Attractive returns across economic cycles
The financial services industry is a large and highly diversified market that is undergoing significant growth driven by regulatory change and technology innovation. Relatively few venture capital or private equity funds specialize in financial services due to the complexities of the financial services industry, the challenging regulatory environment, and the deep industry experience often required for success.
We have asked Strandview Capital, a PE firm that provides growth equity capital and strategic value to companies in the financial services and technology sector, to discuss the attractive opportunity to invest in the financial sector, valuable market insights provided by a contrarian mindset, and the proven investing strategies they have utilized.
OVERVIEW OF FINANCIAL SECTOR
The financial sector is characterized by large sub-sectors that represent huge market opportunities. These subsectors are often highly fragmented and have been slow to adopt newer technologies relative to many other sectors.
Major Subsectors Within The Financial Sector
ADVANTAGES OF INVESTING IN THE FINANCIAL SECTOR
Large market undergoing major change
The financial sector is a large and highly diversified industry that is undergoing significant growth driven by regulatory change and technology innovation.
Underserved by PE and VC funds
Relatively few venture capital or private equity funds specialize in the financial sector due to the complexities of the industry, the challenging regulatory environment, and the deep industry experience often required for success.
Highly fragmented sectors lacking current technology
There are many large and mature subsectors within the financial sector that remain highly fragmented and have been slow to adopt newer yet established technologies. Examples of such sectors include mortgage, title, insurance, debt collection and wealth management. Much of the focus of fintech companies has have been on improving the consumer-facing front end, while back-end processes and infrastructure still require major efficiency improvements. A clear example of this is the mortgage industry.
Large universe of acquisitive buyers
The financial sector is characterized by a broad and active universe of potential acquirers of smaller private companies. This provides substantial exit opportunities for early stage investors in private companies. Given the large financial sector opportunities, buyers are often willing to pay a premium to acquire companies that provide strategic value.
Canary in a coal mine
The financial services industry inherently acts as a “canary in a coal mine” regarding macro-economic indicators and market trends. A major advantage to LPs investing in a specialized financial sector fund is that they gain valuable insights into economic indicators and market trends that other generalist PE and VC funds don’t provide. The insights provided by Strandview and its portfolio companies can help LPs make important decisions regarding their overall asset allocation as investors. In particular, Strandview is expecting and preparing for a significant market correction during the life of our fund, and Strandview and its LPs will likely see it coming well before the general investor population given our pulse on the economy.
We at Strandview have spent most of our careers working within the financial sector and advising and investing in financial services companies. Most of those companies have been directly tied to interest rate, credit and liquidity fluctuations. Our studying of interest rates, credit cycles and the impact of liquidity trends has been an important part of successfully advising and investing in the financial services sector since the late 1980s.
Cyclicality creates investment opportunities across economic cycles, including distressed markets
Strandview anticipates an eventual liquidity-driven economic recession or crisis and believes a compelling opportunity exists to invest in smaller companies in counter-cyclical financial services sectors that may benefit from an economic slow-down of the U.S. economy.
Small companies can grow rapidly and profitably
Many of the historical challenges for smaller companies have recently been significantly reduced. The cost of starting and growing a business has decreased significantly while the ability to grow rapidly has accelerated. The opportunity has never been better for small companies to level the playing field by attracting higher caliber employees, deploying new technology and conducting business with larger counterparties.
VALUABLE MARKET INSIGHTS PROVIDED BY A CONTRARIAN MINDSET
Predicting the mortgage crisis of 2008
Mike Sekits is one of the two Principals at Strandview Capital. His track record and fund performance at his previous firm represents a great example of how LPs benefit from investing in a financial services fund. Previously, Mr. Sekits managed three private equity funds similar to Strandview over a ten-year period from 2006 to 2015. Mr. Sekits and his partners predicted the 2008 mortgage crisis two years before it happened. His prior firm was mentioned in the opening chapter of the book “The Big Short” as an industry expert who saw the crisis coming.
As a result, not only did their fund LPs make money in those previous funds during a time when many other asset managers struggled, but the LPs were also provided a well-informed view, prior to the crisis, on how interest rates, credit and liquidity might change dramatically, which would impact their other investments.
The LPs were provided with valuable knowledge and perspective to avoid much of the downside chaos during 2007-2009; or at least the LPs had a better understanding than most as to why it was happening. LP investors in generalist PE or VC funds typically do not receive this type of critical market insight.
Monitoring dodd frank and the consumer financial protection bureau (CFPB)
As a reaction to the mortgage crisis, the financial sector endured increased regulation that restricted capital flows and created temporary uncertainty within various financial sectors. These constrained capital flows impacted nearly all industries. The passing of the Dodd Frank Act in July 2010 created the Consumer Financial Protection Bureau (CFPB) and essentially gave it unbridled power. As a result, the CFPB created a deep “chill” in the financial sector for years, particularly for lenders and servicers of consumer financial assets. The Dodd Frank Act did serve an important role in identifying systemic risk in the U.S. financial system, protecting bank depositors, requiring more transparency and demanding less leverage. However, the CFPB’s aggressive company review process and ransom-like fines were used to make examples of certain financial services companies and to scare or paralyze others. This chill significantly restrained new investments into the consumer financial sector and constrained the extension of credit to consumers - both terrible consequences for an economy desperately trying to climb out of a deep recession.
Having positions in several financial companies under the CFPB microscope in the past, the Strandview team began to see a less punitive and more accommodating tone from the CFPB as early as mid-2015. At this time, several large financial companies such as PHH had been pushed to the brink by the CFPB. However, PHH fought back and eventually won in court. This represented an important inflection point in the CFPB’s power, with significant implications to the financial sector. This inflection point occurred well before the Congressional changes resulting from the November 2016 election.
Over the past several years, Strandview has provided valuable and accurate forecasts of when and how financial regulation would trend back toward normalized levels to allow businesses to operate more efficiently. As far back as mid-2015, we noted a definite shift in how the CFPB was interacting with financial sector companies. Our view was that the CFPB was moderating its previous aggressive posture after being challenged in several high-profile court cases. Also, with the election of a Republican-controlled U.S. Congress, Strandview immediately recognized that this would moderate the Dodd Frank Act and the CFPB, resulting in reduced regulation, lower financing costs and expanded credit for businesses and consumers. This reduced regulation not only benefits credit grantors such as banks and specialty finance companies, but it also greatly benefits borrowers seeking access to loans.
While the departure of the head of the CFPB made political headlines, Strandview had been anticipating substantial change at the CFPB for several years. These changes significantly benefit nearly all industries, not just financial companies. By identifying these highly technical and specialized financial trends early and understanding the broader impact over time, Strandview is able to deliver significant value to LP investors.
HIGHLIGHT: INVESTING STRATEGIES IN THE FINANCIAL SECTOR
Strandview believes there are several key attributes of the financial sector that investors should consider in defining investment themes with the greatest potential.
New technology reduces risk, cost and time-to-market
Technology tools delivered over the internet and residing in a cloud environment can substantially change how financial assets are originated, processed and serviced resulting in significant efficiencies. Opportunities exist to invest in early stage companies with seasoned management teams and efficient platforms and grow these companies profitably and more rapidly than general market growth rates.
Early stage private companies offer superior risk-adjusted returns
Strandview anticipates investing in niche industries that are highly fragmented whereby a company that receives an infusion of just $3-5 million, alongside the support of a highly focused and experienced investor such as Strandview, will be at a significant competitive advantage.
Preparing for the next economic downturn
Strandview Capital is taking a cautious and often contrarian approach to investment opportunities. The Strandview team has experienced several economic downturns, including the liquidity crisis of 1998, the Internet collapse of 2001, and the Great Recession of 2007. The Strandview team was previously well-positioned in previous private equity portfolio investments going into 2007 and posted strong equity returns for both 2006 and 2009 fund vintages. The Strandview team believes the U.S. economic environment is due to experience a correction after a 10-year period of economic growth. A recession can provide challenges, but also excellent opportunities to invest in companies that typically perform well in market downturns, such as managers of distressed assets, insurance agencies and ancillary mortgage services.
Special Thanks to Our Contributor
Strandview Capital provides growth equity capital and strategic value to companies in the financial services and technology sector. The Strandview Growth Fund is the fourth in a series of successful funds. The Strandview Annex Fund provides follow-on equity investments into three portfolio companies in the Growth Fund.
Strandview Capital has built its asset management platform to deliver attractive equity returns to its LPs. The ready availability of powerful yet inexpensive technology tools allows smaller financial companies to rapidly build value in niche financial services sectors. Strandview’s investment strategy and tactics have proven successful at identifying these types of opportunities and creating equity value across economic cycles. Finally, Strandview delivers a unique advantage to its LP’s by providing sage insight into key economic drivers like interest rates, credit and liquidity all of which have tremendous impact on nearly all industries and asset classes.