Industry Perspectives

2019 Letter To Investors

March 28, 2019

To our investors:

When David and I launched Atlas Merchant Capital five years ago, we understood that the global financial sector was still in a period of significant transformation. In the years after the global financial crisis, as the sheer size of the sector and its interconnectedness were laid bare, it was clearer than ever that a stable and strong financial sector is critical for the creation and maintenance of economic growth and jobs. New financial regulation was essential – and had to be done right. We needed rules to make our institutions safer and sounder, balanced against the imperative for catalyzing growth, and we needed to create a level playing field for firms large and small, old and new, in the US and overseas.

At the same time, our experience in running and investing in financial businesses helped us to recognize an opportunity many others had not seen. Financial services was deeply underinvested, and its capital intensive nature required specialists with deep sector expertise. We believed that the right team and investment model could deploy capital constructively and profitably. We set out to build a world-class investment firm focused on financial services. Our business would be built around our experience and track record in the industry, on a distinctive approach as investors but also operators, and with talent and culture as differentiators, both at the Firm and at our portfolio companies. As we further evaluated the opportunity to invest, we saw four major trends that dramatically impacted the global financial sector, none of which had been seen during the post-war era.

First, while the crisis highlighted the problem of “too big to fail,” regulation intended to mitigate the problem actually further institutionalized it. Instead of balance sheets shrinking, the biggest banks got bigger. While additional capital buffers have served to make banks safer, we now have fewer but larger global banks still fitting the “too big to fail” label.

Europe had its own set of problems where, unlike the US, many banks were not forced to address their non-performing loans and increase their equity capital levels, similar to Japan during the 1990s. At the same time, certain business lines have become unprofitable or non-core for the big banks, whether European or American. While in the lead up to the crisis the predominant banking strategy was to become ever more universal and global, in the subsequent years we have seen the opposite, with a shift toward strategically focused, regional or local models. As a result, businesses that may have previously been viewed as subscale outside the bank model have become attractive growth investment opportunities.

At Atlas, we have leaned into this trend, investing in three independent broker-dealers – Kepler Chevreux, Panmure Gordon, and South Street Securities – who are picking up business left behind by the big banks. We are similarly bullish on banks with the potential to be local or regional champions. We have so far invested in two challenger banks in Europe, Praxia in Greece and illimity in Italy, who are very well positioned, with no legacy non-performing loans, runways to pick up deposits and smalland medium-sized enterprises’ business, and strong digital platforms. We believe these business models will offer substantial investment opportunities in the years ahead. We have also found similar opportunities in insurance, where regulation and subsequent changes in business models have created opportunities in insurance portfolios and companies, highlighted by our investments in Talcott Resolution and Somerset Reinsurance.

Second, technology has transformed the financial industry at a pace and extent that few anticipated. Revenues are accelerating, key costs are being driven down, transactions are moving at the speed of light, and risk is being redefined through increasingly computerized business models that promise to broaden the customer base. At the same time, our own experience has taught us that transformational technology is only half the battle. Our investment in Crux (formerly Incapture Technologies, a prefund investment), a growing enterprise data company, required considerable changes to the business model and strategy to achieve the necessary product-market fit. Today, Crux succeeds by using cutting edge technology to enable financial companies to better compete in the digital age. We believe the winners in this context will be regulated financial companies that adopt or adapt to new technology, rather than standalone technology players. At our European banks, Praxia and illimity, we are deploying state of the art digital platforms to capture deposits and extend credit more efficiently. We are encouraging our companies to prioritize investment in technological transformation that will drive their performance.

Third, the landscape of political leadership in the West has changed dramatically since 2008 for several reasons, including the impact of the crisis and the rise of populism and nationalism, particularly in the US and Europe. The backlash against globalism has reinforced the post-crisis shift in favor of national and regional business strategies, as seen for example in the European banks’ pull back from foreign markets. Several of our investments, such as South Street Securities, illimity, and Kepler Chevreux, reflect our conviction in the lasting impact of this trend on financial services. Concurrently, we see a leadership vacuum in the West that we have not witnessed for decades. The leaders of Europe’s three largest economies, Germany, France, and the UK, are to varying degrees “in office but not in power.” We believe this trend has depressed investor interest, but over the long term, political normalization and greater certainty in western Europe will spur economic growth and benefit investors.

Fourth, the effects of a prolonged period of zero or near-zero interest rates have been profound and widespread, particularly so in financial services. Although this looser monetary policy has benefited broad based economic growth, it has also hampered banks’ ability to achieve their financial targets, which has further dampened investment flow into the sector. As we approach a normalization of interest rates, the financial sector is perhaps the only one that clearly stands to benefit, as higher base rates drive higher interest income and wider spreads. We thus believe the monetary policy environment is likely to benefit our companies in the coming years. At the same time, we cannot ignore the dramatic growth in credit resulting from these persistently low rates. As rates increase, the credit markets will face a difficult period of rationalization as more borrowers are unable to meet their obligations. At Atlas, we believe new investment opportunities are close at hand in the credit sector as this transformation looks poised to begin.

We believe financial services remains the most attractive sector to invest in during this period of change. Regulation and other global policy shifts have created both disruption and incredible investment opportunities. Despite appreciation post-crisis, valuations in the financial services sector are still near the levels of 2008, and the sector remains underinvested. We organized our firm with a specialized focus and an approach combining investment and operating expertise, believing it would make us a preferred partner for financial companies. Our experience to date has borne out this thesis, with every company in our current portfolio having welcomed us as a new investor with genuine value to add to the business.

We also nurture talent and culture as competitive advantages. We believe our investment, regulatory, and operations professionals are the best in the industry. Our operating partners across technology, human resources, risk management, and other areas have achieved extraordinary success in their fields and work continuously to help company management deliver on their business plans. Finally, there is no more important a group of partners at Atlas than our investors. We regularly share our perspectives on investments and seek their advice. We have also demonstrated the ability to provide substantial coinvestment opportunities that offer potential investment returns while deepening our relationships.

At Atlas, we are well positioned to see and understand the opportunities and risks in the global economy, and at the same time take advantage of interesting investment opportunities ahead. We deeply appreciate the partnerships we have with our investors, portfolio companies, and our other constituents, and look forward to another productive year working together

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Industry Perspectives

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