The New Old Bank
As Wall Street's seismic shift goes on, private equity waits to get its crack at banks
October 6, 2008
Manuel Mehos, chairman of Green Bancorp, knows something about buying banks and bringing them back to life amid a financial storm. In 1986, just a year before Black Monday, the former Goldman Sachs investment banker purchased a small bank with a group of local investors in Port Lavaca, Texas, a Gulf Coast town used by blockade runners in the Civil War.
In 1988, Mehos' thrift, Coastal Bend Savings & Loan, embarked on a series of acquisitions, several of them involving insolvent Texas branch banks that were being sold by the Resolution Trust Corp. It was an era fraught with economic peril--oil prices declined, slamming Texas' economy and eroding the state's real estate values. That, in turn, hobbled many banks.
There are parallels to today's troubling days for the US banking industry, says the 54-year-old Mehos, whose Green Bancorp is a holding of San Francisco private equity firm Belvedere Capital.
A large number of commercial banks failed in the late 1980s as borrowers caught in regional downturns couldn't repay debts.
The chaos in financial services now, though, represents an opportunity to invest in what Mehos believes will be a "golden age in banking."
He may not be alone in his thinking.
US commercial banks offering traditional checking and savings accounts, small business credit lines and plain vanilla investment products like certificates of deposit may attract much broader private equity fund interest than in years past. Traditional depository banks with access to the Federal Reserve's borrowing window have proved to fare better overall against the mortgage credit market collapse, spurring Goldman and Morgan Stanley to shed their independent-brokerage style and become bank holding companies this past month.
There are plenty of indications that old-fashioned teller banking will draw more than just passing interest from well-heeled private equity firms like Kohlberg Kravis Roberts, which carried out one of the signature investments in commercial banking in 1989 when it bought a 4.6% stake in First Interstate Bancorp.
Some private equity groups are amassing new war chests to capitalize on investment opportunities in banking and financial services. J.C. Flowers, for instance, has already held a first closing on almost $2.5 billion for its third financial services fund that will invest in US banks, a source tells IDD, noting that a year ago the firm wasn't looking very closely at such prospects.
Officials from J.C. Flowers declined to comment on the fund.
Why now? Banks are eager to replenish their capital and investment fund managers are paid handsomely to put their investors' money to work, and with increased signs of a dramatic economic slowdown that is impacting a broad range of industries there are fewer places to safely invest.
"Suddenly, the old-fashioned traditional banking business is where the margins are good," says Mehos.
Bank regulations revised
The Fed recently eased regulations in the Bank Holding Company Act of 1956, improving the prospects for private equity investment, as well as commercial banks to refill diminished capital reserves and shore up loan loss provisions. The new guidelines--only the second time since 1982 that regulators have addressed in a policy statement whether a minority stake investment would cause an investor to have a "controlling influence" over policy making or a bank's management--allow investors to purchase up to 33% of a bank's stock compared with 25% previously, and gain two director seats.
Although lauded at large by the investment industry as a step forward, there's a sense among some observers that the new guidelines may've come too late. If restrictions were lifted six months ago more private equity funds might have jumped in, says Josh Lerner, a professor at Harvard Business School who specializes in private equity. "It's unclear if all the bad news is out there," he says.
Others question whether the revised guidelines went far enough. One private equity attorney at a prominent New York law firm who spoke on condition of anonymity says: "Nobody I talked to thinks it will result in a flood of new investments."
Moreover, the main beneficiaries are thought to be the large private equity firms like The Carlyle Group, which had pushed hard for changes in banking regulation. The revision will play into the mega-fund buyout groups' favor by allowing a consortium to take control of a bank through a group of minority stake investments, thereby avoiding the triggering of control-ownership thresholds that would transform general partnerships into bank holding companies.
"The recent Federal Reserve guidelines for private equity investments in banks seemingly permits club deals which may be helpful for the very large private equity firms," says William Ruh, a managing principal of Castle Creek Capital, a Rancho Santa Fe, Calif.-based private equity firm that has invested in bank holding companies since the 1990s. "It doesn't change our framework for investing in banks with up to $10 billion in assets."
Banks may be the ideal business to invest in because, once the broader financial system is stabilized, they will be one of the first industries to bounce ahead of a broad economic recovery. Private equity firms, too, ideally will be able to help stabilize the banks so they can return to lending and help generate fees that help banks return to profitability.
In the case of Flowers' purchase of the Missouri bank, which holds $14 million in assets and occupies a rural town with 400 residents, a letter from the regulatory agency granting approval offers what may be the bank's appeal. Its "business lines are non-complex, consisting of traditional lines of business focusing on serving local communities of Cainesville, Mo., and Bethany, Mo."
Flowers plans to let the bank carry on with its traditional community banking activities, though its future growth may well come through acquisitions of troubled depository banks, according to the regulatory letter.
Much of the new wave of private equity investment, however, hinges on whether a bailout is approved by legislators and shores up the financial system enough to improve confidence.
"There is a possibility of that happening once confidence is restored. There is a lot of money sitting on the sidelines waiting to jump in," says Lyle Gramley, a former Federal Reserve governor.
But, before financial sponsors go en masse into banks they'd like to have a way to measure the risk they take on. At present, the assessment of loan valuations is murky, and there is one glaring example of a private equity investment that was sideswiped by the dramatic change in fortunes of banking giants.
TPG's $1.3 billion investment in Seattle thrift Washington Mutual was wiped out following JPMorgan's purchase of the bank from regulators after a $16.7 billion run on deposits.
"It was not so much that it was a bad idea," says Harvard's Lerner, commenting on TPG's investment.
TPG, Lerner explains, had likely thought that WaMu had already worked through much of its mortgage-related pain when it made the investment. "They [probably] thought things were further along."
The run on WaMu, along with Citigroup's acquisition of Wachovia, shook investor confidence in a host of publicly-traded regional banks early last week. Share prices of National City, Fifth Third Bancorp and Sovereign Bancorp, among others, took a pounding. Some banks' stocks rebounded later in the week as news surfaced about legislative progress on the government's bailout plan.
For now, though, the issue of what the loans of a bank are worth is what has most private fund managers sitting on the sidelines. Investors might find some anxiety relief if the government's $700 billion bailout package is passed, helping establish a floor on the hard-to-value assets held by banks.
"If a bailout gets passed and it appears to be working, private equity firms could come in and buy assets at fire sale prices," says Gramley. (The House of Representatives passed the bailout bill on Friday, after IDD went to press, and it was signed into law by President Bush.)
The stable nature of the bank holding company model hasn't been made more evident than in the last couple months when high-flying investment banks were decimated by mortgage-related losses.
The business of retail banking and commercial lending hasn't fared perfectly, but it has managed to become the financial services industry's Miss Universe in little more than a year.
"Ironically the biggest commercial banks, despite taking such huge hits writing off billions of subprime exposures in the past year, outlasted the biggest investment banks," says Randy Schwimmer, head of capital markets with New York specialty lender Churchill Financial. "But, what really positioned the commercial banks as the big winners was their low-cost, long-term deposit base. The investment banks had funded themselves with short-term liabilities, and the weaker ones disappeared."
Following the lead of Goldman Sachs and Morgan Stanley, which secured an $8 billion infusion from Japanese commercial bank Mitsubishi UFJ Financial Group, Raymond James Financial recently sought regulatory approval to become a bank holding company.
The strategy
The community bank investment strategy is predicated on the opportunity to build scale through roll-ups of banks with many branch locations. It revolves around buying an initial platform business, then making subsequent acquisitions of similar or complementary banks to expand a bank's geographic presence within a defined area. The idea is to buy a healthy bank or form a new bank platform company then snap up additional but distressed banks at discounted values.
"They want to create critical mass," says Lewis Ranieri, a former Salomon Brothers banker widely credited for pioneering the mortgage securities business on Wall Street.
Ranieri, who is chairman of Hyperion Partners, says the long-term challenge in banking is to get the housing market right and the short-term task is to settle down the money markets (see related story).
Buying a bank and rolling up several, meanwhile, is an approach that's been proven.
Take the build-up Mehos orchestrated while at Coastal. After making his first roll-up deal in May 1988, he grew Coastal through a series of 13 acquisitions in 17 years. The bank eventually mushroomed from a sleepy one-bank operation with $14 million in assets to more than 45 branch locations in Southeast Texas with $2.6 billion in assets.
In 1993, he took the bank public on the Nasdaq and continued its build up with the hire of loan officers and additional product offerings. Little more than a decade later the CEO sold Coastal to New Orleans' Hibernia for $230 million in 2004.
Mehos parachuted back into the Texas banking scene in 2006, launching another roll-up through Houston-based Green Bancorp and teaming up with Belvedere Capital in order to create a $1 billion bank aimed at small businesses and retail banking. Green completed its first acquisition in January 2007 when it bought Redstone Bank from Houston investment firm Redstone Cos. and added $200 million in assets and three West Houston branches.
Green has since hired 25 loan officers including from national banks and boosted the bank's assets to $300 million.
Mehos is optimistic about the company's growth prospects. "It's a good market for us to grow organically. We also think there are acquisition opportunities for banks that were involved in real estate lending outside of Texas or owned Fannie Mae and Freddie Mac preferred stock."
Private equity buyers, meanwhile, may structure their deals in a variety of ways. They can acquire minority stakes of up to 33% to avoid becoming bank holding companies--which are required to own only financial service businesses. This isn't an appealing notion for general partnerships that with investments in a variety of businesses.
This year's minority stake deals have been carried out by firms like Corsair Capital, which invested $985 million in the $7 billion capital raise by Cleveland-based National City in April. CIVC Partners, a Chicago private equity firm, purchasd 50,000 convertible shares in Chicago and Milwaukee community bank operator Wintrust Financial.
Alternatively, an investor can become an outright bank holding company like Belvedere and Castle Creek. Or, it can set up a separate entity using what dealmakers refer to as a "silo" approach, which keeps the general partnership at an arms length from an investment in a bank.
The silo approach is one JLL Partners took last year. As a New York private equity firm with a diverse array of holdings, JLL didn't have any intention of becoming a bank holding company when it found a bank in Texas to purchase. So, the firm established a separate entity called FC Holdings to buy a controlling stake, or just over 60% in the chartered Dallas bank First Community Bank. It made a $75 million equity investment from a separate funding vehicle called Fund FCH LP, and committed an additional $75 million to the operation.
Paul Levy, managing director and founder of JLL Partners, says the deal was based on a simple, straightforward strategy of providing small business loans to companies located in the Golden Triangle area between the Texas cities of Houston, Dallas and San Antonio as well as Austin.
"Our plan, and we'll find out if it is right, is to build up and get to 50 to 60 branches. The real point of the strategy is to hire people who have been in the community a long time and know the local business people."
JLL is backing Texas bank executive Nigel Harrison, who sold First Community Bank Houston to Wells Fargo for $123 million three years ago. Harrison, who serves as CEO of First Community, "did this once before successfully," according to Levy.
In November 2007, First Community carried out its first purchase with the acquisition of First Crockett Bancshares, picking up a bank with $150 million in assets situated 90 miles north of Houston.
Levy is bullish on Texas. "The State of Texas is great. There's a diverse economy, energy remains strong and there's venture capital, healthcare, retail and it's a low tax state."
Moreover, the Lone Star State avoided the overbuilding excesses in states like Florida, Nevada, California and Arizona, he says.
The opportunity
For private equity firms seeking investment opportunities, the bank market offers a vast array of targets. There are roughly 8,643 banks in the US ranging from small, privately held or private equity-backed community banks to publicly-traded and mid-sized regional institutions and mega-bank holding companies, which are comprised of 8,324 community banks, according to the Independent Community Bankers of America, a Washington organization representing community banks.
The ICBA has 5,000 member banks, representing more than $908 billion in assets and $726 billion in deposits. Whether they're community or larger institutions, many banks will need to find capital to continue doing business, say observers.
"Banks are going to have to raise capital to expand and fill gaps in the market," says Bob Davis, executive vice president of the American Bankers Association. Davis says unlike in past years when banks had loan to asset percentages of around 70%, loans as a percentage to assets now range from 80% to 90%. "That means the ability to dramatically expand lending is limited unless they raise capital," he says.
Last month, one West Coast bank holding company jumped at the chance to shore up its capital reserves through another minority-stake deal. PacWest Bancorp, a San Diego-based operator of 60 branches in Southern California serving small to medium-sized businesses, sold a 12% stake in the form of newly issued shares to New York private equity firm CapGen Financial in exchange for $100 million.
The new interest in banks comes at time when other businesses that have appealed to financial buyers in recent years, such as retail and consumer product companies, aren't performing up to snuff.
Several retailers, including those backed by some big name buyout firms, have landed in bankruptcy while others such as consumer electronics retailer Circuit City Stores are struggling to turn around their operations.
Consumer spending is still lackluster, remaining unchanged in August from July when it rose 0.1%, according to Commerce Department figures.
The outlook
The near-term outlook in the banking industry overall, meanwhile, isn't expected to be pretty, according to analysts who follow the industry.
"Net charge-offs will continue to rise and on top of that a lot of banks remain under reserved for losses. Therefore, I expect many banks to build their allowances for loans losses over coming quarters," says David Long, an equity analyst at William Blair & Co. whose commercial bank coverage list includes Boston Private Financial Holdings, Marshall & Ilsley, Private Bancorp and Signature Bank.
Long believes that as a result it is very likely more banks will look to raise additional capital in the coming quarters.
Many bank executives, particularly in community banking, are already seeking funds.
"We have seen an extraordinary deal flow in the past few months, and currently we're presented with the opportunity to recapitalize or acquire a bank on almost a daily basis," says Castle Creek's Ruh.
Ruh isn't optimistic about the prospects for local banks, but he also doesn't place the blame entirely on the subprime mortgage market. Instead, Ruh points to the way some community banks have been managed as a cause for their collapse.
"I remain convinced that there will be approximately 150 bank failures over the next few years, given that many of these institutions were simply not well run, nor did they have a sound business plan that included developing a good local customer base," he says.
Despite the attractive investment opportunities available to private equity firms and the growing hunger among bank executives for capital infusions to shore up their institutions, most buyout groups are expected to tread very carefully in coming months when it comes to putting their funds to work, say investors. And, Ruh cautions that some banks won't find buyers or investors.
"There are a number of banks in Southern California trying to raise capital today and there's no interest in these banks," says Ruh.
(c) 2008 Investment Dealers' Digest and SourceMedia, Inc. All Rights Reserved.
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