Financial technology, or fintech, includes everything from processing companies to stock exchanges. It includes the companies that make all the software that moves the modern financial system. It is one of those sectors that private equity lavished money on this decade, as technology fueled the globalization of finance. Think bank processing deals, like First Data ($29b), Sungard ($11.3b) and Ceridian ($5.3b).
These processing and outsourcing companies have the one thing that private equity cannot resist: Regular revenue streams and strong cash flow, even in recessions. Portfolio companies need cash flow to pay off their LBO-incurred debt, and there are few other sectors who can promise that kind of regularity.
The wave of fintech love by private equity took a long hiatus in late 2007, when the financial crisis started and private equity investment hit the skids. In fact, there was even one big setback: Blackstone’s broken engagement with Alliance Data Systems. (Dare we suggest that Blackstone’s interest in Fidelity National is the equivalent of the guy who dumps his girlfriend for another woman who looks just like her?)
Private equity’s challenge is getting the companies to agree to go private. That might be an easier sell right now considering that the market is valuing fintech higher than it would appear to deserve. The sector’s price/earnings ratios are at about 90% of their double-digit levels during the boom year of ’07, according to an investment banker in the sector. JP Morgan recently noted that financial processing companies are trading at a whopping average multiple of 18 times 2011 projected earnings per share. The companies, however, don’t have the growth to justify those valuations; growth rates are only about 60% of what they were in ’07. The companies’ customers – banks and other financial firms – also are pulling back on expenditures and are unlikely to embark on any overhauls right now. A banker (admittedly talking his book) reasoned that fintech companies looking to the future may want to go private before shareholders punish their high-flying valuations.
Fidelity National is an excellent example. The company has a price-earnings ratio of 15.75, but JP Morgan analyst Tien-tsin Huang wrote last week that he expects the company’s earning growth to grow at only 3-5% longer-term.
The biggest companies in the sector, like Fidelity National and Fiserv, tend to be active dealmakers, buying up other companies. That also means that it’s easy for private equity firms to buy them and cut leftover costs from those acquisitions and streamline the companies. One adviser to fintech companies said the process of streamlining is inevitable- but compared it to “changing the wheels while the bus is in motion” if fintech companies attempt such big changes while having to deliver big returns to shareholders. JP Morgan’s Huang noted that one of Fidelity National’s top three advantages – besides its recurring revenue stream and high cash-generating business model – is the cost-cutting opportunities presented by its acquisitive past.
There are plenty of candidates, even if just in theory. Fiserv is in almost exactly the same boat as Fidelity National; Fiserv with a 15.75 P/E ratio and a 5% projected growth rate for the year.
Automatic Data Processing, which cuts paychecks for one in every six Americans, was a prime buyout candidate in 2007 but rejected the idea. ADP, which is healthy and which has raised its stock dividend for 34 consecutive years, argues that clients wouldn’t want to do business with a payroll company loaded down with junk bonds. ADP enjoys a high price/earnings ratio of 15.75, but there is a question of whether the company’s plodding, reliable growth of 5% to 6% annually justifies such a high number.
Private equity firms, still sitting on $450 billion of dry powder, almost certainly will end up overpaying for fintech companies. (They’re certainly overpaying for others.) But hey: Doesn’t that only make for more exciting headlines?