Buying distressed financials

Current market turbulence is creating opportunities for private equity financial services acquisitions. But if the upside potential is huge, so is the downside, says Stephanie Schwartz Driver

As the mark ets roll and financial services firms are hit by various crises, it would seem to be a good time for private equity houses to step in, profiting from favourable pricing and cherry-picking distressed deals. And it should be a good time for investors in private equity funds that invest in financial services, too. But behind the positive indications are signs that such deals may present more complexity than many investors are prepared to handle.

"It is a very interesting time to invest in financial services," says Jay Pierrepont, managing partner at Pantheon Ventures, a global private equity investor and private-equity fund of funds manager with $19.8bn (€12.5bn) under management worldwide. "We have stress and we have very motivated sellers. This combination allows for very attractive purchase opportunities."

Many money managers and hedge fund managers have been known to be picking up leveraged loans, distressed debt securities and even bundles of residential mortgages already in arrears.

There is definite interest in the financial services sector, according to Rohit Manocha, managing director and co-founder of Tri-artisan Partners, a merchant bank involved in financial advisory and principal investment activities, headquartered in New York.

"There is clear interest among investors as funds and investors in funds," he notes. "Historically people make a lot of money in downturns, and this time financial services and real estate have been particularly hard hit."

Private equity firms, especially those that invest in distressed ventures, are viewing the sector with interest. However, economic uncertainty clouds the picture. Pierrepont says there are two questions facing private equity firms considering any investment these days, let alone one in the financial services sector. The first is whether one will be able to buy it more cheaply a few months from now or, as he put it: "Are you catching a falling sword?"

Manocha agrees: "None of us knows where the bottom is," he says, adding, "but there certainly is a lot of upside".

In general, pricing is favourable, and Pierrepont notes: "If you liked it last year, it just got a lot more attractive this year". However, there is a great deal of insecurity about when the markets are going to bottom out, and when the financial crisis is going to wane. Pricing is certainly more attractive than it was six months ago, yet nobody can predict where it is going to be in six months' time. "It gets down to how cheaply can you buy it," says Pierrepont.

The second question involves financing. "There are lots of good ideas out there, but where is the financing going to come from?" asks Pierrepont.

He notes that the large buy-out houses are fairly flush with cash. It has been credibly reported that in February the China Investment Fund agreed to put some $4bn in a new fund aiming to invest in ailing financial institutions. Considering that its first fund was $900m and its second was $7bn, a $4bn cash injection is significant.

JC Flowers, founded in 2002, focuses solely on investment in financial institutions. It may be best known in Europe for its attempts to buy into Friends Provident, the UK life insurer in which it had built up a 2.7% stake, as well as Northern Rock.

The fact that sovereign wealth funds are openly interested in investment in ailing US financial institutions is a clear sign that good opportunities exist. By working through a private equity firm, sovereign wealth funds are hoping to protect themselves from both criticism in the US and, if the value of the financial services investment should decline, in their home countries. By working with private equity groups, traditionally famed for their secrecy, the sovereign wealth funds hope to get in under the radar.

However, growing discomfort in the US with the activities of the sovereign wealth funds may also be creating roadblocks for those private equity houses, like JC Flowers and Blackstone, that choose to work with them. The political backlash has long been awaited, and now it has begun.

A bill pending in the California state assembly could prohibit both Calpers and CalSTRS from investing in any private equity firms owned in whole or in part by a sovereign wealth fund or in any funds managed by those private equity firms.

The bill would establish an outright prohibition on doing business with funds affiliated with governments that have failed to sign certain international human rights treaties, and would create onerous reporting requirements on doing business with any firms that are owned by sovereign wealth funds of those nations that have not signed such treaties.

This would take out of contention some of the private equity giants, including Blackstone. In which the China Investment Corporation took a stake early in 2007; Carlyle Group, in which the Dubai-based Mubadala Development Corporation has a 7.5% stake; and Apollo, which is 9% owned by the Abu Dhabi Investment Authority. Calpers also owns stakes in both Apollo and Carlyle.

Another sign that financial institutions represent a good private equity opportunity is the effort that Carlyle has made to build up a group dedicated to global banking and insurance. In June 2007 it appointed two high-profile managing directors to the new team, Edward Kelly, former chairman, CEO and president of Mercantile Bankshares, and David Zwiener, former president and COO of property and casualty operations at The Hartford Financial Group.

And just this March Carlyle added Olivier Sarkozy, formerly joint global head of FIG Investment Banking, as co-head and managing director of the group, which now consists of nine professionals. The group is said to be raising a fund and nobody will be surprised if it receives capital from sovereign wealth funds looking for back-door investments in the financial services sector.

Manocha, whose Tri-artisan has been involved with JC Flowers on several deals, sees good reason for investors to work with big groups like JC Flowers or Carlyle. "If you make smart investments at times of distress, you can make a lot of money - but the key is ‘smart'," he says. "Every investment is risky, but it is particularly risky if you do not understand what you are getting into."

Financial institutions deals are very specialised, and investors have to pore through a huge amount of technical detail and work through complex regulatory issues. Such deals are particularly complex because all financial services firms hold securities, making valuation difficult, and they also tend to be highly leveraged, Manocha points out.

This complexity makes it a risky sector, as Blackstone can attest. Unveiling its fourth-quarter results it announced it had been obliged to write down the bulk of its investment in bond insurer Financial Guaranty Insurance Company.

Blackstone is also in talks with the Office of the Comptroller of the Currency about the level of capital infusions that will be needed at banks that are part of the Alliance Data group, which provides transaction, credit, and marketing services - Blackstone's takeover of the group was put on hold following the OCC's intervention.

The first half of 2007 saw a spate of similar deals, with private equity firms grabbing up payment processors - but this was before the credit crunch had an impact throughout the financial services sector.

Now the chickens may be coming home to roost as many companies in the sector will require capital infusions to survive but at the same time this represents an opportunity for those private equity firms - and their investors - that are flush with cash.

"For pension funds - or any investor - the upside is potentially huge, but so is the downside," says Manocha. "It is important to get into the sector with professionals who understand what they are doing. You stand to do very well as long as you are backing the right private equity fund."