The credit and sovereign debt crises of the past few years continue to profoundly reshape the financial landscape across the developed world. One of the most visible consequences from this difficult era has been the incessant restructuring of major European financial institutions. With low investor risk tolerance, capital-starved governments, and European banks facing the twin headwinds of ongoing economic weakness and more stringent regulation and capitalization requirements, compelling opportunities for well-positioned private equity (PE) investors look likely to remain abundant.
In July 2011, a group of investors, led by turnaround specialist WL Ross & Co., recognized this opportunity and announced they would purchase roughly 35% of Ireland’s largest bank, the Bank of Ireland (BOI). The price tag for the transaction was $1.45 billion (€1.1 billion), representing a post-money valuation of roughly 0.33 x price divided by the tangible book value (TBV — which equals a corporation’s total book value minus the value of intangible assets, including brand value, intellectual property, patents, goodwill and the like). Over a year later, BOI traded at roughly 0.50 x price divided by TBV, generating a 30% annualized return. Below are some of the critical lessons PE investors might consider in their ongoing survey of distressed banking opportunities across the continent.
In the wake of the 2008 global financial crisis, Ireland experienced a near collapse of its financial system, largely driven by a rapid, fundamental deterioration in the country’s largest banking institutions. The situation became increasingly dire following the country’s 2008 decision to guarantee all bank deposits andnearly all liabilities (including forms of unsecured, subordinated debt). In the years following the Irish government’s guarantees, the inextricable relationship between the sovereign and its main banks only intensified.
While all of Ireland’s principal banks suffered from similar exposures, fundamental deterioration, lax regulations and flawed strategies, only the BOI received substantial non-state equity capital. More generally, the Irish banking crisis featured many of the same issues afflicting banks of other developed countries. However, unlike the banking issues within the United States and other EU nations, the Irish crisis was almost entirely related to property speculation and the explosive domestic housing bubble of the preceding 10 years.
During this period, a race to the bottom to gain market share among growing developers and builders ensued among Ireland’s largest banks. As a result:
- Property-related lending accounted for 80% of credit growth among Ireland’s principal financial institutions.This growth bolstered government coffers with significant, albeit unsustainable, revenues. Tax cuts and other reforms correspondingly followed, leaving the Irish government with little to no room to support the economy (and, by extension, its ailing banks) outside of significant policy tightening in the face of falling output and rising unemployment.
- Fundamental deterioration among the most aggressive lending institutions led to a crisis of confidence among more viable lenders. That made an issue that might have otherwise been contained to one or two large banks endemic to all.
- As property lending expanded, the quality of the loans deteriorated,exposing the Irish banks to serious stress when underlyingproperty exposures deteriorated.
Bank of Ireland, Restructurings and Implications for Investors
Founded in 1783, BOI derives a majority of its business from mortgage lending in Ireland and through other financial services throughout the United Kingdom, including business banking and deposit gathering. Within Ireland, BOI holds either the first- or second-largest market share across most key products, such as residential mortgages, personal accounts and credit cards. Going into the crisis, BOI’s strategy and balance sheet reflected many of the problematic symptoms endemic to large lenders afflicted by unprecedented liquidity followed by rapidly deteriorating fundamental conditions:
- Loan and asset growth. From an already substantial basis of €80 billion in 2005, net loans still managed to grow at an astounding rate of nearly 20% over the next three years.
- Extensive and expensive leverage. Return on Average Assets (ROAAs) was tiny compared to Return on Average Tangible Common Equity (ROATCE), which was very high prior to 2007. Meanwhile, net interest margins — at less than 2% over the past eight years — suggested extensive use of leverage relative to fundamental cash flow generation.
- Rapid escalation in impaired, delinquent, charged-off loans (particularly among Irish and UK-based property and construction borrowers). Between 2004 and 2009, every absolute and relative measure of the BOI’s distressed assets escalated materially, particularly among property and construction borrowers, which represented a disproportionate 58% of total loan loss provisions compared to only 26% of gross loan exposures.
Fundamental strains to the system continued to compound within Ireland’s banking system and, in the wake of Lehman Brothers’ collapse, liquidity and solvency contracted among credit providers globally. The prospects of an outright credit system collapse within Ireland escalated rapidly. In response, a series of bailouts, reforms and restructurings unfolded over the next three years, thereby laying the groundwork for the WL Ross transaction. The following points highlight the most salient lessons for PE investors who are considering similar situations:
Uncertainty as an ally: Fundamentals-oriented investors think that the market’s perception of uncertainty can create significant gaps between intrinsic and realizable value. Today’s landscape for eurozone banks contains seemingly endless uncertainty, which, depending on market sentiment, can stretch that value gap beyond what facts should justify. In Ireland’s case, market rumors regarding haircuts (a reduction to less than full repayment) for senior bondholders of liquidating banks increasingly plagued BOI’s securities throughout 2011, throwing the proverbial baby out with the bathwater.
But any investor with access to Google might have seen that not only was BOI more favorably capitalized, provisioned and asset-healthy than its liquidating peers, but also that Ireland’s government had explicitly stated haircuts for BOI were “off the table.” That made the Bank’s then valuation of 0.1 times the price, divided by the tangible book value, a relative bargain. In today’s intensely uncertain eurozone banking environment, many investors will likely take a “fact agnostic” approach to selling at even the slightest hint of concern. For the diligent investor, such selling could provide the ripest investment opportunities.
‘Pretty pigs’ and ‘sacred cows’: Most eurozone banks today remain in varying degrees of distress. While stock prices have rallied over the past year, significant risks remain to the downside, many analysts agree. With this in mind, investors must be sure they have a high level of confidence in their management and their strategy to deal with deeply distressed scenarios. So-called “clean balance sheet bargains” will likely prove rare. Despite this distress, some banks will be stronger and better positioned (“pretty pigs”), and more systemically important for their given economy (“sacred cows”).
For Ireland, BOI was both and, in March 2011, the government announced its explicit intention to rebuild the banking system around BOI and its next largest competitor. Ireland would seek to ensure BOI’s survival. Despite this, the bank’s shares still traded at levels implying “non-survival,” allowing WL Ross to get a deal. Investors should seek to understand the timing and magnitude of the prospective capital needs of those institutions that have the right blend of “sacred cow” and “pretty pig.” Investing when those needs for support become most dire should minimize downside loss potential.
Charging for confidence: Market confidence (or lack thereof) can translate to life or death for banks in struggling eurozone countries. The more a bank can do to regain that confidence, the less the government will have to commit in order to keep it solvent. The Irish government, which prior to the WL Ross investment held approximately 36% of the bank, did not need to raise capital with this group of investors.
But in doing so, Ireland reduced its politically sensitive exposure to the bank and signaled to the world that brand name institutional capital was willing to invest. This was a critical market-based validation. Ireland was wildly incentivized to obtain such validation — the sooner BOI could graduate from taxpayer to institutional capital, the sooner its government could begin positioning other nationalized banks to do the same.
As such, these investors were able to “charge” Ireland for that validation in the form of a remarkably cheap valuation. Potential investors in eurozone banks today also could seek to leverage the prospects of early market validation and the benefits it would bring in exchange for in terms of valuations.
Today, BOI continues to thrive, having recently completed a significantly oversubscribed issuance of contingent convertible bonds, providing further evidence of the market’s faith in the bank and its recovery prospects. This, in turn, has continued to benefit WL Ross and in part validates the lessons described here. These lessons, however, provide only a subsection of the PE playbook for eurozone banks. Examinations of other failures and restructurings should prove instructive as investors continue to navigate the inherent complexities — and opportunities — presented by European banks.
This article was written by Victor Dupont, a member of the Wharton MBA Class of 2013.