After FDIC Rule, PE Wary But Set to Seek Deals

WASHINGTON — In the week after the Federal Deposit Insurance Corp. eased its stringent private-equity proposal, firms appear wary but ready to bid on failed banks again.

Observers said even though the final guidelines are more palatable, they are restrictive enough that private-equity bidders still face tougher standards than competitors and investors must carefully determine if a bid's reward justifies the regulatory cost.

"On balance this is good enough that some bidders may conclude that they're willing to jump in," said William Stern, a partner at Goodwin Procter in New York. But "I'm not sure that it's necessarily going to open up the floodgates."

The FDIC changed key pieces of the rules — including lowering nonbank investors' minimum capital ratio from 15% to 10% — to make sure that, in its attempt to regulate new banking entrants, the agency does not scare private-equity firms away.

Investors who saw the July proposal as a deal-breaker now say they can return to the negotiating table.

"It's at least encouraged me enough to where we will try" to bid, said Wilbur Ross, the chairman and chief executive of WL Ross & Co. LLC.

But Ross and others stressed that under the guidelines, investors will still be extra cautious, and may ultimately stay on the sidelines. They pointed out that normal bank bidders are only bound by an 8% capital ratio, and therefore will hold the upper hand in submitting winning failed-bank bids.

"What we've decided is: We will bid, and we'll see how it turns out," Ross said. "If we're able to make competitive bids, even with the 10%, well then that's fine. If it turns out it's too much of a handicap, we'll stop. We'll let the marketplace tell us whether this is too much or not."

John Douglas, a former FDIC general counsel and now a partner at Davis, Polk & Wardwell, said it was difficult to know exactly how to react to the final policy guidelines.

In his firm's client memo, he said, "We were debating between 'tepid,' 'cautious' and 'tentative.' We settled on 'cautious.' "

Douglas said the administrative costs of submitting bids may persuade private-equity firms that lose out on failure deals not to attempt subsequent bids.

The final guidelines were "certainly better than the proposal," but "it's clear that private equity has to play to a different financial standard than" other bank bidders do, he said.

"These bids for these institutions are very expensive — going through the due diligence and the legal work. There will be bidders who show up," Douglas said. "But unless they're able to get a deal or two done, it will be the last time they show up."

In addition to a lower capital ratio, the FDIC also significantly narrowed a requirement that investors holding large stakes in multiple institutions pledge chunks of their assets should the agency suffer losses, and removed a provision forcing investors to meet "source of strength" obligations for their bank holdings.

The policy also allowed for exemptions, including for investors holding less than 5% of a bank's voting shares. It will also not apply in cases where an investor's bank has maintained a Camels rating of 1 or 2 for seven straight years. After the policy has been in effect for six months, the FDIC will review it to gauge its effect.

Despite the easing of the standards, observers said a 10% capital level still means investment groups will have to be conservative.

"When all is said and done, it's going to be a case-by-case analysis based on cost," said Tom Vartanian, a partner at Fried, Frank, Harris, Shriver & Jacobson LLP.

He added that a private-equity firm will have a better shot at a winning bid in cases where only nonbank firms are bidding.

"It's going to be difficult for you to outbid a bank because you're going to have to ask for more assistance from the FDIC," Vartanian said. By comparison, with two private-equity firms as the only bidders, he added "both are going to ask for more assistance because of the higher capital requirements. That is more workable."

Michael Krimminger, a special policy adviser at the FDIC, said the guidelines should be viewed more broadly than just addressing private equity.

"It is really a focus on new entrants into the market," he said.

Krimminger noted that traditional owners of de novo banks have had to maintain capital levels above 8%, but that there are other reasons why a nonbank investor would need a higher minimum.

"With new investors, we felt that it was more prudent to have a higher capital level," he said.

"This statement of policy is not focused exclusively on private equity but it is trying to set standards for investors who have not been involved in investing in banks before so they can understand what the standards are. We felt it was important to provide standards rather than doing it on a case-by-case basis."

Ross and others praised the FDIC's other changes narrowing the guidelines, but pointed to continuing failures of recently chartered institutions as evidence that private-equity firms do not deserve a higher capital requirement than de novo banks.

"To the best of my knowledge, no failed bank that's been taken over by a private-equity group has ever re-failed," Ross said. "The idea that just because they happen already to have been a bank makes them inherently better as an owner, I think, is a very debatable thing."

Still, some observers said the FDIC is trying to be cautious as well. With a thin record of private-equity firms operating banks, they said it makes sense for the FDIC not to want to open the door too wide before completing more deals.

"Part of this, I think, is shadow-boxing," said Patricia McCoy, a professor at the University of Connecticut's law school. "Private equity to some extent is posturing, trying to get the best deal it can. One of the ways to posture is to threaten to pick up your jacks and walk away. At the same time, the FDIC … has a serious concern about not setting up a new bank — to be run by private equity — for failure.

"New banks in general have a higher failure rate than established banks, and a new bank that's rising out of the ashes of a failed bank is even riskier."