamentally mispriced.

Where companies in other sectors trade at 15-18x earnings or even higher, many banks trade anywhere between 8x and 11x earnings (see table). Such a low caps ratio has traditionally been justified by volatile earnings and perceived high levels of risk. But the hedge fund managing director maintains that better regulation and more effective risk management through the use of products such as credit derivatives mean that this is no longer a viable argument.

“Even in the vicious bear market of 2001/02, no banks got into serious trouble,” he says. “And recently, even if we can argue that the credit environment has been benign, the rates curve has not. Flat or even inverted curves are not a great environment for banks to operate in, yet many of them have continued to turn in good returns.”

More importantly, he believes that there are jewels hidden in bank portfolios that would be priced far more attractively if stripped out. Such operations could also be made to perform more efficiently in companies that are solely focused on that activity.

“Many banks behave like conglomerates – with retail activities, capital markets, asset management, payments and private banking exposures. This often robs them of focus and performance. Generally, the more focused the business, the better it performs – and the better the caps ratios it commands. This is a signal to many buyout firms that there is greater value to be extracted by selling off less core businesses,” he says.

Leverage in cash flows

If banks are leveraged overall, some segments of their business portfolios are not. For example, private equity firms would love to get their hands on the steady, reliable cash flows of businesses such as payments processing.

Only last month, Kohlberg Kravis Roberts & Co paid $26bn for credit and debit card payments processing specialist First Data, a business that was spun out of American Express in the 1990s, during the period when it was retrenching its overstretched business model (also selling Lehman Brothers) to focus on its core card business. Also last month, private equity firm Warburg Pincus agreed to buy out Milwaukee bank Marshall & Ilsley’s Metavante payment processing unit in a $4bn-plus transaction.

“KKR was happy to pay minimum 20x earnings and a 26% premium on the previous day’s closing share price because such consistent cash flows can easily be leveraged,” says a private equity investor. “And by taking it private, it will be easier to do all the painful work that is needed to turn the low-margin business they have bought into the higher-margin business it should be. Three to five years is a reasonable timeframe to monetise the investment.”

If, as seems likely, KKR intends to use First Data to continue mopping up payments businesses in Europe, Asia and elsewhere – in the past two years First Data has made acquisitions across the globe, including in the US, Poland, Austria, Argentina, Greece, Korea and Pakistan – it will probably be in the market for complementary businesses. This may be particularly true given the proposed Single Euro Payments Area (SEPA) mooted for the EU by 2008.

Will the huge multiples that KKR has paid for First Data convince banks or their shareholders that there is a great deal more value locked up in portfolio businesses such as payments processing than they are currently receiving?

Shareholder value

Even disgruntled shareholders in banking giants such as Citi and HSBC may be receptive to private equity overtures if the sums were persuasive enough. At Citi, many believe that peeved major shareholder Prince Alaweed bin Talal has been instrumental in forcing president and CEO Chuck Prince to orchestrate the recent massive job cuts to reduce costs and bolster its flagging share price. If he thought that Mr Prince could get caps multiples in the region of 20+ for Citi’s payments business, would Prince Alaweed be tempted to push for a sale?

The same question could be posed to investors who are fed up with the underperforming share price at HSBC. Many observers believe that the bank began to lose its way after the Household acquisition and has been in a bit of a panic since the subprime market went south in the US.

Asset management businesses – even so-called subscale operations – could also command large earnings if spun out of parent companies. Janus Capital in the US, with a market capitalisation of $4.5bn and assets under management (AUM) of just over $77bn, trades at a caps ratio of 36.5. This compares with the 11.5x earnings at which insurance giant AXA, with a market cap of $93.5bn and whose asset management arm has AUM of €485bn, currently trades.

Moreover, outside of the major players, the value of an asset management business as a diversification tool or to smooth bank earnings is overstated, says the hedge fund manager.

“If it contributes less than 5% of revenues, then it is subscale and expensive to run. And it is difficult to hire the best people for a subscale business,” he says. “The industry is moving towards an open architecture model, where everyone distributes everyone else’s products, so the need to own an asset management business, one that requires regulatory capital to be set against it, will decrease. Bank shareholders may begin to say to themselves, ‘if I can cut the headcount drastically, cut costs and make a killing selling the business into the bargain, why not?’.”

He believes that, as in the payment industry, private equity firms could act as the consolidators. Already, US buyout firm TA Associates is said to be backing the £740m ($1.45bn) buyout of UK-based Jupiter Asset management from its German banking parent, Commerzbank, which will be added to TA’s stable of 10 investments in the asset management sector.

Likely targets

Clearly there are impediments to private equity moving in on the banking sector, not least the regulators, who would often work hard to thwart private equity ambitions in the banking sector aside from rescue operations of distressed institutions.

It is also difficult to get a fix on private equity ambitions or plans because nobody will reveal their hand by naming likely candidates. But JC Flowers’ Mr Sinha does differentiate between earnings-related opportunities – such as KKR’s First Data acquisition and JC Flowers’ own stake in Sallie Mae – that have regular cash flows to be leveraged and balance sheet-related business where value comes from the application of different management strategies and a willingness to take a longer-term view than the public markets, such as JC Flowers’ stakes in NIB and Fox-Pitt, Kelton, for example.

There are other likely strategies for private equity activity in the FI space: picking off the small and vulnerable, whose business models could be revamped and revved-up (according to the Thomson Datastream database, based on the FTSE global index, there are 1419 listed financial institutions with a market capitalisation of less than $25bn – the price agreed for Sallie Mae last month), or extracting value from within large and lumbering organisations.

In the former camp, specialist finance houses can be leveraged by replacing the majority of their equity with debt; other institutions could be made more efficient by securitising balance sheets to make capital work harder.

“Private equity may be prepared to pay a premium to current low market rates for specialist finance companies, such as Kensington in the UK, for example. By leveraging the capital position of these companies, they can generate an even greater earnings yield,” says Vasco Moreno, director of European research and head of European banks research at FI-focused investment bank Keefe, Bruyette & Woods.

“Although more difficult due to regulatory pressures, you could also argue that some mortgage banks offer capital arbitrage plays in the context of Basel II. In that way, they buy into a mortgage company pre-Basel II, then end up with twice as much capital as they need and are left with value to extract,” he says.

There is also some potential in the insurance sector in breaking up bancassurance conglomerates, for example, that have not proved as successful at cross-selling each others’ products as proponents hoped. “There is still some uncertainty over how the insurance part of a business will be treated under Basel, but Tier 1 capital set asides will definitely make it less attractive to own an insurance subsidiary from a capital efficiency perspective,” says John Raymond, European bank and insurance analyst at CreditSights.

Defensive tactics

Whether or not the FI sector is on the brink of a wave of private equity activity, companies’ response to such challenges to their business is changing. The effect of private equity companies and activist hedge funds prowling round is forcing companies to be more proactive. Some are adopting a do-it-yourself private equity defence to keep the wolves from the door. In March, food and beverage giant Cadbury Schweppes pre-empted potential shareholder activism by announcing that it was considering a de-merger of its beverage business just days after US activist investor Nelson Peltz acquired a stake of nearly 3%.

Does this indicate a trend? ABN AMRO’s rapid talks with Barclays’ White Knight were certainly a similarly speedy defence against potential break up – the preferred option of agitator TCI.

Attack as the new form of defence seems to be the tactic of 3i’s new ‘quoted’ private equity business being built by Mr Carnegie-Brown. It intends to help listed companies by applying some of the management and growth strategies that are common in private equity. “Managers have come to us to talk about strategy,” says Mr Carnegie-Brown. “They may also have an investor who is unhappy with their strategy, their acquisition plans, etc, and who is a seller of the company’s shares as a result. Where this is a significant stake, it can depress the company’s share price. One solution could be for us to buy their stake. As an engaged and informed investor, we can give management the courage to act faster or to take more risk, for example.”

The road to activism

If the ABN AMRO case proves anything, it is that even large groups with solid fundamentals but unconvincing growth strategies could fall victim, while the ability of managers, regulators and politicians to block such bids is declining. It is also one more step along the road towards turning traditional investors into active, if not activist, shareholders.

This was illustrated last year when shareholders who were unhappy with RBS’s underperforming share price and its acquisition strategy accused CEO Fred Goodwin of being a megalomaniac and demanded a cessation of overseas expansion as well as share buybacks. Mr Goodwin and his management team acquiesced, smoothing ruffled feathers with promises of a slowdown in acquisitions and limited buybacks. It remains to be seen how shareholders will respond to RBS’s joint bid for ABN AMRO.

These days, fortunes can also change rapidly. “If a leak springs somewhere – say, share price or earnings lag for two or three quarters – then investor sentiment can turn very quickly,” says Simon Adamson, European bank analyst at CreditSights. “Equally, banks can make themselves vulnerable just by having merger talks: if the talks break down, then suddenly one bank is a failed bidder and the other is a target. We will definitely see more ‘bold’ calls for change from equity analysts and investors.”MARKET CAP AND P/E RATIOS30 FINANCIAL INSTITUTIONS WITH A MARKET CAP BELOW THE $25bn PAID FOR SALLIE MAE