Friday Letter: Winning the battle for the banks

Last night the ink dried on a deal expected to set some important precedents for private equity firms wishing to take control of struggling US banking institutions ripe for restructuring.

The $900 million buyout of BankUnited – Florida’s largest independent bank and the largest US bank to fail this year – by a heavy-hitting consortium including Blackstone, Carlyle, Centerbridge and WL Ross swiftly ended a four-month auction process rife with rumour and speculation.

One big talking point was whether or not US regulators would balk at private equity take-over bids, given Federal Reserve restrictions on stakes sizes sold to non-banks. The Fed has been reviewing these regulations, which essentially mean private equity firms cannot hold more than a 24.9 percent stake in a bank without becoming a bank holding company, while the Federal Deposit Insurance Corporation (FDIC), which regulates BankUnited, has yet to establish guidelines.

For BankUnited, which was seized and sold by the FDIC all in one day, none of the private equity firms involved will have stakes greater than 24.9 percent, akin to the $13.9 billion deal for California mortgage lender IndyMac led by JC Flowers.

Mega-buyout firms, particularly those focused on distressed financial services deals, have been lobbying US regulators to ease restrictions deterring private equity investment.

Among the various agencies that regulate US banks is the Office of Thrift Supervision, which already appears to be less Draconian than other US banking regulators, having in December approved the majority stake MatlinPatterson purchased in Flagstar Bancorp. Now the BankUnited deal also sends a strong signal that another regulatory body, the FDIC, is keen to allow private equity firms to control banks in certain instances.

The FDIC even issued a statement yesterday acknowledging a high level of private equity interest in deposit-taking institutions in receivership and said, “in the near future, the FDIC will provide generally applicable policy guidance on eligibility and other terms and conditions for such investments to guide potential investors”.

This is encouraging as it should provide a template for investment that squelches fears about potential conflicts of interest and also open up an alluring deal pipeline.

What is particularly alluring is that the FDIC typically assumes some of a failed bank’s liabilities in a reorganisation with new owners, importantly allowing for the sharing of downside risk between the government and private investors. In the IndyMac deal completed in January, for example, the FDIC assumed some $11 billion of the lender’s losses, while media reports have estimated it will absorb about $5 billion for BankUnited.

This structure should ring some bells for private equity veterans given the parallels to the takeover of Long Term Credit Bank of Japan, which JC Flowers and Ripplewood acquired in 2000 for $1.2 billion and renamed Shinsei. Key to the Shinsei deal was a guarantee from the Japanese government’s Deposit Insurance Corporation that it would buy back any bank loan that lost 20 percent or more of its value. Shinsei ultimately shifted some $10 billion in bad debt to the government under this put agreement. The bank was taken public in 2004, producing a windfall for its owners.

It’s no wonder that Flowers and his peers are keen to do similar deals in the States. The pickings promise to be rich: 34 FDIC-regulated institutions have failed this year alone.