Private equity firms and broken-down model of broking firms - I  

On Monday, Geojit BNP Paribas Financial Services reported an 8% decline in revenue and 65% crash in net profit, for the quarter ended March 2011, over the corresponding previous quarter. Other broking companies haven't reported results so far, but nobody is expecting them to do wonders. What does this mean for a set of private equity firms, which lemming-like, had been clamouring for a piece of the business of stock broking firm in 2007? Very simply, the horror show continues.

Look at the stock performance of these companies from their lifetime highs of 2008. Emkay Global Financial has crashed by 84%, Edelweiss Capital has collapsed by 78%, India Infoline has fallen by 80%, Indiabulls Securities is down by 87%, JM Financial by 84%, Motilal Oswal Securities by 70% and Networth Stock Broking has slumped by 77%. Over this period, the Sensex is down by only about 5%.

This is not what the smart private equity investors who had jumped into the broking companies were hoping for. It was the pre-crisis period of 2007-08, when PE firms were investing in well-established broking companies which were on the path of huge expansion. The idea of course was to offload them within a couple of years to an eager public. What could be easier? After all, they have played the game many times before. Citigroup Venture Capital bought an 85% stake in Sharekhan, India Capital Growth Fund and Caledonia Investments took a stake in Rajkot-based Marwadi Shares, Barings bought a 45% stake in JRG Securities, Gaja Capital a stake in Bonanza and IFC Washington a stake in Angel, among others.

But their timing couldn't have been worse. Within a few months of their investment, financial turmoil rocked the world, deep crises hitting Western economies particularly hard. Brokerage income collapsed. And even though the overall market revived and real businesses are doing well, private equity firms find that they are still badly stuck with their investments in Indian broking firms. So, what went wrong?

In 2007, when the private equity players rushed into unlisted broking companies, they expected a continuation of the long bull market that started in 2003. This would mean robust market volumes and increasing brokerage income. It turned out to be quite different. When the Sensex was at 20,000, in December 2007, there was some optimism among a section of retail investors. Mutual funds were drawing net positive inflows from individual investors.

The mood this time is one of caution, with individual investors busy reducing their stock portfolios and redeeming their fund investments. There are specific reasons why broking income has collapsed now, some of which would have been clear even in 2007, but nobody wanted to see. And so, in 2007, at the height of the euphoria, the assumptions used to project income and profits were deeply flawed.

In the situation they find themselves in, how would private equity players recover their investment or even make an exit from their investments? The investment attractiveness of stockbroking firms has turned out to be a trap. The PE firms have no easy exits. Public issues of broking firms are unthinkable and there are no buyers of their stakes. Scope for 'consolidation' is low for fundamental reasons.

The point is, is this likely to change? When will things change for broking firms and how? Can things really improve for the big brokers, who have expanded with PE money, and are saddled with an inherently-flawed business model? That is what we will highlight in the second part of this series when we discuss the model of broking firms.