An increasing number of private-equity and hedge funds have invested in or acquired bank and savings and loan holding companies in the last 24 months.
In "Some New Dynamics For Troubled Institutions" [July 18], we discussed the investment opportunities that will be created by banks' need for capital. Now we look at how private capital can take advantage of those opportunities.
Regulatory limitations on such investments have impacted the form of these transactions.
Citadel Investment Group made a noncontrolling acquisition of up to 25% of E-Trade. TPG made a noncontrolling acquisition of up to 25% of Washington Mutual. Corsair Capital made a noncontrolling acquisition of 9.9% of National City. A group of private-equity firms not acting in concert and led by Bear Stearns Merchant Bank acquired over 90% of Doral Financial Corp. A group of investors led by J.C. Flowers acquired 26.58% of HSH NordBank through separate trusts.
Paul Levy of JLL Partners acquired all of FC Holdings and First Crockett Bancorp through a separate and newly formed acquisition company. Hellman & Friedman acquired all of Private Trust Co., subject to a capital infusion agreement with the OCC.
Given this trend, there may be a great benefit to a re-evaluating the ways market capital can be matched with the financial needs of the banking industry. As the Federal Reserve Board rethinks its rules regarding such investments and prepares to propose new ones, it would seem that two specific areas may particularly benefit from some modest modernization.
Depository control and holding company rules presume the existence of control and could impose constraints when as little as a 10% of the voting stock (or a range of convertible instruments) is directly or indirectly acquired. These rules, which were largely developed 30 years ago, when private equity was virtually nonexistent and capital markets worked differently, are impacting investments and often discourage private equity from investing in the banking industry.
Current holding company and bank control rules effectively permit only unfettered investments below 10% of the voting stock, including instruments convertible into voting stock; "passive" investments of 10% to 25%, in which the exercise of many customary shareholder rights is restricted; or full registration as a controlling party or holding company, with applicable financial and other limitations.
The question of what may qualify as a proxy for voting stock for control purposes may have been raised in an analogous context. The U.K. Financial Services Authority announced July 2 that it will require enhanced disclosures of contracts for difference (e.g., swap agreements) and will release detailed regulations this year.
In addition, in CSX v. Children's Investment Management, the U.S. District Court for the Southern District of New York held that financial swaps and similar arrangements should be treated as the equivalent of the securities they reference when they were used to avoid disclosure.
These actions deal with market disclosure, but the means by which investors may exercise undisclosed control is getting some attention by banking regulators.
Since the 1980s, failed bank acquisitions have morphed through various incarnations that have used a variety of creative tools ranging from income and asset spread assistance agreements to the more straightforward separate transfer of the failed bank's deposits and assets to the highest bidder. Thus, a bank that is permitted to acquire the deposits may or may not be the winning bidder for the assets.
Private-equity and hedge funds can bid for the assets only after the failed bank is placed into receivership. This limitation would seem to be contrary to the best interests of the Federal Deposit Insurance Corp., which surely would benefit if the number of bidders and amount of capital available increased and the potential cost of resolutions decreased.
Given the changes that have occurred since control rules were developed, and in light of the current turmoil confronting financial institutions, modernization and conformity of control rules by all federal bank regulators may be beneficial, particularly with regard to the following considerations.
- Regulatory presumptions of control that apply when an investor directly or indirectly acquires less than 25% of a bank's voting stock.
- The creation of a new investment status, other than "passivity" and "control," giving such investors more power to exercise shareholder rights without triggering control and holding company requirements.
- Regulatory standards regarding the types of securities, swaps, and other financial contracts that may be treated as voting securities for control purposes.
- Presumptions that determine when investors are and are not "acting in concert."
- New procedures in which regulators work together to issue bank charters to nonbank bidders in FDIC receiverships.
- The creation of a regulatory mechanism to match bank purchasers of failed bank deposits with private-equity acquirers of their assets, so that a consortium of companies can buy failed banks from the FDIC immediately.