Bank regulation doesn’t excite most people. Subjects like capital adequacy, liquidity coverage ratios and counterparty valuation adjustments are dry, even downright boring. Most in the investment community share these sentiments, which is precisely what attracts us to the subject.
Regulatory constraints on banks have been progressively loosened since the 1970s. This was partly a response to political pressure fuelled by bank lobbying and partly driven by a genuine belief in the free market doctrine, which held that market discipline could moderate banks’ irrational tendencies. Whatever the reason, the trend was undeniably one of deregulation. This came to an abrupt halt following the 2008 financial crisis. Political winds changed as former political allies rushed to disassociate themselves from the banks. Regulators, once brought to heel, were now unleashed and have been reapplying the shackles with zeal.
Banks are reeling under the waves of new rules, sanctions, scrutiny and some truly eye-popping fines. Their position is a treacherous one. In their eagerness to appease the public, lawmakers rushed through legislation without much thought given to implementation. Regulators are scrambling to interpret the new rules and figure out how to implement them. Ultimately, this is an evolutionary process that necessitates ‘learning by doing’ which makes life hard for banks who find the goal posts keep shifting. Yet they get little sympathy, with compliance failures likely to attract severe punishment from regulators and capital markets alike. For once, it is not just shareholders who suffer, with senior management necks on the block too; CEOs included.
Predictably, investors see regulation in a negative light: regulation makes banking safer but less profitable. That’s bad for business, right? Well, for banks, perhaps. But it should be great for business, if your business is helping banks navigate this treacherous environment. Nothing loosens a bank’s purse strings quite like a risk that could get the CEO fired.
Hunting for beneficiaries of tighter regulation has yielded a mere handful of candidates, typically US-based. Europe proved fallow ground until the recent IPO of UK-based Markit in which we participated.
Markit is just over a decade old, founded by derivatives traders from Toronto Dominion (TD) Bank. They recognised the difficulty TD’s risk managers had valuing the positions of its traders. Often risk professionals were forced to rely on the very traders they were overseeing for essential information – basically the traders were auditing themselves! This group left TD to provide independent, third-party valuations to risk managers across Wall Street.
The core product here is a contributory database. Banks submit information to Markit which combines it, cleans it and then sells it back to those same banks, as well as asset managers, hedge funds and regulators the world over. A business that gets something for free only to sell it back to its providers, and many others, is an appealing investment proposition.
Originally the business addressed a small niche within the securities market. To create a truly valuable company, they needed to expand to cover as many financial instruments and markets as possible. To this end, the founders sold 70% of the company to their largest client banks. This not only gave them the money needed to build out their business but also ensured the participation of those banks. That participation was critical in the early days because more contributors mean more accurate and reliable data which, in turn, attracted new users and contributors.
With ever greater oversight high on the agenda, bank boards, risk managers and regulators are finding Markit’s data indispensable. It is emerging as the de facto standard for valuing a broad range of financial instruments. This not only underwrites the strong demand for this product but creates a powerful lock on customers. If the regulator and every other bank use this data, no risk manager is going to go out on a limb and start using something else. Today this business generates half a billion dollars of revenue per year and growing, albeit modestly. Not bad for a company just entering its second decade.
Yet management haven’t been idle. Being a trusted provider to, and majority-owned by the banks puts Markit in a unique position to identify new problems that they can help solve. In 2007, they established a second leg to their business: an electronic platform that processes so-called ‘over-the-counter’ derivatives transactions which account for the bulk of derivatives trades. Today, this segment brings in a further quarter of a billion dollars per year, serving those same bank customers, helping them reduce operational risk and stay on the right side of regulators.
The third and final leg to this company is a ‘solutions’ business, the most interesting facet of which is a database Markit is building to help banks comply with onerous ‘Know Your Customer’ rules. This issue is especially pressing because US prosecutors are now applying a much tougher standard than the rest of the world. As The Economist recently put it, it’s no longer enough to merely know your own clients. You’re now expected to know your clients’ clients! The cost of doing so is hefty. The ten largest banks, between them, spend over a billion dollars a year on this effort. Yet failure is more costly still, with French bank BNP reportedly facing a staggering $10 billion fine.
There is undeniable commercial logic to having a third-party build and maintain this sort of database, with banks paying to access this data, rather than each building its own. Banks are desperately looking for someone to fill that role and Markit is endeavouring to assume it. Should it emerge as the provider of choice, the rewards will be significant. The ‘solutions’ business already brings in a quarter of a billion in annual revenue and grows 20% pa. This new venture could underwrite that sort of growth for years to come.
IPOs are typically not our cup of tea. They usually constitute sales by well-informed insiders looking to get out. This one was different because the sellers were the banks, probably motivated by regulatory concerns around conflicts of interest. The founders and senior management chose not to sell their shares. They will stay and grow this business with the bulk of their capital invested alongside shareholders.
At 18.5 times earnings, this company is not a steal although it is cheaper than similar businesses which trade at P/E multiples well over 20 times. The lower multiple reflects investor concern over a regulatory push to have derivatives trades centrally cleared, which will hurt Markit’s business to a degree. This concerns us too, especially since we aren’t exactly buying this company on the cheap. Yet the time frame and extent to which this happens will give this entrepreneurial management team plenty of time to nurture its new ventures to fruition and use its unique relationship with banks to discover new avenues for growth. With the theme of re-regulation in full swing there is unlikely to be any shortage of such opportunities. Rather the shortage is of listed companies that are well-positioned to capitalise on these opportunities and management teams that can develop them.
DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances.