When they were announced in April, the two biggest of these deals --
a $7 billion slug of equity in Seattle's Washington Mutual Inc., the
nation's largest thrift, invested by a consortium organized by David
Bonderman's TPG Capital, and a similarly sized investment two weeks later in a Cleveland regional bank, National City Corp., led by Corsair Capital LLC
-- stood as models of the central role private equity aspired to play in
cleaning up the mortgage mess and healing the financial sector's wounds.
But come autumn, as uncertainty mounted over the true extent of the sector's ills, Lehman Brothers Holdings Inc.
imploded and fear ran riot. Depression-era-style deposit runs prompted
the government to seize Washington Mutual and force National City into
the arms of a healthier rival.
The mayhem has cut a swath through private equity, utterly
obliterating TPG's huge investment in WaMu, squeezing Corsair out of
what it thought would be a long-term investment in Nat City and
ravaging values of most of the industry's remaining investments in the
sector.
| Broken PIPE dreams |
| Most private equity investments in struggling financial services providers are under water |
Announced |
Institution |
Lead investor(s) |
Total capital invested ($mill.) |
Notes |
Oct-08 |
Canadian Imperial Bank of Commerce
(bank) |
Cerberus Capital Management LP |
$1,000 |
Cerberus will buy notes backed by CIBC's U.S. real estate assets |
Jul-08 |
HSH Nordbank AG
(German bank) |
JC Flowers & Co. LLC |
380 |
HSH reportedly is seeking German government bailout funds |
Jul-08 |
Boston Private Financial Holdings Inc.
(bank) |
Carlyle Group |
75 |
Stock trades 20% above the conversion price of Carlyle's preferred; bank recently obtained $150 million in TARP funds |
May-08 |
MF Global Ltd.
(ETF broker) |
JC Flowers & Co. LLC |
150 |
Shares trades 80% below Flowers' conversion price |
Apr-08 |
National City Corp.
(bank) |
Corsair Capital LLC |
7,000 |
Bank agreed under pressure to be bought by PNC; Corsair group will recoup its money |
Apr-08 |
Washington Mutual Inc.
(thrift) |
TPG Capital |
7,000 |
U.S. seized bank and sold it to J.P. Morgan; TPG's equity was wiped out |
Apr-08 |
Hypo Real Estate Holding AG
(German mortgage bank) |
JC Flowers & Co. LLC |
1,700 |
Hypo agreed to a $67 billion German government bailout in October; Flowers' stake is down 85% |
Mar-08 |
Thornburg Mortgage Inc.
(mortgage lender) |
MatlinPatterson Global Advisers LLC |
1,350 |
Matlin put $420 million-plus in junk bonds and warrants, could gain control if company goes bankrupt |
Feb-08 |
Assured Guaranty Ltd.
(bond insurer) |
WL Ross & Co. LLC |
1,000 |
$250 million up front and up to $750 million more; Ross' stock is down 70% |
Feb-08 |
MoneyGram International Inc.
(money transfers) |
Thomas H. Lee Partners LP; Goldman, Sachs & Co. |
1,260 |
$760 million of equity and $500 million of debt; stock trades 60% below investors' conversion price |
Jan-08 |
Legg Mason Inc.
(asset management) |
Kohlberg Kravis Roberts & Co. |
1,250 |
Stock trades 82% below KKR's conversion price |
Dec-07 |
First Mablehead Corp.
(student loan services) |
Goldman Sachs Capital Partners |
193 |
Stock trades 90% below Goldman's conversion price |
Dec-07 |
MBIA Inc.
(bond insurer) |
Warburg Pincus LP |
2,600 |
Warburg invested $800 million; stock trade 74% below its average per-share cost |
Nov-07 |
Shinsei Bank Ltd.
(Japanese bank) |
JC Flowers & Co. LLC |
1,870 |
Flowers' stake in down 65% |
Source: The Deal, financial filings |
In the devastation's wake, the private equity industry has taken a
collective deep breath. It has been forced to take stock of its losses
and to regroup and to rethink the role buyout firms ought to play in
the deleveraging and restructuring of the banking and financial
services sector. How assertively should sponsors pump cash into needy
institutions? Is the safest move the wisest -- namely, to swear off
investing in the sector entirely for now?
There are no easy answers. And a handful of buyout industry
executives and participants surveyed for this story turned up a range
of views on the matter, from those saying they'll steer clear of the
blighted sector to others who contend that the blight is sure to beget
opportunity. No matter where they stood, all noted the sobering effect
of the litany of losses.
"People are quite chastened following some of these
balance-sheet-oriented deals," says one private equity player. "You saw
some smart money going into the sector, and a few of the deals have
been real disasters. That tends to give you pause."
Similarly, some institutional investors in buyout funds, like HarbourVest Partners LLC
managing director John G. Morris, embrace the better-safe-than-sorry
mindset: "We're elated that our buyout managers don't have a
damn-the-torpedoes attitude, because many could find themselves sunk
the way TPG did in WaMu," Morris says. "They're waiting for valuations
to adjust and some sign we've reached a bottom."
Meanwhile, there are other, bolder buyout sponsors who, even though
they've taken a breather, probably won't be idle for long. They yearn
to capitalize on the financial industry's woes and on havoc in the
broader markets.
Prices of assets have dropped so steeply they're hard to resist.
Notwithstanding WaMu-style blowups and the slew of investments under
water, some see considerable upside now in everything from private
investments in public entities -- the PIPE investment TPG made in WaMu
and Corsair made in Nat City -- to buying loans and junk bonds of LBO'd
companies at fire-sale prices to snapping up subprime mortgage
portfolios at pennies on the dollar.
For judicious investors sufficiently attuned to the risks, opportunities abound, argues Carlyle Group's
Randy Quarles. "The sector isn't toxic -- just a certain portion of the
assets are. You have to approach it with caution and understand the
right way to invest in it," says Quarles, a former undersecretary of
the Treasury in the Bush administration who co-heads Carlyle's
financial services investment team.
Risk aside, the case remains compelling for private capital to have
a role in overhauling the financial sector. Many large buyout houses
are sitting on billions of dollars seeking an outlet at a time when the
credit crunch has largely quashed traditional leveraged buyouts,
especially big-cap buyouts.
What's more, the hole in the banking system that needs plugging has
grown into a yawning abyss as asset valuations have plummeted,
markdowns have accelerated and banks' capital foundations have eroded,
making capital transfusions all the more necessary.
Says Andrew Senchak, president of Keefe, Bruyette & Woods Inc.,
"Most banks and thrifts are focused on getting government money"
through Paulson's two-month-old, $700 billion bank rescue plan, the
Troubled Assets Relief Program, or TARP. "As to what to do next, there
still is a capital hole" that TARP alone won't suffice to fill, Senchak
says.
Paulson admitted as much on Nov. 12, when he said, "We are carefully
evaluating programs that would further leverage the impact of a TARP
investment by attracting private capital, potentially through matching
investments." Estimates of how much supplemental equity capital the
banking system needs run as high as $250 billion.
Private equity's recent history in bailouts isn't simply an exercise
in pain, experts say. It also contains lessons -- notably the cardinal
rule that when you set out to brace up a bank, make sure you invest
enough to wipe out the problem. That's the approach Paulson took in
headline-grabbing rescues of American International Group Inc., Freddie Mac and Fannie Mae -- an approach that deviates sharply from some PIPE investments buyout firms have made.
"You can't tiptoe your way in. You can't put in a little and hope it
works. If you do that, you might as well go to Vegas and roll the dice.
Always put in enough to cover all the assets that could be impaired
plus a little extra," advises Joshua Siegel, managing principal of StoneCastle Partners LLC, a New York investor in small and regional banks.
What if you don't? Siegel and others cite the WaMu deal as the
symbol for the perils that might ensue. In April, when TPG engineered a
$7 billion equity booster for WaMu -- the buyout firm put in $1.35
billion and took about an 11% stake; the rest of the capital came from
institutions -- "most of the Street was saying [WaMu] would need $20
billion or $30 billion," says Siegel. Even though Siegel wasn't privy
to WaMu's financials, two private equity investors who were, both of
whom WaMu courted before selecting TPG, backed up Siegel's statement:
One put his firm's estimate of the top range of WaMu's capital need at
$19 billion to $22 billion. The second investor says: "Our number
actually began with a three."
TPG turned down an interview request for this story, and the reasons
why the firm arranged a $7 billion infusion aren't known. But by early
September, it was abundantly clear that $7 billion hadn't done the job.
As panic spread over WaMu's financial health, fanned by rumors the
government was set to intervene, WaMu was hit with a vast wave of
withdrawals by large depositors and began to totter. On Sept. 25, the
government did step in, seizing control of WaMu's core operations and
auctioning them to J.P. Morgan Chase & Co. for $1.9 billion.
With the rest of WaMu's equity, TPG's entire investment was vaporized.
It was among the largest losses in private equity history.
Corsair's contemporaneous investment in Nat City, meanwhile, tacks a
disturbing addendum on to the lesson of WaMu: Namely, sometimes even a
liberal infusion of capital that seemingly exceeds a target bank's
possible write-offs won't suffice. A person familiar with Corsair's
investment notes that the $7 billion Nat City received was $2 billion
more than Corsair's financial models showed was needed. The $2 billion
"cushion" effectively "derisked the deal from [Corsair's] perspective,"
the source says.
Nevertheless, justifiably or not, Nat City fell prey to a run on
deposits the way WaMu had -- a run touched off in part by speculation
that Nat City was under intense government pressure to sell itself to a
financially sounder rival. The rumors were true, and on Oct. 24, the
bank disclosed it would be sold to PNC Financial Services Group Inc.
for $5.6 billion. Even though the $2.23 a share PNC said it would pay
for Nat City was less than half Corsair's investment cost, the firm
escaped with a modest profit on its own $850 million slice of the $7
billion, thanks to downside protections built into its Nat City
investment contract.
Whether Nat City could have survived on its own is open to debate.
After all, depositor runs can doom even an amply capitalized bank.
Although Corsair declined to discuss Nat City, the firms' partners,
sources say, firmly believe that the government's own maneuvers
exacerbated Nat City's plight and made necessary a sale that might have
been avoided.
From both Nat City and WaMu, private equity players derive a third
lesson: that smaller institutions with uncomplicated balance sheets and
relatively modest capital needs make the best investments.
"You don't need to take Sallie Mae private to make a living,"
one executive says. Similarly, Carlyle's Randy Quarles observes: "If
you avoid the things that put you on page 1 and invest in the things
that put you on page D7, you can actually make some money."
One smallish bank PIPE that conceivably could turn a profit is Carlyle's $75 million investment in July in Boston Private Financial Holdings Inc.,
a wealth manager and regional bank operator. Carlyle, says Quarles,
spent weeks vetting Boston Private's assets to ensure that its money,
along with $110 million raised through a rights offering, would erase
the blight of bad real estate loans made by the company's southern
California subsidiary. "The company was of a size we could understand,
with problems we could understand," notes Quarles.
Most investors seem to agree. Of all the banking PIPE investment
done by buyout firms since late 2007, Boston Private is the only one
whose market value is above water.
There is considerable disagreement in private equity circles over
one key matter: whether Paulson's plan for TARP and for private capital
sources to join forces holds any appeal at all. Some contend that
partnering with government always carries risks. "As Paulson's policy
shifts over the last six months show, governments are not stable and
predictable partners," says a partner at a well-known private equity
firm. "They have agendas that are driven by more than just financial
returns."
Quarles, by contrast, embraces Paulson's notion, arguing that
private capital can serve as a counterweight to government influence.
He'll discover soon enough whether that's the case, since Boston
Private recently said it had obtained a $150 million TARP pledge.
In addition to considering PIPE investments, private equity firms
increasingly are targeting fire-sale-priced assets -- everything from
LBO-linked loans to junk bonds or mortgage securities -- being dumped by
hedge funds or others. Like the buyout industry's investments in
banking, many such purchases made over the past year have racked up
hefty mark-to-market losses.
In the case of an estimated $80 billion in LBO loans that buyout
firms bought from money center banks early this year at small discounts
to par, the paper losses stand in the hundreds of millions.
But that experience hasn't necessarily blunted investor appetite for
leveraged loans and bonds. If anything, says Michael Zupon, who heads
Carlyle Group's U.S. leveraged finance team and oversees its
investments in non-investment-grade debt, the plunge in prices has
elevated their appeal. "Since this most recent selloff, our bias has
shifted from being a heavy seller to a cautious buyer," Zupon says.
"It's an unbelievable investment opportunity, but there are
extraordinary risks right now."
Indeed, the risk that the bottom will continue to fall out of the
market looms large. In that event, private equity faces the prospect of
more debilitating losses -- and another round of painful lessons.
Not a few buyout executives guffawed at Treasury Secretary Henry Paulson's suggestion on Nov. 12 that private equity act in concert with the federal government to prop up the nation's faltering commercial banks. He might just as well have invited them to go play in rush-hour traffic.
