Continuing its series of Q&As relating to investment manager deals, IM Deals received the following feedback from Don Putnam, Managing Partner at Grail Partners, a private equity firm focused on financial services companies.
Over the past 30 years, Don has advised many of the largest firms in the industry. He has been a private equity investor in the space for 25+ years, most currently through Grail’s strategy focused on non-deposit financial services companies.
IM Deals: How do you feel about the overall economic picture?
Putnam: Our wretched employment picture, stagnant wage growth and continuing housing crisis worry me. From my vantage point the equity markets are out over their skis, at least in the US. I expect a market reset in the second quarter; and at least another year of “twist again, like we did last summer!”
IM Deals: How would you rate the current environment for investing in financial services?
Putnam: It is a wonderful time: low rates crush profits throughout the sector, and regulators are forcing big institutions to shrink through divestiture. At the same time, after four years with very few deals, private firms are confronting strategic as well as succession needs. Most interesting from our parochial perspective, though, is the continuing search for new ideas and new strategies which might re-energize the industry and help rewrite its future.
IM Deals: Do you invest in banks, public or private?
Putnam: Well we hate deposit banks – they are too big, too commoditized and too poorly led to be interesting for private equity. We invest where the industry is going, not where it has been. In terms of public valuations, our view is that the re-pricing of public bank stocks has been overdone. If we invested in these stocks we would be short the sector – American banks simply have no way to generate the earnings that justify large bank prices, and the balance sheets remain far too global, and surreptitiously toxic.
IM Deals: If not banks, then what?
Putnam: We have five themes which express our views of the direction in which the financial services world is evolving and where we can make a lot of money for our investors. We have corporate-speak ways to express our strategies, but here is my saltier way of describing the list:
- We love non-bank Management Buy-Outs but so does everyone with an MBA and a buck to invest. Our angle is that we know the people involved, so we never have to bid in an auction or go into a deal blind. We do MBOs with people we have known for years and trust, and no one else.
- We once loved sales unreservedly, but times are a’changin. After seven years of investing in guys with client relationships instead of guys trading for them, we see a pendulum swinging. Lots of old white guys will try to re-start their glory days at “the old firm” using some chump’s money. We are not impressed – nowadays we are looking for new sales ideas that get to young rich markets using technology or whatever.
- The crisis wounded the mortgage business and the Executive Branch put a fork in it. The biggest financial service in the United States goes by the moniker “the mortgage supply chain”. It is in ruins after the effects of the crisis and indifference and undue deference from the Executive. We know it is coming back, big time, and we are investing in the new industry as it rebuilds.
- The Cloud and technology are going to change the financial services landscape. Technology has not changed the financial services industry as it relates to the consumer experience for decades. One can argue that technology has enhanced middle-and-back office, made trading more efficient, and made banking easier through ATMs etc.; but we are investing in companies/products that are using technology to be disruptive – the ones that are changing the landscape of where financial services will be.
IM Deals: You invest most of your capital in buyouts, but you like start-ups too. How do you reconcile this?
Putnam: It is a matter of horses for courses: we are stage-agnostic. That means that when we see the potential for returns we are interested. Where others have to worry about timing “too much return too fast is no good” or “the right IRR that takes too long is no good” we are a perpetual investor. Our obsession is the annual return we can get, regardless of how convenient the deal is for us, or how soon it will pay off.
IM Deals: Who are Grail’s original investors?
Putnam: Our initial investors were current and former financial services executives who understood the intricacies of the industry and appreciated our insider access and expertise in doing deals. They knew our history and our credibility would give us a leg up on other sources of capital no matter what kind of transaction or financing was in the offing.
IM Deals: Why do you love this industry?
Putnam: Financial service companies are unique. They have the brightest, most idiosyncratic people on Earth and they know when you are on their side. These companies are the quintessential buy and hold investments: strong cash flow, high operating leverage, high margins, etc. So what do you do? You make sure you are on their side: minority positions where alignment trumps control and no forced transactions for anyone. Offer support with strategy, sales and science; work the board room and help innovate — be useful. Lastly, understand what is changing. This is a deeply conservative sector that has been slow to adapt to new circumstances. People who don’t get this – the slow and the self-absorbed — will die off.