The Debate Over Private Equity In Banking

By John Carney, DealBreaker.com
August 4, 2008

While the collapse of Bear Stearns and financial industry losses now topping $400 billion, many lawmakers and regulators are calling for increased regulation of the banking industry. But a parallel argument has been pointing in the opposite direction: loosening some regulations to allow private equity firms to invest more in banks.

The losses have forced banks to raise somewhere around $400 billion in new capital (the number changes every couple of days, so we forget exactly how much), much of which is now under water from further losses. With estimates of further losses totaling as high as $1 trillion to $2 trillion, many now wonder where the banking industry will find new capital to replace these holes.

One answer might be the government, although contracting revenues due to a dithering, recessionish economy may limit this option. Others have proposed easing rules that have discouraged private equity firms, which have something like $400 billion of capital on hand, from investing in banks.

Those rules subject investment firms which own more than 25 percent of a bank to the full panoply of banking regulations, basically declaring the owner a bank itself. Holders with between 10 percent and 25 percent are prevented from controlling the banks management.

The practical effect of all this limits outside investment firms to holding less than a 10% stake in a bank if they wish to place a director on a bank's board. Perhaps the greatest barrier to private equity investment, however, isn't these limitations. It's the "source of strength" doctrine, which exposes controlling firms to potentially unlimited liability for bank losses. It's meant to ensure depositors that the owners of the banks holding their deposits stand ready to support the banks with their full faith and credit. But it also helps deter investors, such as private equity firms, from taking large stakes in the firms.

Private-equity firms seem eager to invest in banks, and have been encouraging lawmakers to reform the regulations to make this easier. Proponents of the move, including two managing directors at the Carlyle Group who penned an op-ed in the Wall Street Journal in June, argue that the ideas behind the regulations--the need to prevent conflicts of interest and concentration of economic power--do not apply to private equity firms, who generally would only hold their stakes in banks for limited periods of time.

Opponents of the reforms hardly find this reassuring. Andy Stern, president of the Service Employees International Union, last month wrote that "short-term capital infusions from private-equity funds will only make the banking crisis worse, by encouraging risky behavior and abusive banking practices." Of course, the SEIU has become one of the most prominent opponents of private equity firms in recent years.

The fight between private equity and the unionists played out in an especially messy fashion at Washington Mutual. When the Texas Pacific Group's invested in Washington Mutual, the deal diluted shareholder while delivering $50 million in transaction fees to TPG. A pension fund controlled by the SEIU was one of those shareholders. Washington Mutual is now on almost everyone's list of bank's that might wind up in the hands of the FDIC. Not a week goes by that we don't get asked by a WaMu customer about whether they should withdraw their deposits. (As good citizens we naturally tell them that unless they have over $100,000 in the bank, their deposits aren't in danger.)

Yesterday the New York Times weighed in on the issue, accusing the private equity firms of "exploiting the desperation of banks and regulators." It's not exactly surprising to see the Times taking the union position in this matter but the path they took to reach it is unexpected. After echoing the union argument that private equity firms could do a great deal of damage in the short term, the Times concentrates on the need for greater transparency in the banking industry and the allegedly malignant signaling aspect of the reforms.

"Now, when there is great uncertainty about which institutions are too big or too interconnected to fail, is exactly the wrong time to allow less transparency and less regulation," the Times editorialists write. "And with confidence in the financial system badly shaken, it would be a mistake to signal to global markets and American citizens that the government is willing to put expediency above long-term stability."

The Strategic Secret of Private Equity

By Felix Barber and Michael Goold, Harvard Business School
September 2007

Private equity. The very term continues to evoke admiration, envy, and—in the hearts of many public company CEOs—fear. In recent years, private equity firms have pocketed huge—and controversial—sums, while stalking ever larger acquisition targets. Indeed, the global value of private equity buyouts bigger than $1 billion grew from $28 billion in 2000 to $502 billion in 2006, according to Dealogic, a firm that tracks acquisitions. Despite the private equity environment’s becoming more challenging amid rising interest rates and greater government scrutiny, that figure reached $501 billion in just the first half of 2007.

Private equity firms’ reputation for dramatically increasing the value of their investments has helped fuel this growth. Their ability to achieve high returns is typically attributed to a number of factors: high-powered incentives both for private equity portfolio managers and for the operating managers of businesses in the portfolio; the aggressive use of debt, which provides financing and tax advantages; a determined focus on cash flow and margin improvement; and freedom from restrictive public company regulations.

But the fundamental reason behind private equity’s growth and high rates of return is something that has received little attention, perhaps because it’s so obvious: the firms’ standard practice of buying businesses and then, after steering them through a transition of rapid performance improvement, selling them. That strategy, which embodies a combination of business and investment-portfolio management, is at the core of private equity’s success.

Public companies—which invariably acquire businesses with the intention of holding on to them and integrating them into their operations—can profitably learn or borrow from this buy-to-sell approach. To do so, they first need to understand just how private equity firms employ it so effectively.

Clearly, buying to sell can’t be an all-purpose strategy for public companies to adopt. It doesn’t make sense when an acquired business will benefit from important synergies with the buyer’s existing portfolio of businesses. It certainly isn’t the way for a company to profit from an acquisition whose main appeal is its prospects for long-term organic growth.

However, as private equity firms have shown, the strategy is ideally suited when, in order to realize a onetime, short- to medium-term value-creation opportunity, buyers must take outright ownership and control. Such an opportunity most often arises when a business hasn’t been aggressively managed and so is underperforming. It can also be found with businesses that are undervalued because their potential isn’t readily apparent. In those cases, once the changes necessary to achieve the uplift in value have been made—usually over a period of two to six years—it makes sense for the owner to sell the business and move on to new opportunities.

How Private Equity Works: A Primer

The benefits of buying to sell in such situations are plain—though, again, often overlooked. Consider an acquisition that quickly increases in value—generating an annual investor return of, say, 25% a year for the first three years—but subsequently earns a more modest if still healthy return of, say, 12% a year. A private equity firm that, following a buy-to-sell strategy, sells it after three years will garner a 25% annual return. A diversified public company that achieves identical operational performance with the acquired business—but, as is typical, has bought it as a long-term investment—will earn a return that gets closer to 12% the longer it owns the business. For the public company, holding on to the business once the value-creating changes have been made dilutes the final return.

In the early years of the current buyout boom, private equity firms prospered mainly by acquiring the noncore business units of large public companies. Under their previous owners, those businesses had often suffered from neglect, unsuitable performance targets, or other constraints. Even if well managed, such businesses may have lacked an independent track record because the parent company had integrated their operations with those of other units, making the businesses hard to value. Sales by public companies of unwanted business units were the most important category of large private equity buyouts until 2004, according to Dealogic, and the leading firms’ widely admired history of high investment returns comes largely from acquisitions of this type.