US banks need money. Private equity firms have money. You'd think it would be an easy match. It's not. Private equity firms attempting to woo banks are being forced to convert to a restrictive religion called “bank holding company”.
Of the many attractive buying opportunities now littering the landscape, banks especially are catching the eyes of general partners. Weakened asset valuations have caused many of these institutions to be badly in need of capital. But while the sub-prime meltdown began on US soil (one prominent GP has called it “American SARS”), the most notable private equity deals in the banking sector have been overseas.
JC Flowers has been the most active – no surprise, given its financial sector focus. In addition to upping its stake in Japan's Shinsei Bank, the Christopher Flowers-led firm has also taken stakes in Germany's Landesbank and Hypo Real Estate. Other notable deals have included SAC Capital's investment in Taiwan's Cosmos Bank and TPG's stake in the UK lender Bradford & Bingley.
In the US, last April saw a consortium led by New York-based Corsair Capital agree to purchase a $985 million (€631 million) stake in National City bank. To date the most significant deal involving a US banking institution has been the TPG-led $7 billion equity injection in Washington Mutual, the mortgage giant.
Private equity firms large and small are clamouring for more bank deals, but must first change their typical fund structure to comply with the Bank Holding Company Act of 1956. Without this, the Act makes it “really tough” for a non-financial company to control a bank, according to Stuart Stein, a partner at Washington DC-based law firm Hogan & Hartson.
The Act requires banks to register with the Federal Reserve Board, and prohibits them from engaging in non-banking activities. The rules stipulate that any institution that seeks to exercise control over banks must also register as a bank holding company. Control is defined as a stake anywhere north of 10 percent. A stake of greater than 25 percent is considered “absolute”.
Stein says that private equity firms have for years pondered investments in banks and related financial institutions, but “the nature of the control rules never seemed consistent” with their business model of diversification, he says. However, the historic turbulence in the banking industry has convinced a growing number of private equity firms to wrangle with the Fed's rules. Stein declines to comment on any particular deals, but says: “The last nine months to a year has certainly seen more private equity interaction than previously, that's for sure. My expectation is that through 2008 you will see a lot more interest in financial institutions from private equity firms.”
GPs with a desire for more than a paltry 9.9 percent in a bank have options, but these involve great feats of fund structuring. A standard limited partnership that takes a stake of more than 9.9 percent in a bank must register as a bank holding company, and this can affect its relationship with the other, non-bank portfolio companies, which will be required to serve as “sources of strength” to the bank-related portfolio companies, among other entanglements.
For bank-minded fund managers, it is not enough to set up a bank holding company as an affiliate of the main limited partnership, because “every holder in the chain of ownership is going to be deemed a bank holding company”, notes Stein. What this means is a separate general partnership must be established to manage a separate fund, both of which are registered as bank holding companies.
It means general partners are advised to not simply redirect capital from an existing private equity fund into a new bank holding company venture, because this would still create an economic tie to a general partnership that is not a bank.
GPs are therefore going back to their limited partners and having separate conversations about establishing new financial institutions-focused funds with fresh capital commitments. This exercise is entirely necessary from a regulatory perspective, and also gives GPs a nice excuse to do something they love – raise more capital.
Just as private equity firms have expanded their franchises to include infrastructure, real estate, hedge funds and the like, an opportunity has now arisen to add one more investment platform to the family of funds – bank holding company. But this particular family member has to sleep under a different roof.