Heightened Bank Deal Activity Stokes Regulatory Debate

Buyout shops have plenty of dry powder and the struggling banking industry needs capital. And now that momentum for deals is picking up, the nuances of structuring private equity investments in the sector is a hot topic.

The transaction that could be the tipping point in the debate is the purchase of BankUnited by a consortium of buyout shops, including The Blackstone Group, The Carlyle Group, and WL Ross & Co. in late May. In its press release announcing the BankUnited agreement, the Federal Deposit Insurance Corp. disclosed plans to address the issue, saying it plans to provide a “generally applicable policy guidance” for investments by private equity firms in banks in receivership in the near future.

Some official word from regulators appears to be in order. So far, deals have mostly been clubbed up. That was the case with the acquisition of IndyMac, valued at $13.9 billion, so far the biggest buyout of the year, in March. The most recent private equity investment in the sector was also a club deal. On May 30, First Southern Bancorp Inc., the parent company of Boca Raton, Fla.-based First Southern Bank, reached an agreement-in-principle for investments totaling $450 million from Crestview Partners, Lightyear Capital, and Fortress Investment Group. Each firm would invest up to $150 million in the deal, receiving common and convertible preferred stock in exchange that would, upon consummation, give each shop “separate, significant non-controlling stakes” in First Southern.

And therein lies the crux of the debate about private equity investments in the banking sector going forward – the size of the stake assumed by any single entity and the control it offers. By nature, buyout shops prefer to be lead investors and, in the wake of the credit crisis, they’ve been probing for ways to replicate that kind of ownership in the financial sector. One approach has been to create what are commonly termed ‘silos’, separating the entity that controls the bank from the buyout firm itself.

This was the method at work in the summer of 2008 when J. Christopher Flowers, the founder of J.C. Flowers & Co., moved to personally purchase First National Bank of Cainesville, a tiny Missouri-based bank with total assets of just $14 million after he received approval for the change of control from the Office of the Comptroller of the Currency. Flowers, who told the OCC he planned to inject $1 million of new equity into the bank, is expected to use the company, since re-named Flowers Bank, as a platform to acquire financial services companies but he has yet to make a deal.

The ‘silo’ approach is viewed as way to potentially work around the various regulatory restrictions, which differ between the Federal Reserve, which sets the rules for national bank holding companies, and the Office of Thrift Supervision, the authority for savings and loan institutions. The Federal Reserve made a concession with regard to minority, non-controlling stakes in banks back in September 2008, when it boosted the maximum ownership percentage to 33.3 percent of total equity from 25 percent, as long as entity’s voting rights don’t exceed 15 percent. The Office of Thrift Supervision has generally been receptive to the ‘silo’ approach, although the number of deals completed remains small.

The message being sent by the recent spate of deal-making has raised the ire of Senator Jack Reed, a Democrat from Rhode Island. In a May 22 letter to representatives of the Treasury Department, Federal Reserve, and the Office of Thrift Supervision, he expressed concerns that “a significant shift in regulatory policy may be occurring regarding private equity purchases of banks, without a consistent approach by regulators and with virtually no Congressional oversight.”

Reed cited the purchase of Michigan’s Flagstar Bank by MatlinPatterson as well as the BankUnited deal in his letter. The Flagstar deal in particular, he found troubling, as he said it “appears to represent a reversal of decades of public policy prohibiting commercial entities from owning majority stakes in banks.” Using the ‘silo’ approach, the firm was able to win approval from the Office of Thrift Supervision to assume a nearly 70 percent stake in Flagstar. Reed called for a “consistent comprehensive policy” from the government on private equity investment in bank deals in his letter, saying the current situation was akin to “regulatory arbitrage whereby institutions and firms shop around a potentially risky activity until they find a regulator who will allow it.”

Government officials seem on board with developing such guidelines, as in addition to the previously cited comments from the FDIC, Treasury Secretary Timothy Geithner has also gone on the record as saying a review of the differing standards for approval of private equity investments in banks is in order.

Meantime, buyout firms are getting increasingly comfortable with club deals. At press time, The Carlyle Group was reportedly in talks to purchase Atlanta-based Silverton Bank, a commercial bank providing lending services to other banks, which was seized by the FDIC on May 1. At the time of its closing, Silverton Bank had assets of $4.4 billion and $3.3 billion in deposits, according to the FDIC, which formed a bridge bank to take over operations. The Wall Street Journal said Carlyle was pursuing the deal in concert with a number of other investors.

If bank failures have been the engine for the club deals of late, plenty more activity may be in the offing. Twenty-one FDIC-insured institutions failed in the first quarter, the FDIC said on May 27. This was the largest number of failures since the fourth quarter of 1992. What’s more, the first quarter saw a healthy 20 percent increase in the FDIC’s tally of ‘problem’ banks, viewed as vulnerable to failure, to 305 from 252 in the fourth quarter. Those institutions had total assets of $220 billion.