[Collections & Credit Risk - Table of Contents] March 2000

The Art of Building Deals
As industry consolidation creates bigger and bigger agencies, the need for financing is critical. Who puts these deals together, anyhow?

By Joanne Y. Cleaver

It’s almost like watching a town transform itself into a metropolis.

Twenty years ago, the collections industry was already past the village stage, a fair-sized burg of modest houses in a haphazard pattern. Ten years ago, some homes were replaced by bigger, two- and three-story abodes. Five years ago, the first mansions started popping up along the main drag as agency owners accumulated wealth and bought out smaller independents. Now, the central area is cluttered with construction cranes as agency consolidators compete to assemble ever-taller high-rises.

It’s likely that in five more years, the collections skyline will be dominated by a few towering skyscrapers surrounded by smaller mid-rises, giving way to the neighborhood houses that represent medium-sized and small, privately owned agencies.

Behind all the construction is, of course, the muscular mergers and acquisitions trend.

According to brokerage and consultancy Kaulkin Ginsberg Co., agencies representing $1.2 billion dollars’ worth of contingent collections revenues were acquired in 1999 — a stunning rise from 1998’s $772 million’s worth, and nearly triple the 1996 level. Like building a metropolis, all these deals require capital — loads and loads of it. The push to build, to be sure, includes other trends such as massive outsourcing of collections operations and the general trend of consolidation in financial industries. And other, equally powerful equations also are factors — the inexorable push of technology, forcing agencies to upgrade or cede market share and clients to more wired competitors, and the incorporation of debt into every phase of American consumers’ financial lives. But these factors don’t take concrete form until they invite the close scrutiny of sophisticated investors who like what they see in collections’ recession-resistant earnings record. Here’s the investor’s perspective:

  • Investors want returns. Obvious, but their lust for profit explains why collections and debt buying have more sex appeal than, say, trucking, says Cory S. Gunderson, manager of the financial services practice for consulting giant Arthur Andersen. “You’ve got some pure speculative plays [when] you’ve got an industry that can yield 30%, 50%, 100% returns. Capital is attracted by that — and there’s plenty of capital today. You have equity and hedge funds that are looking for the next big thing and they are taking equity in collections organizations,” he says.

  • Investors see how to frame a reasonable exit strategy to liquidate their positions, says Philip A. Canfield, a principal with GTCR Golder Rauner LLC, a Chicago investment firm that backs Dennis M. Cunningham and Risk Management Alternatives. While only a handful of collections agencies are publicly held, that’s a handful more than there were five years ago. Besides launching an IPO to recapture their appreciated investment, financial backers also perceive that some of today’s mega agencies will soon reach $1 billion in annual revenues — big enough to be purchased back by some of the very companies that have fed their growth by aggressively outsourcing. Major national retailers and non-bank financing companies have been “kicking tires,” says Canfield. He believes that the mega-agencies’ returns may be so tempting that they may be acquired by even larger companies that simply covet the cash thrown off by profitable agency operations as a source of internal funding to fuel expansion of other, unrelated, ventures.

  • Investors understand collections, points out Richard V. Romer, executive vice president with CIT Group Inc., a Manhattan-based investment firm. “There’s nothing profound about collections industries,” he says. “It doesn’t require a lot of technical knowledge to invest in an agency or a group that’s aggregating agencies.” The highly publicized run-up in American consumer and commercial debt has persuaded many investors that companies and households are hooked on leverage and won’t get over it soon. As well, prosperous times have served up an unprecedented number of high-net-worth individual investors who actively manage their portfolios and work with investment advisors and venture capitalists. As people gain experience in managing their portfolios, they generally become more sophisticated about analyzing investments — and it’s not hard to put all the pieces together to get a well-rounded understanding of collections industry trends.

  • Technological advances will continue to pave the way for added agency profitability in the foreseeable future. Richard Schultz, chief executive of IntelliRisk Management Corp., a Columbus-based firm whose strategy is buying medium-sized agencies to build a mega-agency, believes that inexorable advances in technology will become an even more important factor in undergirding collections efficiency and, therefore, profit growth. “All organizations are seeking best-in-class competencies to serve clients, and a small organization won’t put together a world class international recovery program,” he says. “Technology requires capital, and by boosting productivity you get more resources to serve the clients, and so get better collection results.”
Realizing efficiencies by streamlining the back-room and administrative functions of acquired agencies is a classic tactic for delivering an immediate, albeit short-term, lift in profits in the months immediately after a deal is consummated. However, these days, a parent corporation can then launch into a longer term technological overhaul, such as introducing e-commerce tools that streamline communication among executives and corporate clients, and arming collectors themselves with powerful tools for finding debtors and information about them.

New Buying Patterns In years past, only collections agencies used to buy other agencies. The industry was little-known outside its own tight circle, and the relatively small number of institutional and qualified individual investors tended to focus on more superficially appealing places to park their money -— such as the 1980s obsession with commercial real estate.

Thanks to a heightened general awareness of the pervasiveness of debt in the lives of most Americans, plus a growth in the number and sophistication of investors, collections has gained a bit of a pretty sparkle, says Geoffrey J. Finkel, a principal with Kaulkin Ginsberg. He lists three categories of buyers now chasing collections operations: strategic buyers, typically other agencies that want to complement their existing operations with complementary specialties; other agencies that simply want to get bigger quickly; and consolidators, which buy agencies for the express purpose of rapidly building a large, multi-faceted operation from the ground up.

Private equity groups are backing each of these sorts of deals because they perceive that combining back-room efficiencies and technological innovation with already-strong internal growth can result in jet-like expansion.

So far, financial backing is streaming in from pension funds, insurance companies, universities, corporations seeking to diversify their own portfolios, and equity funds representing wealthy individuals. Mutual funds are conspicuously absent from the mix, says Finkel.

Strategic buyers include huge national retailers, such as Sears, Roebuck and Co., and J.C. Penney, which have been steadily consolidating their back-room operations into super-regional hubs. They may soon emerge as prime buyers of specialized agencies to round out their general collections expertise. “You’ll see more contingency agencies and debt purchasing companies buying specialists for their technology, back office support, and cash flow,” predicts Ginsberg.

Of course, investors fully expect acquired or consolidated agencies to aggressively pursue growth plans to deliver that all-important return. The steady growth of outstanding debt and the determination of many credit originators to outsource as many functions as they possibly can set the stage, but investors expect agency executives to use those favorable trends only as a launching pad.

Satisfying Investors

For example, there are the investor relationships that Cunningham, president of Risk Management Alternatives Inc., must balance. Based in Duluth, Ga., RMA is a consolidator. Since mid-1997, it has made eight acquisitions with GTCR backing. Most recently, RMA acquired NRC, which had 1999 revenues of $125 million — more than twice RMA's 1999 revenue of $65 million. Cunningham expects RMA to have a total revenue this year of more than $250 million and is actively hunting for more agencies to acquire.

He says that post-merger strategy is very important to investors. They want to know specifically how a company they back will make the most of what it buys. His very explicit and up-front strategy is to “consolidate and form one company culture as soon as I can.”

Cunningham works with GTCR, and says the executives there are “very encouraging. They want me to go out there and find deals that add value.” Private equity firms should not be confused with venture capital firms, Cunningham believes, because in his experience private equity firms typically hold their investments for a long time. While venture capitalists look to exit the investment in two or three years, equity companies will hold for as long as 10 years. His position with RMA is to keep it privately held “as long as it makes fiscal sense.”

Internal growth is an important indicator to potential investors. “It's cheap growth,” says Cunningham. “It costs much less to hire and support a top salesperson and pay even a hefty commission or bonus than to just eat up another company and bulk up that way.” Internal growth also indicates two key things about an executive team, he adds. First, the team is actively supporting the talent it already has on board, and, when the company gains new business from existing clients (that presumably are taking that same business away from competing agencies), it is winning at providing what the big clients want — which demonstrates it is really paying attention to the market.

Operations bulked by acquisition must quickly get organized to pursue even more, ever-larger national contracts, points out Charles “Chuck” D. Bertrand, principal of M&A; specialist Marion Financial Corp. of Houston. Nearly all collections operations can be ramped up to national scale, except when debtors must be sued, a process that requires the help of a local lawyer.

Creating huge collections centers with national reach means that managers have plenty of flexibility to organize internal specialties in different ways to suit the needs of particular clients — while still maintaining enough staff power in each specialty to handle large accounts.

“You can divvy up specialties by functional lines of business or by type of client, not by geographic synergy,” says Bertrand. “That underlies the economies of scale and gives the M&A; people a channel to reorganize the assets they’ve accumulated.”

As the larger players continue to grow, who will in turn acquire them? While Ginsberg doesn’t discount the importance and likelihood that several major agencies will go public, providing their investors with the ultimate tool for cashing out, he emphasizes that large, highly profitable agencies are probably going to become juicy targets for multinational corporations.

Agencies with operations overseas and depth in multiple languages and cultures will be extremely attractive to global companies that want an integrated financial policy for all their operations. “We don’t think that the larger players will just gobble each other up,” he says.

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