Don't count private equity out yet. Even as all the typical options to put cash into banks—and make a worthwhile profit—seem to be playing out, another tactic is emerging.
The rollup is the classic strategy: buy a good company, ideally at bargain price, go on an acquisition spree and sell a few years later. Banking would have been as good a venue for all that as the retailing and steelmaking industries have proven to be, were it not for the regulatory scrutiny and tight parameters around the control of depositories—which makes the bank sector a place where privacy and equity are very tough to come by.
A small batch of savvy, aggressive firms had found some creative ways to invest: blind capital pools and bank-chartered shell companies for buying failed institutions, and minority stakes in relatively healthy banks that might become consolidators. But the window for those kinds of opportunities is closing fast. Securing a charter is no easy task, failing banks are smaller and less attractive, and healthy, would-be consolidators generally have all the capital they want.
Sensing the need for another workaround, Warburg Pincus, one of the oldest and best-known private equity players, has arrived at a strategy that experts say might offer a blueprint for the next phase of private equity investing in banks.
Warburg calls it "just-in-time" investing, and it works like this: Warburg agrees to make an investment in a bank only when the bank strikes a deal to buy another institution. In exchange, the New York firm gets a stake in the merged entity, most likely in the form of common or preferred shares.
Just-in-time investing lets Warburg provide input on any purchase an acquirer might be considering, while the acquirer lands immediate funding for the cash portion of a transaction. The arrangement negates the risk of getting tied to a bank that winds up being a consolidation wallflower, which suits Warburg's interest in focusing on active buyers.
"If they make the acquisition, we write a check alongside them to facilitate the transaction," says Daniel Zilberman, a managing director at Warburg. "This construct is appealing to both us and the people we look to work with, as we only fund if there is a deal, and they only need our capital if there is a deal."
Zilberman says the firm already has lined up several institutions interested in the arrangement and stands at the ready to provide the just-in-time capital, but no deals have come to fruition yet.
The firm can afford to be patient. Waiting is a small inconvenience compared with what private equity has shown itself willing to put up with, and find ways to circumvent, for a chance to play in an industry where even strong banks are trading at historically low multiples of 1.5 times tangible book value or less.
Warburg is looking to invest in banks that are big, but not super-big. The banks it has been involved with on other kinds of deals—primarily recapitalizations—have had between $10 billion and $20 billion in assets. Any smaller, and the deal becomes an inefficient use of financial and human resources for an investment group with more than $35 billion in investments. Any larger, and the bank is likely to have enough liquidity and access to the capital markets to do deals on its own.
Despite calling the strategy "just-in-time," Warburg would not get involved at the last minute. It would have worked with the bank to explore potential transactions, affording it some influence over the process and allowing for a deep understanding of the deal before an agreement is struck.
There are benefits for the acquirer, too. Tapping a firm like Warburg for an infusion of cash at the time of a transaction means a bank can avoid the fees and headaches involved in a pre-merger or post-merger issuance of debt or equity. No need to worry about getting an offering thrown off by market volatility. No risk of looking overcapitalized if an acquisition falls through.
If the concept catches on with othere private equity firms, just-in-time capital could be the next big thing in bank mergers. How big, though, is questionable.
Robert Kafafian, president and CEO of the Kafafian Group, estimates that of the more than 7,000 U.S. banks, just 18 percent of them are large enough to get any access to private equity. He expects the bulk of the industry's consolidation to involve banks with $500 million in assets or less, in deals done far off the radar screens of private equity firms.
Banks in a position to become serial acquirers are few in the space where big firms like Warburg would want to play. Keefe, Bruyette & Woods sees active-buyer potential in fewer than 40 of the 165 banks it covers, including about a dozen could-be buyers that are big and strong enough to do a transaction on their own.
But Kafafian, whose Parsippany, N.J., firm provides consulting services to community banks, says Warburg's idea fits into a broader trend that has banks of all sizes lining up rainy day capital from institutional investors or other potential sources.
"I would tell you that there are probably lots of banks that have relationships with various sources of capital that they're constantly nurturing as part of the capital plan should they grow their bank," he says.
In this market, the promise of a cash component no doubt makes a bid more competitive. For banks aligned with a firm like Warburg, just-in-time backing can further strengthen a bid. The arrangement would let a potential target know that the suitor is serious and could close a deal quickly. And it might help reassure regulators that the buyer can pay for the deal and still maintain appropriate capital levels.
Chip MacDonald, a partner in the financial institutions practice at the law firm Jones Day, says there are precedents for the idea of just-in-time capital. "This is not dissimilar to an equity line of credit" from a hedge fund or investment bank, he says. "We have done those on a public basis for a few banks." Other permutations of the idea include situations in which banks have sold pre-emptive rights to investors in stock offerings.
What makes just-in-time capital from private equity firms novel, MacDonald says, is that "they're looking at supporting mergers and acquisitions."
He says the concept would probably work, although he suspects that public institutions would need a hard agreement in advance that regulators could review, given regulatory suspicions about private equity in banking.
The Federal Reserve and the Federal Deposit Insurance Corp. are deeply reluctant to let buy-and-flip investors control depositories. If a private equity firm wants to own 25 percent or more of a bank, it generally has to be willing to become a closelyscrutinized bank holding company. Those realities have acted as a kind of poison pill against buyouts by private equity firms, which generally want to call the shots on things like cost cuts and mergers, their best tools for fattening returns, if they are going to be writing big checks.
Still, some of the biggest names in private equity—including Carlyle Group, Blackstone Group and financier Wilbur Ross—remain deeply interested in banks. Warburg has been active too, participating in the recapitalization of a handful of large community banks when the institutions were ready to return their federal aid. It invested in National Penn Bancshares of Boyertown, Pa., and Webster Financial of Waterbury, Conn., among others.
Recap opportunities are getting scarcer, though, with the most attractive banks having already returned their bailout money.
If the next big need for capital is for acquisitions, just-in-time investing may be just the thing to keep private equity in the picture while banks prepare to make their move, MacDonald says. "I think this is a good harbinger of the consolidation that we're anticipating."
