The Private Equity Effect

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It's only natural to look at successful private equity deals in the banking industry and think about what might have been-the failures that might have been avoided had private equity money been allowed to flow more freely into the sector, the balance sheet health that might have been restored by now at banks needing to be recapitalized.

Indeed, in the midst of crisis, Washington went only so far in easing the long-standing restrictions on private equity's control of depositories, even as regulators scrambled to contain the influx of failed institutions.

A focus on short-term profit-making is partly what makes regulators leery. Private equity firms generally raise money to acquire, fix and sell companies, at a profit, on a timetable of five years or less.

Nonetheless, a number of buy-and-flip artists breached the regulatory bulwark around banks. Since the start of 2008, there have been at least 187 private equity transactions involving banks, with more than $31 billion changing hands, according to SNL Financial. The tally is based on publicly announced deals including buyouts, growth capital investments, private placements and exits via public offerings of stock, among other types of transactions.

The legacy of these deals is fairly straightforward on the surface: private equity shops purchased a handful of failed banks and rescued many more that otherwise might have failed; they also bankrolled a handful of new lenders set up to capitalize on a void when credit dried up in 2008, and purchased.

But private equity's imprint on the banking sector goes deeper than that. These investors, obsessed with generating returns relatively quickly compared with bankers, have introduced a new discipline and a different set of priorities to an industry that, by design, had long been shielded from private equity's influence.

At a glance, banks with private equity investors aren't intrinsically different from other banks, as Mary Lynn Lenz would attest.

A veteran banking executive, Lenz was recruited by a private equity firm in 2009 to run Professional Business Bank in Pasadena, Calif., and she arranged for its sale to another private equity investor, Carpenter & Co., at the end of the following year.

"We ran the bank as a bank-a traditional bank," says Lenz, who stepped down after Professional merged with another Carpenter holding, Bank of Manhattan in El Segundo, Calif. "Our partnership with the private equity fund did not change our product line. It did not change our strategic direction. It just added another partner [and] in our case, several board members."

But partners and board members affiliated with private equity firms-even the ones who have signed passivity agreements meant to limit the influence they can exert over the banks in which they've invested-still bring something to the table that others don't, be it capital markets expertise or the urgency of a stakeholder with a short investment horizon.

There are indirect effects as well-on the institutions that have to compete against banks with private equity capital; on regulators, who are still tangling with a variety of questions about private equity and its role in the financial system; and on the price tags for acquisition targets, which are being driven up by aggressive bidders financed by private equity.

PacWest Bancorp, based in Los Angeles, is the poster child for sharp-elbowed, private equity-fueled banks. Its CEO, Matthew Wagner, scuttled Umpqua Holdings' deal for a small bank called American Perspective by making a higher offer in May. Also that month, he made a hostile bid for First California Financial Group, a move that effectively put a for-sale sign on that company.

PacWest's backers include CapGen Financial, a private equity firm run by former Comptroller of the Currency Eugene Ludwig.

"They want to become a big player in California and then sell to a very big player that wants to grow in California," says Joe Gladue, an analyst with B. Riley & Co. who follows West Coast banks. "That creates a different mindset and a different way of operating than someone who wants to keep a bank around for a long time."

Even technology vendors are noticing the difference.

Several say that private equity-owned banks seem to have a heightened interest in finding software and systems that will make their banking operations more productive and afford greater transparency to root out inefficiencies.

"I am going after bank holding companies that are typically backed by private equity," says Pierre Naudé, the CEO of nCino, a startup that offers technology for tracking loan documentation and other paperwork in the cloud.

Of course there are plenty of other bank owners focused on improving their returns. But private equity tends to keep to a tight schedule-firms have limited time to boost returns and exit the investment-so the tactics used to achieve those goals frequently are more aggressive than the norm.

Some private equity investors will hold onto an investment for as long as 10 years if necessary. Most, however, expect to start generating higher internal rates of return much sooner than that and plan to cash out within three to five years.

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(Image: Bloomberg News)

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