This article was written by Tim Burroughs of the AsianVenture Capital Journal.
Proposed reforms could redraw Australia's financial services landscape as tougher regulatory requirements see banks back away from certain areas. PE investors want to pick up the pieces
The first casualties of Australia's regulatory crackdown on financial services emerged on February 5 as listed mortgage brokers saw nearly one-third of their value wiped out. Investors deserted the likes of Mortgage Choice and Australian Finance Group due to fears that the brokerage business model would be rendered obsolete by proposed changes to compensation structures.
At present, the mortgage brokers that account for 60% of Australia's home loan market receive upfront and trailing commissions on every transaction. This is paid by the banks. The Financial Services Royal Commission recommended that borrowers cover the upfront portion and banks be prohibited from paying the trailing portion, thereby reducing the risk of a broker recommending products based on economic self-interest.
Of the 76 recommendations made in the report, this was the only one the Liberal government did not fully accept. While agreeing to phase out trailing commissions, it announced plans to place restrictions on upfront payments rather than overhaul them entirely – immediately drawing criticism from the Labor opposition for falling short of full implementation. With industry lobbyists out in force, Labor duly backtracked and it remains to be seen how the policy pans out.
Private equity investors hope to benefit from dislocation within financial services, picking up assets in areas where the banks no longer want to operate. However, the mortgage broker episode serves as a reminder that the landscape remains uncertain.
"Inevitably, private equity will be looking at a number of those assets," says Mark McNamara, a partner at King & Wood Mallesons (KWM). "But PE sponsors will be questioning the true underlying earnings of these businesses because clearly they will likely have to go through some level of transformation to comply with the expected tighter regulatory framework."
The commission was established in 2017 following a series of scandals involving the Big Four banks – Commonwealth Bank of Australia (CBA), National Australia Bank (NAB), Westpac, and Australia and New Zealand Banking Group (ANZ). Kenneth Hayne, a high court judge, was tasked with probing misconduct across banking, superannuation, financial advice, and insurance.
He found a culture of greed had led to the pursuit of short-term profit often at the expense of basic standards of honesty. The recommendations are intended to reform compensation so that it doesn't encourage misconduct; ensure consumers are informed about the products they are buying; remove conflicts of interest; and hold financial institutions to account more effectively.
Impending fallout
While the mortgage brokers suffered in response to the government's endorsement of most of the measures, bank stocks went up. Notably, there was no call for the integration of financial services that took place 15 years ago – as banks bought up insurance companies and financial planning businesses – to be pulled apart. But industry advisors warned that banks would still have to consider changes to processes and operating models in anticipation of reforms to come.
"The absolute prioritization of customer outcomes by the commissioner has led to a strong emphasis on the extended application of best interest obligations across the industry. This leads to a focus on whether customer interests are met, rather than the question of how they are to be achieved," PwC noted. As a result, it believes the onus is on companies to establish protocols in areas like governance and remuneration, and then demonstrate that they meet customer interest.
Given regulators will be endowed with greater powers of investigation and enforcement, financial services companies are facing much higher compliance costs. The large banks may decide it is no longer worth being in certain areas of consumer finance, so elements of structural separation within the sector end up happening by choice rather than by decree.
From a PE perspective, one of the immediate impacts has been a change in bank behavior. For a turnaround investor like Allegro Funds, it means less distressed deal flow, because rather than sell their debt positions, banks have become more borrower-friendly. Meanwhile, traditional buyout players point to opportunities arising from a general pullback in new lending to businesses as banks become more cautious.
"As an equity provider, banks pulling back is a positive thing, provided you haven't got a lot of debt in your portfolio companies – and, fortunately, in our case we don't," says Jeremy Samuel, a founder and managing director at Anacacia Capital. "It is going to lead to more situations where equity providers can step in and play a role where the equity risk is appropriate."
It may take longer for the divestment picture to fully present itself, but industry participants know roughly what to expect. Chris Hadley, executive chairman at Quadrant Private Equity, identifies wealth management, financial planning and investment management as the areas that the Big Four are most likely to vacate. There may also be reduced activity across lending to small and medium-sized enterprises (SMEs), higher risk home loan lending, and broking services.
Several assets have already been offloaded or put on the block. Last October, AMP and CBA announced sales of their insurance and global asset management businesses, respectively. The buyers were both international strategic players. Advisors speculate that CBA's general insurance division and the wealth management operations of Westpac and NAB could follow.
"If you are big sponsor and those businesses are for sale, you would be silly not to look at them," says Simon Moore, a senior partner at mid-market GP Colinton Capital Partners. "Generally speaking, when banks decide they are moving out they run no-reserve auctions. I wouldn't be surprised if at least one of those large franchises ended up with private equity."
Competition will come from international financial groups, but there could also be regulatory opposition. Buyout firms do not have a long track record of success in Australian financial services. There are no more than half a dozen deals every year and only one has crossed the $1 billion threshold, excluding transactions with a real assets angle. Anything that involves taking deposits or policyholders' money and underwriting risk on a long-dated promise is seen as problematic.
One executive recalls an official with the Australian Prudential Regulation Authority (APRA) explaining why a foreign insurer would be an infinitely preferable buyer for a local insurance business than PE. "Their willingness to let one of their subsidiaries go would be much less than yours because they have an international brand name in that industry. You run a portfolio of investments and if one doesn't work out you have another eight or nine to make work," he was told.
Beyond the banks
Investors stress that there is plenty to look at beyond bank carve-outs, especially in spaces such as non-bank lending, where companies can take advantage of withdrawals by traditional banks. "We see a number of logical opportunities for PE firms – indeed a number have already invested into the sector including companies that have specialist skills in higher risk lending, property lending, SME lending, investment property lending, and other areas," says Quadrant's Hadley.
In 2015, KKR participated in a consortium that bought GE Capital's Australia and New Zealand consumer lending unit, now known as Latitude Financial Services. The firm's credit unit followed up in 2017 with the purchase of Pepper Group, a mortgage lender and distressed debt servicing business. The Blackstone Group and Cerberus Capital Management have also entered the mortgage lending space through La Trobe Financial and Bluestone Mortgages.
More recently, Affinity Equity Partners completed a privatization of Scottish Pacific, a debt and trade finance provider to SMEs. CEO Peter Langham said earlier this month that the company gets many referrals from banks and he expects this to continue in the wake of the commission's recommendations. Investors add that Scottish Pacific could consolidate its market position if tighter regulation makes it more difficult for smaller players to operate.
Finding white space in financial services appears to be the prevailing investment trend but operating independently of the banking system is easier said than done, especially for smaller players. "A lot of guys trying to do small financing operations for commercial equipment, arguing that the banks are going to be stepping out of that. But they must still find funding and all roads lead back to the banks providing warehousing facilities," says Colinton's Moore.
Areas of comfort for PE will become apparent once the recommendations are implemented. However, this year's federal election could delay any comprehensive legislation. "It's not until a new government is sworn in and tables its legislative amendments that we will actually start to understand the longer-term impacts of the commission's findings," says KWM's McNamara. "A lot of people are waiting for that response."
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