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Making banks PE-friendly

The US banking system needs capital, but private equity is still sitting on the sidelines. What can be changed on the regulatory front to lure them back in?

In March, Federal Reserve chairman Ben Bernanke said one of the first signs of recovery will be “when a large bank is successful in raising private equity”.

“Right now, all the private money is sitting on the sidelines saying, ‘We don’t know what these banks are worth. We don’t know that they’re stable.’ And they’re not willing to put their money into the banks,” Bernanke lamented.

What will it take to motivate private equity to take the plunge? There are numerous factors contributing to a general lack of interest in bank investing at the moment: early movers like TPG have lost money, bank balance sheets are notoriously difficult to interpret, and the accompanying regulatory burden would be significant.

There’s nothing to be done about the first two, but there are ways around the regulatory concerns, say Gordon Bava and Craig Miller, partners at law firm Manatt, Phelps & Phillips.

The key provision that private equity firms are concerned with is that investors with a control stake in a bank or savings and loan institution need to be regulated as banks or thrift holding companies, and by virtue of such regulation must be subject to regular examination, as well as serve as a “source of strength” for the institution.

“What private equity institutions have done in order to work around those regulations, especially for those that have existing operations, is either form a club group where they’ll make an investment side-by-side with other investors where no one investor will be in control, or put together a fund devoted exclusively to the acquisition of a bank or holding company and silo off that fund from their other funds within their network, so that the only fund that ends up being regulated is the one that is devoted exclusively to being a bank holding company. Recent statements from the Federal Reserve, however, have cast a negative shadow on the use of silo funds,” Miller says.

Regulators have loosened some of the control definitions to allow private equity firms to invest more without triggering a bank holding company registration requirement, by raising the maximum ownership stake that can be deemed “non-control” to 25 percent, and by allowing private equity firms one or even two seats on the bank’s board of directors, so long as they agree to certain passivity commitments, Bava says.

He adds that regulations could also change to allow the Federal Deposit Insurance Corporation to enter into some sort of open bank assistance programme, perhaps including loss-sharing arrangements in conjunction with a private capital infusion. In the past this has generally has not been the government’s policy because FDIC funds or government funds are not to be used for the benefit of any shareholder. But if the government wants private capital to invest in banks, it might have to change that policy.

“There’s so much regulation and legislation in this area that it can be a mine field for private equity to walk through, and that’s something that they have to be careful of,” Miller says. “Private equity needs to be very concerned about how investments are structured, and structure them in the right way to accommodate the regulatory framework, and then understand what comes with that regulatory framework and the responsibility to act in a manner that’s conducive to safety and soundness in financial institutions.”