BankWatch: Private Equity Firms Ramp Up Investments in Failing Banks

In recent weeks there have been at least two bank deals where private equity firms bought stakes in failing banks, bypassing special rules created by the FDIC to prevent such actions. The two firms, Thomas H. Lee and another owned by billionaire Gerald Ford, bought stakes in weak banks before they were seized by the federal banking regulator.

"This signals that private equity firms are showing their desperation in their dealings with the FDIC," says Linus Wilson, an assistant professor of Finance at the University of Louisiana at Lafayette, who has followed the bank bailouts closely.

Failed banks are an attractive acquisition target for private equity investors. Not only can these firms buy banks at a cheap price, but the investments also have a great deal of upside. That's because when a bank fails, the FDIC will assume a bulk of the losses from bad loans and assets in a portfolio of the failed bank.But the FDIC urges that private equity firms limit their involvement to "passive" investments and that they keep their investments below certain thresholds to avoid becoming a bank holding company, which would then require them to adhere to strict banking regulations.

Amassing a War Chest

But private equity investors are now hinting that they aren't willing to wait any longer for the FDIC to assume a failed banks losses. Instead, they would prefer to make significant investments now and possibly even get out instead of waiting to see if the FDIC will assume the losses. As a result, some private equity firms are now amassing large war chests to make such acquisitions. They are now starting to strike deals directly with the U.S. Treasury, which has invested large amounts of TARP money in regional banks, some of which have been greatly weakened by bad loans.

For instance, Ford Financial Fund four weeks ago announced it is buying community bank Pacific Capital Bancorp (PCBC) $500 million. For the deal to go through, the U.S. Treasury is expected to convert its $181 million of TARP investment in the California bank to $36 million of common stock, an 80% discount.

Another deal this month was announced Monday when private equity investors Thomas H. Lee Partners and Warburg Pincus said they would jointly invest $278 million in Sterling Financial (STSA). The Spokane (Wash.) bank has entered into a definitive exchange agreement with the U.S. Treasury, which has agreed to take a 75% haircut on its $303 million TARP investment in the bank, converting it to $76 million of common equity.

Indeed, the deals also show willingness on the part of the U.S. Treasury to be more practical and salvage as much as possible of its TARP investments. After all, if the FDIC decides to fail these banks, Treasury's investments go down to zero.

"The steep discount that the Treasury is willing to absorb from such transactions indicates its willingness to assist in the recapitalization of regional banks using private equity investments," says Juan Lopez, associate analyst at Moody's Investors Service. "Without conversion and additional capital, institutions such as Pacific Capital and Sterling would risk becoming under-capitalized. This could lead to more severe regulatory enforcement action, and possibly receivership, resulting in a complete loss of the Treasury's TARP investment," says Lopez.

Shaking Up Unstable Banking System

The FDIC, on the other hand, is a bank regulator and has signaled that it wants to be careful about not shaking up the already unstable banking system with private equity investors. The FDIC released rules last year that specifically target private equity investors, forcing them to hold on to their acquisitions for a minimum of three years, and also to maintain a Tier One leverage capital ratio of at least 10%, a higher requirement than the 5% it allows regular banks. (The ratio reflects the amount of capital held by a bank in relation to its total assets.)

In a statement, FDIC Chairman Sheila Bair said, the rules strike "a thoughtful balance to attract non-traditional investors in insured depository institutions while maintaining the necessary safeguards to ensure that these investors approach banking in a way that is transparent, long term and prudent."

Still, Wilson of the University of Louisiana points out that there aren't that many private equity deals that have taken place among failed banks either. "Private equity buyers might feel that there is a bias against them," says Wilson.

Indeed, of the 238 banks that failed in the last three years, most of them have been merged into healthier regional banks. Barely a handful of failed banks, including BankUnited of Florida and IndyMac were bought by private equity investors.

For private equity investors, that has been a big loss in opportunity. The Thomas Lee and Ford deals are signaling that private equity buyers aren't willing to sit around keeping their powder dry and waiting for the FDIC. Over 700 banks are in the FDIC's "problem list" and these deals might just be the beginning of more in the future. Several regional banks might be weak enough that they are ripe to be acquired cheaply by private equity firms for upside gains, once the economy picks up steam.