There's little appetite among traditional investors to recapitalize banks these days, and no wonder since those who did step up early to help the nation's flailing banks have seen their positions quickly sink underwater. Yet, as much as banks need access to capital, one group of investors representing a big pool of capital is having a hard time getting into the game-private equity. The problem is that PE raises thorny regulatory issues about how much control a non-regulated PE firm can have over a regulated bank-issues that PE firms, regulators and banks have yet to sort out.
This tension is playing out against a backdrop of significantly diminished M&A activity. The deals that have been announced are struggling to find financing and reach completion, further proof that PE offers the greatest pool of capital for cash-starved banks and may be their best chance to avoid failure. For example, SNL Financial LC's ranking of the top M&A advisors for the first half of 2008 reveals that only 29 deals were announced between January and June, and Bank of America's acquisition of Countrywide was the only multi-billion-dollar deal on the list.
Globally, banks have lost $300 billion during the credit crisis and stand to lose another $600 billion, according to the International Monetary Fund's conservative estimates. Clearly not all banks are great investment opportunities. But PE managers have $400 billion to put to work and some have said that parts of the banking industry are becoming undervalued.
Before the PE spigot can open for banks regulatory issues must be addressed. "These buyout firms have usually been 'control' investors, and that means playing activist management roles at the very least. But regulations preclude them from doing so in the case of banks," says Colin Blaydon, director of the Tuck Center for Private Equity and Entrepreneurship, and a Buchanan professor of management at Dartmouth College.
Randy Quarles, managing director of the Carlyle Group and former under secretary of the Treasury for Domestic Finance in the Bush Administration, argues that a clear interpretation of existing Federal Reserve rules could ease restrictions that prohibit commercial firms from owning more than 25 percent of the voting stock of a banking company, and prohibit the appointment of a board member if the voting stake is 10 percent or more. Also, he and other PE managers want an official Fed interpretation of existing regulations to clarify the necessary level of corporate "separation" between a private equity firm's bank investments and holdings in other industries.
The Federal Reserve would not make an official available for an interview, but it's reportedly about to release a clarification on investment percentage rules and voting stakes soon. "While the regulations unnecessarily limit the amount of investment, there will still be some bank investments by private equity firms, even if there's no change in the regulations at all," Quarles says.
Richard Thornburg, vice chairman of Corsair Capital Partners in New York, a private equity firm that specializes in underperforming financial institutions, says the primary focus is on helping banks recover financially rather than assuming a direct management role. "A new investor wouldn't put money into a firm unless it agreed with the strategy that's being laid out," he says. "The investment is to help the bank get back to their business, get healthy, and longer-term, in some cases, help the bank make or be part of acquisitions down the road."
Still, private equity's need to flip investments in three to five years in order to meet the expectations of its own investors concerns some. Andy Stern, president of the Service Employees International Union, worries that banks may take unnecessary risks to achieve high returns, and complains about favorable below-market terms wrangled by private equity investors for stakes in Washington Mutual and National City. Stern, who wrote an op-ed piece in The Wall Street Journal, did not return calls.
And, in point of fact, money does bring influence, whether the regulations are changed or not. "If you own a $100 million firm, I can come in with a $3 million investment and have a lot of influence," says Richard Beidl, an independent consultant based in San Diego. "If your company needs capital and somebody comes in with a large sum, they have leverage."
Other market observers say it's unlikely that PE firms would encourage banks to take reckless risks, however. "I think it's more important today to monitor growth and new financial arrangements, because that creativity means these new arrangements may blossom in ways that you didn't anticipate going in," says Joe Mason, a Louisiana Bankers Association professor of banking at LSU in Baton Rouge.
Regulators do have an incentive to work with PE since the alternative is that taxpayer money may get put to work in the form of bailouts. "If the capital needs of banks can't be filled because of various obstacles, that will increase exposure to taxpayers if the FDIC is forced to recapitalize the industry," Quarles says.