Banking on Returns
Private equity investors find new opportunities to deploy capital in troubled banking sector.
By Kelly Holman June 16, 2008
It's provided a booming source of fee income--and has been equally problematic for Wall Street when deals sour--but private equity may be an anchor for banks and financial-services companies seeking stability in the wake of last year's credit storm and ongoing loan portfolio problems.
Private capital interest in the banking sector exemplified by deals involving Washington Mutual and National City--structured as minority-stake investments from high-profile financial sponsors TPG and Corsair Capital Partners--couldn't be more auspicious for banks and financial institutions.
Billions of dollars in write-downs resulting from the subprime credit meltdown have left large banks with diminished capital reserves which, in turn, has spurred the institutions to turn to the private investment community to shore up faltering capital positions.
One of the most recent and highest-profile examples involves Lehman Brothers, which just announced it had secured $6 billion from investors in the wake of posting a $2.8 billion second quarter loss.
Wall Street wasn't a huge fan of the offering, which came on the heels of two other fund-raising efforts from the brokerage firm. However, Moody's Investors Service lauded the move, calling it "a positive step in bolstering both the balance sheet and investor confidence" in light of balance sheet de-leveraging. Although it didn't identify the investors that supplied capital for the new money-raising effort, the New Jersey Division of Investment and Maurice R. "Hank" Greenberg's CV Starr investment firm were said to be involved in the new capital infusion.
Lehman's deal was announced less than a week after TPG agreed to invest $350.4 million in Bradford & Bingley to acquire a 23% stake in the London retail banking house and shore up its reserves. Reports, meanwhile, have continued to swirl around Barclays' plans to raise as much as $5.8 billion from deep-pocketed sovereign wealth funds. A Barclays press officer declined to comment.
The next big opportunity for private equity firms, though, isn't necessarily involving direct investments in bulge-bracket firms. Some investors in the finance industry believe investment prospects will come from the regional and community level, ranging from troubled banks to businesses embedded within financial institutions.
"Given the current environment, we believe that there will be an opportunity to make attractive investments in the financial services sector over the next 18 months," says Richard Thornburgh, vice chairman of Corsair Capital Partners. "It's not just companies that are under the weather, but smaller to midsize businesses with a good operating history inside organizations that will be sold."
Thornburgh, a former executive vice chairman of Credit Suisse, should know. Corsair, a 15-year-old private equity firm that invests exclusively in the financial services industry, ploughed $985 million into NatCity as part of the $7 billion capital raised by the Ohio bank in late April. The investment in NatCity helped the bank increase its pro forma Tier 1 risk-based capital ratio to 11.4% from 6.6% as of March 31. Like other banks that have received capital infusions, NatCity reported its share of losses this year with its first quarter loss of $171 million, compared with a net loss of $333 million for the fourth quarter of 2007.
"NatCity needed capital," says Thornburgh. "It has a very sound core commercial bank and retail banking franchise in the Midwest, which hasn't been subject to the excesses and contractions we've seen in other banking markets," he says, adding, "The new capital will allow them to grow their business and deal with their liquidating portfolio."
Corsair isn't the only big-name investor to spot opportunity in the troubled sector. The chance to invest in troubled investment banks or asset management firms seeking to rebuild capital positions after massive losses as a result of last year's mortgage finance meltdown, or regional banks with commercial real estate development loan exposure has private equity firms, including those with experience in banking and financial services, targeting the sector.
TPG, for instance, is raising a $6 billion financial institutions group-focused fund, sources say, while The Carlyle Group launched an effort to pursue investments in financial services last summer when the subprime market began unraveling. The Washington private equity behemoth appointed Oliver Sarkozy, the former joint global head of FIG investment banking at UBS, to serve as managing director and co-head of its global financial services group in April of this year alongside Keith Taylor, a former FIG investment banker at Goldman Sachs and JPMorgan. Sarkozy told IDD in March that: "Private equity is going to have a role to play in the recapitalization and restructuring of this industry. Clearly, there's a need for capital and there is investor interest in providing that capital, as evidenced by all the recaps that have occurred to date."
US financial institutions have already amassed more than $110 billion in new capital by some estimates, whereas global financial houses have drawn some $200 billion of capital since last August.
The need to replenish capital reserves is only expected to intensify over the next few years.
William Ruh, executive vice president and co-founder of Castle Creek Capital, a Rancho Santa Fe, Calif.-based private equity firm that has acquired stakes in more than 49 banks since its founding in the early 1990s, agrees there will be more bank failures. "The real pain in the regional and community banking sector will be felt by those institutions that have grown aggressively through land development and construction loans. As we go through this [business] cycle there's going to be more bank failures, primarily by those institutions that lack a good core franchise," Ruh says.
Some banks and financial institutions, meanwhile, have resorted to raising capital through public issuances of preferred shares or a combination of preferred and common stock rather than from the private equity market.
Last week, State Street announced that it would sell $2.5 billion in common stock to counter mortgage finance-related losses and UCBH Holdings, the San Francisco parent of United Commercial Bank, said it secured $135 million from an 8.5% preferred stock offering managed by Merrill Lynch and Sandler O'Neill & Partners. Moody's Investors Service said that the issuance by UCBH will further increase the bank's capital above regulatory well-capitalized minimums and that it expects UCBH's regulatory capital surplus to be sufficient enough to absorb "heightened losses" in its commercial real estate portfolio.
In April, Wachovia raised $8 billion in preferred and common equity from an offering it coordinated in April with joint bookrunner Goldman Sachs.
The opportunity in credit
Private equity investments in the banking industry aren't a new phenomenon. Financiers Ron Perelman and Robert Bass bailed out various savings and loan institutions in the late 1980s. In August 1989, Merrill Lynch Capital Partners, the private equity arm of Merrill Lynch, acquired Lomas Bankers from Lomas Financial for $500 million.
And, Kohlberg Kravis Roberts & Co. purchased a 4.6% stake in First Interstate Bancorp in 1989, a year after the banking company's former chief financial officer, Donald Griffith, reportedly launched an investment venture with KKR to pursue financial service deals. In 1990, KKR increased the size of its holdings in First Interstate to 9.9% through an affiliate partnership with the purchase of 3.38 million shares at $33 per share, or $111.5 million, when First Interstate went public.
KKR exited the business with a profitable return following First Interstate's acquisition by Wells Fargo in April 1996.
KKR also made a more recent investment in the financial services industry with its $1.2 billion investment in asset manager Legg Mason.
But, there are few private equity firms that invest in banks as bank holding companies given the regulatory oversight involved. Most private equity firms have historically gravitated towards unregulated businesses.
Castle Creek, a firm that seeks to invest $10 million to $100 million of equity in banks operating in "under-banked" markets with assets ranging from $100 million to $5 billion, was an early pioneer of the bank holding company approach by private equity firms with its formation as a bank holding company in 1995, according to Ruh.
One of its landmark deals, though, was executed a few years earlier in 1992 by Castle Creek chief executive John Eggemeyer, a former Drexel Burnham Lambert banker. Castle Creek orchestrated the $34 million recapitalization of United Postal Bancorp, a St. Louis thrift, by seasoned investors Michael Price and Harry Keefe. The investors' firm exited the business two years later when United Postal was acquired by Mercantile Bancorp, generating a lofty 156% internal rate of return and 6.1 times return on investment.
The regulatory challenge
While a number of private equity firms have deployed money in the financial service sector over the last five years, leveraged buyout firm involvement in US banks has largely been limited compared with the recapitalizations of traditional manufacturing or business service companies, for instance. Investors that typically acquire majority stakes in target companies are accustomed to deploying capital rather freely, compared with making investments in the highly regulated banking industry. The bulk of financial sponsors invest in largely unregulated industries, say industry participants like Corsair's Thornburgh.
Because of the Bank Holding Company Act of 1956, which stipulates that any investor in a bank that exceeds an ownership threshold of 10% or 24.9% has to register as a bank holding company--unless it can prove it is a passive investor--private equity investments in banking tend to be growth equity infusions. Those investments invariably do not involve the use of leverage, which also explains why some leveraged buyout firms are making the investments since leverage for larger transactions still remains an iffy prospect and fund capital still needs to be deployed.
As a bank holding company, a private equity investor is restricted to investing in financial-services companies. Regulations prohibit bank holding companies from owning any non-financial businesses. It's not exactly an appealing option for most financial sponsors that own majority stakes in a multitude of different businesses.
"What you see typically is a lot of private equity firms taking common stock or convertible preferred stakes just under the control threshold of 9.9%, or non-convertible preferred stock positions of just under 24.9%," says Joseph Vitale, a partner at New York law firm Schulte Roth & Zabel.
There are only a select few private equity firms that invest in banks as holding companies. Besides Castle Creek, Belvedere Capital, a 14-year-old San Francisco firm which typically looks to deploy $5 million to $40 million of equity in banks with assets ranging from $100 million to $10 billion, is one.
The reasons, industry observers say, center around the highly regulated nature of banking as well as because of strategy-related reasons. Most leveraged buyout firms seek to exert influence on a company's strategic direction or operations as active investors with a strong board presence. The idea of making growth capital investments with limited board representation isn't ideal.
Operating a bank also involves an inherently different skill set than overseeing the operations of the typical metal bender private equity portfolio company, say dealmakers. "In banking, capital is the key ingredient and risk management is the ultimate key operating factor," says Corsair's Thornburgh.
Despite the challenges in investing in the banking industry, one well-established New York private equity firm with a good track record of investing in traditional business, JLL Partners, decided to take the plunge last year.
"We wanted to do a control deal, and we came up with a structure that has enabled us to buy a controlling stake in a federally-chartered bank. That has enabled us to avoid some [regulatory] problems," says Paul Levy, managing director and founder of JLL Partners.
A firm known for its buy-and-build approach to private equity investing, JLL invested $75 million of equity in FC Holdings, the holding entity of First Community Bank of Dallas, through a separate funding vehicle called Fund FCH LP. Its investment, which also includes a commitment to invest an additional $75 million, gave it a 55% stake in the community bank.
The deal wasn't predicated on a distressed play in a troubled bank, but on the opportunity to expand the Golden Triangle branch network of First Community from the area between the cities of San Antonio, Dallas and Houston, according to Levy.
"The deal we're doing is not a workout of a troubled company. Our plan is to help continue the rapid growth of these banking outlets at a time when the big banks are troubled. I think the banking sector is going to present an enormous number of opportunities," he says.
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