Bank shots

Since the beginning of the financial crisis, there has been much discussion about private equity firms investing in banks. But, despite several minority PE banking investments (e.g., Boston Private Financial Holdings Inc.) and even a few investments in which a consortium of PE firms has constituted all or a substantial part of a control group (e.g., Flagstar Bancorp, BankUnited and IndyMac), no significant wave of PE banking investments has yet materialized.

There are likely many reasons for the relative paucity of deals. Valuation and other economic concerns have contributed, but the economics of many deals will now likely be attractive. Instead, in our view, a more significant obstacle has been regulatory -- federal bank regulators have established barriers to participation by the private equity industry in this sector.

The federal banking agency with the greatest proclivity to permit outside investments in banks should be the Federal Deposit Insurance Corp. The FDIC is charged with resolving problem banks while protecting the rapidly shrinking deposit insurance fund, which rests at its lowest balance since 1993. From a deal perspective, the FDIC has been willing to do much, such as entering into loss-sharing agreements with acquirers of failed banks, often committing to assume 80% or more of the loss on a failed bank's loan portfolio.

Yet even the FDIC has been unwilling to allow PE investors to participate in bank acquisitions on equal footing with strategic investors.

Indeed, FDIC Chairwoman Sheila Bair has declared it "self-evident" that PE firms present a risk posture different from strategic acquirers.

The FDIC's Aug. 26 Policy Statement on Qualifications for Failed Bank Acquisitions reflects this view. Although certainly an improvement over what the FDIC originally proposed, the policy statement still imposes special requirements on PE bidders in failed bank deals, including special capital, cross-collateralization (which allows the FDIC to recoup costs in resolving a failed bank at the expense of common investors in a healthy sister bank), and affiliate-transaction limits.

It remains to be seen how the FDIC's approach will affect private equity investments in banks. The FDIC has said it will review the policy statement in six months. Given the number of banks on its "problem list" (416 as of June 30, the highest number since 1994), the agency may have to be more accommodating.

Even if the FDIC further relaxes the policy statement's more burdensome conditions, though, action by other regulators will be necessary to encourage extensive PE participation in the banking industry. For example, the FDIC's qualification standards and regulatory requirements do not supplant those imposed by the Federal Reserve or the Office of Thrift Supervision under their respective holding company frameworks. Thus, even if a group of firms decides to buy a failed bank from the FDIC, and meets that agency's guidelines, one or more of the acquirers may still need to undergo a lengthy process with a different banking agency to determine if they will need to register, and be subject to supervision and regulation, as bank or thrift holding companies.

To foster needed, meaningful participation in the banking sector, federal regulators must provide a coordinated, transparent, and comprehensive framework that is receptive to private equity investment. For example, an interagency statement creating a presumption that a group of unaffiliated private equity firms, each holding less than 25% of voting interest in a bank, would not be deemed bank holding companies and would be able to engage in acquisitions of live or failed banks without added regulatory burdens, should promote the flow of capital into the banking sector.

To be clear, this approach does not require that regulators allow significant additional risk into the banking sector. Despite a presumption of permissibility, the agencies would retain the ability to evaluate each structure on a case-by-case basis.

Such an approach would, however, create relative regulatory certainty and transparency and, thus, make the principal investment criteria with bank acquisitions, as with other private equity acquisitions, economic. Given the financial benefits provided by the loss-sharing agreements and the current financial climate, such a framework would create an enviable opportunity for private equity investment. n

Gregory J. Lyons is a New York-based partner and co-chair for the Americas of the financial institutions group at Debevoise & Plimpton LLP. Satish M. Kini, based in Washington, and Paul L. Lee, based in New York, are partners and co-chairs of the firm's banking group.