| |||||||||||||||||||||||
| |||||||||||||||||||||||
 When struggling Cleveland-based commercial bank National City Corp. hired Goldman, Sachs & Co. in March to advise it on a strategic review, one of its cross-state rivals, Cleveland's KeyCorp. or Cincinnati-based Fifth Third Bancorp, was expected to snap it up. But that's not what happened.
With National City's stock having fallen about 70% in 12 months, trading at a tangible-book-value-to-earnings ratio of 0.83 times, the bank was a sitting duck, leaving its competitors a rare opportunity to snare $150 billion worth of assets and a network of 1,400 branches in nine states, including Ohio, Florida, Illinois and Indiana. While KeyCorp and Fifth Third took a hard look at Nat City, they passed on the opportunity to buy the 12th-largest bank in the U.S. and build their deposit bases in the traditionally slow-growth Midwest. Instead, National City turned to a group of investors, led by New York private-equity firm Corsair Capital LLC, to inject $7 billion into the bank by buying company stock and preferred shares at about $5 apiece -- a 40% discount to the $8.33 price on the last trading day before the announcement. All told, Corsair and other investors, including hedge fundTPG-Axon Capital, took a 70% stake in National City, severely diluting many of the bank's shareholders. "If National City could have gotten a premium, a merger solution would have been preferable," says one source close to the deal. Preferable, but not likely. Indeed, the troubles besetting the entire banking system, driven by the questionable credit quality of the loans, particularly mortgages, on many banks' books and leading to depressed valuations for both potential buyers and sellers, mean we won't see banks buying other banks anytime soon. "Nobody's going to pay a big premium today," says Gerard Cassidy, a banking analyst at RBC Capital Partners. Instead, private equity firms now have a golden opportunity to invest in the financial sector as a whole, including banks. As Keefe, Bruyette & Woods Inc. analyst Melissa Roberts estimated in an April 18 research report, about 42 U.S. financial institutions may require capital infusions this year, including regional banks, real estate investment trusts and mortgage insurers. And private equity funds, their coffers stuffed with billions of idle dollars waiting to be invested in buyouts, are eager to provide it. Corsair, in fact, wasn't the only private equity firm interested in Nat City. Rumors had Kohlberg Kravis Roberts & Co. backing a possible bid by Fifth Third, while Warburg Pincus was also a rumored bidder. Earlier this year, TPG Capital bought a 14.4% stake in Seattle-based Washington Mutual Inc., a big thrift led by chairman and CEO Kerry Killinger and suffering from a raft of mortgage woes, in another $7 billion capital raise. And other firms have been setting up for an expected flood of investment opportunities.Carlyle Group recently hired Olivier Sarkozy, the former global head of UBS ' financial institutions group, to invest in financial services. Master of distress Wilbur Ross snapped up John Kanas, the former CEO of Melville, N.Y.-based North Fork Bancorp (who cashed out in a 2006 sale to Capital One), to helpWL Ross & Co. LLC identify and invest in distressed financial institutions. Private equity firms have been active in the broader financial services industry for years, taking stakes in everything from bond insurers to stock exchanges to financial data companies. But except for a few bailouts following the savings and loan and real estate crises of the late '80s, PE investments in commercial banks and thrifts have been rare. In more normal times, would-be private equity buyers are elbowed out of bank deals by better-positioned strategic acquirers, whose ability to close branches and cut costs enable them to outbid financial buyers. The other big deterrent is banking's ownership rules. Buyout shops generally like to take hands-on control of the businesses in which they invest, but federal regulations make that difficult at commercial banks. "Many private equity firms have trouble getting their arms around bank investments, chiefly because of their inability to get governance provisions," says one banker. "Private equity firms want control." Although there are differences in control limits placed on banks, which the Federal Reserve regulates, and thrifts, which the Office of Thrift Supervision regulates, generally speaking, acquirers that do not want to be regulated as depository institutions must take passive roles in their investments and acquire no more than 25% of their targets in question. Less than 10% is the safe zone, but between 10% and 25%, the situation gets murkier. One fear that dates to the Great Depression is that if corporate entities are allowed to affiliate too closely with banks, they could secure loans on a favored basis and gain too much power. Regulators are not expected to eliminate, or even modify, these ownership rules anytime soon. But industry sources say they have recognized the importance of private equity investment in banking when the sector desperately needs capital. KBW's list of financial services companies likely to seek a capital infusion names 24 banks, includingBank of America Corp., Fifth Third Bancorp and Sovereign Bancorp. "As the problems have developed, the regulators have realized that the resources to solve the situation don't rest with the strategics," says one banker. "They rest with private equity firms, hedge funds and institutions which are very flush. To get the capital the sector needs, the regulators will have to facilitate the process." Regulators did just that in the WaMu deal. TPG will end up with around 14% of the thrift, and the private equity firm's founding partner, David Bonderman, who served on WaMu's board from 1996 to 2002, will rejoin it. One banker notes that the OTS approved TPG's investment in WaMu, as well as Bonderman's placement on the thrift's board, in one day. The normal approval process takes two to three weeks. In the Nat City deal, Corsair, which is led by J.P. Morgan Chase & Co. alums Nicholas Paumgarten and Ignacio Jayanti, will hold a 9.9% stake and install its vice chairman, Richard Thornburgh, on the bank's board of directors. How much control these board members will have remains to be seen. When Saudi Prince Alwaleed bin Talal bought 15% of troubled Citibank in the early 1990s, he assured the Federal Reserve he would take a purely passive role in the institution. But asCitigroup Inc. 's largest shareholder, he has tremendous influence on the company and its board, most recently displayed in his public condemnation of CEO Charles Prince's performance, which preceded Prince's resignation. In any case, observers say private equity has an opening to invest in the banking industry today because most would-be strategic buyers worry more about capital than growth. "Banks are the more logical buyers for troubled competitors," says one financial services lawyer. "But banks today are so weak that adding assets to their balance sheets means they will need more capital." Raising capital has indeed become the focus of many banks' efforts. According to SNL Financial, the amount of Tier 1 capital -- the most commonly used measure of a bank's core financial strength -- raised by banks has exploded. Banks and thrifts have raised about $91 billion of capital to date this year, through the sale of common and preferred stock. That compares with $58.2 billion for all of 2007. Meanwhile, strategic M&A volume in the sector has fallen off a cliff. According to SNL, there have been only $6.2 billion in traditional bank-to-bank transactions announced or completed so far this year. There were $72 billion worth of deals in 2007, down 33.7% from the $108.7 billion worth in 2006. In 2004, the height of banking's last consolidation wave and the yearJ.P. Morgan Chase brought its current CEO, Jamie Dimon, into the fold by buying Bank One Corp., deal volume totaled $130.8 billion. The reasons for the drop-off: Banks across the country have seen their valuations plummet as the housing loan crisis has called into question the health of their balance sheets. In fact, SNL's bank and thrift index is down 26.56% over the past year, compared with a 5.18% decline in the S&P 500. This has made it more difficult for buyers to use their stock as acquisition currency. Meanwhile, continuing uncertainty about the economy as a whole has made it almost impossible to know how much further deterioration in asset quality will likely occur, increasing the risk inherent in mergers. Aggravating the problem is purchase accounting, which would force any buyer to immediately mark-to-market the assets on a target's book. Given the weakness in the markets for securitized credit, it is almost a given that the assets would be marked down, meaning the buyer would have to take an immediate charge from the resulting write-downs. Still, it's unclear how long private equity's window of opportunity in banking will remain open. One investment banker says the weakest players are often the first to fall during a down cycle, suggesting future capital raising may not afford PE firms the chance to invest as much as Corsair and TPG did in their respective deals. "There's a limited number of institutions that have problems of that magnitude on their plate," says the banker. "You'd need a deepening of loan losses before you see another large round [of capital raising]." The banker says low stock valuations are also making it difficult for banks to raise money from private sources. Indeed, as valuations drop and capital needs increase, it won't take much for investors to break the ownership limits the regulators set. As one banker describes it, the Corsair- and TPG-led investments were "unique" in that they were done very quickly and featured the PE shops as "anchor" investors. Corsair's investment in Nat City totaled $985 million, but the anchor was needed to bring in the fund's co-investors, such asMSD Capital LP , and large institutions, including existing shareholders, who covered the rest. TPG put in $2 billion of the total $7 billion WaMu raised. "The buyout shops gave the others comfort with the deal," the banker says. Ironically, those initial investments may have allowed institutional investors to recognize the potential latent in the investments, says one partner at a buyout shop. "[The PE firms] are going to see more competition from traditional public investors," the partner predicts. Of course, not everyone is happy about the recent private equity investments in the big banks. In fact, the nature of the Nat City and WaMu offerings has some shareholders complaining bitterly that they were unfair. Indeed, both transactions diluted the shareholder base severely and rubbed salt into already raw wounds by giving the new investors the shares at healthy discounts. In the TPG deal, for example, investors received shares for $8.75 apiece, a 25.7% discount to the $11.77 at which WaMu's shares closed the day before the deal was announced. The deal, which featured the issuance of common stock as well as preferred shares convertible into discounted common, doubled WaMu's shares outstanding, diluting shareholders by nearly half. In the Nat City case, Dispatch Printing Co., which owns the Columbus Dispatch newspaper, in Ohio, has sued to block Corsair's investment, claiming the bank's board neglected its fiduciary responsibilities to its public shareholders. One WaMu shareholder says that the private offerings disenfranchise shareholders. He points to Charlotte, N.C.-based Wachovia Corp.'s decision in mid-April to slash its dividend and raise $7 billion through a public offering after the bank reported weak first-quarter earnings. "At least everybody had a chance to invest," the disgruntled shareholder says. Bankers on the Nat City and WaMu deals, however, note that it was unclear whether they would be able to entice shareholders to buy enough shares to cover the firms' capital needs without the anchor private equity investors. They add that most of the largest institutional shareholders, notably major mutual fund companies such asBrandes Investment Partners LP, Capital World Investors, and T. Rowe Price Group Inc., all had the opportunity to take part in the offerings. Left out, however, were the smaller shareholders, who have seen their stakes in the banks diluted, even as the stock prices have fallen and the dividends reduced. So why not a rights offering through which the banks could have issued rights to their existing shareholders, allowing them to buy a proportional number of shares at a discounted price? That option, says Anton Schutz, portfolio manager of Burnham Financial Industries Fund, would at least have limited the dilutive impact of the deals. However, when speed is of the essence -- as is the case when questions begin to swirl about a bank's fiscal health, raising the specter of a run -- rights offerings make little sense, one investment banker says. National City, for example, had seen its stock fall by more than two-thirds in a year amid worries about its exposure to the housing market and construction lending. One source close to the bank says the risk to the corporation could have increased in the time it took to find an underwriter for the offering, getting shareholder and Securities and Exchange Commission approval and the 15- to 30-day period during which the offering must remain open under SEC rules. "This is not the sort of situation where you want to take market risk," the source says. While conceding the unenviable position of those investors, another banker says that given the nature of the troubles facing the industry, and the lack of an M&A solution, the private offerings were the best options available. "The offering is not helpful to smaller shareholders," he says. "But National City is one of the largest banks in the country. The alternative [to a failed capital raising] was not at all something you want to contemplate for the health of the economy." Of course, future PE interest will ride on how these deals perform. RBC's Cassidy compares the private equity firms' bank investments with the early wave of sovereign wealth fund investments in companies such as Citigroup andUBS -- banks that continue to struggle. "It's an open question as to whether the PE money is smart money or too early money," he says. But, if history is any guide, for patient firms, the investments could prove to be very lucrative. For example, KKR almost quintupled an initial $221 million investment it made in First Interstate Bancorp of California in 1988 whenWells Fargo & Co. bought First Interstate in 1996. Warburg Pincus, which bought a 20% stake in Mellon Bank Corp. in 1988 for $158 million and a 12.5% stake in Dime Bancorp in 2000 for $238 million profited handsomely from both of those deals. According to Warburg Pincus, the Mellon investment produced a 30% compounded annual return, or $1.47 billion, as the buyout shop progressively sold its stake in the bank over eight years. Even more lucrative was Dime. The firm's original $238 million investment was valued at $750 million; less than two years later, Washington Mutual bought Dime for $5 billion. TPG's Bonderman also has a history in banking. In 1988, Bonderman and Robert Bass, founder of PE firm Oak Hill Capital Partners, bought Irvine, Calif., thrift American Savings Bank for about $500 million. The two sold it to Washington Mutual in 1996 for $1.4 billion. As one industry source says, "If Bonderman at TPG has made a good bet that $7 billion is enough to allow [WaMu] to withstand losses over the next couple of years, he could see substantial gains." -- Vipal Monga See TheDeal.com story on National City's capital infusion Categories Deal Video
    Community
 Elsewhere on The Deal.comDealwatch
The Deal MagazineCorporate Dealmaker
The Deal VideoCategories
Blog roll
Archives
| |||||||||||||||||||||||
|
|
|
|
|
