A weak economy and continued pressure on bank earnings will likely cause serious soul searching this year at a number of private-equity firms that have invested in the industry.
Dozens of banks received capital infusions from private equity after the financial crisis. Those deals are now reaching the three- to five-year windows where investors start to envision an exit strategy such as a bank sale or a stock offering.
Current conditions are making it more difficult for private equity to find its way toward an exit, industry experts say. In the past year banks were hit with more regulation. Meanwhile, low interest rates, and tepid loan demand continue to constrict earnings growth.
The performance of banks backed by private equity is "a mixed bag," says Joe Thomas, a managing director at Hovde Private Equity Advisors. "The profitability equation has proven to be more difficult than one would have expected, particularly for banks that don't have large concentrations of fee-based revenue."
Some industry observers say an unclear future for profitability will cause private-equity investors to push more banks to sell.
Others say the uncertainty could force investors to hold onto their shares, and point to BankUnited (BKU) in Miami Lakes, Fla., as an example. The $12.7 billion-asset company's board tested the market in early 2012. A lukewarm response from possible bidders led BankUnited to affirm its independence.
"In terms of banks, the main thinking that maybe people had not anticipated was the duration of the low interest rate environment and the very high cost of regulation," says Wilbur Ross at WL Ross & Co., which is one of the key backers of BankUnited.
"For the most part, the investments are manageable within the scale of the portfolio we have," adds Ross, who has investments in several other community banks. "If we have to wait longer for realization, I don't think that [negatively] impacts us."
The 2013 forecast for banks backed by private equity is rather mediocre, according to a September report by KBW. The firm projected that just three of the 27 private-equity-backed banks it covers would outperform expectations. Last January, KBW forecast that six of those banks would outperform.
"There's certainly been a recovery in the banking sector, but I don't think private-equity investors anticipated the really sluggish economic recovery and what that meant for the ability of a bank to grow organically," says Jeff Davis, the managing director of the financial institutions group at Mercer Capital.
Investors say it's often difficult to identify exactly why certain private-equity-backed banks underperform. Still, some of those banks are based in stagnant markets or have been unable to complete anticipated acquisitions.
Then again, big investors may have also been a bit too eager to pump capital into the banking industry. "Private-equity money probably invested too early in the economic cycle," Thomas says.
Many private-equity firms passed regulatory hurdles in time to buy failed banks, but the pace of failures has slowed, leaving fewer opportunities. Industry observers say consolidation will pick up but that banks backed by private equity will most likely be sellers.
That was the case when West Coast Bancorp (WCBO) in Lake Oswego, Ore., agreed in September to sell to Columbia Banking System (COLB) for $506 million, notes Chris McGratty, an analyst at KBW's Keefe, Bruyette & Woods.
In its fall report, KBW pegged two of the 27 private-equity-backed banks it covers as sellers and six more as "flippers," or near-term buyers that would ultimately sell.
KBW also assessed the price appreciation of the initial private-equity infusion, finding that the median investment earned 44% through Sept. 25. Just seven of the 27 banks had lost money for their private-equity investors.
Six of the banks tracked by KBW, including Bridge Capital Holdings (BBNK) in San Jose, Calif.; Webster Financial (WBS) in Waterbury, Conn.; and BankUnited — have more than doubled returns. Last month, Webster said that investor Warburg Pincus would sell some of its stock, taking advantage of the price gains.
"The best performers tend to have been those operators that received capital to acquire failed banks and have been successful in resolving the problem assets," Thomas says. "They've stabilized the institutions while integrating the banks into a … growth strategy. Those will be the more spectacular performers."
A nominal rate of return may be insufficient. McGratty says that private equity usually wants to double or triple its money, meaning that 44% appreciation would underwhelm historical expectations. "There have been instances where there's very good performance but it has taken a lot longer to get there, given what's happened in the banking industry," he says.
Some industry experts say that disappointed investors are victims of their own misplaced expectations.
"A lot of the PE firms that looked at the sector post crisis did not come with the experience" of investing in banks, says Oliver Goldstein, a managing director at Pine Brook Partners in New York. "There were a fair amount of tourists with a short-term mind-set."
Pine Brook was one of the last firms to unveil a bank investment in 2012. Last month, it was among three groups to inject $85 million into Community Trust Financial in Ruston, La. Goldstein says his company typically holds its investments for an average of five to eight years. They held an investment in the former Mellon Bank for a decade.
"We are happy to own these positions for the long term," Goldstein says. A short-term mentality has "never been the way we've looked at the sector."
Robert Barba contributed to this story.