Why should Private Equity houses invest in Financial Services?

06 May 2022

Relative to other sectors, private equity (PE) has played a relatively small role in shaping the financial services (FS) sector over the past two decades. A handful of specialist houses have been confident enough to focus on balance sheet plays, for example, in complex restructuring of non-performing loans (NPLs) and in alternative lending. Though the big financial institutions are now returning strongly from the lows of the global financial crisis, supported by intrinsic profitability and valuations, there are opportunities for financial investors that are too valuable to ignore. After all, FS is by various measures as much as 30% of GDP.

The FS ecosystem remains hugely inefficient and is ripe for smart, focused private investment. An excellent example of this consistently woeful engagement of retail customers in FS, and hence continually poor outcomes. Indeed an Opinium survey in 2021 found that that 65% of UK adults either (1) did not know that their pensions were invested in the stock market or (2) were seemingly certain they weren’t.  This astonishing lack of understanding is a sign of the challenge financial services has engaging with its retail customer base. The size of the opportunity for any business that can solve this problem is enormous, for example in offering proper mass market investment advice where we are beginning to see meaningful deal activity in this space (from trade and PE).

Across the corporate sector, from SMEs to larger businesses, customers are all too often underserved and overcharged. Even ‘challenger’ banks and financial institutions are not solving this challenge as they get larger and more institutionalised. Borrower, lender and broker anecdotes abound about poor speed, decision-making and overall service are now being levelled at ‘challengers’ as well as larger institutions.

Opportunity for Private Equity houses

Mainstream PE houses are slowly moving beyond the consolidation plays of insurance brokers and wealth management (where BDO is currently highly active in M&A), where entry prices are now rising markedly. However, there are real opportunities for private equity across financial services, and they should take comfort from, among others, the highly profitable JCFlowers experience in OneSavingsBank where skilled entry into the specialist lending sector created very substantial shareholder value, despite the challenges of regulatory risk and oversight which, as they showed, is manageable if addressed properly and need not be considered insurmountable. Indeed, this acts as a barrier to entry for those able to navigate it.

The fundamentals of financial services are astonishing, with digitisation and ever-increasing regulation being just two themes that will support strong growth for the foreseeable future. There is also arguably less correlation to actual economic growth than it might at first appear. Areas such as payments, accounts servicing, collections, shared services and other costs centres, compliance and financial crime are all ripe for value creation and successful investment. Other specialist lending areas of interest should include bridging, and equity release where significant growth can be expected (and where BDO’s team head led the sale while at a previous adviser of the Responsible Group to Royal London).

Underpinning the whole “plumbing” of the system is of course data and software. Better, more precise risk-based lending or product design, or indeed just more efficient and insightful analytics, are critical to success as the high valuations of the data-rich stock exchange sector demonstrate. These are excellent opportunities for those investors understandably more averse to balance sheet risk.

Financial services is a broad, vibrant sector with a wealth of opportunities for PE houses that can bring the right expertise and services. It is clear that the sector represents more than ever a “too good to miss” opportunity for those PE houses that have in the past ignored the sector.