Financial services industry outlook
INSIGHT ARTICLE |
As the financial services industry continues to be upended by the coronavirus pandemic, businesses of all kinds are having to rethink their strategies. Banks are looking to technology to maintain margins in a low-interest rate environment. In venture capital, the traditional initial public offering is now not the only way to go public as alternative approaches like special purpose acquisition companies (SPACs) and direct listings become more common. Auto insurers are quickly realizing that the key to their future lies in data. And specialty finance companies are girding for a wave of delinquencies and defaults as the pandemic drags on. Across the financial services industry, just about the only thing certain is that the pace of change is accelerating.
- Specialty finance—lenders in specialty finance face a wave of delinquencies as the economy deteriorates.
- Private equity—secondary fund buyers are poised for potential upside once the pandemic eases.
- Insurance—the use of telematics is disrupting the way the industry operates—and now Tesla is about to enter the market.
- Venture capital—SPACs and direct listings have disrupted the way companies go public.
- Financial institutions—banks can restore profitability through smart, targeted investments in technology.
- Mergers and acquisitions—deal flow among middle market private equity firms has suffered, but the top of the market is doing well.
A gathering storm in consumer lending
The federal government’s fiscal response to the coronavirus pandemic, along with lenders’ quick actions to modify repayment terms, helped ease early on what already was a severe economic shock in the consumer finance markets. But now, with the government’s stimulus program running out and loan delinquencies poised to surge, lenders are facing difficult choices if they are to weather the economic storm.
The CARES Act, signed into law March 27, authorized one-time $1,200 payments to many taxpayers, expanded eligibility for federal unemployment benefits and temporarily increased the amount of money paid to the millions who were thrown out of work.
At the same time, many lenders eased repayment terms on loans. Reports from the Kroll Bond Rating Agency compiled from loan-level performance data show that lenders modified repayment terms throughout the spring, with the percentage of modifications peaking in June across the credit spectrum.
For instance, approximately 16% of near-prime consumer loans, defined as those loans included in securitizations with a weighted-average FICO score of between 630 and 660, included a loan modification. This compares to less than 4% reported on remittance reports during each of the first four months of 2020. For prime consumer loans, defined as those loans included in securitizations with a weighted average FICO score of between 680 and 710, less than 2% had modifications during each of the first four months of remittance reports for 2020. This peaked at approximately 10% in June’s remittance reports.
The effect was a decline in loan delinquency rates and annualized net losses—no small accomplishment during an unprecedented health and economic crisis.
Note: Super-prime represents loans collateralizing consumer loan securitizations with a weighted average FICO score of between 710 and 740. Prime represents those with weighted average FICO scores between 680 and 710. Near prime represents those with weighted average FICO scores between 630 and 660.
But with the expiration of the temporary federal unemployment benefits at the end of July, talks over a new round of fiscal stimulus proceeding in fits and starts in Congress and the end of many loan modifications, delinquencies and losses are expected to increase in the last quarter of 2020.
How can lenders weather the storm of increased losses?
- Maintain a focus on customer engagement. Staying close to customers is critical to loan servicing and collections. This includes multiplatform engagement beyond the traditional face-to-face interaction at brick-and-mortar stores. Customers of traditional loan companies increasingly are digitally savvy and are seeking ways to interact with their lenders through a variety of on-demand options, including mobile applications that allow for customer inquiries as well as payment options.
- Don’t let up on digital transformation. In response, lenders should maintain investment in digitally transforming their businesses to meet customer needs and behaviors. This includes developing and supporting more mobile and interactive communication channels.
- Revise cash flow forecasting. Companies should ensure that forecasts and budgets are revised to reflect expected declines in cash receipts. Companies may need to alter their underwriting criteria or reconsider the types of loans they want to originate if cash receipts fail to provide sufficient cash flow to finance growth. Companies will also need to evaluate the impact that revised projections will have on their own compliance with lender covenants.
Consumer lenders across the credit spectrum should be prepared to handle increased losses from their portfolios during the fourth quarter absent any further stimulus programs aimed at the consumer. Such companies have been able to stave off many delinquencies and losses, but the tide is quickly turning.
MIDDLE MARKET INSIGHT: Customers increasingly are digitally savvy and are seeking ways to interact with their lenders through a variety of on-demand options.
Secondary fund buyers poised for substantial upside
What if you had the chance to invest in a fund at a 50% discount? How much capital would you seek and how quickly could you deploy it? Investors may have that chance in the months and years ahead as the economy recovers with a vehicle known in the private equity world as secondary fund investments
Secondary fund investments involve buying and selling preexisting investor commitments to private equity funds. They are purchases of funds that are three to seven years old with existing underlying companies and are often driven by an investor’s need for liquidity.
Generally, primary investors set and execute an operating agenda and forecast returns in the later years of a fund, while secondary funds hope to receive those returns in a shorter investment period.
The pandemic has caused a significant price dislocation that makes it difficult to determine the true value of risk assets. A drop in risk asset prices harms investors with a short-term mindset seeking liquidity, but poor economic conditions offer upside for those with capital and a long-term investing horizon.
LPX AG is a leading research firm in the field of alternative investing, and it manages an index that contains the largest private equity companies listed in global stock exchanges. The index composition is diversified across all industry categories, regions and vintage years. After reaching a high score of 3,133 Feb. 19, the index plummeted to 1,627 by March 23, and since then has leveled off around 2,400 since mid-May. Meanwhile, the S&P 500 staged a swift recovery over the spring and summer, leaving many investors struggling to make sense of its rise despite overall poor economic fundamentals.
The current macros in alternative investing play well for middle market secondary managers. Liquidity remains an important issue for all alternative funds and one that presents a significant opportunity for secondary fund returns. With record amounts of investable capital, there is a strong foundation between capital available and attractive buying opportunities of depleted risk asset prices.
An investor with exposure to fitness centers or gyms, for example, has been upended because of closures during the health crisis. Even with reopenings happening state by state, these companies have lost substantial earnings, and the funds that hold these investments have taken material write-downs. If the investor had plans to dispose of its investment in a set time frame, a secondary buyer would offer liquidation and benefit from buying an investment that has upside.
The financial crisis of 2008-09 sets a good example for what may follow a pandemic recovery. As net asset values declined in private equity funds, fund valuations became even more attractive for secondary investors, and substantial discounts to these lower net asset values allowed secondary buyers to purchase some of the strongest funds at attractive target returns.
In the period following the Great Recession, middle market secondaries—funds with $1 billion in assets under management and with vintage years beginning in 2008—outperformed buyout strategies by roughly 4 percentage points, or 13.5% compared to 9.7%. As the market recovered, buyout funds fared better, and funds beginning in 2012 later surpassed 14% returns.
Secondary fund managers are struggling through fundraising amid COVID-19, no different from most other alternative funds. With on-site meetings paused for the most part, diligence isn’t happening at the same pace as it was pre-COVID, despite available dry powder. Through August, secondaries raised $29.6 billion compared to $68.1 billion targeted, or 43% achieved. But these marks are better than buyout strategies who achieved only 37%, and we expect this may be a trend to follow through the pandemic.
MIDDLE MARKET INSIGHT: The need for liquidity among some private equity investors plays well for middle market secondary managers.
The auto industry’s data revolution: How will insurers adapt?
The pandemic continues to change how businesses operate, and the auto insurance industry is no exception. The use of telematics has been a critical technology for auto insurers in monitoring the impact of COVID-19. The insurers that had already launched usage-based insurance products powered by telematics were able to identify changes in driving behavior quickly, and provide lower insurance premiums as a result.
This swift action of insurers early in the second quarter has in turn opened the eyes of their customers, who saw the link between lower vehicle use and an immediate reduction in insurance premiums. As the future of work and return-to-office initiatives remains uncertain, people realize that they may be driving less and will be working from home for an extended period.
This has prompted drivers to become more open to usage-based insurance products, enabled through telematics. In earnings calls over the summer, insurance carriers reported significant increases in the adoption of mobile applications, telematics and usage-based insurance offerings, which is key to the success of these programs and the quality of the data collected.
Early-stage telematics was achieved primarily through onboard devices (often referred to as dongles) that drivers had to install in their vehicles. The technology was primitive, lacked scalability and was expensive to administer. With the advancement of technologies in mobile devices (accelerometers, gyroscopes and internet connectivity), mobile apps have quickly become the preferred solution for insurers to deploy telematics programs. But mobile devices are limited to detecting speed, acceleration, hard braking or sudden cornering, with little additional information about the vehicle or its surroundings.
Enter Tesla, with its array of beautifully designed electric cars that essentially act as data collection machines on wheels. Tesla’s telematics data, gathered with sensors, cameras and radar equipment, is an enormous competitive advantage that Tesla has on any auto insurer, and Tesla plans on using it. In Tesla’s second-quarter earnings call, Elon Musk, Tesla’s founder and chief executive, announced the expansion of the insurance strategy through Tesla Insurance.
Tesla Insurance will be able to use the data captured by the car to create a profile of the driver, to assess the likelihood of an accident and to estimate an appropriate insurance premium to charge that customer. A future where your car can provide real-time driving behavior feedback might be only a software update away.
Imagine entering a destination into your GPS and the car returning projections of insurance premiums alongside expected time of arrival and battery usage. Every policyholder would be able to control and mitigate the risk, resulting in lower insurance premiums and total cost of ownership for a Tesla.
As the value proposition of owning a Tesla increases and more vehicles hit the road, data is continuously gathered to improve Tesla’s artificial intelligence and full self-driving (FSD) capabilities. Musk has been quoted as saying that full self-driving, or Level 5 autonomy, may arrive as soon as the end of 2020 with the launch of the RoboTaxi network shortly after. This would pose an existential challenge for the auto insurance industry.
FSD will not care about your age, or your gender, or your driving record, which are all variables used by auto insurers to segment and price risks. All FSD pilots will exhibit the same driving behaviors and will eventually outperform their human counterparts. Once the RoboTaxi network goes live, driving on your own will make less and less financial sense.
The auto insurance industry collects billions of dollars of revenue and employs tens of thousands of people. Insurers need to begin preparing for the long-term threat of FSD capabilities that will cascade through their companies and the broader economy.
“This gives us a unique advantage in terms of information.” Zachary Kirkhorn, Tesla’s chief financial officer, on the data-gathering abilities of Tesla cars and developing an insurance product, Tesla second-quarter earnings call on June 30, 2020.
Venture capital exits and investment opportunities
This year has seen venture capital exit strategies upended as uncertainty put mergers and acquisitions on hold, and volatile capital markets made the traditional IPO challenging. As a result, alternative options like special purpose acquisition companies, or SPACs, and, to a lesser extent, direct listings have become more common.
SPACs emerged as an alternative by offering a clearer exit point to private companies through a pre-assembled pool of capital, avoiding some of the complications of pricing an offering in a shaky market. SPACs also offer target companies more leverage to negotiate better terms and the ability to raise more capital. The stock price performance of SPACs post-merger has also shown SPACs to be more effective at avoiding the so-called IPO-pop that may leave target companies with a sense of having left money on the table.
As SPACs have gained momentum, the deal terms and structures have evolved to offer more flexibility to sponsors and target companies, which has strengthened their appeal. Still, limitations exist that suggest this option will not entirely supplant the traditional IPO.
A SPAC will often put up only a portion of the total proceeds, and additional equity financing has to be lined up to complete the merger through a private investment in public equity (PIPE). SPACs also have a limited time to complete the merger. Identifying a suitable target, getting the target ready for the public market and securing the financing can be challenging within the typical 24-month prescribed period.
As fundraising conditions improve, sponsors may prefer to revert to the pooled vehicle, given its ability to invest in multiple deals and a less restrictive timeline. For companies targeted by a SPAC, this option is compelling. But only a limited universe of companies will attract interest from SPAC sponsors who will be selective with their bets because they get one shot for each SPAC raised, leaving most other startups out of play.
The buzz around direct listings will also continue, yet a significant pickup in companies pursuing this route is also unlikely. Established companies with steady cash flows and no immediate need to raise cash may prefer this route as a way to offer investors liquidity. But the majority of venture capital-backed companies need the capital, the support of underwriters and the restriction period to help smooth volatility in post-IPO share price performance.
On the investment side, fintech has emerged as one of the verticals attracting capital and interesting investment opportunities. According to PitchBook, the total global venture capital deal activity in fintech as a percentage of total venture capital deal activity has been growing since 2010. At the end of August, the percentage of venture capital deal value and the deal count has exceeded 2019’s percentage. The interest in fintech has been amplified by the pandemic, which accelerated consumer behaviors like online banking and online shopping. The shifting behaviors have propelled businesses to accelerate their plans to adopt more digital business models and have sprung new business models that are digital by default.
Venture capital firms’ interest in fintech is likely to continue as new business models allow tech companies to embed financial services products into their current service offerings. Embedding financial services is the practice of integrating a traditional product like a loan or credit card within a nontraditional financial service platform like Amazon or Uber.
One of the best examples of embedded finance is the rise of online payment options like buy now, pay later (BNPL). Providers of banking as a service (BaaS), which have also flourished during the pandemic, are working to deliver compliance, payments, loans and multiple other capabilities as a service in a highly customizable approach.
The emergence of additional exit options beyond the traditional IPO or acquisition route should continue to be a positive development for deal flow, especially in evolving and fast-changing ecosystems like fintech, which have novel business models that demand greater flexibility. We expect to continue seeing more exits via SPACs and direct listings even as traditional exit options will continue to hold sway.
As banks’ margins shrink, technology offers a way out
Despite the federal government’s distribution of $525 billion in Paycheck Protection Program loans to help keep small and midsize businesses open, the recession and related monetary policy response have combined to create a perfect storm of increasing credit risk and shrinking margins for financial institutions. This has all taken place while a fundamental new reality was realized—traditional banking as we know it is changing.
For many institutions, the concern isn’t so much that banking will never return to the way it operated before the virus. Rather, it’s the speed at which these changes are taking place. It’s time to adapt or risk being left behind.
While the second half will prove to be the turning point leading to the increasing concerns over credit quality given the uncertainty over economic recovery, the release of the Federal Deposit Insurance Corporation’s Quarterly Banking Profile for the second quarter clearly showed the impact of low rates. Net income for the quarter declined roughly 70% over the same quarter in 2019, driven by a record contraction in net interest margin to 2.81%—the lowest level reported in the FDIC Quarterly Banking Profile.
While the data shows that larger financial institutions have clearly felt the pain brought about by this low-rate environment first, it is only a matter of time until smaller institutions see the contraction in margin given the Federal Reserve’s recent commentary indicating it is likely it to hold rates at their current levels through 2023.
Despite the decline in profitability, the prevailing time-tested method to offset such revenue declines of cutting expenses will simply not provide the same economic benefit over the long run as it did during previous economic downturns or crises.
In yesterday’s environment, the traditional methods of banking—such as reliance on branch activities—were still widely viewed as being critically important to banking infrastructure, even as they evolve.
In today’s environment, as financial institutions were forced to close branches because of state-implemented restrictions, banks were forced to pivot, becoming almost fully reliant on technology and digital tools to conduct business with customers and borrowers.
In tomorrow’s environment, when we emerge from this pandemic, the use and purpose of the branch will certainly look and feel different.
Throughout this pandemic, J.D. Power has been conducting a survey to gauge how people will act when the crisis is over. When asked in April about how in-person interactions would look with a bank or financial services provider once the crisis was over, 46% of respondents said they would go back to pre-COVID behaviors.
But when the same question was asked in August, only 34% of respondents indicated that they would go back to pre-COVID behaviors. The change, as reported by the survey, is that consumers were becoming much more likely to use digital channels like online or mobile banking.
These responses should not come as a surprise. The longer consumers and businesses live and operate in this environment, the more likely the behaviors change, which will affect how banks interact with their customers and borrowers.
It is now that bank leaders need to assess how they balance profitability with long-term investments to ensure that as the low-rate environment persists, it doesn’t become the drag on revenue that leads to a more difficult operating situation.
The path forward may be long and difficult, but one thing is certain: Banks that aren’t evaluating digital and innovative options will fall behind.
During the Barclays Global Financial Services Conference in September, where some of the largest public banks provided updates to investors on financial measures as well as strategic initiatives, several themes emerged—cost reduction and management, branch rationalization or review, and innovation and digital transformation.
None of these themes are new. But the importance of each has changed.
According to a search of public company filings during the great financial crisis, banks referred to digital transformation and innovation roughly 600 times from December 2007 through June 2009. A similar search since February 2020 until mid-September came back with nearly 4,000 references.
While concerns around declining margins and credit quality will persist, banks must also evaluate their technology investments. Here are some key areas to focus on:
- Technology that streamlines the back-office. Simply reducing headcount solves one issue in cost management but not all, which is why making strategic investments in streamlining and innovating back-office processes and operations becomes critical to long-term success.
- Technology that improves top-line revenues. Top-line revenue does not grow simply by making investments in back-office technologies, which is why consideration must be given to solutions that maximize efforts to grow revenues. These include leveraging data to make decisions and improving the customer experience that will allow a bank to grow in a less branch-reliant environment.
- Technology that promotes a new working environment. As many banks pivoted to a remote environment, the adoption of these technologies will lead to a radically different working environment that will make remote or alternative working arrangements an option.
While we don’t expect branch banking to disappear, we do expect it to change. And while banks may view all three technology investment alternatives as reasonable options to adapt and survive in tomorrow’s next normal, it is important to know that a failure to appropriately invest in all three will lead to challenges that may be far greater than what they are experiencing today.
“We are seeing increased adoption raised with about 75% of all transactions now occurring through our digital channels.” Greg Carmichael, chief executive, Fifth Third Bancorp, second-quarter earnings call on July 23, 2020.
The only way is up for middle market private equity firms
Deal-making and fundraising among middle market private equity firms remained slow through June as the COVID-19 health crisis continued to weigh on the economy.
The number of middle market deals—those of $1 billion or less—totaled only 1,048 through the first six months of 2020, representing $147.1 billion of assets, a projected 39% decline from the previous year, according to PitchBook.
This represents a projected $191.1 billion decrease in middle market dollars from the prior year and indicates that many investment managers are taking a disciplined approach despite record levels of dry powder.
The size of the deals has also plunged, with the median declining from $200 million per deal in 2019 to $167 million in 2020. As managers grow more careful, they are holding positions longer to ensure that they are able to complete operating agendas and to mitigate the business disruption. This is reflected in median holding times, which have increased from 5.24 years in 2019 to 5.46 through June 30.
Adding to the standoff in deal-making, median enterprise value multiples remain elevated, measuring 12.1 times as of June 30 compared to 12.0 times in 2019, despite poor economic fundamentals.
Private equity firms are left to prioritize their existing portfolio investments and must measure the continuing uncertainty. With many middle market companies still frail, and with market pricing still elevated, it’s no wonder that managers have favored add-ons. Through June, 72.5% of all middle market deals were add-ons, which is the highest total over the past 10 years and more than 10% higher than the next highest year, in 2019.
Not all news is bad, however. With fewer on-site meetings, investment managers have upgraded their technology to improve virtual interactions. And as we see from our clients, a growing number of staff members are returning to the office, even if only under abridged hours. Interest in new deals is poised to grow through the end of the year.
Although the year will finish softer than 2019, funds in the $1 billion to $5 billion assets-under-management category will fare much better. These larger private equity firms tend to have more established business continuity and more resources. Because of this, they often receive allocations and hold deep relationships from the major allocators.
The same is not always true for middle market firms. Through June 30, private equity fundraising in the below $500 million category has been disproportionately affected by COVID-19 and is on pace for a 39% decline in fundraising, compared to only a 32% decline for larger funds in the $500 million category and up. This is likely because middle market firms often lack people and financial resources to move swiftly, and instead, prefer a first-to-follow approach.
Still, to put this into context, middle market fundraising after the Great Recession was $17.0 billion, and is now on pace to be $24.8 billion, so don’t send out any alarm signals just yet.
As middle market private equity firms have struggled, this is not the case at a rarified end of the market. Known as ultraprivate equity, it has attracted a growing number of family offices that are enticed by the potential of reaping significant gains from direct investments.
A number of families have exited highly successful direct investments recently. One example was the IPO of Snowflake, a cloud-based data warehousing company that attracted money from several families over the course of its incubation as a private company. On the first day of trading, its shares more than doubled, and have largely held on to those gains.
With examples like Snowflake, the shift to ultraprivate equity will only gain momentum. What characterizes this new subset of private equity is investors’ ability to invest without a traditional asset manager. These investors with a longer time horizon will have the greatest flexibility to manage the terms of any deal, while reducing outside costs.
And they are concentrating their investments in a few sectors. The last 1,800-plus deals made by family offices were in three main industries: information technology, financial services and health care, according to PitchBook.
The outlook remains bright, regardless of the current pandemic. Even as middle market firms try to find their footing in an uncertain market, they are poised to end the year on an upswing. And the world of ultraprivate equity will continue to grow with a focus on the industries that have been vital to establishing and maintaining our new normal.