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IMAS in the news: Power shift

Credit Today, 15 May 2013

In the past 12 months, the credit industry has done some growing up. Following in debt buyer Lowell Group’s footsteps, two other companies in the sector issued bonds. Private equity houses also demonstrated their confidence in the industry with further funding for credit firms, including alternative lender Borro. More recently, private equity-backed enforcement firm Marston Group acquired its competitor Rossendales. Alongside this flurry of activity, the consumer credit industry has been preparing for its move to the new regulator the Financial Conduct Authority (FCA) in April 2014, having been regulated by the Office of Fair Trading (OFT) to date.

New regulation has been proposed for the enforcement sector, while the payday loan industry has also come under scrutiny from the OFT. It is against this backdrop that private equity firms will continue to invest in the coming year.

Market activity

Tony Green, partner at financial services advisory business IMAS Corporate Finance, says the data shows that historically, the area of most interest to private equity has been lending services. He believes that this sector of credit, which he defines as debt purchase, debt collection and debt management firms, will continue to attract attention. “I think in debt purchase we’re waiting for a number of exits to take place. In 2011 and into 2012 there was a lot of activity in that part of the market, driven by private equity in a large number of cases,” he says. “But what I think they saw was that a lot of the high street banks needed to deleverage to boost their own capital ratios. So they positioned themselves with debt purchase firms to acquire those portfolios that were coming up for sale,” adds Green.

Lawrence Guthrie, director at adviser Hawkpoint Partners, believes that the opening up of the bond market has been an important development and that there are other bond issues in the pipeline. Both Lowell Group and Cabot Credit Management placed seven-year bonds in 2012, followed by Arrow in January this year. Guthrie says: “It feels like a more positive basis on which these businesses are funded because one of the issues that has always come up when selling these types of businesses in the past is whether their financing is completely solid “With seven-year bonds outstanding. It gives a sense of solidity to the future of the financing of these businesses and, when you add in other market functions, that makes it quite a sensible time to be contemplating and realising investments in the sector.” Guthrie observes that there has also been interest from US private equity firms in the UK debt purchase industry, which he claims is delivering better returns than its US counterpart. But venture capitalist Jon Moulton, who founded turnaround private equity firm Better Capital, is less sanguine about activity in this sector of the credit market. “In terms of the collection of debts there is still private equity interest in that segment, though it’s a much less profitable segment than it was,” he says. “Apart from Cabot, nobody really seems to be prospering. Probably [due to] excess capacity in the market.”

Neil Clyne, chief executive of Cabot Credit Management, thinks that as the debt sale sector matures, the opportunities for growth will continue to make it an attractive sector for private equity. He says: “In the longer term the potential for the elite businesses to move into originations, or to move upstream into complete outsourcing solutions for the banks, will encourage the biggest funds to become active in the sector.”

Alternative avenues

Moulton believes that a “good chunk” of the industry remains open to private equity interest but suggests that it is alternative lenders which are proving more attractive to investors. He forecasts more venture capital investment deals in the coming year in asset-based lending companies, and other non-banks which specialise in commercial lending, to plug the funding gap left by the banks. Anacap Financial Partners took a shared stake in challenger bank Aldermore in July 2009 with Morgan Stanley Alternative Investment Partners. Personal asset lender Borro secured a £16m funding round led by venture capital firm Canaan Partners in October 2012,with participation from Ribbit Capital and previous investors Augmentum Capital, Eden Ventures and Rockridge.

This was followed by a £20m lending facility through investment fund management company Octopus Investments later in the same month. Octopus first financed the company’s loan book in 2011. Hugh Costello, investment manager in the specialist finance team at Octopus, says: “We are more nimble than the banks and we’re willing to put the work in for a sum of money which might be too small to be on a bank’s radar. I think that’s the story across specialist finance as a whole.” Costello also expects more activity in the alternative lending space in the next 12 to 18 months. He says: “There are lots of people looking for funding. We’re in the market and we’ll continue to back best in class operators.

“But we would only back [a company] if we were confident that the processes they were running were rock solid.” He argues that with the advent of increased regulatory oversight those businesses which are not charging egregious interest rates will succeed. He cites Borro’s business model, which relies on affordability and only lends to individuals he defines as “asset rich and cash poor”.

Payday lending has received some private equity backing in the past few years. Online lender Wonga, which also provides business loans and has not ruled out a move into the mortgage market, has several private equity firms behind it, including Wellcome Trust, Balderton Capital and Oak Investment Partners. But the publication of the OFT’s review into the sector, which gave the top 50 lenders in the market 12 weeks to change their business practices, and the prospect of more regulatory scrutiny under the FCA, could deter investors. However Keith Breslauer, managing director of Patron Capital, does not think that private equity houses will turn away from payday loan companies. “I think the payday issue is much less about whether investors will like it or not like it and much more about the size of that market and how much it will grow,” he says. “The reputational risk is far less the issue. Wonga is well capitalised and a lot of people want to be in business with them.” But for Guthrie, the uncertainty surrounding how payday lenders will be regulated makes it a difficult area to invest in. “If a maximum APR was imposed, for example, which ran into the hundreds of per cent rather than the thousands of per cent, that would be a very dramatic change to their economic model, which may be difficult for them to adjust to,” he says. Instead, Guthrie points to the “fast growing” challenger banks as an area of the credit market which is likely to see private equity activity. He expects more businesses to obtain licences to hold retail deposits and cites the Paragon Group of Companies, which confirmed in February that it will become a deposit-taking bank “within months”.

The group is currently waiting for regulatory approval but has already launched a retail bond seeking £1 billion in new finance at a 6% annual coupon, which will help support the start-up of a deposit-taking arm. Guthrie adds: “In an environment where the banks are unable immediately to write down their assets properly to reflect reality, the only way they are able to adjust their balance sheets over time is to generate profits to create capital. So the spreads between what can be earned on loan assets and what has to be paid on deposits will need to remain high for some time to come, which means that a challenger bank without any material legacy loans is in a good position and can generate much better returns on capital.”

Regulation, regulation, regulation

He suggests that the credit market will see a number of initial public offerings (IPOs) over the next few years among challenger banks and debt purchase companies. For example, Arbuthnot Banking Group’s retail subsidiary Secure Trust Bank floated on the Alternative Investment Market (AIM) in October 2011.

He adds: “Subject to market conditions we could see an IPO of one or a number of those businesses; they’re certainly large enough. Better businesses have quality management teams that would be very presentable to the market; they have good growth prospects, and they can pay dividends – so they tick the boxes.” The consumer credit industry will come under the FCA from April next year, after it replaced the Financial Services Authority on 1 April 2013. The new regulator has pledged to operate a proactive, as opposed to reactive, approach but has acknowledged that this will push up costs. Those in the credit industry are hopeful regulation will boost investors’ confidence in the sector. “I believe it will provide more reassurance to potential investors that there is effective control and oversight, and that the higher cost of that control will act as a barrier to entry,” says Clyne. Green thinks any changes within the industry will be gradual and not immediately widely felt, but that from a private equity perspective those firms that have strong compliance records will “always be attractive”. “The cost of compliance is increasing and the FCA has set out that it will continue to take a tough line and inevitably one way of addressing that is through consolidation,” Green adds. Moulton agrees that consolidation in the market is a likely outcome of the new regime but he is concerned that it will act as a deterrent to new entrants. He observes that while alternative funding businesses, such as peer-to-peer lenders Zopa and Funding Circle, have been calling for regulation for some time now, the recent entrants to that market are less enthusiastic. Moulton explains that this is because the more established businesses have a competitive advantage. “Too much regulation of what has been an unregulated business could kill it,” he says. “I think the adverse effects of regulation will greatly outweigh the favourable effects. I’m not concerned about it; I’m convinced of it.”

Industry contraction

Meanwhile, the private equity industry itself has been struggling to raise funds over the past 12 months and longer. Breslaur says: “Many people simply haven’t been able to raise that much capital. As a result of which they have had to shut because they can’t raise the capital they need to cover their overheads, or they’ve had to shrink considerably, or they’re holding on.” Moulton calls it a period of “slow contraction”, with new funds typically taking a year to 18 months to market. With that in mind, he plays down the returns that can be expected from the credit industry this year: “Decent returns definitely, excellent ones, no.”

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