Maybe no bank can be trusted
"What did we learn? I don't know either. I guess we learned not to do it again."
If you’ve been following me for a while, you know that I’ve taken a very strong interest in the financial sector over the years, and that many of my largest portfolio holdings have been financial companies.
Despite this, I’ve always been extremely wary of the banking sector, and specifically High Street banks.
During my tenure in the fund management industry, I attended presentations by large global banks to their investors (both debt and equity investors). I remember one slide in particular - from an extremely large global bank - which would make your head spin. But that was not the purpose of the slide.
The purpose of the slide was to explain the structure of the PLC and its subsidiaries to investors. The subsidiaries were spread across Asia, South America, and so on.
The notion that anybody inside the bank could understand these vast international operations, and the risks that they were all taking, struck me as dubious.
And how much harder for anybody outside the bank, who merely has a 400-page annual report at their disposal?
Combine this complexity with the unfortunate fact that banks can’t earn a respectable return on equity (thanks to regulations imposed after the global financial crisis), and I came to the decision that I would be steering clear of banks.
There are plenty of other types of financial companies to invest in, after all. There are investment companies, niche lenders, fund managers, insurance companies, and so on. I still had more than enough investment opportunities, while leaving banks on the shelf.
But I was happy to make an exception when I came across PCF Bank (PCF.L), and I invested in late 2017/early 2018.
This was an up-and-coming challenger bank in the UK, without any of the legacy features of traditional banks. It was purely online, was growing very quickly, and promised to increase its return on equity as it grew in scale.
I held on until January 2020, making a modest return. And when I sold, it wasn’t because I had suddenly turned bearish on the stock. Rather, it was to help fund a house purchase. I can be a lucky general sometimes!
When I look at the results announcement for FY September 2019, the signs were still very positive:
return on equity 12.6%, ahead of the company’s medium-term target of 12.5%
pre-tax profit up 54% (to £8 million)
new business origination for its lending book up by 50% to £222 million, with the total lending portfolio reaching £339 million
It was full steam ahead, or so it appeared.
So why did I sell out the following month?
I had no special insights into the stock, but I had read its reports carefully and had met the long-standing CEO at investor presentations.
He had been in the job for 10 years - some might view that as a red flag, but for me it was a positive sign.
There were just a few things I was disappointed or became worried about:
PCF had raised money at 30p per share, when the prior share price in the market had been 38p.
While I always try to ignore short-term fluctuations in a share price, I was disappointed that the company hadn’t been able to raise money at a higher level.
I worried that future fundraisings, to assist in the company’s ambitious growth plans, would also be at a significant discount to the prevailing share price.
This could hold back share price performance, and put existing shareholders like me at a disadvantage, compared to those who took part in the placings.
This wasn’t a huge acquisition - £5.6 million - but it was non-organic growth and in a new (riskier?) sector compared to the company’s prior focus (car finance for consumers and vehicle/plant finance for businesses).
For most businesses, I value organic growth far more than growth by acquisition.
I was slightly concerned that PCF might attempt to hit its future growth prospects with the help of more acquisitions. These acquisitions might add complexity to the overall group, when complexity is something that I (as a shareholder) wanted to avoid, especially when it comes to investing in a bank.
Despite the overall positivity in the results statement of December 2019, there was a small warning sign as impairments ticked up to 0.8% (from 0.1%).
Additionally, the lending portfolio that was categorised as “up to date” (i.e. in good standing) fell to 95% from 96%.
These were only minor warning signs, but gave rise to mild feelings of discomfort.
In the end, selling out of PCF was a close decision for me.
It came down to these slight feelings of unease, which lowered my conviction just enough for me to hit the sell button when I needed the cash.
March 2021: Disaster Strikes
On 17th March, shareholders were treated to the following news:
PCF Group plc announces that… during the process of finalising the audit of its financial statements, for the year ended 30 September 2020, a number of adjustments will be made to the previously announced profit.
The adjustments are expected to constitute a net reduction of not more than £750,000 against a previously announced profit before impairment of goodwill and tax of £3.9m. The principle adjustments relate to the charging to the profit and loss previously capitalised costs for software projects, a reduction in an interest receivable balance from the Employee Benefit Trust and adjustments to accruals for interest due on stage 3 loans offset by lower staff incentive rewards.
This came just two weeks after the MD/Company Secretary had announced his retirement. He had been with the company for a remarkable 27 years, so that should not have raised any red flags.
More interesting was the absence of a permanent CFO for the prior six months. On 19th March 2021, PCF finally hired a new permanent CFO.
But the bad news kept coming after that:
26th March 2021 - the company said that it was no longer attempting to increase its lending portfolio, “until we judge that resuming stronger portfolio growth is prudent”.
Also on 26th March 2021 - the company obtained an extension of the reporting deadline for its FY September 2020 results.
19th May 2021 - PCF shares were suspended from trading, “while the Group undertakes a further review in relation to its financial controls and reporting processes.”
21st May 2021 - the longstanding CEO - who I had met at investor conferences, and thought highly of - resigned from the company with immediate effect. No explanation was given. In the circumstances, maybe no explanation was needed?
On 28th June 2021, shareholders finally learned about what happened:
“funding provided to Azule by PCF Bank was not correctly reflected in the calculations of Large Exposures within the regulatory returns for PCF Bank”
PCF had committed “the potentially incorrect application of certain unaudited profits when reporting PCF Group's and PCF Bank's capital position to the PRA”
there were “a number of deficiencies and failures in PCF Bank's financial control and reporting function, including members of the finance team, under instruction, manually adjusting certain accounting entries for both financial and regulatory reporting purposes which appear to the Board to have been a deliberate effort to facilitate specific results or compliance with rules regarding Large Exposure limits”
“these matters may be driven by possible collusion by some members of the finance team, under resourcing, an inadequate level of skill and experience within the finance team, technological limitations and a poor culture in the finance team resulting in a lack of, and a reluctance to, challenge its leadership.”
The good news (!) was the company continued to operate normally.
On 21st October 2021, PCF announced that it expected to suffer an impairment charge of £6 million arising from “receivables which were either seriously in arrears or where the asset which acted as security for the receivable had been sold and a balance of the receivable remained outstanding ("defaulted receivables").”
Most of these defaulted receivables have now been sold to a specialist debt purchaser.
The shares remain suspended, and the results for FY September 2020 remain unpublished.
PCF might still turn out to be a decent investment, but I’m obviously relieved that I didn’t find myself holding it throughout this fiasco.
My escape was more through luck than skill, and I know there are plenty of highly skilled and experienced investors who do continue to hold the stock.
Here’s what I take from the experience:
Don’t do it again. Banks are even harder than I thought. Even small, online, apparently simple banks.
Trust my gut when it comes to acquisitions. It turned out that the Azule deal involved taking on some large debtor exposures, which caused some regulatory problems, which then caused reporting problems, and then much bigger problems after that. It’s hard to predict which problems will be caused by an acquisition, but it’s easy to predict that acquisitions will cause problems.
Trust my gut when it comes to companies that need fundraisings to carry out their business plan. I’ve done much better by sticking with companies that are at the stage of buying back their own shares, rather than raising equity. I should continue to focus on the former, and try to avoid the latter.
The experience of studying, investing in, and analysing PCF has been a useful one for me, though not a particularly profitable one - and much riskier than I anticipated.
As the saying goes: experience is what you get when you didn’t get what you wanted!