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Don’t let the banks break you

Five things a GP should know before taking the plunge in an attractive but potentially risky sector. By Dory Wiley

Many private equity funds seeking to do deals in this environment find themselves with a large bid/ask spread between buyer and seller — and without the available credit to bridge the gap. These funds are increasingly considering opportunities outside their normal investment parameters. In keeping with this trend, there has been a tremendous rush to the banking sector. Why the interest?

Banks are battered, beaten up and in desperate need of capital. Pricing is the cheapest it has been in 20 years. But while many investors will spend enormous amounts of time, energy and capital investing in the sector, few can pull it off successfully. Case in point: in 2007 to 2008, private equity, sovereign wealth funds and other large pools of capital committed to more than 50 large-cap financial services companies – yet the majority of those deals are now underwater and many have lost much of their original investment.

Several factors must be considered before investing in this niche area. Although the factors discussed in this article may only scratch the surface, they can help guide general partners (GPs) before committing precious time and resources.

It is commonly held that private equity returns tend to outperform in years of recession. When considering the lack of credit available to private equity, it stands to reason that credit has to repair itself before private equity returns can outperform. In other words, banks lead the downturn as well as the upturn.

different this time

The recession in 2001 was moderate because of the banking industry’s strength and the continued supply of credit. The only area really damaged was large syndicated and technology credits. Otherwise, the contraction in credit was hardly noticeable to the economy or, in particular, to private equity. As large private equity deals continued to receive funding from the capital markets, the inherent risk to large GPs became one of a meltdown in capital markets and large banks.

That is precisely what happened, and those capital markets are now in repair. Large banks were over-levered and were shifting credit risk off the balance sheet through structured investment vehicles. Now they can’t. The speed at which these large banks are manoeuvring to recover is amazing, but another couple of years are needed for full recovery.

In contrast, smaller banks are properly managing real estate issues and failures. Of the more than 8,000 banks in the US, more than 3,000 do not have asset quality issues. Investing in clean banks that can steal market share from problem banks and underwrite today’s credit at today’s pricing is a viable strategy reminiscent of 20 years ago.

One of the most valuable tools to access in the current market is leverage. Bank investing does not require leverage because it comes in the form of low-cost, fixed-funded deposits. Yet it is priced very cheaply as one of the most valuable “assets” in the marketplace. Here we’ll focus on the pitfalls of bank investing and how to address those risks.

The following are five things every GP should know before investing in a bank:

1. Portfolio structure risk: When considering a GP’s portfolio, geographic diversity is critical. Large banks tend to be geographically diverse; smaller banks are rooted in their local geographies. Two-thirds of bank failures in the late-1980s were in Texas. Today, heavily concentrated investments in California, Florida, Georgia and Nevada could cause havoc for an investor. Banks enjoy low failure rates, but when they do fail (i.e., the “fat tail” events of today, the 1980s and the Great Depression), the way to mitigate risk is by making more investments than usual.

2. Investment risk: Banks are unique vehicles in that fixed, low-cost funding provides a way to make money. However, creativity and aggression can substantially increase risk. Institutions that keep their strategies simple and ‘middle-of-the-road’ tend to do best in the long run. Two small banks started in the early 1990s did just that and made 33x and 35x cash invested over a 10- to 12-year period. Low-risk strategies should be preferred.

3. Assets and liabilities risk: In today’s environment, the best banking assets are its liabilities, and the assets are likely liabilities. Confusing? Low-cost, core-funded deposits (liabilities) are valuable and should be a high priority. Problem loans and securities (assets) can be costly and have a tendency to deteriorate more than expected. One example is a GP that purchased a large West Coast bank. The GP underestimated the asset risk and was caught with a deteriorating loan portfolio. Having the seller guarantee the risk in the loan portfolio, or pursuing an FDIC failed bank acquisition, is often a better approach. Although either option requires considerable experience working with regulators, such an investment can be profitable if done correctly.

4. Regulatory risk: For years, most private equity firms have avoided the banking sector primarily because of heavy regulation. Now they flock to banking in spite of regulation. Many private equity and hedge funds are currently looking to use a bank charter to buy distressed assets. This is a great idea in theory, but investors often waste a small fortune in time and energy. Regulators frown upon these strategies and are not likely to approve them. Regulators want bankers running banks — not private equity firms. They want a long track record from a bank’s management team, and a clean bill of health to buy failed bank acquisitions. Simply put, regulators want simple, traditional banking strategies, and they are right to do so. Regulators are happy for private equity shops to participate in the purchase of distressed assets, but the preferred method is for those firms to invest in existing banks, not new ones. Private equity firms can visit regulators all they wish, but they will be assigned little credibility unless the management team they are backing leads the way.

One of the greatest sources of risk for private equity is managing to the “source of strength” doctrine of the Fed’s Bank Holding Company Act and the cross-guaranty provisions of the FDIC. These regulations hold investors at risk for more than their investment amount in certain situations of defined regulatory control. The reflex of private equity is to scheme around these regulations, which is a poor approach. Investors need to learn to embrace certain levels of regulation and realise that control comes at a price.
Acquiring board seats is another risk to private equity — one that is peculiar to banking and misunderstood by most private equity investors.

5. Valuation: Banks are valued differently from companies in other industries because there is no EBITDA and buyout leverage is not needed. However, the devil is in the details of the thousands of assets and liabilities on a bank’s balance sheet.

This discussion is not meant to be all-inclusive, but it does highlight some of the issues involved. Many private equity firms pride themselves in leading and executing proprietary deal flow. However, in the banking sector, without proper help and understanding, it can break you. 

Dory Wiley is president and chief executive of Commerce Street Capital, a Dallas-based privately held fund management and advisory firm focused exclusively on the regional and community banking sector in the US

This article is for information purposes only and does not constitute a solicitation or offer by Commerce Street Capital, LLC, to buy or sell any securities, futures, options, foreign exchange or other financial instrument, or to provide any investment advice or service.