The Private Equity Effect

It's only natural to look at successful private equity deals in the banking industry and think about what might have been-the failures that might have been avoided had private equity money been allowed to flow more freely into the sector, the balance sheet health that might have been restored by now at banks needing to be recapitalized.

Indeed, in the midst of crisis, Washington went only so far in easing the long-standing restrictions on private equity's control of depositories, even as regulators scrambled to contain the influx of failed institutions.

A focus on short-term profit-making is partly what makes regulators leery. Private equity firms generally raise money to acquire, fix and sell companies, at a profit, on a timetable of five years or less.

Nonetheless, a number of buy-and-flip artists breached the regulatory bulwark around banks. Since the start of 2008, there have been at least 187 private equity transactions involving banks, with more than $31 billion changing hands, according to SNL Financial. The tally is based on publicly announced deals including buyouts, growth capital investments, private placements and exits via public offerings of stock, among other types of transactions.

The legacy of these deals is fairly straightforward on the surface: private equity shops purchased a handful of failed banks and rescued many more that otherwise might have failed; they also bankrolled a handful of new lenders set up to capitalize on a void when credit dried up in 2008, and purchased.

But private equity's imprint on the banking sector goes deeper than that. These investors, obsessed with generating returns relatively quickly compared with bankers, have introduced a new discipline and a different set of priorities to an industry that, by design, had long been shielded from private equity's influence.

At a glance, banks with private equity investors aren't intrinsically different from other banks, as Mary Lynn Lenz would attest.

A veteran banking executive, Lenz was recruited by a private equity firm in 2009 to run Professional Business Bank in Pasadena, Calif., and she arranged for its sale to another private equity investor, Carpenter & Co., at the end of the following year.

"We ran the bank as a bank-a traditional bank," says Lenz, who stepped down after Professional merged with another Carpenter holding, Bank of Manhattan in El Segundo, Calif. "Our partnership with the private equity fund did not change our product line. It did not change our strategic direction. It just added another partner [and] in our case, several board members."

But partners and board members affiliated with private equity firms-even the ones who have signed passivity agreements meant to limit the influence they can exert over the banks in which they've invested-still bring something to the table that others don't, be it capital markets expertise or the urgency of a stakeholder with a short investment horizon.

There are indirect effects as well-on the institutions that have to compete against banks with private equity capital; on regulators, who are still tangling with a variety of questions about private equity and its role in the financial system; and on the price tags for acquisition targets, which are being driven up by aggressive bidders financed by private equity.

PacWest Bancorp, based in Los Angeles, is the poster child for sharp-elbowed, private equity-fueled banks. Its CEO, Matthew Wagner, scuttled Umpqua Holdings' deal for a small bank called American Perspective by making a higher offer in May. Also that month, he made a hostile bid for First California Financial Group, a move that effectively put a for-sale sign on that company.

PacWest's backers include CapGen Financial, a private equity firm run by former Comptroller of the Currency Eugene Ludwig.

"They want to become a big player in California and then sell to a very big player that wants to grow in California," says Joe Gladue, an analyst with B. Riley & Co. who follows West Coast banks. "That creates a different mindset and a different way of operating than someone who wants to keep a bank around for a long time."

Even technology vendors are noticing the difference.

Several say that private equity-owned banks seem to have a heightened interest in finding software and systems that will make their banking operations more productive and afford greater transparency to root out inefficiencies.

"I am going after bank holding companies that are typically backed by private equity," says Pierre Naudé, the CEO of nCino, a startup that offers technology for tracking loan documentation and other paperwork in the cloud.

Of course there are plenty of other bank owners focused on improving their returns. But private equity tends to keep to a tight schedule-firms have limited time to boost returns and exit the investment-so the tactics used to achieve those goals frequently are more aggressive than the norm.

Some private equity investors will hold onto an investment for as long as 10 years if necessary. Most, however, expect to start generating higher internal rates of return much sooner than that and plan to cash out within three to five years.

It's been four years since the collapse of Lehman Brothers, and many of the private equity firms currently involved in the sector started shopping for banks soon after that, in 2009.

This September seemed to mark the beginning of what is likely to be a long wave of private equity-funded banks mapping out an exit. West Coast Bancorp, a lender in Lake Oswego, Ore., with nearly a quarter of its stock held by private equity investors, agreed to sell for $506 million to Columbia Banking System of Tacoma, Wash. Castle Creek Capital Partners and other investors in West Coast paid $10 per share for stakes they are now poised to sell for more than $23 per share.

Also in September, National Bank Holdings in Denver and Capital Bank Financial in Coral Gables, Fla., both assembled three years ago to buy troubled banks, filed to go public.

Because of regulatory restrictions on private equity control of depository institutions, perhaps only two dozen or so of the country's 7,500 banks can truly be considered private equity-run institutions, says John Roddy, managing director in charge of financial institutions investment banking for Macquarie Group. "It's a small number," he says.

But private equity still generates a ripple effect in the sector when it makes a move.

There is perhaps no better illustration of this now than the relatively robust scene for mergers and acquisitions in states like California and Texas.

Growth-hungry banks with private equity backing "have done the bulk of the deals" in these markets, says Rory McKinney, a managing director at investment bank D.A. Davidson in Portland, Ore.

"They have also paid up," he says.

When Cadence Bancorp, a Houston bank holding company with private equity backing, agreed in March to buy Encore Bancshares for 240 percent of tangible book value, it was the highest premium that any bank in Texas had seen in years.

Cadence CEO Paul Murphy Jr. wasn't going to waste his time with a bid that wouldn't immediately grab Encore's attention. "We knew they were not for sale," Murphy told American Banker after the deal was announced in March. "We had to claw our way in."

Analysts were certain the unsolicited bid would give additional leverage to would-be sellers across the state. The deal closed in July.

McKinney says private equity-owned banks "have a significant pricing advantage right now because they don't have to worry about the reaction in the public markets to their stock price.

"They also want to deploy this capital as quickly as possible," he adds. "If they want to do an IPO or ultimately want to sell they have to deploy the excess capital."

Not every exit is expected to be graceful, as some investors in the industry have fared very poorly.

New York turnaround specialist MatlinPatterson Global Advisors, for instance, put up $1 billion for majority control of Flagstar Bancorp of Troy, Mich., only to watch much of its investment evaporate.

Other deals have been masterful-among them, the financier Gerald Ford's play for Pacific Capital Bancorp.

Two years ago, the Texas billionaire poured $500 million into the Santa Barbara, Calif., institution. He agreed this year to sell the now-stronger company to UnionBanCal, the Japanese-owned parent of San Francisco's Union Bank, for $1.5 billion in cash.

Pacific Capital fetched 160 percent its tangible book value-not rich by current standards, but perfectly respectable. The sale price was enough to more than double Ford's money, with his 76 percent stake now worth $1.2 billion.

UnionBanCal's chief financial officer, John Woods, told American Banker this spring that Ford's group did "something we couldn't do, which is take a huge risk that is not safe and sound," to turn a damaged franchise into a business worthy of a normalized valuation.

What happened at Pacific Capital may have made some in the industry wistful: how might have other distressed cases played out if the federal banking agencies had abandoned their fox-in-the-henhouse line of thinking and allowed private equity even greater access to the sector?

Some accommodations were made, first on an ad hoc basis and later in formal policymaking, but investors like Wilbur Ross, the financier behind WL Ross & Co., continue to complain that their firms are treated unfairly.

At American Banker's annual M&A Symposium in May, Ross railed against rules that say private equity investors have to hold their bank investments for a minimum of three years and keep capital at higher levels than what startup banks are expected to maintain.

"Bureaucrats fear private equity players as slippery, clever sharpies and are far more comfortable regulating commercial bankers," said Ross. He described the restrictions on private equity as "draconian," and said bank regulators in Europe were far more welcoming to firms like his.

Private equity continues to be a conundrum to U.S. regulators in other ways. While the Financial Stability Oversight Council has been making headway in its determinations about which nonbanks will be considered systemically important financial institutions, regulators already have said they will postpone making decisions about any private equity firms or hedge funds.

Investors who seek to hold 25 percent or more of the voting stock of a U.S. depository generally are required to shed their non-financial interests and become regulated bank holding companies. So the vast majority of the buyout fund money that has been funneled into banks is composed of ownership stakes of 24.9 percent or less.

Some private equity firms have run around the restrictions at least partially, banding together and taking de facto control of institutions by investing in a quorum. The most high-profile example of this is the group through which four investors-Blackstone Group, Carlyle Group, Centerbridge and WL Ross-took ownership stakes of 15 percent or less in BankUnited of Miami Lakes, Fla., run by John Kanas.

Other blue-chip private equity firms attracted to the industry include Warburg Pincus, which took stakes in two otherwise solid banks that hit a rough patch-Webster Financial, of Waterbury, Conn., and National Penn Bancshares, of Boyertown, Pa. It also invested in a company that may have failed without the injection of capital, Sterling Financial of Spokane, Wash. Thomas H. Lee Partners is a co-investor in Sterling.

Chip MacDonald, a partner with Jones Day in Atlanta, says private equity backers-even the passive ones-can have a big impact on future capital raising for banks they're attached to.

"What they do is bring some very good knowledge of the capital markets," MacDonald says. "And because of their names, they bring market interest when banks need to raise more capital, because people want to invest" alongside them.

And though some private equity investors already are cashing in, like Ford with Pacific Capital Bancorp, the impact of private equity likely will be felt for some time.

Robert Clements, the CEO of EverBank Financial (which just acquired GE Capital's business property lending unit for $2.4 billion), told American Banker last month that the private equity investors backing EverBank-they include Sageview Capital, New Mountain Capital and TPG Capital-aren't rushing for the exit.

"There is a strong view that this company is in the very early stages of our growth and development," Clements says. "They share the view that our growth prospects are very attractive."

Matt Monks covers M&A for American Banker.