Bank buyers beware

Private equity firms who had hoped to avoid burdensome regulation by the Federal Reserve by buying only minority stakes in US banks should take note of a new set of proposals recently released by the Federal Deposit Insurance Corporation. New rules the FDIC could apply to its decisions on whether to grant deposit insurance could cause private equity investors to break the terms of their limited partnership agreements, and, as written, could even trigger registration as a bank holding company.

The FDIC regulates state banks outside of the Federal Reserve system and provides deposit insurance for all banks. In a policy statement released in July, the FDIC targeted “private capital investors interested in acquiring or investing in failed insured depository institutions”. The FDIC invited public comment on the proposals, and was immediately met with objections from the private equity community on nearly every point in the policy statement.

Of the proposals, the most fraught is a rule that would require “cross guarantees” from private equity owners. If a consortium of investors owns a controlling stake in more than one insured bank, that consortium is required to pledge to the FDIC their proportionate interests in each bank to pay for any losses resulting from any one bank they own.

The rule has its roots in a bank holding company regulation enacted in the early 1990s, but applied to private equity club deals, it becomes legally baffling, says  Jeff Berman of law firm Clifford Chance. Suppose a group of 10 private equity funds bands together to buy a bank, which later fails. If that same consortium also owns another bank, one could reasonably assume that the other bank would be responsible for paying back the FDIC’s losses from the first bank’s failure. But suppose only five of the 10 private equity investors in the first bank are invested in the second bank – is the second bank then on the hook for 50 percent of the first bank’s losses? What if just one of the original 10 private equity investors owns a very small stake in a second bank as part of a completely different syndicate?
Furthermore, this type of cross guarantee would violate sections of most limited partnership agreements that prohibit the creation of these kinds of liabilities among the fund’s portfolio companies, Berman says.

And perhaps most troublingly, as written these cross guarantees could jeopardise one of the safe habours by which private equity club deals are able to avoid registration as a bank holding company.
The reason the Federal Reserve has decided that buyout consortia are not bank holding companies is that private equity firms don’t agree to cooperate on an ongoing basis, Berman says. “They work together putting together the transaction and making a common application to the Fed, but after that there is no cooperation. There are no buy-sell arrangements, no dispute resolution procedures, no shareholders’ agreement, nothing like that. But if you want to organise a cross-guarantee, you’re going to have to put in place arrangements for how you’re going to share losses, and there’s a danger that in the Fed’s view, you’re creating a company by doing that.”

Another rule likely to create headaches for private equity bank owners is a prohibition on the bank lending to the private equity fund, its affiliates, or its portfolio companies.

“The fund ends up with a small minority position in a bank and suddenly they’ve got to make sure that none of their portfolio companies anywhere, in any of their affiliated funds, enters into a lending relationship with that bank,” Berman points out. “It becomes a real compliance issue.”

Finally, one of the proposals would require private equity owned banks to maintain a Tier 1 leverage ratio of 15 percent – somewhere between two and three times the leverage ratio that non-private equity owned banks are required to maintain – for at least three years after acquisition. This requirement alone would dampen returns on private equity firms’ investments in these banks significantly. But in addition to that, private equity firms would be required to “immediately facilitate restoring” the bank’s capitalisation if necessary.

The rule is effectively an open-ended, three-year commitment to keep the bank healthy – something the funds’ limited partners aren’t going to like. If the fund has outstanding capital commitments undrawn, then those undrawn commitments would be vulnerable if the obligation arose to contribute more capital to the bank. If the fund were fully drawn down, then the other assets of the fund would be subject to that liability.

“If it’s a real obligation, it will be like levering the fund,” says Berman.  “The FDIC will end up with a superior claim on the fund’s assets.”