Private equity was borne of Wall Street, but that relationship now is under regulatory attack.
As we’ve discussed before, the Dodd financial reform bill’s Volcker Rule would prohibit banks from investing either directly or indirectly on the equity side of private equity deals. Moreover, proposed Basel III language would make PE fund commitments difficult for any G20 bank, given the capital holding requirements for unfunded commitments.
Private equity’s response to all of this has been a claim of systemic impotence: “Hey, we didn’t cause the financial meltdown.” And, to be fair, it’s a legitimate defense. Relatively few big buyouts have gone bust, and many deals (and funds) on life support last year are now breathing on their own. Moreover, most systemic risk posed by private equity relates to poorly-priced leveraged loans – a side of the business that no proposed legislation looks to curb.
So let’s stipulate that the proposed rules to “break up” Wall Street’s bonds with private equity are unnecessary from the point-of-view of future economic cataclysm. Instead, let’s look at a deeper question: Will such regulations save the banks from themselves?
Last week, Harvard Business School professor Josh Lerner sent over a working paper on the economics of bank-affiliated private equity deals. The paper’s co-authors are Lily Fang of INSEAD and Victoria Ivashina of HBS.
It found that around 26% of all private equity deals transacted between 1978 and 2009 included equity participation by a bank or bank-affiliated group (excluding VC and distressed deals). It also found that such deals had significantly higher rates of bankruptcy (7.7% compared to 5.7%) and significantly lower rates of profitable exit (63% compared to 74%). This is particularly striking, given that “targets of bank-affiliated investments have significantly better operating performance than other buyout targets, though their size and other features are similar.”
One explanation, Lerner writes, is that banks are hyper-cyclical when it comes to private equity investments. Buyout deals obviously spike in boom times, but bank-affiliated groups sit atop that spike – participating in over 30% of deals during the recent boom. Conversely, they become particularly shy during down markets, participating in just 10% of deals during the early 1990s recession.
Then there is the whole conflict of interests issue, which helped prompt some banks to abandon direct private equity in the 2000-2002 timeframe (before rushing back in 2006-2008). Lerner finds:
“Bank-affiliated deals are generally associated with lower lending amounts, shorter maturity, and higher yield spreads. However, the situation is dramatically different when the parent bank of the affiliated private equity group is in the lending syndicate. When this is the case, deals done by affiliated private groups enjoy a significantly larger borrowing amount, a longer maturity, and a lower spread.”
Lerner doesn’t go conspiracy theory here, instead believing the explanation to be either increased access to information or cycle-related balance sheet expansion. But the findings do make the aforementioned deal performance stats even more damning, given that many bank-affiliated deals come with particularly-friendly sponsor-friendly terms.
It’s important to note that Lerner is not arguing that banks would be better hiding their money in a mattress, because he does not have cash-on-cash or IRR data for bank-affiliated PE deals. Indeed, such transactions may perform better than T-bills, even if they perform worse than non-bank-affiliated PE deals.
But he is, indeed, arguing that banks are dumb money (my words, not his).
And this isn’t a new conclusion for Lerner. A few years back, he found that banks also under-perform in terms of their LP commitments to private equity funds (all-inclusive). Banks’ mean IRR for PE investments at the time was -3.2%, compared to positive mean IRRs for endowments (20.5%), public pensions (7.6%), corporate pensions (5.1%) and insurance companies (5.5%). The only other “negative” group was advisors, and they still beat banks with a -1.8% mark.
Now there are obviously exceptions to the rule, and plenty of savvy bank-affiliated PE managers with strong performance. But, for the banking industry as a whole, one’s got to wonder if fighting Volcker or Basel III on private equity grounds is a smart financial decision. It may be wiser to let the regulators have their way…
*** You can download both Lerner studies here.
*** Permira seems to have caved on the Hugo Boss plant issue. It will stay open, pending a worker vote. More to come at www.peHUB.com shortly.
*** Have a great weekend…
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