Back in 1987, Chemical Banking Corp. pumped $2.5 million into an equity stake in Office Depot Inc. of Delray Beach, Fla. When Delray went public a year later, Chemical found itself sitting on top of $31 million in stock.

In 1989, Chase Manhattan Corp., together with a Columbus, Ohio, steelmaker called Worthington Industries Inc. and Ford Motor Co., spent $5 million to acquire Rouge Steel Co., a struggling steelmaker in Dearborn, Mich.

When Rouge went public last year, the bank and its two partners got back a total of $352 million for their investment.

In 1988, Bank of Boston Corp. invested $1.3 million in In Focus Systems Inc., a maker of graphic presentation systems based in Wilsonville, Ore.

After In Focus went public in 1990, the bank sold off its stock, cashing in on $7.3 million in earnings.

Hoping to back more such big-time winners, major U.S. banks are revving up their equity investments.

Executives in charge of such programs say they are boosting staff, adding capital, and increasing investments. They are also looking further afield to stakes in companies outside the United States.

Bankers Trust New York Corp., for example, is adding $500 million to its program, on top of some $400 million in existing investments and several hundred million dollars more in passive investments through equity funds.

Executives at the bank say the extra capital will be used to expand investments abroad. Bankers Trust is setting up a team that will specialize in Latin American investments and is increasing equity investments staff in New York, Los Angeles, London, and Asia .

"We think we can dramatically leverage the value of our portfolio," says Douglas Brent, managing director for the bank's Global Strategic Investment Group.

Other banks are moving in the same direction.

J.P. Morgan & Co., which has $1.5 billion in private equity holdings and runs three other funds in which outside investors participate, is also looking overseas to Latin America, Europe, and Southeast Asian countries like the Philippines and China.

"This is not a good time to buy U.S. private equity, so a lot of new investment is going overseas," says David M. Cromwell, managing director at J.P. Morgan Capital Corp, Morgan's venture capital investment unit.

"Stock markets in the U.S. are at record highs, and the best time to buy is when capital markets are dead," he observed.

The Morgan executive also stressed that economic growth is as important as low prices and competition for investments in arriving at a decision whether or not to invest.

"Some of the best opportunities are in economies that are growing rapidly," he said.

"There's nothing like the speed of growth in Southeast Asia or, until recently, in Latin America."

Pretax earnings from equity investments at Morgan rose to $600 million last year, up from $225 million in 1993, and accounted for more than 25% of the bank's total pretax earnings. Mr. Cromwell said the goal is to derive around 15% of pretax earnings from equity sales, but emphasized that such revenues are highly volatile, depending on where the stock market is going.

Meanwhile, Chase last year more than doubled its annual private equity investments to $110 million from $50 million a year earlier, and now has more than $500 million in direct equity investments. The bank earned about $215 million in pretax revenues from equity investments last year. A year earlier, it earned $259 million.

"We've stepped up our activities," says Maria Willets, executive vice president and head of Chase Global Specialized Finance. "The total amount is going up."

Adds Jeffrey C. Walker, managing general partner at Chemical Venture Partners, the equity investment arm of Chemical Banking Corp. that has more than $2 billion in investments: "We invested about $200 million last year, and we plan to pump more in."

Bank of Boston, the first bank to open a small business investment company back in 1959, committed a similar amount to 25 new investments in 1994.

"We're committing larger amounts into individual transactions than was the case a couple of years ago," says Rick Fritz, managing director at BankBoston Capital Inc., Bank of Boston's equity investing unit.

The bank is planning to use its large retail banking network in Argentina, Chile, and Brazil to develop Latin equity investments. It handles European investments out of London.

"The market has been pretty good the last couple of years," says Mike O'Neill, group executive vice president in charge of equity investments at BankAmerica Corp. in Chicago.

U.S. commercial banks began investing in equity in the 1950s, but their investments remained fairly small until the mid-'80s, when they began participating in large management buyouts and taking stakes in high-growth technology and health care companies.

"The scale of the potential, absolute profits (from private equity investments) became clear in the mid-'80s and put the business on the map," says Mr. Fritz.

Banks like private equity investments for a simple reason: If done carefully, they provide enormous returns, even if yields fluctuate with the ups and downs of the stock market.

According to a study of 18 banks by Asset Alternatives Inc., a Wellesley, Mass.-based financial research firm, venture capital of commercial bank affiliates has earned a 25.9% average internal rate of return since 1980.

The study, titled "The Economic and Financial Impact of Bank Venture Capital Companies," found that over the past decade those same banks have invested a total of about $4.7 billion, written off around $611 million, or 13% of the total amount they invested, and earned around $5 billion on their investments.

Meanwhile, the firm adds, profits at bank equity, or venture capital, units soared from $113 million in 1985 to $746 million in 1993.

"Banks are clearly doing more of it," says Steven Galante, president of Asset Alternatives.

"It's an activity that's proved much more profitable than traditional lending, so it definitely looks like it'll continue to expand."

As a measure of how much mileage commercial banks are getting out of their investments, the report notes that venture capital investments provided 6% of banks' earnings during the 1991-93 period, even though such investments accounted for less than 0.3% of total assets of their parent banks.

Citicorp, for example, booked $365 million in pretax gains from venture capital in 1994, $143 million in 1993, $192 million in 1992, and $231 million in 1991.

"It's been an important contributor to earnings," says John Morris, a spokesman for Citicorp.

Banks have a built-in advantage over other investors, like specialized funds, when it comes to private equity investments. For one thing, they use their own capital and don't have to worry about nervous investors pulling out at the wrong moment.

Another advantage: Banks get an awful lot of information about companies with promising prospects that are looking for capital, and they have the kind of people who can evaluate proposed equity offerings.

"Bank groups employ more investment professionals per dollar under management," Asset Alternatives noted in its study. "This allows them to spend more time identifying, analyzing, structuring, and monitoring each investment."

Other bankers also emphasize that they are well placed to handle equity investments which can also help them develop new banking relationships and reinforce existing ones.

"It's an opportunistic type of business," Mr. Cromwell observed.

"Getting interesting deal flow to look at is critical.

"We've got global reach, in-house expertise and a built-in referral source from relationship managers," says Mr. Fritz. "We can spot transactions before other intermediaries."

Having already used this advantage to their benefit in the United States, big banks think they can repeat their success by leveraging their international networks to invest outside the country.

"We've got global reach, we've got an array of products we can offer, and we've got people who have spent a lot of time analyzing companies from the financing and merger and acquisition perspective. We think we can be pretty darn good at this business," says Mr. Brent.

Although U.S. commercial banks have been investing in equity in the United States for decades, they are far from novices when it comes to investing abroad.

In fact, big money-center banks swapped billions of dollars in loans for equity in Latin American companies that were privatized after many Latin countries defaulted on their debts. Chemical, for example, held nearly $1 billion in such holdings in 1992.

Although such holdings are managed separately from domestic private equity investments, they gave banks an extra edge when it came to investing in companies outside the United States.

Unfortunately for banks, there are some specific limitations on the extent to which they can play the private equity market.

First, they are restricted under two sets of rules that allow them to invest in start-up or promising companies - banking law and the Small Business Investment Company program.

Under the Bank Holding Company Act of 1956, banks are barred from acquiring more than 4.9% of the voting stock or 24.9% of all classes of stock in a U.S. company that is not engaged in banking.

Outside the United States, under the Federal Reserve Board's Regulation K governing international banking operations, they can acquire up to 25% of the Tier 1 equity and 40% of all classes of stock.

Under the Small Business Administration's Small Business Investment Company program banks can acquire 49% of the voting stock, but only in a company that has a net worth of less than $18 million or has had less than $6 million in average after-tax annual income for the two years prior to an investment.

As a result, though banks might like to expand their investments, there are limits. But some of that may yet change.

With pressure mounting in Congress to modify Glass-Steagall Act barriers to banks engaging in investment banking activities, banks are also gearing up to try to get some of the restrictions on private equity investments eased as well. Around a dozen banks have set up a working committee that will try to liberalize regulations.

"We're seeking more flexibility," says Mr. Walker. "The whole idea is to put us on a level playing field with offshore banks, other financial services companies, and private pools of capital that are not limited by these same constraints," says Mr. Fritz.

"We'd love to see both regulations (Reg K and Reg Y) go away," Mr. Cromwell said. "They really hurt us in our ability to compete."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.