Hannah Smitterberg

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Hannah Smitterberg Vice President Nelnet Capital
Markets
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Presentation Outline
Presentation Outline

• Why MA in the student loan industry?
• The industry has developed into a mature market
• The product life cycle drives need for efficiency
  gains
• Value chain management becomes key to growth
• The importance of vertical integration
• What is the value chain?
• Filling out the value chain platform
• Recent transaction examples
• The valuation process
• The adjusted balance sheet method
• The discounted cash flow method
• Conclusion of part one

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The student loan industry is a mature market
1960s 70s Industry in its infancy, many new
unsophisticated players, limited access to credit
products/capital markets, low level of
technology 1980s Industry coalesces, increasing
sophistication of all players, enhanced access to
credit products/capital markets, technology
improvements 1990s Industry experiences rapid
growth, sophisticated market players pull ahead,
well-established access to credit
products/capital markets, technology improvements
drive efficiency gains 2000s Industry reaches
maturity, commoditization of product achieved,
value oriented, technologically driven highly
efficient financial services companies dominate
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• Some predominant characteristics of a mature
  market
• Increased competition for market share with more
  emphasis on price
• Experienced buyers (i.e., schools, students)
  have increased leverage over producers (i.e.,
  lenders)
• Falling industry profitability, which typically
  accelerates over time
• Commoditization of product is characteristic,
  with segmentation and differentiation key
  variables to achieve growth market share

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Falling industry profitability
The total return to the holder of a Stafford
loan, based upon the weighted average spread to
T-Bill of SAP throughout the life of the loan,
has been steadily declining.
2000 data point represents an average spread
between T-Bill and CP of 0.25 (from 1/1/2000 to
6/30/2003). Assumes four years school, six
months grace, 10 years repayment.
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• Commoditization of the product
• The standard product life cycle has five phases
  that follow an S curved shape
• Product Development (authorization through HEA)
• Introduction (to schools and borrowers)
• Growth (increases as demand increases, revenues
  may grow, but profit margins start to get
  squeezed)
• Maturity (product perceived as a commodity,
  profits squeezed further)
• Decline (old loan type phase out, e.g. SLS)

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The Boston Matrix

• According to the matrix theory, a product starts
  out as a Question Mark (i.e., the company has
  low market share, and spends heavily to establish
  itself as a lead industry player)
• The product then moves counterclockwise around
  the matrix to Star status, and then ultimately
  to Cash Cow status
• The company may lose market share due to
  increased competition by providers with lower
  costs or better alternatives, in which case the
  product may convert into Dog status

Not to be confused with any of the theories set
forth in a certain movie of the same name
starring a pale and skinny Keanu Reeves, who
habitually wears a black trench coat and ugly
sunglasses.
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A practical application for the student loan
industry, in decreasing order of profitability

• Originate Stafford, hold to maturity
• Purchase Stafford _at_ premium, hold to maturity
• Originate Stafford that consolidates with holder
• Originate Consolidation loan
• Purchase Consolidation loan _at_ premium
• Purchase Stafford that consolidates with holder
• Originate Stafford that consolidates away from
  holder
• Purchase Stafford that consolidates away from
  holder
• Originate loss leader or add on or
  opportunity fund alternative loan

Development of a suite of benefits value added
services that are perceived to enhance the basic
product
True product innovations (few recent examples,
like MPNs) primarily reauthorization driven
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• In a mature market, value chain management is key
• At its most basic level, a company is a
  collection of activities that are organized to
  design, manufacture, market, deliver, and support
  its product
• This set of interrelated activities is called the
  value chain
• Control over the value chain enables production
  of value added services (vs. producing just the
  product) and is a key factor in successful
  market segmentation and product differentiation
• Control over the value chain also promotes the
  creation of barriers to entry (e.g., economies of
  scale, deep market penetration, brand awareness,
  switching costs, control over distribution
  channels)
• In essence, the value chain of any given company
  defines the strength of its competitive
  advantages in the marketplace
• Student loan organizations around the country
  have merged/acquired/converted/partnered in part
  in order to enhance control over their value
  chains

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Questions?
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• In order to deliver maximum value for customers,
  it is critical to identify who the customer is
  and what their needs and desires across each
  component of the value chain are
• Only then is it possible to decide how best to
  meet those needs at a price that the customer
  will pay and that will be profitable for the
  organization

Value Chain Competitive Advantage

• Competitive advantage is achieved when all
  components of the value chain are delivered in an
  integrated fashion
• Vertical integration is the term used to describe
  the alignment of each of the components of the
  value chain

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• Existing business models commonly seen in the
  student loan industry include
• Fully Vertically Integrated Originates and
  purchases, holds loans, rarely sells, provides
  servicing and origination functions for self and
  others
• Partially Vertically Integrated Originates and
  purchases, holds loans, rarely sells, requires
  third party servicing and/or origination
  functions
• Traditional Banking Model Originates and sells
  loans, does not want to be vertically integrated
• Pure Secondary Market Purchases, does not
  originate, holds loans, may require third party
  servicing
• Loan Consolidators New entrant, direct to
  consumer marketing experts, originates and
  holds/sells loans, may require third party
  servicing and origination functions

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Recent industry examples of filling out the value
chain
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• The first stage of the MA process is a lot like
  flirting
• The second stage is like dating
• The third stage is getting engaged drawing up
  the pre-nup
• The fourth stage is marriage
• The valuation process is only one part of the
  pre-nup (other parts include agreeing upon how
  combined assets will be deployed, how employees
  and other constituents will have their needs met,
  how future revenues will be allocated, etc)
• Simplistically speaking, the valuation process is
  designed to derive the net worth of an
  organization by valuing its assets, liabilities
  and future revenue potential
• In the student loan industry, predominantly two
  valuation methods are utilized the Adjusted
  Balance Sheet method and the Discounted Cash Flow
  method

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In a nutshell, the Adjusted Balance Sheet method
takes an organizations balance sheet, nets out
intangibles, assigns a premium to certain of the
hard assets, builds in a plug for future
revenue opportunities, and derives the value the
company
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The Discounted Cash Flow method is more
sophisticated. It derives the future revenue
stream of a companys assets, nets out the future
expense stream, applies a discount rate to the
net revenues to derive the present value of the
cash flows
A range of discount rates is typically used, with
the weighted average cost of capital being the
target
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• Primary reasons why organizations in the student
  loan industry have chosen to merge/acquire/convert
  /form strategic partnerships
• To better compete in a mature market by filling
  out the components of the value chain, thus
  creating robust platforms that foment the
  creation of competitive advantages
• To better fulfill their mission statements
• To better serve their other constituents