For sometime now the UK retail banking industry has enjoyed enviable year-on-year growth and profitability spurred by high consumer confidence and low interest rates. Such conditions have naturally attracted a significant amount of private equity investment, particularly into the niche providers.
The future, however, does not look as rosy. Consumer confidence has taken a turn for the worse with consumer indebtedness at record levels and uncertainty in the housing market. UK retail banking margins are also being squeezed with interest rates and industry competition at levels higher than in recent years. With the changing market conditions, many private equity firms are asking whether the UK retail banking industry still holds high return potential or whether it is time to exit and focus efforts elsewhere.
Our experience suggests that when markets take with one hand, they give with the other, and the changing market conditions will create pockets of new opportunity in different areas to those seen previously. Private equity firms that are able to look beyond past opportunity and uncover where new value in the market is being created, will see the potential for outstanding returns. We explore three such potential opportunities below.
The first area of opportunity we see is in the consumer debt recovery market. As UK retail banking profits have soared so in parallel has the level of consumer debt, both good and bad. UK consumer debt stands at roughly £1.3 trillion and as a proportion of income has risen to 164 percent in 2006 – the highest ever recorded and the highest in the developed world. All of this debt is not however good. The value of UK consumer debt currently overdue is estimated to exceed £50bn, having risen by more than 46 percent in just five years.
This rise in consumer debt has fuelled the consumer debt recovery market with £6bn in debt being sold to recovery firms for collection in 2006 (up from £2bn in 2003). Despite this growth, the indicators underpinning future growth are arguably stronger. Analysts are forecasting rises in bad debt with fears of US-style subprime lending issues and more firms are selling debt to relinquish value from delinquent portfolios.
The debt recovery industry provides great opportunity for private equity firms. The industry has real growth potential, it is still immature in terms of consolidation and IPOs, and early private equity activity has already reaped significant reward.
The second area of opportunity we see is in the peer-to-peer lending market. The high levels of growth and profitability experienced in UK retail banking have attracted more and more players to the industry. As with any industry, when competition has risen and growth starts to slow, price becomes a dominant factor in competition. Although there are other important factors at play in UK retail banking, inevitably those players that have cost bases that allow them to compete and win on price will continue to enjoy healthy growth and profitability into the future.
Peer-to-peer lending represents a business model whereby individual consumers can transact loans without the cost bases of traditional intermediaries, such as banks. Consequently, such lenders are in a superior position to meet the price challenge.
The specific services differ from firm to firm but range from providing a legal framework around a pre-arranged loan, to the creation of risk-weighted loans and savings products involving, potentially, hundreds of anonymous borrowers and lenders. From a customer perspective the rates offered, including fees, represent a premium for savers (or lenders) and a discount for borrowers over those available from the mainstream retail banks.
The sector is still in its infancy with the adoption and profitability of the business model to be proven. However, the scale of global growth predicted – from $300m of new loans processed in 2006 to $5bn in 2010 – leads the sector to be of high potential for private equity firms.
A further area of opportunity we see is in the buy-out of market sufferers. The global financial markets and UK economy have both entered into a period of turbulence. Over recent years both have been buoyant and both have underpinned the high growth and profitability in UK retail banking. However, when booming financial markets and economies start to cool they react in ways which are often hard to predict. This is due in part to the number of outcome permutations possible, but also as there is not always a precedent to learn from, or indeed we forget the experiences of previous generations. The outcomes of turbulent financial markets and economies can however change the value of healthy companies overnight.
This is what has happened to firms like Northern Rock. They have suffered tremendously from an unprecedented event (for this generation anyway) in the global financial markets (ie the ‘credit crunch’), emotional customers and nervous shareholders - the combination of which has crippled the value of these companies. However, when the dust settles, they are still potentially viable businesses which can bounce back, and if bought at the right price can be lucrative.
The Northern Rock has been a well publicised example. Other companies will no doubt suffer from unexpected or unprecedented financial market or economic events which reduce the value of those companies overnight. If the price is right and the business model is not irreparably flawed, there is the potential for healthy Private Equity returns.
In summary, the changing market conditions in UK retail banking will create two types of new opportunity for private equity investments. The first will be in firms whose business models will benefit from the changing market conditions and who can expect a mushroom in growth. The second will be in firms whose business models will suffer from the changing market conditions in the short to medium term but who experience a disproportionate hit on price.
Such opportunities will not be in short supply and the challenge for private equity firms will be to calibrate their target risk/return plane so as not to be seduced by good (suddenly improved returns) when there is better out there (similar returns on a lower risk or better returns on the same risk basis).
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