Private Equity Must Get More Hands-On in Bank Investments

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Many private-equity firms hoped to capitalize on the financial crisis through two waves of bank investments. The first, in 2007-8, focused on large investments in major banks. These disappointing investments were too early as industry conditions worsened dragging down these investments.

As the crisis continued during 2009 and 2010, large sums of capital were deployed by private-equity firms and their close cousins, blind pools. No one wanted to miss what appeared to be an opportunity of a lifetime to exploit historically low bank valuations.

This second wave focused on the discounted purchase and roll-up, with FDIC assistance, of the growing number of smaller failed community banks. The banks would be stabilized and sold at a premium once the industry recovered.

Unfortunately, the results of the second wave investments were mixed at best as private equity underestimated the challenges. Industry multiples kept falling, reflecting concerns about asset quality, loan demand and rising regulatory costs. Additionally, turnaround efforts took longer and were more difficult to complete than originally thought. Of course, regulatory suspicions did not help. The FDIC effectively blocked many private-equity bidders of failed banks. These suspicions, however, were largely a result of private-equity firms' failure to recognize regulators as counterparties. Furthermore, weak capital markets delayed exits, as the abortive Bank United exit in January demonstrated.

Final results will remain unknown until at least 2013 and 2014 when exits are expected to materialize. Nonetheless, problematic interim results have slowed further deployment of private equity's substantial uninvested capital.

Some are beginning to question the continued commitment of private equity to banks. Private equity is, however, likely to evolve its investment thesis to profit from the restructuring and consolidation of the banking industry.

This will involve a shift from market-timing-based purchases of troubled banks at cheap prices to a new strategy encompasses investing in well-managed, scalable banks at fair price and growing them. This requires bringing more than just capital to a transaction. It requires becoming a long-term partner providing advice and support on strategy and governance. This is more difficult and takes more time, but it's more sustainable.

The focus should be on banks with assets of $1 billion to $10 billion with established management teams and credible business plans. They should be located in markets with attractive demographic characteristics. Additionally, they should have franchise value reflected in solid earnings, core deposits and a strong market position. Such institutions would be highly rated and have minimal asset quality issues. Thus, regulatory growth constraints would not be an issue.

The new investments would support the exploitation of organic growth and merger opportunities. The investments would likely take place through a private placement with registration rights to ensure quick execution. Board memberships would be granted within regulatory ownership. This management partnership approach with solid banks should reduce regulatory complications.

The number of attractive targets with these characteristics is limited. Also, the number of private equity firms with the required skills and patience to enact this new investment thesis is small. Thus, many recent private equity entrants into banking will undoubtedly exit. This should improve the prospects for the remaining committed firm.

The postcrisis banking market has evolved. Regulatory clarity has improved, loan portfolio confidence has grown and the economy has stabilized. Substantial private-equity banking opportunities exist for those private-equity funds capable of adapting to the new environment as the secular drivers of industry restructuring remains intact.

The strategy of purchasing troubled banks at depressed prices no longer works. The focus is now on a long-term partnership based on operating improvements and growth. Many private-equity investors have received an expensive banking education over the past few years. Some are likely to use this education as they refine their investment approach.

Hopefully, for both private equity and banks, this third investment wave will succeed. If so, private-equity bank investments will become an attractive value play instead of a value trap.

Joseph V. Rizzi is a senior strategist at CapGen Financial Group, a private-equity firm. He spent 24 years at ABN Amro Group and LaSalle Bank.

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