Signaling the end of a chapter when financial risk was rife, General Electric has announced it's selling off the bulk of GE Capital, divesting out of the financial-services market within the next two years. While many in the general public may still think of GE as an industrial company that makes jet engines and CAT scan machines, GE had in fact ballooned into a major player in the finance sector.
During the financial crisis, GE took a huge hit, even getting a large government bailout. Afterward, federal regulators enforced stricter guidelines for financial institutions that they deemed too big to fail. GE fell into that category. While the significance of such a move is not obvious to all, the massive slimming down of GE Capital is one of the foremost examples of how the increased scrutiny of federal regulators is forcing big financial institutions to take a hard look at themselves.
With the shedding of GE Capital, the manufacturing giant is returning to its industrial roots, say Wharton experts. "GE is the largest single diversified conglomerate and it's now moving in a new direction," Wharton management professor Michael Useem notes. "It's the end of a conglomerate era and that's probably a good thing."
What's the Deal?
GE Capital includes real-estate assets spanning the globe, a $74 billion U.S. commercial lending and leasing business and a $16 billion sponsor finance unit, which lends money for private-equity buyouts.
The idea of a sale has "been under discussion for a long time. It was better for GE to wait to get a good price and it's been worth the wait," says Useem, who is also director of Wharton's Center for Leadership and Change Management. He adds that GE's board of directors include John J. Brennan, former CEO at Vanguard, who brought the discerning perspective of an institutional investor.
"It makes sense to sell [the real-estate] all at once to a major firm like Blackstone. No one has better access to global capital." -Susan Wachter
In an interview with CNBC, Jeffrey Immelt, GE's chairman and CEO said, "The wholesale financial model is tougher and we're disadvantaged from the banks.... It's the perfect market to sell financial assets. There's slow growth, low-interest rates, lots of equity, people searching for yield." Private equity firms and banks are looking for wholesale financing opportunities, itching for higher returns with low loan-to-deposit ratios.
Lawrence Hrebiniak, Wharton emeritus management professor, notes, it was "a whole different world in the 1980s and 1990s. Going forward, Immelt has realized that GE, being of large financial size, is very risky and the financial crisis has shown that."
In one of the first deals announced, Blackstone, the largest real-estate private equity firm in the U.S., and Wells Fargo agreed to buy GE Capital's properties in an exclusive $26.5 billion deal. Most of GE Capital's real-estate assets include office buildings, rental homes and shopping malls around the world. In a fast-moving campaign, code-named "Hubble," JPMorgan Chase shepherded the deal along in six weeks of frenzied meetings. John Percival, a retired finance professor at Wharton and executive education consultant, says Immelt was "waiting for the right buyers to pay the right price. Things have gotten better in real estate markets and it seemed like the time is right."
"It makes sense to sell [the real estate] all at once to a major firm like Blackstone," adds Susan Wachter, a Wharton real estate professor. "No one has better access to global capital than Blackstone. With a very large deal like this, the transaction costs of selling piece by piece would be high. GE Capital probably didn't want to get into different competitions with having people second-guess if they're getting assets at the right price."
And there's no better time than now. Wachter adds, "The market is very strong. GE is selling at a time with low interest rates and high asset prices." The Feds are expected to raise interest rates by the end of the year.
Moreover, there's been "big applause from large equity stockholders with a pop in share prices" after the announcement, says Useem. When the deal was publicly announced, GE's stock jumped up almost 11% to $28.51 a share, the highest level since the financial crisis. The company plans on returning a total of $90 billion to shareholders, including $50 billion in stock buybacks as well as bringing $36 billion in cash back from foreign accounts, incurring a $6 billion tax penalty. Hrebiniak adds, "Investors are happy now. Since Immelt took over in 2001, share prices have fallen by 38%."
Going Back to Basics
In shedding its finance arm, Useem notes, GE is returning to its roots, when the company was founded by Thomas Edison to manufacture the lightbulbs he invented. GE only started getting into the business of loaning money so people could buy the company's household appliances during the Depression.
When the industrial company first began to expand its financial services in the 1980s, it did so to bolster profits as it faced fierce competition from manufacturers, especially in Asia. "Management decided GE was going to be more of a service company instead of sticking to stodgy manufacturing," Percival explained. "GE had a services industry, but it was all associated with GE products. They expanded into other financial services that went beyond GE products. They got into movies, theme parks, broadcasting and all sorts of other things" that faced less competition than manufacturing.
"[CEO Jeffrey Immelt] never had the same feeling about the financial services business that previous management had." -John Percival
GE Capital had an enviable triple-A credit rating, higher than most banks, which meant that it could borrow more money at cheaper rates than many other financial institutions around. And since GE wasn't exactly a bank, and not subject to federal regulatory standards, it became more of a shadow bank. This in turn, translated into hefty profits for the entire company, contributing up to 60% of GE's earnings in its heyday. "It sounded like a wonderful marriage," Percival notes. "They had a manufacturing business with strong balance sheets -- steady but low profits. And a financial services business that would provide growth potential. It worked wonderfully for a long time. However, in a marriage, when one party grows and the other becomes stagnant, the marriage becomes dysfunctional."
Lucrative profits don't come so easily anymore for those in the financial market. In the last quarterly earnings report, GE Capital brought in 25% of the company's earnings. "GE Capital has been fairly profitable. You might wonder why they want to get rid of a profitable unit, but the company wants to be seen as an industrial company. There are too many questions about risks and too many government regulations," explains Hrebiniak.
Moreover, under the 2010 Dodd-Frank Wall Street reform legislation, GE has been designated as a "Systematically Important Financial Institution," or Sifi. This means that the government deems GE Capital too big to fail -- therefore, it must retain a large amount of capital on its balance sheets, which could reduce profits. GE then falls under the scrutiny of the Financial Stability Oversight Council (FSOC), which forces the company to comply with tighter regulations.
"GE Capital is a victim of Dodd-Frank, which increased oversight of large financial institutions. Immelt wants out from under Dodd-Frank and for the government to leave GE alone," says Hrebiniak.
When the 2008 financial crisis hit, the company got a bailout of $139 billion in government-guaranteed debt, after GE Capital grew into one of the biggest mortgage insurers in America, dabbled in subprime mortgages and involved itself in other risky short-term deals. With the sale of the majority of GE Capital, the company is expected to get out from under the onerous Sifi designation by next year. Percival notes that Immelt "never had the same feeling about the financial services business that previous management had. Even if he didn't get the Sifi categorization, he would've reduced the size of GE Capital substantially."
Other non-banks, like MetLife and Prudential Financial, are also categorized as Sifi. Currently, MetLife is arguing against the designation in federal court. However, other institutions are more hemmed in than GE, which has a robust manufacturing unit to fall back on. MetLife's options are limited, says Hrebiniak. "GE has lot on the industrial side. They have something to go to.... MetLife is basically insurance. What are they going to do? They certainly can't divest into jet engines."
"[Immelt is] betting on the future of industrials with greater margins and greater returns. This will increase the valuation of the company." -Lawrence Hrebiniak
If it isn't able to shake off the designation, MetLife may also try to break up. Credit Suisse analysts suggest separating the international unit from the domestic business, according to The Wall Street Journal.
To read more of my article, go to Knowledge@Wharton.