In this episode of Looking Ahead, David Ingles and Stephen Amdur, partners at Pillsbury Winthrop Shaw Pittman, focus on the rapidly evolving financial industry. Some of this technological shift, they explain, has been propelled by declining development costs and greater access to capital —and they point out where private equity investors are seeing opportunities. They also explore how large regional and national banks have shifted their M&A strategies to acquiring technology platforms.
The leveraged loan market has experienced a roaring recovery from the depths of 2020. The industry has already set a full-year issuance record with $505 billion of new issuance through October, topping the previous full-year peak set in 2017 of $503 billion.
A leveraged loan is typically secured by a first lien on the assets of the business and will often have the following characteristics:
- Debt based on a multiple of Earnings Before Interest, Depreciation and Amortization (EBITDA).
- 5 to 7 year maturity.
- Floating interest rate tied to an index (LIBOR, but soon to be SOFR).
- Amortization ranging from 1% to 5% per year.
- Private equity (“PE”) contributions typically ranging 25% to 50%, implying loan to values of 50% to 75%.
The most frequent issuers in the leveraged loan market are companies backed by PE firms that seek to lever their investment in a business to maximize the return to investors. Strategic acquirers or public companies often don’t need to access this market; they have currency in the form of their stock or readily have access to other forms of capital, such as investment-grade bonds.
The primary investors in the leveraged loan market are collateralized loan obligations, or CLO funds, which represent about 70% of the primary issuance market. The Federal Reserve estimates that institutional investors, including insurance companies, mutual funds and pension funds, and banks hold about three quarters of U.S. CLO securities owned by U.S. residents. Insurance companies alone account for about a third of U.S. residents’ holdings.
In practice, both regulated and non-regulated financial institutions will arrange a loan, either fully committed or on a “best-efforts” basis, and syndicate the loan to investors. However, there has recently been an influx in the market of direct or private lenders that look to commit to and hold an entire loan facility, thereby eliminating the uncertainty of the syndication process.
The V-Shaped Recovery
The leveraged loan default rate briefly spiked to about 5%, due to the Covid-19 lockdowns, before quickly returning well below the historical average of around 3%. This compares to a default rate of 10.8% during the peak of the recent financial crisis. The default rate is now well below 1%, its lowest level since December 2007.
Another market barometer is pricing on secondary loans. Based on the S&P/LSTA loan index, which reflects the performance of the largest facilities in the leveraged loan market, prices for over 95% of the loan market for performing loans fell below 90 cents on the dollar for a brief period in early 2020. As we enter the fourth quarter of 2021, the market has stabilized with most performing loans trading at or near par value.
Fueling the Recovery
There are several key factors driving the booming leveraged loan market. From the demand side, investors continue to seek higher-yielding debt due to low Treasury yields. Additionally, the current mix of high-yield debt outstanding has significantly shorter average durations than investment-grade bonds, which makes high yield less exposed to value degradation as rates rise.
On the supply side, competition among an influx of lenders has caused PE firms to take advantage of the demand through record-setting new leveraged loan issuance. PE firms are taking advantage of the frenzied demand for high-yield debt — not only to fund leveraged buyouts, but also for record levels of dividend recapitalizations and refinancing activity. Firms are looking to utilize low rates before an anticipated Federal Reserve interest rate increase in 2023. PE firms have closed on over 6,000 deals worth a combined $787.6 billion through the third quarter of 2021 — already the highest ever full-year numbers — according to Pitchbook.
Where Do We Go From Here?
Based on S&P’s LCD Leveraged Finance Survey for the third quarter, the average expectation of the default rate is 0.98% in one year. This signals a slight increase from where the industry is today, but is well below the historical 3% average.
The same survey revealed that credit managers see pandemic-related impacts, inflation and Fed liquidity as potential speed bumps to a continued recovery. However, the low default rate forecasts indicates that these concerns are not significant enough to blunt the recovery. Not surprisingly, industries that have low price elasticity and/or are viewed as “Covid-19 resistant” are leading the way for areas of perceived outperformance.
While there have always been risks associated with the leveraged loan market, it has once again proven resilient. Unlike the Great Recession and financial crisis, there is no impending near-term maturity wall and, at least for the time being, smoother sailing ahead.
Alternative investments are on a tear, and no asset class has seen more growth than private equity. According to a recent study by eVestment, assets under administration grew 44 percent from 2015 to 2016. This influx of capital has caused major ripple effects across the entire private equity landscape, with fund managers competing intensely to attract investor capital.
This competition has reinforced the importance of the overall experience that private equity managers provide to their investors, and as a result managers have increasingly been looking to their fund administrators for solutions.
Technology is widely seen as the solution to many of the challenges facing both private equity managers and fund administrators. Yet despite this consensus, “private equity is in the dark ages when it comes to technology” as Allison Piet, director of alternative investments accounting and reporting with insurer MetLife, puts it.
Private equity fund managers and fund administrators alike are finding themselves at a crossroads on two key issues:
- Delivering on investor demands for greater transparency and a more modern digital experience.
- Handling the operational burden of labor-intensive and margin-constraining processes that are insufficient to meet growing regulatory requirements.
A study by technology provider FIS, titled “The Promise of Tomorrow: Private Equity and Technology,” brings context to these two important issues:
Delivering on investor demands for a more transparent and modern digital experience.
One of the greatest obstacles to solving this challenge is the proliferation of systems that fund administrators and fund managers use across areas like accounting, reporting and document storage.
This multi-system approach adds a great level of difficulty to the process of collecting and preparing data required to provide investors with transparency. Further, maintaining multiple systems often proves to be arduous and time-consuming.
This demand for a more modern experience has placed tremendous pressure on fund administrators in particular, as their fund manager clients increasingly look to them to meet this need. Fund managers are sending a loud message by walking away from administrators that can’t help. In fact, according to a Preqin study, 28 percent of fund managers fired their fund administrator in the past 12 months.
This helps to explain why, according to the FIS study, 26 percent of respondents felt “threatened” by technology. That said, those that are leveraging the power of technology to improve their offerings are realizing that it can become a competitive advantage, as evidenced by the 74 percent of respondents that affirmed this in the study.
A quote from the FIS study makes this key point: “The private equity industry’s effortsto reinvent its relationship with technology also reflect recognition of the critical importance of technology to winning and retaining customers and to penetrating new markets.”
Handling the operational burden of labor-intensive and margin-constraining processes that are insufficient to meet growing regulatory requirements.
The private equity and the alternative investment industries have also been going through a metamorphosis over the past few years in the area of operations, driven in large part by the imposition of ever-increasing regulatory requirements. Compliance is the great equalizer, affecting all stakeholders in the industry from the fund administrator down to the investor.
These requirements become a business-breaking burden when operational efficiency is dictated primarily by the number of people that a company has available to help tackle them. The alternative investment industry is notorious for how heavily it relies on people to handle manual and repetitive tasks that should be automated. These are things like document preparation and distribution, tracking and receiving needed approvals, sending emails for notifications and more.
These manual tasks are exponentially more troublesome when legal and regulatory requirements come into play as most fund administrators have to add one full-time employee for every three or four new clients that they win.
This results in a vicious cycle for fund administrators as they far too often expand their budgets by adding additional staff instead of investing in technology that could solve their root problems.
Technology provides the clearest path to help private equity get out of the dark ages. This is the one solution that will help all key stakeholders improve the overall offering to investors without compromising their ability to build profitable businesses.
This quote from the FIS study encapsulates it best: “Firms that embrace this world of innovative technologies are likely to be the ones that win out in the marketplace.”
During Bank Director’s 2015 Acquire or Be Acquired conference in January, this session explored alternatives for raising capital required to close a specific M&A transaction. The discussion included the pros and cons of both public and private transactions with specific examples of offerings that worked well and those that faltered. The presentation also focused on the evolving role of private equity as a source of acquisition related capital.
Video length: 54 minutes
About the speakers
Todd Baker – Managing Director & Head of Americas Corporate Development at MUFG Americas Holdings / MUFG Union Bank NA
Todd Baker is managing director and head of Americas corporate development at MUFG Americas Holdings / MUFG Union Bank NA. He has had a lead role in scores of bank and financial services M&A transactions over the past 30+ years. Some of his more recent transactions in the community bank sphere include the 2012 acquisition of Pacific Capital Bancorp by MUFG Union Bank, the 2009 acquisition of The South Financial Group by TD Bank and the 2006 acquisition of Commercial Capital Bancorp by Washington Mutual.
Frank Cicero – Global Head of Financial Institutions, Managing Director Investment Banking at Jefferies LLC
Frank Cicero is the global head of financial institutions, managing director investment banking at Jefferies LLC. He specializes in M&A and capital markets transactions for depository institutions. Previously, Mr. Cicero was the head of investment banking coverage for banks at Lehman Brothers and Barclays Capital.
John Eggemeyer – Founding & Managing Principal at Castle Creek Capital LLC
John Eggemeyer is a founding and managing principal at Castle Creek® Capital LLC which has been a lead investor in community banking since 1990. The firm is currently one of the most active investors in community banking with approximately $700 million in assets under management. Prior to founding Castle Creek®, Mr. Eggemeyer spent nearly 20 years as a senior executive with some of the largest banking organizations in the U.S. with responsibilities across a broad spectrum of banking activities.
A few private equity firms stepped in during the financial crisis and recapitalized struggling banks, but what is private equity doing now that bank stock prices have largely improved? Some private equity firms already have exited their investments, making hefty returns by doing so. Bank Director magazine talked to investment bank Hovde Group’s Joe Fenech and Kevin Fitzsimmons, both managing directors in the equity research department, about recent research the two conducted on private equity ownership of banks and the potential for future M&A activity.
You’ve done some research on private equity ownership in banking companies. What did you find?
Joe: Private equity firms were obviously a sorely needed source of capital for smaller banks during the downturn, and the track record for private equity would seem to suggest that these firms will remain involved for up to five to seven years at most. And, with most of these investments having been made roughly three to five years ago, we think the exiting process for private equity could result in a sale of the company or some other event that is likely to have a meaningful impact on the stock.
What are the possible outcomes for banks with private equity ownership?
Joe: We cite three examples that illustrate the different paths that these PE firms may elect to take to exit their position. First, Sterling Financial Corp. was a classic, textbook-type PE opportunity. PE invested at $13 per share in 2010, they oversaw the cleansing of the balance sheet, and the company was then sold to Umpqua Holdings Corp. earlier this year for $33 per share. Second, in the case of BankUnited Inc., the PE firms partnered up with a highly respected management team, invested at $10 per share in May 2009, and following an early 2011 IPO at $27 per share, opted to divest its stake gradually, and was completely out of the shares by late 2013.
Kevin: And third, in the merger between Yadkin Financial Corp. and VantageSouth Bancshares Inc., we saw PE holders opting to remain with the company through the merger. This could suggest an extended investment time frame or maybe that the PE firms see considerable value still to be realized.
Haven’t there been private equity investments that didn’t do well?
Kevin: In one example, CommunityOne Bancorp has two main private equity backers that have a cost basis of $16 per share, and today the shares trade at about $11 per share [as of mid-November 2014], so it most definitely is underwater as of today. That said, management would emphasize that this was a longer-term project and that private equity was very aware of that from the start.
What do you predict will happen to banks that have private equity ownership in the next year or two?
Joe: A lot of these stocks are at or near post-crisis highs and some of the PE positions are sitting at substantial gains. At the same time, regulators appear to be softening their stance on M&A, particularly for mid-cap acquirers. If we’re right, and the pace of M&A continues to accelerate, it only furthers the notion that we’ll probably see resolution of several of these PE investments over the next couple of years.
Which banks have the highest potential to sell?
Kevin: One example is Palmetto Bancshares Inc., although we should note that the possibility of a sale is just one of the reasons we’re positive on the name. PLMT has a very attractive franchise and management has done an impressive job overhauling the company, and we think it’s possible that private equity could be open to an exit via M&A.
Joe: Stonegate Bank in Florida is another one, although not tied to PE involvement. We think Florida as a whole will have a pickup in volume of M&A deals and pricing given its increasing return to health. South Florida, in particular, is on fire.
What does the future hold for more private equity investments?
Joe: Private equity firms tend to make most of their investments during times of acute stress, so with the stocks nearing post-crisis highs, we think the question is more about how private equity looks to exit these stakes, as opposed to making new investments.
As U.S. equity markets climb higher—the S&P 500 has set a new record 10 times already this year—initial public offering (IPO) activity has returned to levels last witnessed during the tech boom. In 2013, 222 U.S. companies went public, raising $55 billion—the most activity since 2000. This IPO momentum has continued into 2014.
Now that the banking industry has returned to health and equity markets are on fire, IPOs have become viable options again for banks seeking fresh capital.
Disregarding mutual-to-thrift conversions, four banks completed IPOs in 2013, raising $335 million. Seven banks have already filed for IPOs in 2014, four of which have completed offerings and raised $254 million. As a result, 2014 is shaping up to be the most active year for bank IPOs in a decade.
What’s contributing to the revival of bank IPOs?
The banking industry is as healthy as it has been post-recession, but the extended low interest rate environment has changed the industry’s profitability playbook. Most banks have improved asset quality, returned to profitability and boosted capital ratios; however, net interest margin compression is overpowering those banks that lack sufficient loan growth. As a result, opportunistic banks capable of growing loans through acquisition or market expansion are attracting the most investor interest. Given the current market appetite for growth, access to capital is becoming a larger consideration for management and boards, especially if it gives them a public currency with which to acquire and expand. A bank’s ability to articulate its growth story remains critical to completing a successful IPO.
The same factors that are fueling IPOs in other industries are at play in the banking industry. Equity markets have recovered from the recession, and valuations have improved sufficiently for banks to consider an IPO. The SNL Bank & Thrift Index now trades at approximately 165 percent of tangible book value and 15 times trailing earnings.
Furthermore, many banks that recently completed IPOs have since outperformed the market. The four banks that went public in 2013 have returned 49 percent, on average, since their IPO dates, compared to 20 percent for the SNL Bank & Thrift Index and 21 percent for the S&P 500.
Private equity (PE) firms are also playing a pivotal role in the revival of bank IPOs. PE firms that entered the banking industry during the downturn now view the market as ripe for an exit. Valuations have increased and firms are nearing the end of their typical investment horizons. Five of the last six banks that went public were owned by PE firms. Private equity’s business model depends upon a successful investment exit, and an IPO exit may be preferable for those investors who want to take some money off the table, but still believe in the growth opportunities of their franchises.
Additionally, certain regulatory changes under the JOBS Act have made it less burdensome for companies to raise capital publicly. In particular, new issuers that qualify as “emerging growth companies” (i.e., those with less than $1 billion in gross revenues) can submit a draft registration statement to the SEC for confidential review, thus avoiding any public stigma associated with a failed IPO if they decide not to complete the offering. These changes may result in more IPOs in the pipeline than are publicly reported.
The confluence of factors leading to the revival of bank IPOs could also warrant investor caution. Banks that have completed IPOs in 2014 saw their stock drop 1.5 percent, on average, since their IPOs. The two most recent bank IPOs in 2014 had stock price declines of 6.6 percent and 2.2 percent, respectively, on their first trading days.
The market’s upward trajectory—fueled, in part, by the Federal Reserve—will not last forever. The S&P 500 now trades at about 25 times earnings—a level rarely reached over the past century. And while bank stocks trade at more reasonable multiples, a steep macro correction would stall the recent bank IPO momentum.
Furthermore, since loan growth is critical to shareholder returns in the current low interest rate environment, banks must remain prudent while executing their growth plans. Interest rate and credit risk monitoring is paramount to sustained, profitable growth—particularly at a time when it’s tempting to chase yield. PE firms have had mixed success investing in banks, and their aggressive roll-up strategies have not been time-tested in the banking sector.
Despite some warning signs on the horizon, the IPO window remains open, and bank investors are still captivated by unique growth stories. If the trend continues, 2014 should remain on pace as the most active year for bank IPOs in a decade.
Private equity funds are playing an increasingly vital role in recapitalizing the U.S. banking industry. A unique example of this trend occurred earlier this year when four independent PE firms joined forces to make a $160 million capital investment in Birmingham, Alabama-based AloStar Bank of Commerce, a new institution which acquired the deposits and certain assets of the failed Nexity Bank from the Federal Deposit Insurance Corp.
Advised by FBR Capital Markets Corp. and the law firm Davis Polk & Wardell LLP, AloStar successfully negotiated an 80/20 loss-sharing agreement with the FDIC on $384.2 million in assets. The four PE firms are Fortress Investment Group, Oaktree Capital Management, Stone Point Capital and Pine Brook Road Partners, and each owns approximately 24.9 percent of the company.
FBR worked closely with AloStar’s founders, Chairman and CEO Michael Gillfillan, who previously was chief credit officer and vice chairman at Wells Fargo & Co., and Executive Vice President Andrew McGhee, the former head of asset-based lending at SunTrust Banks Inc. AloStar is a banker’s bank that will use consumer and commercial deposits collected nationwide largely over the Internet to fund an asset-based lending program for small- and medium-sized businesses. Recently, FBR Capital Markets Senior Managing Director Ken Slosser talked about the deal and its importance to the industry.
What are the unique aspects of this transaction?
We believe this is the first time that four private equity firms bid on a failed bank through the resolution process and won. We also believe this is the first time that the FDIC has approved a business plan for a bank receiving assistance that will use, as a primary deposit strategy, a nationwide Internet deposit gathering system to fund asset-based lending for small businesses across the country. There have been a whole host of transactions, both assisted and unassisted, where they have not allowed Internet deposits as a primary funding strategy.
Was it hard getting four private equity firms to agree on a transaction?
It was very difficult to raise capital for Nexity without government assistance because of the level of perceived losses in its loan portfolio. Once it was decided that any transaction would need to involve an FDIC receivership action, and we started working on an assisted deal with Michael Gillfillan and Andrew McGhee at AloStar, it was very straight forward to assemble the private equity group. All four firms really worked well together evaluating the opportunity, although they each evaluated the opportunity independently and their boards approved their bids.
Was there anything else about this deal that you thought was distinctive or unusual?
The regulators, including the Federal Reserve and the Alabama Banking Department, worked very closely with the old Nexity management team and the new AloStar team for months. They were unbelievably helpful in terms of evaluating and facilitating this transaction. We felt that the regulators were partners in solving a problem and they worked with both management teams to find the lowest cost solution for a troubled bank. I really believe that was critical. We also had an outstanding management team at AloStar that had the depth of experience to work through the deal and also had the expertise to implement the new business plan.
Why is this deal important to the rest of the industry?
It demonstrates that thoughtful and creative solutions involving private equity, when they are appropriately structured, will be well received and approved by the regulators. I think the private equity partners here were terrific and cooperative and very helpful. They put in $160 million and were thoughtful and constructive about how that was done.