Things haven't been going very well in banking for private equity. What was once an area of great opportunity has turned into a source of frustration amid a series of stymied deals, failed investments, political missteps, regulators' lingering suspicions and growing competition from strategic buyers and other funding sources.

Take the case of First Southern Bancorp Inc. The Boca Raton, Fla.-based bank announced May 29 it had reached preliminary agreement to receive a combined $450 million equity infusion from Fortress Investment Group LLC, Crestview Partners LP and Lightyear Capital LLC. Although the bank received $10.9 million in funds through the government's Troubled Asset Relief Program, the tiny five-branch bank wasn't in trouble. Rather, it had growth ambitions, and the PE investment was meant to give it enough capital to embark on a shopping spree of weaker Florida rivals. For the PE firms, First Southern offered the opportunity to grow a midsized institution that might become an attractive acquisition target and offer investors a high return when it sold itself.

So confident were parties to the transaction that they unveiled it before they had signed a definitive agreement, announcing instead that they would have one completed within 60 days.

But more than 150 days later, there is still no agreement. Sources close to the transaction say it has fallen apart and the bank is scrambling to put together a new investor group. The reason for the deal's implosion? The Federal Reserve Board refused to give the clearance to complete the deal.

"What does private equity even mean to them?" says one annoyed private equity investor focused on banks.

"The regulators view private equity through the lens of more risky capital," says Douglas Landy, head of the U.S. bank regulatory practice at law firm Allen & Overy LLP. "They want capital coming into the industry to be long-term and conservative. In that respect, private equity will always be their last choice."

Soon it may not even need to be a choice at all. As banks are increasingly able to turn to public markets to raise money, and as stronger banks gain confidence in their ability to buy weaker ones, PE firms are finding themselves shunted aside by market forces and by regulators looking toward more traditional avenues to replenish a capital-starved sector. Add to that competition from new investment vehicles specifically tailored to meet regulators' concerns, and there's a growing sense that the best opportunity in a generation for private equity to invest in banks is passing them by.

Although the markets have undoubtedly recovered from the darkest days of the financial crisis, the banking industry is still struggling. As of Oct. 23, 106 banks had failed in the U.S. in 2009, up from 26 in 2008 and the highest total since 1992, when 181 failed. There will undoubtedly be more to come as the balance sheets of banks and thrifts continue to deteriorate in a weak economy with rising default rates.

In many ways, this is the scenario PE investors envisioned when they started ramping up efforts to invest in the sector last year. Even a high-profile setback like TPG Capital's lost $1.135 billion investment in Washington Mutual Inc., the Seattle thrift that went bankrupt in October 2008, didn't dampen investors' expectations. After all, the government had few options to bolster the sector, and there was already precedent for a lucrative private sector-led rescue of the banking system. That's what happened when investors like Robert M. Bass, Tom Barrack Jr., Leon Black and TPG's David Bonderman made fortunes by buying up failed savings and loans on the cheap from the Resolution Trust Corp. during the savings and loan crisis of the early 1990s.

The early signs during the latest crisis were encouraging.

When the Federal Deposit Insurance Corp. agreed in January to sell the assets and operations of failed California mortgage lender IndyMac Federal Bank FSB to IMB Management Holdings LP, backed by private equity firm JC Flowers & Co. LLC, Dune Capital Management LP chairman Steven Mnuchin and hedge fund Paulson & Co., it agreed to limit the buyers' losses. Although the regulator nominally sold the Pasadena, Calif.-based thrift for $13.9 billion, only $1.3 billion was paid by the buyers in cash. To get the bank off its hands, the FDIC agreed to assume the first 20% of losses, after which it would assume 80% on the next 10% of losses, and 95% on losses after that. The sale cost the FDIC's insurance fund $10.6 billion.

Consequently, firms such as Blackstone Group LP, Carlyle Group and WL Ross & Co LLC hired bankers and former bank CEOs to expand their investment efforts, in the belief there were immense profits to be made by either investing in or buying up troubled banks with government assistance.

Unfortunately, those plans seem to have been overtaken by events.

"The window for private equity is not shut," says Andrew Senchak, president of Keefe, Bruyette & Woods Inc., an investment bank focused on financial services. "But the window is only open in inverse proportion to how far the public markets are open."

And the public markets look very open indeed. According to SNL Financial LC, banks and thrifts had raised about $180 billion in the equity and debt markets for the year up to Oct. 16. That compares with about only $12.2 billion in 23 banking deals (both share purchases and outright buyouts) that Dealogic estimates financial sponsors have completed since the beginning of 2008 (see related story).

Much of the capital has been raised to either repair balance sheets or repay TARP loans. But enough stability seems to have returned to allow a few ambitious banks to begin filling up their acquisition war chests.

"The resurgence of interest by strategic investors has changed the bidding landscape," says a lawyer who specializes in bank deals.

That's not surprising. Few PE firms expect to be able to compete with strategic buyers in auctions, given the higher prices strategics can pay. But what is surprising is the willingness of regulators to tilt the playing field even more in favor of strategic buyers.

In May, for example, the FDIC announced it had seized South Florida thrift BankUnited Financial Corp. and sold its assets to a consortium of PE firms, led by the former head of North Fork Bancorp Inc., John Kanas, who will be CEO of the bank. Kanas worked with private equity firm WL Ross, with which he formed a joint venture in 2008. They were joined by Blackstone, Carlyle Investment Management LLC, Centerbridge Capital Partners LP, LeFrak Organization Inc., Wellcome Trust, Greenaap Investments Ltd. and East Rock Endowment Fund LP.

Sources say bidding deadlines for the deal were pushed back repeatedly as the FDIC tried to entice a competing bid by Canada's Toronto-Dominion Bank and Goldman, Sachs & Co., which frustrated several of the PE bidders who wanted to close the deal.

In another instance, the FDIC decided to shutter failed Atlanta bank Silverton Bank NA after unsuccessful efforts to sell it as a whole. Carlyle, Lightyear Capital, Harvest Partners LLC and Colony Capital LLC were reportedly in talks to buy Silverton in what would have been the latest in a string of bank deals involving private equity, but the FDIC deemed their offers too low and decided to close the bank rather than hand it to the buyout shops.

Adding to the annoyance is a recent FDIC policy statement that places larger capital burdens on banks controlled by private equity. According to the rules, which were put into place in late August, PE firms must maintain a Tier 1 capital ratio of 10% after acquiring a failed bank. Although that's down from the 15% originally proposed, it's still twice the 5% cushion required of other banks. PE buyers are also now restricted from selling stakes for the first three years after their purchase, and, if the same group of PE firms own 80% of two separate banks, each institution can tap the other for funds should it struggle, which increases the cross-guarantee risks for PE firms that make multiple investments.

The uncertainty over capital requirements was one of the factors cited by the losing PE bidders when failed Texas thrift Guaranty Financial Group Inc. was sold late in August to a U.S. subsidiary of Spanish bank Banco Bilbao Vizcaya Argentaria SA. The bank beat out a competing bid from a Gerald J. Ford's Flexpoint Ford LLC, Blackstone, Carlyle, Oak Hill Capital Partners and TPG.

The 10% capital rule was put in place three months after the FDIC sold BankUnited, with buyers asked to hold only 8% Tier 1 capital.

"It's unclear why the folks in D.C. have made it so difficult," says a partner at a prominent PE firm. "Our capital is as green as the next guy's."

Private equity hasn't exactly helped its own cause. Several sources cited as a big problem comments made in January by J. Christopher Flowers, the founder of financial services-focused PE shop JC Flowers. Flowers, who's been ubiquitous circling troubled banks like Bear Stearns Cos., Lehman Brothers Holdings Inc. and American International Group Inc. in recent accounts of last year's crisis, raised hackles in Washington for seeming to gloat over the fate of the industry. A New York Times story in May quoted Flowers telling a banking conference in January that "the government has all the downside and we have all the upside." His comments apparently were referring to the IndyMac deal in which he participated. Flowers added that "lowlife grave dancers like me will make a fortune" by investing in ailing banks.

Although some argue that the impact of his remarks were exaggerated, it's inarguable that the Fed has taken an increasingly unbending attitude toward PE. The Fed's issue revolves around control. In the case of First Southern, the Fed refused to clear the deal because it didn't believe the buyers wouldn't control the bank, even though no individual investor would have a controlling stake. Under existing rules, any investor in a bank that owns over 24.9% voting stake must be classified as a bank holding company, putting it under Fed jurisdiction and restricting nonbanking activities. The restriction is a problem for PE firms that would have to divest any nonbank portfolio companies if they became bank holding companies, and consequently they have tried to structure their investments to fall below the threshold.

The problem with the First Southern deal, however, is that, collectively, PE investors would own a majority in the bank, and the Fed felt they would "act in concert" to assume control, which effectively means that each investor would have to register as a bank holding company. The Fed's stance, which sources say is being most forcefully pushed by Fed Gov. Daniel Tarullo, the board member in charge of bank regulatory matters, is chilling PE efforts to club together to pursue bank deals.

"There's a natural institutional suspicion against private equity," says KBW's Senchak. "They're worried about the issue of risk to the system as a whole."

"It's entirely possible we've seen the last PE club deal for a bank," says one financial institutions banker.

Given this state of play, it's not surprising that investors are searching for ways around regulatory obstacles. Some firms are eschewing the idea of taking large stakes in banks and pursuing instead what one partner at a PE firm calls "buying enterprise value and investing in growth." This is a reference to the two-part $115 million investment by Warburg Pincus in publicly traded Webster Financial Corp., a Waterbury, Conn.-based bank. The private investment in a public entity, or PIPE, gave Warburg a 9.9% stake in the bank, through investments completed in July and October. The New York PE firm also acquired preferred stock that will convert into an additional 5.3% interest after shareholders other than Warburg vote to approve the deal. Warburg also received warrants that, if exercised, would lift its stake in Webster to 24%. Webster Bank has $17.5 billion in assets.

At the time Warburg's investment was announced in July, Webster chairman and CEO James Smith said additional capital would enable Webster to capitalize on "extraordinary banking opportunities" in its local market,

"That's a different investment thesis," says a lawyer involved in banking deals. He notes that those involved in deals such as the BankUnited acquisition are looking for a "pure play" that will allow them to reap high M&A-type multiples once they sell the rehabilitated bank to another buyer. Those investing in PIPE deals will instead likely have to be willing to take a smaller "trading multiple" by selling stock in the open market. While those returns might be too low for some private equity shops, the strategy also presents other problems.

One private equity investor says that his limited partners are already wondering why they need to pay the general partners management fees and carried interest if they can simply invest in healthy banks through public markets.

Although sponsors counter that they can get better deals from the companies -- including preferred stock or board seats -- other investment structures may offer opportunities that avoid entirely the stigma now attached to buyout players and the issues of control their strategies raise.

Take the recent advent of blind-pool funds several banks are raising to help bank management teams fund future acquisitions in banking.

The first pool of this sort, named NBH Holdings Corp., in mid-October raised $1.15 billion through a private placement arranged by Arlington, Va.-based investment bank FBR Capital Markets Corp. The money will be controlled by a group of former executives from Citizens Financial Group, the Providence, R.I.-based subsidiary of Royal Bank of Scotland Group plc, which will use it to buy and merge troubled banks.

According to the offering memorandum, prospective investors are limited to holding 9.9% stakes of the Class A common stock if they are institutional investors. Individual investors will be limited to a 4.9% stake in Class A, which carry voting rights. Investors can also hold Class B shares, which have no voting rights. The restrictions will keep investors in the fund from tripping over the FDIC rules, says FBR. Another investor says the restrictions will make it hard for the Fed to use the acting-in-concert rules to quash any purchases by NBH.

"It's a blind pool where most of the investors hold less than 5% and don't know each other," says one banking lawyer. "How can the regulators say that it's worse than any publicly traded bank holding company?"

Such is confidence in the concept that other banks have started raising others. Sources say Goldman Sachs is raising a $1 billion pool for former Downey Financial Corp. CEO Charles Rinehart, while Deutsche Bank AG is also trying to raise a pool, sources confirm.

But that strategy has not yet been tested. One banker believes "it will end badly" because investors can't approve acquisition decisions made by management, and it will take only a few failures to sour pension funds, mutual funds and family trusts on the idea of blind pools.

Despite the negative trends, it may still be too early to write off private equity's ability to invest in banks.

Early in October, a PE group led by Starwood Capital Group Global LLC and TPG agreed to buy a 40% stake in the assets of failed Corus Bank NA for $554.4 million. The FDIC is putting in $831.6 million of equity for the remaining 60% stake and provided $1.386 billion of debt to finance the total purchase price.

The transaction suggests that, despite their misgivings, regulators are prepared to allow PE firms into the sector when needed.

While the system has stabilized, uncertainty persists, notably about losses in commercial real estate. Many fear that a weak economy will cause lessees to default, and the resulting losses to landlords, not to mention the overall decline in the market, could cause many regional banks to take losses and push still-weak banks down another notch and threaten their ability to raise capital.

If that happens, regulators may very well need to show some flexibility. As one banker says, "The regulatory view to date has been perfectly correct. The strategics have been able to step in when needed. When they didn't, the regulators have been flexible. To a certain degree, you have to suspend disbelief to believe that the PE firms won't act in concert. But the feds have been willing to do that when they've had to."