Last week we attended a New York-based conference titled “Private Equity: Investing in Banks: Opportunities in a Perfect Storm.” Over 200 bankers, lawyers, and analysts participated in a session that was taking place at a particularly appropriate time for the PE industry.

Why Banks Need Private Equity
Over the next few years, Private Banking (PE) will play an increasingly important role in the banking industry, providing a significant portion of the capital that the industry will require. The conference’s keynote speaker, Randy Quarles from the Carlyle Group, quoted his own and other analysis suggesting that the banking industry will require an additional $500 Billion-$1 Trillion in capital to replace write-offs. PE will play a relatively small role in bridging that gap. Quarles estimated that PE firms have in total $400 Billion in available equity capacity. However, only about $20 Billion (five percent) is currently focused on financial services. While that amount will be leveraged, it still means that PE investors will be highly selective in the banks they target.

What Private Equity Firms Look For
Much of the PE industry’s focus centers on investing in opportunities in which banks are suffering from loan losses and need an equity injection. PE firms need to believe that the capital they will invest solves the equity problem. They also view their investment as a statement of trust in the bank’s future and intend their dollars to play an important role in restoring confidence in the institution. Quarles said that their investments are meant to communicate that they understand the bank’s situation and to bring confidence to other investors.

So far, the experience of many PE firms in US and overseas bank investments has been mixed at best.  TPG’s investment in WAMU is the most notable but certainly not the only example of a deal gone bad. Therefore, expect PE firms to engage in very strong analytics and an extensive due diligence process employing firms like FIC to assist. This process could include assessment of management, analysis of performance versus peers, loan-by-loan quality review, and discounted cash flow analysis of the loan portfolio. The PE team will evaluate the bank’s growth opportunities, its market and customer demographics, the quality of existing customer relationships, the diversification of the business model, and the bank’s core deposit position, among other areas. They can and will “demand” access to a wide range of information, both quantitative and qualitative.

Several years ago, one client told us, with great surprise, that the bank that was then in the process of buying them had conducted no due diligence on them. Apparently, the buyer relied on the acquiree’s strong historic performance; the buyer was also anxious to expand. Those days are long gone and unlikely to soon return. Banks unwilling to work with smart and (appropriately) demanding investors should look elsewhere for new capital. However, working with a PE firm and embracing what they have to offer can offer a substantial upside to bank management and shareholders.

How Banks Should Evaluate PE Firms
Just as the PE firm conducts due diligence on its bank target, so too should the bank evaluate the PE firm’s suitability as an investor. (Of course, this assumes that there are multiple investor options for the bank to explore.)  Another speaker at the conference, Timothy Vaill, Chairman of Boston Private, discussed the experience of finding and working with a PE firm. In addition, we have spoken to others who have gone through a similar selection process.

Vaill commented on the commitment shown to his bank by the PE investors and the expertise they brought to the company. The PE firm visited all the bank’s subsidiaries, and “they confirmed the bank’s underlying business strategy and business model.” In addition, the firm had six very senior bankers, one of whom Vaill, at his option, selected to serve on the Board. Further, since being on the Board, the PE firm representative has demonstrated his focus on the bank’s well being rather than simply acting as a PE representative.

Banks should pursue a mutually beneficial relationship, given the capabilities of some PE firms; all PE money is not simply equal in value. So, how should a bank considering a PE investment proceed?

First, it needs to ensure that its internal house is in order. As earlier comments indicate, PE firms will require extensive access to historic, current, and pro forma data. Ultimately, the PE firm needs to determine whether it can trust current management to recover from past problems and execute growth strategies. And, since it has neither the staffing, inclination, nor the regulatory authority to run a bank, it needs to rely on current management.

Second, banks need to aggressively evaluate potential partners. Everyone I know who has dealt with PE firms has found that, not surprisingly, some offer a better “fit” than others. The major PE players look to invest $250 Million+ with a clear focus on banks with assets exceeding $10 Billion or more. Therefore, many banks will be working with mid-sized players. The good news is that some of them have specialties in banking and can quickly bring value added as well as dollars to a bank.

Final Thoughts
Volatility is as high as it has ever been. Challenges to the banking industry are increasing. For many banks, Private Equity firms can offer a path to capital stability and longer-term growth.