PE & Asian banks: Once-in-a-decade opportunity

Gaja Capital has made two investments in RBL Bank: the first in 2010, supporting a management buyout; and the second in August as part of a private equity consortium that injected INR15.6 billion ($209 million) to boost the Indian lender’s capital adequacy ratio. The significance of the timing – one during the fallout from the global financial crisis, the other amidst the COVID-19 pandemic – is not lost on Gopal Jain, Gaja’s founding managing partner.

After the global financial crisis, public sector banks were preoccupied with a government-mandated credit boom that ultimately led to a non-performing loan (NPL) problem. They lost sight of the emerging consumer lending opportunity, leaving the door open for private sector players like RBL.

Public sector banks used to dominate the industry by market share and market capitalization. While still responsible for two-thirds of banking activity, their combined market cap – excluding State Bank of India – is now less than 10%, a reflection of where investors see value and incremental growth. Jain believes this shift in momentum from public sector to private sector could receive another turbo-charge courtesy of COVID-19. This time the onus is on reach and digitization.

“Just as the global financial crisis led to an ATM revolution, I think COVID-19 we will see a big movement towards contactless banks. Can the public sector banks lead this charge? Some of them can, but it really is an opening for the private sector to take more market share,” he explains. “Ten years from now we might be in another crisis. But five to seven years from now, we could be talking about COVID-19 as another turning point for Indian banks.”

RBL is one of a handful of Indian private sector banks raising capital for defensive and offensive purposes. There is desire to shore up the balance sheet in expectation of near-term headwinds – though the lender responded to queries about its financial health earlier this year by noting that its capital adequacy ratio was 16.4%, well above the required 9%. At the same time, RBL wants to accumulate a war chest to take advantage of an expansion opportunity.

Banks across Asia operate under specific local conditions, characterized by regulation, competitive dynamics, and financial system maturity. But the combination of caution and opportunism in India is apparent elsewhere in the region as lenders wait to see how protracted – and economically damaging and transformative – COVID-19 turns out to be.

Private equity players often point to banks as a proxy for the general economy. Pick the right bank at the right time – such as now, with lenders trading at relatively low price-to-book (P/B) multiples – and ride the wave as it grows or bounces back faster than its peers, taking market share along the way. While there are numerous success stories, plenty of other investors have misjudged the timing.

“Banking is a low ROE [return on equity] business, so you want to buy in when valuations are below book value. Ultimately, banks are valuable because they have licenses to take public money and lend it out and because they’re a leverage play, capital is 10% of the balance sheet,” says Jovasky Pang, CEO and co-founder of Southeast Asia-focused Archipelago Capital, who previously worked on bank restructurings and M&A in Asia. “But there must be future growth in the market. You don’t want to be just replenishing capital because the NPLs [non-performing loans] are never-ending.”

This view is echoed by Sunil Kaul, a managing director and Asia financial services sector lead at The Carlyle Group. He observes there is always a business case for looking at better franchises operating in economies with attractive demographics during downturns, but it’s important to understand what impact a downturn will have on asset quality. “You don’t want to catch a falling knife,” Kaul says.

It does rhyme

It might be argued that the best time to invest in a bank is during a crisis. First, the lower the entry valuation, the higher the potential return. Second, regulators are generally wary of private equity investors, perceiving them as short-term money versus the long-term stability offered by strategic players. If a financial sponsor is pursuing a stake large enough to warrant government approval, the absence of any other buyers willing to take on the turnaround risk can be helpful.

PE firms notably prospered from deals following the Asian financial crisis when banks in the likes of Korea and Japan needed restructuring. A string of doomed pre-global financial crisis transactions are examples of investors getting the timing wrong, while there were post-crisis wins in China, India and Southeast Asia, although not necessarily as a direct consequence of global economic troubles.

Referencing past downturns to plot a likely course for the next is complicated by changes in banking systems over time and the different origins of crises. While major ratings agencies have downgraded their outlooks for Asian banks in response to COVID-19, these revisions were accompanied by words of warning rather than predictions of immediate doom.

“The banks will be affected but it will take some time for that to manifest through their financial statements. To some extent that’s already been happening with regards to the impact on profitability, provisioning levels, and lower interest rates. However, we haven’t seen the deterioration in reported asset quality that we ultimately expect to see, and the deterioration in capitalization that could follow. Liquidity has broadly held up, but it has been aided by central banks,” says Jonathan Cornish, head of Asia Pacific bank ratings at Fitch Ratings.

There are two components to a Fitch bank rating: the intrinsic credit profile of a target company and the long-term rating, which considers factors such as state and institutional support. The latter has saved India from a downgrade, with state banks expected to struggle to meet capital adequacy requirements. More broadly, there are concerns about looser rules on asset quality classification, which could cause problems given India’s economy is among the worst affected by COVID-19 in Asia.

Eugene Tarzimanov, senior credit officer for the Asia financial institutions group at Moody’s Investors Service, points to India and Thailand as the markets most likely to see an NPL spike in coming years, which would put pressure on core capital ratios. In general, he expects Asia’s banking systems to remain well capitalized, but conditions are uncertain. Meanwhile, trends such as reduced net interest margins and the threat posed by digital-only platforms have long been evident.

Private equity firms have invested $10.1 billion in Asian banks and bank holding companies since 2016, according to AVCJ Research. India accounts for about half, underscoring how the post-global financial crisis NPL boom remains an issue. The Korea share is 25%, but this rises to nearly 75% of deals announced after the pandemic hit.

In June, The Carlyle Group made the first significant investment by an international private equity firm in a Korean bank or bank holding company in 15 years when it committed KRW240 billion ($200 million) to KB Financial Group. Asked why activity has been limited, John Kim, head of Korea at Carlyle, observes that there has been no need: Korea’s banks are well capitalized. Carlyle’s KB deal was largely about supporting the acquisition of Prudential Financial’s local business.

“There was a discussion about solidifying a strategic MOU [memorandum of understanding] on ways we could work together. That discussion started in the spring,” he says. “They were evaluating Prudential Life and wanted to utilize the treasury shares they had, so we were able to invest in KB in the form of an exchangeable bond, which they used to help fund the Prudential acquisition. We also signed the MOU – for us to work with them on doing things overseas, particularly in Asia, and for them to work with us more closely on deal sourcing and financing of transactions.”

Three months later, Affinity Equity Partners and Baring Private Equity Asia agreed to invest KRW1.16 trillion in Shinhan Financial Group. This was described as a rare opportunity to get exposure to a leading financial group at an attractive valuation. Shinhan is trading at a book value of 0.35, down from 0.57 at the end of last year.

“Their loan books were cleaned up years ago and they are heavily capitalized. They have decent ROA [return-on-assets] and ROE but the share prices have gone down 30%,” a source close to the deal says. “Stakes in listed banks are mature, uninteresting investment vehicles. But every 10 years, when there is a crisis, it’s good to buy a bank. Share prices get crushed and they trade well below book.”

Shinhan noted the importance of third-party capital in terms of shoring up equity levels and strengthening loss absorption capacity, but – not unlike the KB situation – there are strategic goals to consider. The firm is said to be keen on adding to its growing list of acquisitions in Southeast Asia.

Times of need

More capital raising activity is expected across the region – although much of it will not involve private equity – as central bank moratorium programs for borrowers, which have suppressed NPLs in the near term, wind down. Gaurav Malik, a managing director at Olympus Capital Holdings Asia, estimates the overall cost of COVID-19 will emerge over the next three to four quarters.

Within Southeast Asia, Archipelago’s Pang expects Thailand, Malaysia and maybe Indonesia to come under pressure because of relatively high levels of consumer debt and strong bank exposure to auto loans and unsecured loans. Archipelago is an investor in One Network Bank (ONB), the rural subsidiary of Philippines-based BDO Unibank. Pang says the lender is benefiting from strong deposit growth as many Filipinos return home from overseas and a flight to quality within the local system.

Vietnam is in a similar position. Andy Ho, a managing director and CIO at VinaCapital, estimates that one-fifth of the country’s banks need to raise capital, compared to half pre-COVID-19, because deposits are flowing in and there is a reluctance to lend. However, Vietnam is also an example of recent private equity exuberance in financial services, with $1.8 billion plowed into local banks in 2018 and 2019, more than one-third of the Asia total. Techcombank alone attracted $1.3 billion in pre-IPO commitments, listed in mid-2018, and is now trading below its offering price.

“When Techcombank did its private placement, valuations were lofty, so it was a great opportunity for the bank to raise capital but maybe not so good for the investors. With bank shares getting hit hard in the past few months, we think it’s a good time to get into high-quality banks,” says Ho.

The emphasis is on taking a long-term view and waiting for the qualities that bring investors to Vietnam – expanding middle class, young demographics, strong consumption trends – to prove out. Warburg Pincus is among the foremost advocates of this approach, frequently feeling its way into new markets by using financial services and real estate to tap consumer growth. The firm backed Techcombank, with its consumer-centric approach, to take market share from state-owned banks.

There is some opposition to the banks-as-proxies-for-GDP-growth thesis. While high growth generally drives high levels of credit, the correlation could be shaken by changes in strategy or regulation, and it rests on the assumption that the banking system is sound. Cornish of Fitch Ratings contends this is not the case in Vietnam.

“Vietnam has been a high growth economy that’s been negatively affected, and we expect it to rebound, but the banks have been expected to lend at pretty high rates to support that economic growth. That’s unsustainable and it’s a banking system that is also lacking in capital,” he says. “We’ve seen the same problem in India – it led to the last NPL crisis, which the banks clearly have yet to recover from – and we’ve seen problems in China when banks grow too quickly.”

Digital distractions

Regardless of market, the long-term challenge facing all lenders in Asia is digitization, and the notion that COVID-19 is accelerating the transition to cashless transactions and reduced physical contact. With digital-only banking platforms emerging to various degrees in different markets, traditional banks must reinvent themselves by investing in technology. This may eat into profitability, but those that get it right could gain far more in the long run.

A common message from industry participants is don’t expect the rest of Asia to follow China’s lead. Alibaba Group and Tencent Holdings have built substantial digital financial ecosystems, leveraging their core businesses – in e-commerce and social networking, respectively – to move from plain vanilla payments into more sophisticated categories. Both now operate digital banks. Platforms in other markets either can’t build on an existing business or they don’t have early-mover advantage.

“There are many digital-only players trying multiple business models and I’m sure a few in each market will get traction, but the banks have been quite effective in offering solutions, along with trust, familiarity, and physical presence,” says Carlyle’s Kaul. “Low-margin products will be offered by these digital-only players, but it will take time for them to monetize their business through lending and using data.”

Data is a key differentiator. Alibaba and Tencent can draw on customer information from a range of verticals and feed it into algorithms. Not many digital platforms in certain other markets can say the same. “In Southeast Asia, there is not much in terms of social media and e-commerce data, it’s just transportation data. Can you lend against it?” says Archipelago’s Pang. “And if you don’t have your own balance sheet, you need a banking partner. Sooner or later, that partner will figure it out.”

The combination of data disadvantages, extreme fragmentation, unsustainable funding sources, and high customer acquisition costs are expected to restrict the growth of digital-only players. This will allow traditional banks time and space to develop their own digital competencies. Moreover, COVID-19’s impact could be more keenly felt by digital-only players. Malik of Olympus describes it as potentially “the dotcom moment for fintech” as many start-ups endure their first downturn and see credit, collection and risk models put to the test.

India’s incumbent lenders are perhaps better insulated than most because local regulators refuse to issue licenses to digital-only platforms. Non-banking financial companies (NBFCs) are essentially the fintech opposition and they will remain prominent in categories that don’t appeal to banks because of the risk (structured finance) or the distribution requirements (small business lending). In areas such as housing finance, the transition from NBFCs to traditional banks is already underway.

According to Gaja’s Jain, this phenomenon will take hold across other categories as they mature. Meanwhile, banks are beginning to fill the digital void. In the quarter ended June, more than half of all new accounts with RBL were opened through online channels and one third of all financial products were sold digitally.

Even as more private sector lenders look to raise capital at knockdown valuations, and despite the expectation that they will continue to take market share from their public sector peers, some GPs are refusing to budge. ChrysCapital Partners decided to steer clear of lending businesses for the next 3-5 months. The firm’s reasoning is that the current crisis is unprecedented, as evidenced by the government’s six-month moratorium for monthly payments on medium to long-term loans.

“The economy is expected to decline by more than 10% this year, so it’s tricky to invest in banks at this point in time. We want to hold back, see what happens once the moratorium ends and what problems the banks have,” says Ashish Agrawal, a managing director at ChrysCapital. “Everybody looks at the P/B and says it’s gone from 2.5x to 1.5x. But is that book real given the delinquencies that can start hitting some of these banks?”

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• Topics
• GPs
• Investments
• Financials
• PIPEs
• Expansion
• Asia
• Financial Services
• Economy
• coronavirus
• covid-19
• NBFCs
• Olympus Capital Holdings Asia
• Gaja Capital Partners
• Archipelago Capital Partners
• The Carlyle Group
• ChrysCapital Management
• VinaCapital