It has been nearly six years since I collaborated with Dan Helle at Chicago-based CIVC Partners, a private-equity firm, on an article that addressed the role of private-equity investors in the mortgage banking industry (see "Smart Capital," Mortgage Banking, October 2000). In this column, we discuss some of the trends in the current environment, concluding that once again private-equity investment is poised to play a major role in the mortgage industry.
The cyclical nature of the mortgage banking industry generates windows of opportunity for private-equity investors. When interest rates decline, there is generally an influx of new marketplace entrants, and existing origination platforms expand in anticipation of increased origination volumes. However, when interest rates subsequently rise, origination volumes usually decline, often creating excess capacity and depressed margins. Such periods are usually followed by increased merger-and-acquisition activity as larger firms look to consolidate their positions in the marketplace and weaker firms are forced out.
While these conditions pose a challenge for the mortgage industry, they create opportunities for private-equity firms to make well-timed investments that can lead to real value creation.
Because mortgage stocks tend to fluctuate in an inverse correlation to the interest-rate cycle, private-equity firms can create significant value by intervening during turbulent times when valuations are at their lowest, and exiting from their investments when origination volumes peak and investor confidence is restored.
Looking back at the era of the Resolution Trust Corporation (RTC), a number of private-equity investors made notable acquisitions near the peak of the interest-rate cycle in the late 1980s and early 1990s. During this time, the RTC was required to dispose of $400 billion worth of insolvent thrifts and their mortgage banking subsidiaries. This led to an oversupply of mortgage banking assets. However, banks--the most logical buyers of these assets--were faced with a shortage of capital at the time, and did not have the risk appetite to place further bets on the mortgage industry.
Private-equity firms, such as CIVC Partners and New York-based MacAndrews & Forbes Holdings Inc., took advantage during this period of the markedly depressed prices for mortgage banking assets. They acquired Irving, Texas-based Sunbelt National Mortgage and Monroe, Louisiana-based Troy & Nichols Inc., respectively.
After Sunbelt was purchased in November 1992, CIVC Partners worked with management to expand the company's origination platform. When origination volumes rebounded in 1993 as the Federal Reserve cut interest rates and the economy strengthened, banks once again became active suitors for mortgage banking assets. In January 1994, CIVC Partners sold Sunbelt to Memphis, Tennessee-based First Tennessee National Bank, realizing an internal rate of return in excess of 100 percent.
MacAndrews & Forbes saw similar success with its investment in Troy & Nichols as it grew the company's origination franchise and scaled its servicing platform by integrating it with Houston-based First Gibraltar Mortgage Corporation, another one of its portfolio companies. In June 1993, MacAndrews & Forbes sold the company to New York-based Chase Manhattan Bank, realizing a return in excess of 100 percent.
In both cases, the private-equity investors understood that their franchises would better withstand the next inevitable downturn in the hands of companies with scale. They justifiably sold their investments to commercial banks that were committed to building a significant presence in the mortgage industry.
In May 1996, Boston-based BankBoston Corporation and Jacksonville, Florida-based Barnett Banks Inc. joined forces with Boston-based Thomas H. Lee Partners LP and Chicago-based Madison Dearborn Partners LLC to create the seventh-largest residential servicer at the time. …