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Why Carlyle is betting on an interest rate windfall at Metro

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Are the tables about to turn? Investment banks have prospered in recent years, thanks to dealmaking and trading booms, turbocharged by ultra-low interest rates and quantitative easing.

But have they finally passed their peak? And will their retail and commercial banking cousins, which have suffered squeezes on lending margins as a result of those same ultra-low rates, finally prosper? If the smart brains of private equity are any guide, the answer may be yes.

The US Federal Reserve said last week it would begin an immediate tapering of its QE bond-buying programme. In the UK, the Bank of England surprised markets by not raising base rates last week, but there is a consensus expectation that rates will rise at the central bank’s December meeting. In other countries — from Norway to Poland — rises have already happened.

It is clear we are at a pivotal juncture for global economies. It is also a big moment for banks.

The loose-money environment has driven an investment banking boom. JPMorgan last month trounced third-quarter profit expectations, reporting a 26 per cent return on equity in its investment bank and a group return of 18 per cent. JPMorgan’s market capitalisation grazed $500bn last month after doubling in barely 18 months. Bank of America, Morgan Stanley and Goldman Sachs have also thrived.

Wall Street executives know the best may be over — the exuberant bond and M&A markets will be constrained by tighter monetary policy and they may have to boost staff pay in a more inflationary environment.

Conversely, if interest rates have bottomed, retail and commercial banking should — all else being equal — be set for a rebound as the gap between the cost of funding and what they make from lending widen. In Europe, where such models dominate, that could help close a longtime valuation gap with US giants.

It is against that background that the mid-tier UK banking market is becoming the unlikely focus of interest for big-name US dealmakers, particularly private equity firms looking to deploy their plentiful “dry powder”. 

Last week, Metro Bank announced it had received a takeover approach from Carlyle. A few weeks earlier, Co-op Bank — backed by JC Flowers and Bain Capital and a clutch of hedge funds — approached Spain’s Sabadell about a £1bn-plus potential purchase of its UK subsidiary TSB.

These are tiny deals for huge firms. Metro, for example, has a market cap of barely £200m. So why bother? Well, there is the appeal of cheap price tags and a core logic of arbitraging the firm’s ample cheap funding on an operation with lending margins that look set to widen.

But buyout executives will also be eyeing the consolidation opportunity of rolling up other lenders. If Carlyle did buy Metro, it could look at the Co-op and TSB, too, not to mention other mid-tier lenders. Flowers and Bain, via the Co-op, could do the same.

For a listed lender such as Metro, with capital levels stretched by thin interest rate margins and persistent losses, the prospect of a private equity capital injection resolves the Catch-22 alternative of trying to raise capital from existing shareholders at a stubbornly low valuation. Its shares currently trade 93 per cent below a March 2018 peak and the lower the valuation, the more dilution existing shareholders would suffer from an equity issue if they do not participate in it.

The pandemic has heightened the opportunity to make cost savings on branch networks in a roll-up. At Lloyds, nearly three-quarters of customers now bank online, up from less than two-thirds pre-pandemic.

There are a few examples of private equity turnrounds of troubled banks — from JC Flowers’ takeover of Japan’s Shinsei to Cerberus’s acquisition of Austria’s Bawag. But regulators have tended to be nervous of large-scale buyouts, given concerns about the potential “double leverage” stemming from private equity’s normal operating model and banks’ capital structures. They also tend to prefer the diversity of capital backing that comes with a listed shareholder base.

Beggars, though, can’t be choosers. Both Co-op and Metro have come close to failure in recent years, after scandals and capital mismanagement. A sturdy owner could fix that and might also help Britain’s weak mid-tier consolidate into a viable challenger to the big players. As long as interest rate rises are contained, that sounds like an attractive investment case. If economic stresses get out of control, however, it could prove a high-risk one.


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