Regulated financial institutions should have ample opportunities in 2008 and 2009 to partner with private-equity firms to compete aggressively to acquire healthy and troubled institutions, as well as failed bank assets from the Federal Deposit Insurance Corp.
The rules of engagement for these partnerships and investments seem to evolve with each transaction.
On Sept. 22 the Federal Reserve Board issued its "Policy Statement on Equity Investments in Banks and Bank Holding Companies." At the very least, it signals that the Fed is prepared to evaluate control issues more flexibly within the context of particular transactions. Specifically, the policy statement clarifies that investor control should not be found in the following situations.
- Owning up to one-third of the total equity of the bank or bank holding company, as long as voting securities are limited to 15%.
- Having a single representative on the board of directors, as long as the investment is less than 25% of the voting stock.
- Having two representatives on the board, depending on the size of the board, the amount of the investment, and the holdings of other investors.
- Shareholder advocacy of policy and operating positions that are not accompanied by the threat of a proxy contest or a disposition of the investment.
The rules of the Fed, the FDIC, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision continue to differ in meaningful ways, but the trend, particularly at this time when banks need capital, is toward increased flexibility to accommodate private-equity investments.Since private-equity funds may generally not be able to acquire "control" of a bank, for fear of becoming a regulated holding company, they will generally want to invest in or partner with a bank with a superior management team. They can invest in a combination of common stock, preferred stock, warrants, and convertible debt to strike a balance between the requisite oversight and covenants they will need to protect their financial interests.
They also will want financial protection against dilution resulting from the issuance of additional equity. However, in some recent transactions, private-equity firms have waived these rights, perhaps with regulatory prodding, to attract additional capital to the bank.
No matter the form, new capital will help banks avoid regulatory issues, facilitate balance sheet restructuring, mitigate shareholder unrest and public scrutiny, and fund geographic and product expansion. Banks can also benefit from the strategic, financial, technological, and other market expertise private-equity firms can bring to the table. In that regard, banks are likely to welcome private-equity representatives on the board to the extent compatible with regulatory limitations.
There are five basic structures available to private-equity firms to invest in and acquire banks. Many variations on these basic themes are also possible.
Stay below 10% of the voting stock. Generally, if an investor stays below this threshold, federal regulatory limitations and prior approvals are not triggered.
Stay below 25% and execute a passivity agreement. A private-equity fund making an investment this small can avoid holding company status, which would subject it to federal regulation with regard to its capital, leverage, investments, and activities.
An investment in excess of 10% will require the execution of a rebuttal or passivity agreement that will limit the actions the private-equity investor may take, the information it may have access to, and the extent of its business relationships with the bank.
Under such an agreement, a private-equity fund may have representation on the bank or bank holding company board of directors, and in that way it can have access to information it might otherwise be prohibited from obtaining.
The policy statement also indicates a greater willingness to consider private-equity funds' access to financial information.
Dispersed ownership of between 25% and 100%. The acquisition of more than 25% of the voting securities — even up to 100% — can occur and still not trigger holding company status for any of the investors, but only if there are multiple acquirers, none of whom ends up with control, and if none of them act in concert with regard to the operation or policies of the bank or its holding company.
Become a bank holding company. Some private-equity firms have simply bitten the bullet and acquired 100% of a company that controls a bank, because they can live with the restrictions attached to holding company status, or because the bank subsidiary is or can be converted into an industrial loan company, trust bank, or credit card bank, none of which would be considered banks for the purposes of holding company laws.
Use separate acquisition silos. A principal of a private-equity firm can establish a separate acquisition company in which some or all fund investors participate. It may become a holding company, and as long as an individual sits atop that structure and/or it is in a separate silo from the funds, holding company limitations will not generally infect the funds controlled by that principal.
Given the growing capital needs of banks throughout the country and the vast amount of capital controlled by private-equity funds, we anticipate that these parties will continue to find ways to address each other's financial needs. These will no doubt include arrangements where banks partner with private capital to purchase troubled banks either before or after they have been put into FDIC receivership.
Regulators should continue to be attuned to this trend and the benefits it can provide. To the extent that control rules need to be further modified or clarified to facilitate these transactions, now is the time for such action to redefine the definitions of passivity, voting stock, and acting in concert to encourage the types of transactions that have already occurred and stimulate even more creative ones.