To launch the Web-exclusive content feature for the new abfjournal.com website, we thought it would be interesting to speak with PiperJaffray’s Thomas Chen on the state of commercial finance/specialty finance M&A activity. The firm has taken the #2 spot for Top Specialty Finance Advisor for 2007 and 2008 as ranked by SNL Financial based on the number of deals transacted in 2007 and aggregate deal volume in 2008.
And while these specific sectors have not been exempt from the chilling effect of the frozen economy, we think it an important point to consider, since the future holds the emergence of a new normal for buyers and sellers of commercial finance portfolios.A Conversation With Thomas Chen
Managing Director & Financial Institutions Group Head for Piper Jaffray & Co.
ABF Journal: Tom, can you give our readers a sense of investor interest in commercial finance/specialty lending company acquisitions? Are they happening, and if so, what’s the general mood or approach to M&A activity in these sectors?
I would say the general mood remains very uncertain one year post the disastrous week that Lehman Brothers failed, when Bank of America announced its intention of acquiring Merrill Lynch and when AIG got $80 billion-plus in government funds. If you think about historical M&A and the level of activity, the banking sector has always led the financing services sector in terms of both deals and size. If you use this as a general indicator, year to date bank M&A volume is just at $1.1 billion as compared to an annual run rate of over $200 billion a year looking at the past ten years. Even more startling is that of the deals that have been done in the bank sector this year, 43% of those deals were done on an FDIC-assisted basis. If you look at every corner of financial services, M&A transaction activity is at a standstill.
Specific to commercial finance and specialty finance shops, I would argue that there has probably been no other time — at least in my career — that I have seen more sellers. And a couple of issues have arisen around this. The first issue is centered on the viability of wholesale funding going forward versus deposit-based funding. This issue has surfaced in a couple of commercial finance companies either partially or completely converting to bank holding status. Also, I think there’s a lot of uncertainty around those companies that hold an ILC charter and what that will ultimately look like and mean.
The second issue is around legacy assets. I think that buyers, even if they see a great management team in place and a terrific opportunity in terms of pricing and deal volume going forward, still have a question: How do you price a transaction in terms of what’s at the bottom of the legacy portfolio? So, it’s not surprising that across financial services and in particular specialty finance, there’s just no M&A activity for all intents and purposes.
ABF Journal: Does that mean the pipeline is completely dry with nothing on the horizon even among well-funded strategic buyers?
Thomas Chen: Well, I would argue that the 19 institutions that participated and passed the Stress Test and received the government’s blessing, raised capital and are at adequate capital levels. Obviously the larger, “too big to fail” institutions could make very low-priced acquisitions in the commercial finance/leasing space. But they aren’t.
ABF Journal: Logically, this would be a good time to be on the buy side of a transaction. But is lending still so restrictive that the economics don’t work?
Thomas Chen: Well yes, this is a terrific time to be a buyer if you have the due diligence acumen to go in and re-underwrite a seller’s portfolio. If you can get comfortable and price the transaction accordingly, it’s a really good time because there are traditional lending sources back in the market. And as a buyer, you have an automatic demand for loans and leases, which you can price at attractive levels and also earn some nice up-front fees.
ABF Journal: What about sellers? What are your recommendations to sellers with regard to the steps they would need to take to attract buyers in the current environment?
Thomas Chen:Well, most likely if someone is looking to sell in this horrible market, they really need to. So, I think it goes back to the basics. As a seller, you need to be very transparent with your balance sheet. Buyers today are going to do twice as much, if not more in terms of due diligence than they have historically. And you have to have a top management team – you have to show a real track record of being able to run a business effectively and demonstrate that whatever has happened with your portfolio is a function of the market, not bad credit or strategic decisioning on your part.
And you have to be able to articulate a vision. You need to be able to answer questions like: What is the pro-forma outlook for this company? How am I going to take advantage of the attractive marketplace for commercial loans and leases? And of course, how can I do that prudently? And in the end, it’s about funding. Everyone out there is trying to find the depository either to sell or convert to. But without naming names, if you look at the larger financing companies that have tried to convert to a depository, it hasn’t been all that successful. If you’re relying to heavily on a deposit-based funding strategy, it’s probably a foolish approach at this point – you have to think more broadly.
A good strategic question to ask is, “Is there room for a non-bank independent provider of these services?” I would say there should be, but at this point in time the deck is stacked against them — particularly in accessing deposit-based lending.
ABF Journal: Let’s dig down to your thoughts on asset-based lending shops? Is there a unique dynamic there in terms of M&A activity in this environment?
Thomas Chen: No, I view ABL as part of the whole and I don’t think that there have been as many headline “blow-ups,” if you will, in the asset-based lending space. I would argue that most of these deals need to be done by large banks, many of them in the Stress Test-approved category. I don’t see the ABL space as “top of mind” as some of the other sectors in commercial finance like captive finance companies that have brought on some financial pressures to their non-financial parent companies.
ABF Journal: Is there anything you’d like to add at this point?
Thomas Chen: My advice to your readers is to re-calibrate what the “new normal” is – I think that’s important for everybody. The realities of today kind of wipe out historical perspectives and expectations. The world has changed and the influence of government has changed. And, the overall economic growth and profitability opportunities have changed. Every constituent involved in the process has a very different outlook going forward. Therefore, valuations won’t be the same and M&A activity won’t be the same.
The impact of government on the entire financial services industry will have a profound effect on many things – whether it’s in terms of regulation or on capital requirements or even in the matter of who survives and who doesn’t.
So, expecting to sell a business for 1.5 times or 2 times book value looking to the historical norm has flown completely out of the window. And since there’s no real answer, everyone needs to formulate their own perspective on the new normal in financial services and go from there.ABF Journal:Tom, thank you for your time.Thomas Chen:You’re welcome.