Current StatusInvesting in Europe is complicated. From the outside looking in, the European Union (“EU”) and its related institutions such as the European Central Bank (“ECB”), may appear to operate as if the EU were one country. In reality, Europe is far from that — the EU comprises 27 member countries, and has trade and financial ties to the UK, Switzerland and other non-EU members on the continent of Europe. While the Single Market is one of the EU’s proudest accomplishments, and in theory is meant to make cross-border operation of EU business seamless, the reality is a patchwork of national and European regulatory frameworks (more on this later under “Hamilton Moment”).
This is even more true in what is perhaps the most regulated industry of all — financial services. As the Founder of Financial Services Capital Partners (“FSC”), an operationally-focused private equity investment firm concentrated on the European financial services sector, I believe that fundamental transformation of European financial services sector is both necessary and ultimately inevitable. This inevitability has been brought forward by the global pandemic and associated dislocation in the financial services sector. This fundamental change has to be driven by concentrated equity ownership committed and incentivized to make the transformation happen quickly, which will necessarily involve breaking up the rigid and slow-to-react legacy tech infrastructures and institutional inertia that protects the status quo. Where there is complexity, there is mispricing, which creates opportunities for those with the domain industry knowledge to execute.
Due in part to the COVID-19 pandemic, valuations in European financial services are currently at multi-generational lows. We recently did a study (full study here) of quarterly valuation metrics and daily stock prices going back over 120 Quarters showing that — across the board — valuations are at their lowest point over that entire period. Below is an excerpt:
Furthermore, while financial institutions had long-term plans to move to mobile digital infrastructure and systems, these plans have been dramatically fast-forwarded. For example, we own a fully digital cloud-based core banking system. Before the pandemic, the company had attracted circa 10 banks onto its platform in the past several years. Since the onset of the crisis, the company has grown its customer base of banks by circa 150%, selling to an additional 15 banks in just two months. These new customers were also much larger and more complicated institutions than the previous cohorts. The first 10 institutions generally had less than $1bn in asset base, while this new cohort has on average billions of dollars in asset base, some in the $10s of billions. There is no question that this pandemic has been a watershed in the shift to digital-end-to-end back office IT and virtual mobile front ends in the banking sector.
E-commerce digital payments and transactions have also experienced rapid growth since the onset of the pandemic. We own a company that enables bricks-and-mortar retailers to sell online via an e-portal in 24 hours, and captures all the payment flows and transactional data from the customers’ newly established e-shop storefronts. This business has surged dramatically, especially in cash-based economies such as those in Central Europe which as a region, had a 75% bias towards cash-based transactions pre-crisis (unlike in America and Western Europe where cash represents 20% of transactions or less).
Longer-Term ConcernsThe European financial system going into the pandemic was just recovering from the 2008 Global Financial Crisis (“GFC”), but still had many bad loans and NPLs on their books (for more detail please see our study IFRS9 meets COVID-19: The Best Laid Plans). Many insurance and banking institutions were already undercapitalized. These problems have has been dramatically worsened by the pandemic. And the worst part is, that in the 10 years since the GFC, insurance companies and banks and other credit providers had been convinced that asset classes such as Commercial Real Estate (“CRE”, meaning office buildings and the like) were “safe,” taking comfort in what they considered to be low Loan To Value (“LTV”) ratios. Loans to rental car companies, hotels, and fleets of logistical vehicles were also deemed “safe”, so credit poured into them. As a “safe” asset class, very little capital and very little provisioning was done for these loans. Now they are the hardest hit by the pandemic.
We have yet to see the effects of a 20–30% decline in commercial real estate values resulting from the tectonic shift towards working from home and lower utilization of formal office settings. Obviously, REITs, hotels, and car rental companies are experiencing the worst financial results in recorded history. When all those properties get re-valued, the insurance, bank loan, and credit provider LTVs will go from a “safe” 70% to an overextended 110%. Stretched LTVs will require massive amounts of new capital for higher risk-weightings on those assets, not even accounting for inevitable loan losses, just risk-weightings. Further additional capital will be necessary for inevitable losses, for which little had been provisioned. I think we will see waves of new insolvencies in the financial services sector based on declining asset values in formerly “safe” lending sectors, like commercial real estate. It’s likely to get ugly, and I’m not the only one who thinks this. Even before the pandemic, the European Systemic Risk Board (“ESRB”) has voiced their concerns about European financial institutions’ exposure to commercial real estate in their recent report on vulnerabilities in the EU commercial real estate sector.
European financial services companies are currently valued at 40-year lows. In late April 2020, the Europe Stoxx 600 Banks Index reached levels last seen after the stock-market crash of 1987. Other industries such as insurance, asset management, and payments have fared somewhat better than banks, but even so are valued at a considerable discount to their US and Asian counterparts. It was not always like this. Until the 2008 GFC, the valuation metrics for European and US financial services companies were broadly comparable, but have diverged over the last ten years. The primary reason is that whereas US financial institutions had equity capital forced into them by TARP to allow for loss recognition, maintained strong underlying earnings power, and had a sense of urgency to address their problems head on, their European counterparts (including EU politicians and regulators who were aligned with management in this respect) generally preferred a more gradual approach (also referred to as “extend and pretend,” or “kicking the can down the road”).
Noteworthy AspectsIt is not the high-risk asset classes that get insurers and banks into trouble, but rather those areas that start out as low-risk and become high-risk. For most of the past decade CRE loans have been seen as a safe category in European banks’ loan books, especially when banks could report a conservative loan to value (LTV) ratio. But CRE LTV ratios are entering an era of great uncertainty due to COVID-19. Consider whether a shop or a restaurant can afford to pay the same rent if the maximum occupancy of their space is limited at 20–30% of pre-COVID levels? We are at the very beginning of what is likely to be a multi-year trend of significant revaluation in the CRE space.
Important VariablesPerhaps the most important variable (which is at the moment impossible to quantify) is how the trillions of government stimulus will percolate down to the real economy, and how the stimulus will impact the asset quality of European financial institutions. While regulators have been very quick to relax the rules in order to incentivize banks to continue to lend, it is yet to be seen whether this was a good idea or not.
Analyst AssessmentsAt a risk of being unfair to some, equity analysts often tend to focus on the waves in the ocean rather than the ocean itself. What do I mean by this? Excessive attention is being focused on quarterly earnings per share at the expense of long term strategic change and fundamental asset quality and adjusted LTVs in the performing loan books.
Ones to WatchI believe the ones to watch are in fact the ones that are not being watched. The media focuses way too much attention on a dozen or so fintech companies, while ignoring the fact that their market share is tiny as compared to the traditional incumbent long-standing banks, insurers, and lenders (and their far-flung subsidiaries) — in terms of the fintech companies’ number of customers, total assets, total deposits and other operational metrics. But with the right technology and operational support, many overlooked old-line companies (and subsidiaries thereof) have the potential to become superstars with the right sponsor supporting them on their journey.
Personal NoteI have been investing in European financial services for the past twenty years and never been more excited about the opportunity ahead. And it hasn’t always been plain sailing along my journey either. During the 2008 GFC I moved to Vienna, Austria with my family for four years and took on the challenge of an deeply operational role as inside BAWAG Bank in Austria as the shareholder representative. BAWAG Bank in Austria was Cerberus’ largest European financial services investment, and there was a very real possibility of the investment being a difficult one on the back of the GFC. In that event, it turned out to be a successful deal for Cerberus. Very broadly speaking, we turned a 2008 annual €650mn net income loss into a sustainable ~€650mn profit by 2012 and beyond, drove Return on Equity (“ROE”) from 4% to 17% — one of the highest ROEs in all of Europe, and reduced the cost to income ratio from 90% to 40% — one of the lowest in all of Europe. It was a lot of operationally intensive heavy lifting, but focusing on the small details, internal loan pricing models, internal pricing transfers, nitty-gritty blocking and tackling, being honest about divisions and lines-of-business not returning their cost of capital, and being resilient and persistent, we prevailed and turned BAWAG into one of the most stable and valuable banks in Europe.
Based on my own experience with BAWAG, I believe the European financial services space is ripe for multiple similarly operationally-focused value creation turnaround stories now. But this time heavily accentuated and dramatically accelerated by fully utilizing enabling technologies in financial services that have come to the fore and been aggressively adopted in other industries in the past couple years but have not been adequately adopted by old-line incumbent financial services companies (and their associated subsidiaries): cloud-based software as a service, end-to-end digital payments, and “Big Data”/AI for credit analysis and monitoring.
The COVID-19 Pandemic as the Catalyst for Europe’s Hamilton MomentAs mentioned in the first section of this piece, the EU might look like a monolith from the outside, but the reality is more like a loose conglomeration of often like-minded club members (and sometimes not so like-minded). Almost un-noticed in the middle of race riots in the US, the COVID-19 pandemic, and political hysteria, Europe has quietly experienced a “Hamilton Moment”. The “Hamilton Moment” in the United States describes the historic constitutional compromise forged by the first US Treasury secretary Alexander Hamilton, James Madison, and Thomas Jefferson in 1790, where the US federal government assumed all the debt incurred by the US states during the War of Independence, laying the foundation for a strong central federal government in the United States.
In March 2020 the ECB announced the €750bn Pandemic Emergency Purchase Program (“PEPP”), which has been topped by an additional €600bn in early June bringing the total fire power to €1.35trn. This is bringing the continent closer to political and financial unity than was previously imaginable, rescuing a dream that has receded in the last few years. What enabled the United States 1790 compromise, was the imperative to redeem all US states’ debt incurred while fighting a common enemy, forcing a new country to establish a common destiny.
The comparison to the birth of a federal United States is all the more fitting as the EU has come close to unravelling in the last decade (while it is long out of living memory, the US had its share of make or break moments as well). In reaction to the sovereign debt crises following the GFC, Europe set up a range of crisis-fighting tools — but they were through the European Stability Mechanism (“ESM”) and contingent on exacting fiscal discipline and structural reform in return for aid.
PEPP, on the other hand, is unconditional and covers all member states. That is crucial, as the euro area now avoids alienating an already struggling Italian (and other member states) public trying to contain COVID-19. The ECB’s actions may well have avoided a political path for the euro area ultimately ending in Italian exit from the euro.
Unlike the United States, Europe has only limited mechanisms for budgetary transfers from prosperous parts of Europe to those less fortunate. There is no single European spending plan comparable to the US federal system. That said, on 27 May 2020 the European Commission proposed a €750bn Next Generation EU fund, which together with the long-term EU budget for 2021–2027 will bring the total financial firepower of the EU budget to €1.85 trillion. It needs to be said that the ECB’s intervention via the PEPP is far more effective at least in the short term as it ensures that member countries’ funding costs do not rise to levels where they would threaten financial stability.
It almost goes without saying such federal integration at the EU level would have been impossible were the U.K. still a loud and active voice within the EU. “Brexit,” in many ways, both cleared the way for this federalism to happen, and united the EU through the closed-ranks period of self-definition that the EU’s unified negotiating of Britain’s departure from the EU subtlety brought on.
In the time of COVID19 — amid myriad other global attention-sapping tribulations– the EU has unassumingly had what I believe to be its very own “Hamilton Moment.”