After a lull in portfolio M&A activity during the financial crisis, banks have again begun to trade card portfolios. As in the past, healthy credit card portfolios tend to sell at a premium to the outstanding receivable balance. Conceptually, the premium relates to the expected profit from the credit card accounts over a time horizon, discounted at the buyer's cost of capital. But numerous factors may influence consumer behavior over the valuation time horizon. At the moment, credit card fundamentals are strong and portfolios have an intrinsic premium value which should be achievable in an auction.
Which begs the question: Is it a good time to buy or to sell credit card portfolios?
Buyers and sellers each bring their own unique perspective (which is what makes a market), but there is an additional factor that is often overlooked. As in many other aspects of banking, Basel III rules (or the likely implementation of the rules as outlined in the recent notice of proposed rulemakings of the U.S. bank regulators) have magnified the importance of regulatory capital in the decision-making process.
Under the previous regulatory guidance, a credit card portfolio premium (that is, the identifiable intangible asset) was treated favorably. Unlike goodwill, which would be a deduction to capital, the Purchase Credit Card Relationship intangible asset (PCCR) was not generally deducted from capital unless it exceeded 25% of the acquiring bank's Tier 1 capital. This 25% safe harbor was the regulatory acknowledgement of the inherent quality of the credit card business and, more specifically, the value of the customer list.
While the credit card business is still strong, the regulatory reaction embodied by Basel III included a move to make the qualification for Tier 1, by asset type, much more stringent. In addition to eliminating preferred stock or deferred tax assets from inclusion in Tier 1 capital, the PCCR asset has also been slated for elimination. That is, under the new rules, PCCR will eventually be treated like goodwill from a regulatory capital perspective. The implications of this are enormous. It may seem wonky, but here's why it matters: Future credit card portfolio prices will be lower than current prices, all other factors remaining constant.
Here's a simple example: a credit card portfolio is sold at a price of 115% of the outstanding receivable balance (a 15% PCCR) and let's further assume the amount of regulatory capital needed for the receivables has remained constant at 8%.
Under the old rules, the capital needed would be a total of 9.2% (8% for the receivables and 8% of 15%, or 1.2% for the PCCR). Accordingly, a portfolio with a 2% ROA would produce a 21.7 % return on capital (2%/9.2%). By contrast, that same 2% ROA would yield a paltry 8.6% return on capital (2 %/ 8%+15%) under the new capital regime. The natural reaction to this by a potential buyer is to lower the purchase price until the buyer's hurdle rate of return is achievable.
If we know that the amount of capital needed to buy a card portfolio in the future will be two to three times higher than the amount needed today, it's a safe bet that prices will decline. If this is the case, why should anyone be a buyer today?
Is there such a thing as a buyer's market and a seller's market?
Fortunately, the new Basel III rules phase out the PCCR safe harbor over a five year period, from 2013 to 2018. During the five years, the safe harbor amount is reduced 20% each year. The amount of PCCR not covered by the safe harbor is a dollar for dollar deduction to Tier 1 capital. (The amount covered by the safe harbor is treated as a 100% risk weighted asset.) So the full impact of the Basel III regulatory capital is gradual and a card portfolio purchased in 2012 retains much of the PCCR safe harbor benefit.
In fact, the phase out of the safe harbor makes this a great time to be a buyer if you're a long-term strategic card issuer. By taking advantage of the safe harbor while it lasts, an acquirer can be more aggressive and increase its chance of an acquisition.
Although a future price for a portfolio sale will be lower as a result of the new capital rules, the inherent profitability of the card business will remain unchanged. While a future buyer would have to discount earnings at a higher rate to account for the larger required equity investment, the then owner of the portfolio would enjoy those same projected earnings from its lower required equity position (as the PCCR only exists for the acquirer).
A long-term player (who is unlikely to be a future portfolio seller) shouldn't be dissuaded from buying today. At the same time, a non-strategic issuer may be looking at the last, best opportunity to capture a big capital gain by selling a card business. At a time when some banks are exploring options to raise capital, a card portfolio sale at a premium is a source of non-dilutive, incremental capital.
But if future prices are likely to be lower, why shouldn't a potential buyer wait on the sidelines for the inevitable bargain? While this is certainly a logical strategy, it is impossible to time what is essentially a very idiosyncratic market. (How would HSBC have reacted if Cap One said, "See us in a few years.") As we approach 2018, sellers will have less incentive to sell, especially for the best performing portfolios.
So, oddly enough, it is actually a good time to be a buyer and a good time to be a seller. Perhaps the real question should be "Do I have a long-term strategic interest in the credit card business?" If not, take advantage of the current environment and sell; if so, reap the benefits of the existing safe harbor and buy.
John A. Costa is managing director of corporate finance for Auriemma Consulting Group.