Executive Summary: Banks should be leading the effort to loosen regulations in order to encourage private equity firms to invest in banks. Not only is the infusion of capital important, but even more critical may be the mindset that private equity firms bring to their investments.
The Wall Street Journal on June 26th featured an opinion column by Olivier Sarkozy and Randal Quarles, two Managing Directors of the Carlyle Group, a top private equity player, titled “Private Equity Can Save the Banks.”
Private Equity to the Rescue?
In their view, the crisis impacting much of the financial-services industry will continue with the result that “it is clear that the financial-services industry will continue to need unprecedented amounts of new capital over the rest of this year.” This capital is unlikely to come from the public markets: “Of the 42 equity issuances undertaken since July 2007 by U.S. financial institutions, 39 are trading below their issue price.”
Because of the weak public markets, the private investment sources have been critical to banks such as Washington Mutual and National City and will become increasingly important: “Private sources of capital…have the time, resources, and capability to evaluate the assets of financial-services firms and make informed investment decisions. For this reason, the industry has increasingly turned to private equity as a capital source.”
The authors also state that the financial sector’s losses, which have already reached $350 billion, could rise to $600 billion or more, necessitating increasing capital; they note that the private equity industry has in excess of $400 billion in available funds.
While the need exists and the funds are available, the article outlines the regulatory restrictions on investors and suggests immediate changes to established policies: “Private equity is ready and willing to step forward in large amounts — restoring lending capacity, encouraging efficiency, and protecting the taxpayer.”
A subsequent June 30th “Heard on the Street column” painted a different picture stating that “the rules are less restrictive than they first appear,” and that “regulators also have to doubt how much money private-equity firms would put into banks.” These writers point to increased transparency and higher near-term write-offs on the part of banks as the way to increase investor confidence and reopen the public markets to banks. In other words, “to heal the system” banks need to come clean about bad assets as they have yet not “confessed enough to regain investor trust.”
However, the need to “confess” hardly conflicts with the valid argument that private investors should be able to take more prominent equity positions in banks. Yet another article, this time in the The Financial Times of June 26th, underscores the perspective and value that new investors can bring to banking.
Gone by the Board?
The FT essay with the above title critiques the stewardship offered by bank boards and their ability/focus on anticipating emerging problems:
- Regarding Citi, JPMorgan Chase, BofA, Goldman Sachs, Merrill Lynch, Lehman, Bear Stearns, and Morgan Stanley, “more than two-thirds of the occupants of those board seats had no significant recent experience in the banking business. Fewer than half had any financial services industry experience at all.”
- “Many of the directors without a financial background happened to sit on highly technical board committees,” for example, the finance and risk committee.
- One executive commented that most boards resemble “a retirement home for the great and the good.”
- However, not all observers cite inexperience as the key problem: “Many corporate governance experts maintain that the biggest deficiency among financial directors during the crisis has been one of attitude and effort rather than knowledge or experience.”
The article goes on to suggest that current boards are at jeopardy as shareholders organize and direct their ire at those whom they believe should have been more effective guards against value eroding actions. However, introducing more private equity money into the banking industry should address corporate governance as well as capital issues.
The FT article cites board members as insufficiently attentive to detail and hesitant to put in the necessary time and quotes a business professor saying: “Boards did not ask the tough questions and did not have the stomach and the interest in working with the CEO to reinvent the business and challenge the status quo.” What an indictment! What the banks need the most is exactly what some boards were incapable of providing: hard questions, a willingness to drill down to understand the detail, a commitment of personal time and energy despite other responsibilities.
The best board person I ever met (so far) was an ex-GE industrial executive who knew little about banking. However, he was highly inquisitive and demanding and when he retired from GE, he put significant energy into digging under the numbers to understand what was going on at his bank. It is that type of focus, attention, hardheadedness, and creativity that private equity investors frequently bring to their companies. The fact is that most bankers do not want that level of scrutiny, although increasingly they will be unable to avoid it.
Concluding Thought
More private equity investment in U.S. financial services is inevitable. While in previous years the emerging markets have been more attractive to these investors, attractive opportunities now exist in the U.S. Private equity investors want to invest in U.S. banks, and more banks will need their dollars. Despite the roadblocks, investments will increase. However, the biggest benefit to banks from having these investors may center not on their balance sheets but on the quality of thought and discipline that private investors and their representative can provide to a bank. That is why regulators, shareholders, and many bank executives should welcome their interest.