BROKER-DEALERS and investment advisers don't want to see their clearing firms in the headlines. They don't mind the press releases on new-client signings or announcements about technology platform upgrades. But clearing firms are like commuter trains: You think about them only when something goes wrong.
“Nobody says, "I had a great train ride today,'” said Bing Waldert, a director at Cerulli Associates Inc. “You only take notice of them when something bad happens.”
Investors took notice of Penson Worldwide Inc. this year when the clearing firm disclosed it was carrying collateral of $42 million in illiquid racetrack bonds. Its share price dropped by nearly half to just over $3 and has yet to recover.
The competitive pressures in the clearing business, combined with a low-interest-rate environment that's hurting lending and cash management operations, have made life difficult for all clearing firms. With prices only going down and costs rising from increased technology- and compliance-related spending, margins in the business are currently slim to nonexistent.
“The big firms are getting bigger and the smaller firms are struggling to make the needed investments,” said Alois Pirker, senior analyst with Aite Group LLC.
Industry observers expect the clearing industry to consolidate. Here are three firms that, for various reasons, are at risk of being acquired:
PENSON WORLDWIDE INC.
Penson Worldwide disclosed in its 10-Q earnings release in early May that it had accepted $42 million in bonds issued by an entity that controls the Retama Park racetrack as collateral from a number of customers. With a development project at the facility now in doubt, the bonds have become illiquid and no longer pay interest.
“It is possible that the value of the collateral ... might be impaired, resulting in a write-down of a portion of these receivables that could be material in amount,” according to Penson's financial filing. It didn't help that Penson board member Thomas Johnson, who has since resigned, is chief executive of the company that managed the racetrack and owned a large slice of the bonds.
The disclosure prompted Raymond James & Associates Inc. analyst Patrick O'Shaughnessy to write in a May 12 report that “the firm's perception with investors may be permanently impaired” and that the board of directors should explore a sale. “Investors will always be worried there's another skeleton hidden in the firm's closet, and Penson may not ever receive what the board would deem a “reasonable” market valuation as a result,” he wrote.
From an operational point of view, however, the shaky collateral has had little impact on the company's financial strength or its relationships with clients, said Bill Yancey, CEO of Penson Financial Services Inc., the U.S.-based clearing firm. It does not affect the company's cash flow or regulatory capital.
“Clients may roll their eyes today, but if they're two years into a five-year contract, chances are, they'll forget about it down the road,” said Mr. Waldert. “It's too much trouble changing clearing firms.”
Mr. Yancey said the firm has been reaching out to customers to allay fears. “We've spoken to our clients and given them clarity on the issue,” he said, adding that the incident has not hurt the firm's reputation in the market. In fact, since the news broke, Penson has signed up a dozen new clients.
With 437 revenue-generating correspondent firms, Penson is the second-largest clearing firm in the country by clients.
Mr. Yancey said the firm intends to be a buyer in the industry, not a seller. Last year, Penson purchased Ridge Clearing & Outsourcing Solutions Inc., adding about 100 new clients.
The firm remains focused on signing up new correspondents and trying to convince self-clearing firms that they can save money using Penson. The firm's independence and the fact that it does not compete with clients gives it a big advantage in the market, Mr. Yancey said.
Unless industry fundamentals start to improve soon, Penson may not get the chance. The firm lost just under $20 million last year and had a $2.8 million loss in the first quarter.
SOUTHWEST SECURITIES INC.
With scale being the most important factor in the clearing business, it helps to have a big parent behind you. Industry leader Pershing LLC has Bank of New York Mellon Corp., National Financial Services LLC has FMR LLC — Fidelity Investments. It doesn't always help to be part of a bigger entity, however.
The clearing division of Southwest Securities Inc., for example, is suffering from problems at its parent, SWS Group Inc. Bad loans in the firm's banking division contributed to a loss of more than $20 million in the third quarter last year that left SWS in need of capital. It attempted to raise $95 million in convertible notes last December but pulled the offering due to “unfavorable market conditions,” according to a company statement. It has been forced to raise $100 million from two investment groups, Hilltop Holdings Inc. and Oak Hill Capital Partners, in return for warrants that, if exercised, would give them each a 17% stake in the company. The transaction is awaiting regulatory approval.
How the turmoil in the larger company affects the clearing operations remains to be seen. With 183 correspondents, according to the InvestmentNews database, Southwest has scale. But given its financial problems, it may not be able to keep up with the market leaders in terms of technology investments. “In the clearing industry, scalability comes from technology,” Mr. Waldert said.
Larry G. Tate, CEO of SWS Financial Services, and James H. Ross, CEO of SWS Group, were not available to comment.
LEGENT CLEARING LLC
Legent Clearing LLC is on the block. Smaller than Southwest and Penson, Legent is one of the dozens of small clearing firms that analysts believe will have difficulty surviving in an increasingly competitive industry in which costs are rising.
According to InvestmentNews data, the private company is the 14th-largest clearing firm in the country, with 80 broker-dealer clients. It was set to be purchased by United Western Bank in June last year for $13 million before the bank ran into trouble and was closed by regulators.
More recently, rumors have been circulating that private-equity investors are interested in the firm (InvestmentNews, June 2). Ray Maratea, president of Legent, did not return calls for comment.
If private investors are interested, they'll need to roll up several smaller players to achieve scale. Small firms such as Legent will find it increasingly difficult to make the investments needed to service clients from a regulatory and compliance standpoint, suggested Mr. Pirker. “Unless you're the size of a Pershing, a stand-alone clearing firm is a tough proposition,” he said.
E-mail Andrew Osterland at -aosterland@investmentnews.com.
