The story behind the year's biggest bank failure was, in many ways, typical of the financial crisis. BankUnited Financial, Florida's largest homegrown banking company, was knee-deep in bad housing loans. It had tried several times to raise capital, and couldn't. With its failure less a matter of "if" than "when," government regulators had set up shop in the $12.8 billion-asset company's Coral Gables headquarters, overseeing its operations as would-be buyers kicked the tires.
What happened next went off script: On May 21, in a quick one-two strike, BankUnited was seized and sold for $900 million to a consortium that includes several of the biggest names in private equity — Blackstone Group, Carlyle Group, WL Ross & Co. among them. Led by former North Fork Bancorp chief executive officer John Kanas, the group made concessions to meet regulators' concerns and was willing to pay more than anyone else — banks included — that had reviewed BankUnited's books. While the transaction is expected to cost the deposit insurance fund $4.9 billion, the hit could have been worse.
It wasn't the first time private equity has invested money in a teetering banking company, and it almost certainly won't be the last. Last year, private equity firms took large stakes in Boston Private Bank and Flagstar Bancorp, a Troy, Mich., thrift. In January, PE firms paid $13.9 billion for the remains of failed California mortgage lender IndyMac Bancorp. More recently, deals have been struck to inject capital into two struggling California institutions — Temecula Valley Bancorp and Plaza Bank — and First Southern Bancorp, a relatively healthy bank in Boca Raton, Fla.
How big a role private equity will play in the industry's recapitalization remains to be seen, however. While interest is undoubtedly high, many PE firms remain in the "just-looking" phase. Concerns about pricing — no one wants to overpay for a bank that might later fail — unknowns of the economy, cultural issues and government ownership restrictions are all issues that could keep PE firms from making a big splash.
"Private equity is, by its nature, a control investment. And banking, by its nature, is a non-control investment," says Jay Sidhu, former CEO of Sovereign Bancorp, and one of a number of ex-bankers to have formed or joined PE firms. If private equity invests passively, as the laws that govern banking mandate, "then it's not really doing its job."
Even so, against a backdrop where capital is king, private equity definitely has something to offer: a cash hoard, estimated at $1 trillion, eager to be put to work if the terms and conditions are right. It's a treasure chest that the industry might need to tap deeper as a necessary rush to capital evolves.
"Private equity has an enormous amount of capital to invest, and what sector needs capital the most? It's banking," says Steve Nelson, a principal with Hovde Financial in Inverness, Ill. "It's a match made in heaven; a natural marriage."
In addition to the monster issue of banks' and thrifts' need to shore up battered balance sheets, some healthier institutions are looking for capital to buy their ways out of the government's Troubled Asset Relief Program. Others are eager to take advantage of competitors' woes by stealing their customers or simply buying them, and need capital to expand.
Estimates of just how much capital will be needed vary substantially. Keefe Bruyette & Woods Inc. has projected that banks and thrifts could eventually need as much as $1 trillion over the next few years. But critics of that figure note that the 19 banks subjected to the government's stress tests account for more than 70 percent of the industry's assets, and they only needed to add $75 billion to their common equity rolls to safeguard against the Treasury's worst-case economic scenario. Sandler O'Neill & Partners has suggested that the remainder of banks might need as little as $25 billion to shore-up their balance sheets.
"If things are so bad that another $1 trillion — or anything near that — is needed, who would want to invest?" asks Bill Isaac, chairman of LECG Global Financial Services and a former FDIC chairman. "An estimate that says banks won't need to raise a lot of capital rings more true to me."
Others aren't so sure. Through the end of May, banks and thrifts had already raised $49 billion in common equity, $45 billion in preferred equity and $96 billion in senior debt this year, according to SNL Financial. That tally doesn't include most of the stress-test banks' requirements, nor does it count what might be needed to cover some $160 billion in TARP repayments either announced or being considered.
New limits on the percentage of projected future earnings that can be counted toward capital requirements have boosted the need further. SNL calculates that 417 banks with assets between $1 billion and $10 billion could need as much as $62 billion if the standards are applied to them.
None of the above takes into account the economy. While the housing market has shown some signs of stabilizing, there's still a ways to go. Office and retail vacancy rates are rising and the unemployment rate, at 9.4 percent in June, is expected to climb. Credit card defaults are increasing, as are defaults on most other forms of consumer debt.
In its recently published annual review of the banking sector, Moody's Investors Service predicts that the 69 larger institutions it follows will need to set aside an additional $600 billion in provisions through 2010 to cover bad consumer, housing and commercial loans. That doesn't include most regional and community banks that have yet to absorb what are expected to be big losses on commercial real estate loans.
Charles Wendel, president of Financial Institutions Consulting in New York, says he's heard estimates that banks could eventually need as much as $3 trillion in fresh capital. "The size of the commercial real estate problem is large, and potentially enormous," he says.
In theory, banks have a number of capital-raising alternatives. But over the course of the crisis, regulators have made tangible common equity, or TCE, ratios — not the more traditional Tier 1 capital — the litmus test for an institution's health, making it the coin of the realm.
While the stress-test banks have blown through their equity raises with relative ease, they've had a huge advantage: The stress tests came with an implied "too-big-to-fail" guarantee from the government. Treasury "took zero off the table," says Bill Hickey, co-head of investment banking at Sandler O'Neill. "We're at historically low valuations and people are willing to invest as long as they believe the big banks won't be allowed to fail."
Others meeting with success on the public markets include some stronger, smaller players. The list includes companies such as Smithtown Bancorp, Berkshire Hills Bancorp and First Niagara Financial Group — all in positions to grow loan books or acquire weaker rivals.
"We're all about playing offense," says John Koelmel, CEO of the $9.6 billion-asset First Niagara, which has kept loan losses to a minimum and is still making money. The Lockport, N.Y., thrift company recently raised $380 million in common equity, using part of the proceeds to acquire 57 branches and $4.2 billion in deposits that PNC Financial Services Group was required to divest following its purchase of the embattled National City Corp. It also bought its way out of a $184 million TARP investment. "We're operating from a position of strength, and want to take advantage of the opportunities we see," Koelmel says.
For much of the rest of the industry, traditional sources of equity — pension plans, mutual funds, retail investors and the like — remain reticent. With the economy uncertain and no government assurances, no one wants to catch a falling knife.
That's where private equity could potentially come in. In addition to investment dollars, PE firms have an appetite for risk, the creative flare that troubled times demand and a strong interest: Wendel is tracking more than 50 PE firms that are nosing around the space looking for investment opportunities, attracted by beaten-down valuations.
The question is, can the banking industry, private equity and the regulators find a way to live happily together? PE firms typically promise investors that they'll generate superior returns over short periods of time, and then seek an exit — hardly the kind of stable ownership structure regulators or bank boards crave. "Either the bank has to be large enough to buy the position back, you do a public offering or the bank is sold," Nelson says. "And the latter is the most-likely scenario."
Private equity firms are known for taking hands-on approaches to their investments, and placing short-term profits over longer-term strategic goals. This penchant for control can be a threat to bank managers and boards that might prefer more-passive shareholders. Wendel tells of one PE firm he knows that has discussed possible investments with 30 banks, but has yet to find a taker.
Fund managers can be hard negotiators. The $1.5 billion-asset Temecula Valley, reeling from losses on construction loans, was slapped with a cease-and-desist order in February, and told to raise capital by July. After a long search for investors the company in May announced a $210 million deal that will give an investor group led by Bancroft Capital 95 percent ownership. "We've had some shareholders disenchanted by the dilution," says CEO Frank Basirico. "But what are our options? If we didn't get the capital from somewhere, we would have to close." Regulators have been encouraging, but had yet to sign off on the deal when this story went to press.
Private equity's ownership of companies in multiple industries at the same time can also be a sticking point, since regulations pretty much ban the mingling of banking and commerce. The fear is that, say, a bank owned by an auto company will use its guaranteed deposit base to finance cut-rate car loans. "Private equity firms are not transparent," Sen. Jack Reed, a Rhode Island Democrat, told reporters in May. "There are potential conflicts with their other holdings, investors, management and sources of funding."
A handful of specialized PE firms, including Castle Creek Capital and Belvedere Capital, have taken bank holding company structures, which satisfies regulators. But even those relationships are sometimes colored by distrust.
John Eggemeyer, Castle Creek's co-founder and managing principal, says his firm has been working on a recapitalization of a subsidiary bank in Denver. "It's completely benign in structure — easily within the rules — but because private-equity funds are involved, it gets pulled to Washington," Eggemeyer explains. "I think the regulators are afraid that private equity guys will somehow sneak something by that will embarrass them."
Private equity has reasons of its own to move cautiously. In 2008, two big, ostensibly savvy firms lost their shirts on banking deals. Texas Pacific Group invested $1.35 billion in Washington Mutual last April, only to see the thrift fail five months later. Corsair Capital led a $7 billion infusion into National City around the same time; in October, the entire company was sold for $5.6 billion. Corsair was left whole on its 7.8 percent stake, due to previously negotiated agreements, but "everybody saw that an equity investment can vanish quickly in the bank and thrift space," Hovde's Nelson says. "It made all private equity firms more cautious."
The opportunities made available to private equity are typically more desperate situations, which can tamp down enthusiasm. Last November, the $4.5 billion-asset PacWest Bancorp in San Diego, one of Castle Creek's portfolio banks, acquired $450 million in deposits from the failed Security Pacific Bank in an FDIC-assisted deal.
"We paid almost nothing for it, but I'm still not sure it was worth the effort or money," Eggemeyer says. "The franchise was so atrophied, most of the customers were there only for the high rates. Once we began applying normal rates to those accounts, they left."
For all that, everyone has an interest in making private equity a player. On the regulatory front, the Office of Thrift Supervision is, by law, the most accommodating to PE ownership. "Historically, (lawmakers) have always felt it was OK for thrifts to accept different forms of capital to help promote real estate," Isaac explains. One investor can own up to 24.9 percent of a thrift company, provided it signs a "passivity agreement" and takes just one board seat. BankUnited is a thrift, as was IndyMac. Up to 33 percent ownership is possible in some cases, but with more restrictions.
The other agencies — most notably, the Federal Reserve Bank — haven't been quite so willing, due to the tight ownership restrictions. The FDIC, however, is under pressure to keep losses to the insurance fund low. And in a clear sign that the regulators are serious about attracting more private equity to the sector, the Office of the Comptroller of the Currency has granted so-called "shelf charters" to two Texas private-equity groups, Carlile Bancshares, run by longtime bankers Tom C. Nichols and Don E. Crosby, and Flexpoint Ford, run by Gerald J. Ford, who made his reputation rolling up failed savings and loans in the late 1980s and early 1990s. A shelf charter permits companies that do not already own banks to bid on failed institutions.
Temecula Valley's sale of a 95 percent stake is being watched closely for signs of further regulatory give. In May, the FDIC said it would soon provide "policy guidance" for private-equity investors, although no one knows exactly what it will say.
Lawmakers, too, seem willing to crack the door for greater participation by PE firms in the industry. "There is a need for private equity investment in our banking system, but there must be clear rules for all of the regulators," Sen. Reed said.
As for the PE firms, they are under pressure to generate returns. Many took investor money near the tail end of the boom, and have been sitting on it, collecting management fees, as the crisis plays out. Now, they need to find some homerun investments to offset those fees before they're due to return money to investors. The battered banking sector provides some of the best opportunities.
Some of the biggest names in private equity — J. Christopher Flowers, Blackstone's Stephen Schwarzman, Steve Mnuchin of Dune Partners — have already made significant bank investments and could be looking to do more deals.
To gain better access, some PE firms are hiring ex-bankers. New York firm Aquiline Capital Partners added former Wachovia CEO Ken Thompson to its team. Former bank CEOs, including Kanas, Sidhu and ex-Commerce Bancorp chief Vernon Hill, are working with investors on PE style deals.
The firms also are becoming more adept at modifying their structures and ceding some of the control they crave to fit the rules. In the process, variations on the private-equity theme have emerged, most of which involve trying to look as un-private-equity-like as possible. Some funds are sidestepping limits on firm ownership by approaching investments as individual entities. Sidhu has been working on two deals — one each in the southeast and northeast — as an informal lead investor, not a PE fund manager, even though he has set one up.
"Right now, a fund doesn't give you anything extra, and it could be a disadvantage," he explains. "We just basically have a following of investors who say, 'If you find something, count me in.' But we don't have any formal agreements with them." Temecula Valley's arrangement is similar: "The structure is different investment groups, all taking percentages below the maximum," Basirico says.
Ultimately, the depth and length of the downturn will determine how much banks and PE firms will need each other. "We're in the first-date stage," Wendel says. "There's some tentativeness on both sides. Everyone is trying to define the ground rules."
If the investments in companies like BankUnited result in stronger franchises, it will confirm that perhaps there is a greater role for private equity in the banking industry.
