Private Equity players are in the banking industry to stay. They find the industry of interest because of the number and type of opportunities they believe it provides a disciplined investor.  In addition, recent regulatory actions by the Office of Thrift Supervision (OTS) and FDIC offer clear signals that these and other governmental agencies welcome PE involvement, particularly in distressed situations. However, up to this point it appears that bankers are insufficiently knowledgeable about the approach and philosophy behind PE investments. In some cases they may be avoiding an investor group that can play an important and beneficial role for them.

 
Private Equity Fundamentals
PEs have money to invest, see the market need, and believe they can achieve the type of returns they require from working with the banking industry.

As for the available investment dollars, in a 2008 Wall Street Journal article, two senior bankers from the Carlyle Group (investors in BankUnited and Boston Private) state that PEs have $400 billion in available capital versus what they then saw a capital gap of $1 trillion in bank capital needs. (Others put PE funds actually available for financial institutions at a much lower level of $20-50 billion, still a significant figure.)

 

Related to returns, typically PE firms are not long-term investors, if one defines long term as more than the usual three-five year hold period. They expect to liquidate their investment either by resale to another company (often a strategic buyer) or by sale to the public markets. While some variance exists, PE firms usually aim for a minimum 25-35% IRR.

 

FIC has developed a list of about 50 PE players that have made investments or are actively engaged in analyzing opportunities; virtually dozens of other firms are also sniffing around the banking space. While we think most PE firms operate with similar IRR hurdles and timeframes to the above, these 50 and the other firms entering this area segment their approach to the business. PEs appear to operate with one or more of three strategic approaches:

 

* Line of business focus. One set of PE players focuses on selectively buying “distressed” assets at a discount from banks and then rehabilitating them. In recent months, several types of assets have fallen into disfavor within banks, including indirect auto, credit cards, student loans, and various types of real estate, among others. PE firms that focus in this space are comfortable with these specific areas and possess expertise in workouts and asset recovery.

 

* Minority investments in “distressed” or underperforming banks. Given regulatory constraints, until recently, minority investments were the only approach available to PE investors. We will not go through the litany of regulatory hoops through which PE firms need to pass, as many of these rules have been or are being changed. Minority investments allow less than 25% ownership and include limits on Board seats and the degree to which the investors can influence management.

 

Focusing on this area requires excellent due diligence skills and a bank management team that sees the value not only in the dollars that investors bring but in their analytic focus, management discipline, and bottom line focus. One transaction that, from the outside, appears successful is Carlyle’s investment in Boston Private. At an American Banker conference late last year principals from both Carlyle and the bank spoke about the extended process they went through to make certain that a good fit existed between the two companies. Carlyle worked hard to understand and gain the trust of the bank; due diligence was very complete with its personnel visiting all the bank’s divisions and assessing the bank’s business strategy in detail. Boston Private said they rejected other suitors along the way because of a perceived poor cultural or management fit.

 

The Boston Private deal had an engaged management team and a very knowledgeable and hard working PE group. Conversely, TPG’s investment in Wamu seems to offer a case example concerning what happens when due diligence in insufficient and results in too rosy an outlook. A February Financial Times article underscores this, reporting that while Carlyle was then raising a $3 billion fund to invest in distressed situation, TPG had decided to scale back its similarly-focused fund and return some of that money to its investors. Similar investment strategy, yes, but very dissimilar execution and success.

 

* Control. Prior to recent regulatory changes, a handful of PE firms, Belvedere Capital among them, were willing to operate as a bank holding company, in part to gain majority control of its bank investments. PE players following this approach tended to focus on smaller institutions, primarily below the $1 billion mark in assets.

 

Recent changes in OTS and FDIC regulations have larger much larger control-oriented deals to occur, if focused on distressed situations. Transactions include: MaitlinPatterson’s deal for Flagstar Bancorp ($16B in assets), a group purchase (including J.C.Flowers and Paulson & Co.) of Indymac ($16B est.) and the most recent group transaction (including Carlyle and Blackstone) for BankUnited ($14Billion).

 

The Indymac and BankUnited deals may provide templates for future large transactions of distressed banks; however, the government will probably not allow this type of deal for “healthy” institutions. In these deals a group of highly sophisticated investors join together to take an ailing bank off the government’s hands. The government agrees to a loss sharing arrangement, whereby the acquirers gain confidence that they can manage through the bad loans and come out with a healthy institution positioned for growth. While the group as a whole controls the bank, no one entity goes beyond 24.9% ownership, eliminating bank holding company issues.

 

Concluding Thought
While PEs taking control of banks has received much of the publicity, in fact, more transactions will occur related to business line/select asset sales or minority investments. We will focus more on both of those areas in our next newsletter.