As regulators meet with private equity managers and consider the rules that govern PE investment in banks, a principle they should keep firmly in mind is the benefit of clarity. Despite the gnashing of teeth among regulators that private equity shops are secretive and will wreak havoc if let loose on the banking industry, it’s a bit ironic how opaque the regulatory process itself is. Regulators should start the discussion with PE firms by bringing clarity to the rules as they currently exist. What’s the difference between influence and control? Does having just one board member really mean a private equity firm can’t own 10 percent of an institution? If the ownership limits are supposedly 25 percent for a non-controlling stake, why do regulators rarely approve transactions involving greater than 15 percent?

This kind of vagueness makes private equity investors uneasy, and not without reason. Regulators for their part should see that their interests, and the industry’s, are served by giving PE the confidence to invest in the industry. Regulators want banks to raise capital as their balance sheets deteriorate, and so far they have to the tune of about $400 billion. The trouble is, it’s conceivable they will need to raise several hundred million dollars more before all is said and done, but investors who participated in early funding rounds are reluctant to commit more. It’s no wonder: Those sovereign funds, pension funds and other big institutional investors have seen their stakes sink like stones.

That leaves private equity funds as a major pool of untapped capital for the banking industry, and, as luck would have it, it’s also a group of investors eager to puts its money to work. J.C. Flowers & Co., Carlyle Group, Kohlberg Kravis Roberts & Co. and Warburg Pincus have reportedly been in direct discussions with the Federal Reserve. (Their interest, by the way, implies a reasonably bullish outlook for the industry. PE guys expect big returns.)

“The pros [of PE involvement] are fairly self evident,” says Gregory Lyons, head of the financial services practice at law firm Goodwin Procter. “These are huge pools of capital. The banking industry is in need of liquidity and capital; banks are failing, and these private equity pools are sitting on the sidelines.”

The reason these pools are sitting on sidelines, the hitch preventing an obvious marriage of interests, are federal rules intended to prevent control of financial institutions by unregulated entities such as private equity firms. To own more than 24.9 percent of a bank an entity must register as a bank holding company, subjecting it to heavy regulations, and the investor must make a so-called “source of strength” commitment, which puts additional capital at risk.

To be clear, these rules are not without merit. However, in reality, regulators take a harder line. For instance, though a 24.9 percent stake in a bank is possible, ownership is usually restricted to 15 percent or less, according to Olivier Sarkozy and Randal Quarles, managing directors at Carlyle Group, who wrote an opinion in The Wall Street Journal in June.

Even if ownership is as little as 10 percent, firms are subject to regulatory scrutiny to make sure they aren’t controlling the bank’s operations. There’s also the regulatory penchant to deny private equity board representation entirely to prevent any control.

Of course, taking a controlling interest and influencing operations are precisely what PE managers are trained to do. This makes banking—an industry PE has historically shunned—an awkward fit. So it’s a conundrum, but not without solutions. First and foremost regulators should clarify existing rules such as board representation. Too often, clarity is studiously avoided by lawmakers since it curbs their flexibility to interpret rules on a case-by-case basis.

Making regulatory interpretation more opaque is the competing regulatory regimes. The Fed recently objected to the private equity agreement between National City and Corsair Capital, which put $7 billion into the bank. Apparently, the Feds worried the agreement might limit the bank’s ability to raise more capital since it promised Corsair compensation if the bank sold shares at less than Corsair’s $5-a-share buy in. While the Fed objected to the NatCity deal, a similar agreement between PE firm TPG and Washington Mutual passed muster with the Office of Thrift Supervision. The irony is that the language of the NatCity deal was largely taken from the Wamu agreement.

For all the regulators’ talk about the need for transparency from sovereign wealth funds, Wall Street research analysts, rating agencies and private equity, regulators themselves do not practice what they preach. That shouldn’t be so. Their transparency is vital to smoothly running financial markets and improving it would go a long way toward solving the private equity conundrum. (c) 2008 U.S. Banker and SourceMedia, Inc. All Rights Reserved.

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