Private Equity Law Review : New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

We recently discussed the FDIC's adoption of a final policy statement governing private equity investments in failed banks.  As we and other commentators have noted, the final policy continues to put private equity investors at a disadvantage when compared to strategic investors such as existing regulated bank institutions.  Most importantly, the policy imposes a substantially higher capital requirement for private equity firms (10% of Tier 1 capital vs. 5%) which must be maintained for at least 3 years.

The final policy statement reflects the FDIC's earnest desire not to turn over bank deposits -- that amazing funding source guaranteed by the full faith and credit of the United States -- to unschooled and possibly unscrupulous owners.  That mistake was made during the last banking crisis, and one thing that people in large bureaucracies learn well is not to repeat the mistakes of the recent past.  Accordingly, the FDIC must do what it can to ensure that the private capital which comes to the rescue of failed banks is provided this time by firms and management teams that respect the sanctity of bank deposits, and the FDIC's guarantee.

The policy statement is just that -- a statement of policy.  In many important areas, there are no detailed regulations, defined terms, or clear rules to guide deal making.  Sooner or later, any private equity firm looking at purchasing a troubled bank must contact the FDIC to get its opinion on the meaning of key provisions of the policy.  One may justly conclude that this is exactly what the FDIC wants to have happen.  By compelling firms to get critical interpretive clearance on key deal terms, the FDIC has the ability to screen firms and their management teams and sift the wheat from the chaff, so to speak.

The final policy statement is an important road map for well-regarded and experienced private equity firms to invest in troubled banks.  Other players, without deep experience and respected management teams to run the banks, may as well sit out this round.  Of course, things can change.  The crisis may escalate and the need for fresh capital may become acute.  Also, given the large number of troubled banks on the horizon, there may be opportunities to purchase the assets of institutions that must be liquidated because they fail to find buyers deemed worthy by the FDIC.

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The FDIC made some compromises, but will continue to hold private investors in failed banks to a higher standard than strategic buyers. The FDIC’s board approved a final policy on private equity investment in troubled financial institutions by a 4-1 vote; Director John Bowman stood alone in opposition to the measure. Even so, the FDIC expressed a commitment to review the policy in six months. The chair of the FDIC Board, Sheila Bair, said that the 61 private comment letters “gave us a lot to think about.” In today’s post, we’ll summarize public comments and the final rules for the policy’s capitalization, source of strength, and cross guarantee requirements.

Capitalization.   The majority of comments opposed the FDIC’s proposed rule that private equity investors maintain a 15% Tier 1 leverage ratio in failed banks. Some pointed out – as we did over a month ago – that the suggested ratio was three times that currently imposed on healthy banks. The heightened capitalization requirements, many argued, would place private equity investors at a competitive disadvantage to strategic buyers. Others predicted that private equity firms would be less likely to invest in failed banks and more likely to offer less competitive bids to the FDIC.       

Final Rule. Banks owned by private equity investors are required to maintain a 10% Tier 1 leverage ratio for the first three years. The FDIC reserves the right, however, to impose a higher leverage ratio on a particular investor if it determines that the situation warrants special treatment. After three years, private equity-owned banks must remain “well capitalized” (or maintain certain financial ratios specified in FDIC regulations). The FDIC justified the increased capital requirements as a necessary protection against the “higher risk profile” of private investments in troubled financial institutions.

Source of Strength. The controversial source of strength requirement would have required private equity funds to infuse ailing banks with additional capital. Comment letters overwhelmingly objected to this rule, claiming it could create unlimited liability for private investors. Even more to the point, a number of commentators observed that the rule would bar private equity firms from investing in failed banks altogether. By the terms of their organizational documents, private equity funds are prohibited from providing capital support to or making subsequent investments in their portfolio companies. 

Final Rule. It’s gone. The FDIC deleted the source of strength provision, noting that it would not be possible for private equity firms “as a practical matter.” (It’s not clear why the FDIC did not take practical matters into account when drafting its initial proposal.)    

Cross Guarantee. Commentators complained that the cross-guarantee requirement would place the other investments of private equity investors at risk. They emphasized that different funds – even those managed by the same private equity firm – have different investors and accordingly should be treated separately. Several commentators claimed the rule would impede a private equity manager from investing in two different banks through two different funds with two distinct groups of investors. As we wrote earlier, the rule would also inhibit club deals in failed banks.   

Final Rule. The FDIC raised the threshold for the cross guarantee rule to apply. Under the revised rule, if investors own 80% or more of two or more banks, the stock of the banks commonly owned by those investors must be pledged to the FDIC. If one of the banks fails, the FDIC may exercise its pledge to the extent necessary to recoup any losses it incurs. 

It looks like the FDIC will have a lot of inventory on hand in the coming months. Every week we witness more and more bank failures. The forecast doesn’t bode well either. According to the Financial Times, Dick Bove of Rochdale Securities predicts that another 150-200 banks will likely fail in the next several months. So far, the FDIC has not been able to get rid of all of the failed banks already on its books.  The New York Times reported that of the 77 banks that have failed this year, the FDIC has found buyers for only 69 of them.

We suspect the FDIC hasn’t gone far enough to make investments in failed banks attractive to private equity firms. If banks continue to fail, the FDIC will most likely have no choice but to open the market to as many potential buyers as possible. In six months’ time, it wouldn’t be surprising if we see the FDIC Board revisiting these issues once again.

Related Posts: 

Revised FDIC Policy Clears Way for Experienced PE Firms

Flawed FDIC Guidelines May Block Funding for Failed Banks

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The proposed guidelines published by the Federal Deposit Insurance Corporation for private equity investments in failed banks were in line with what was expected, though they did not fail to displease private equity firms. The guidelines require that investors maintain a 15% Tier 1 leverage ratio in the failed bank for three years. This compares with the 5% Tier 1 leverage ratio required for healthy banks.  The obligation to “maintain” this capital ratio means the private equity firm would have to ante up more capital if the numbers slip. And the fuse would be running – the guidelines say the sponsor must “immediately facilitate restoring” the capital.

The private equity sponsor must also act as a “source of strength” to the bank, suggesting they would have to inject additional capital if trouble arises. At a minimum this would require a commitment to raise new capital if necessary.

Also, there is a significant expansion in the cross guarantee requirement. Under the proposed guidelines, a sponsor would have to pledge its investment in each institution in which it “individually or collectively” has a majority interest to cover the FDIC against potential losses. The guidelines would sweep up each participant in a club deal, whether or not it owns a majority stake. For example, a firm that had a 10% club investments in 2 failed banks would somehow have to pledge its investment in both deals to the FDIC. That requirement alone will likely rule out club deals for failed banks. The requirement raises big practical concerns, as each participant in the club would have to cross pledge its interest in different banks to other club-owned banks, all to make the FDIC more secure.  

And there are other problems, such as the 3 year holding requirement. All in all, the guidelines are not friendly toward private equity sponsors, and will go a long way toward dissuading them from investing in failed banks. This may come under political fire, as the FDIC will sooner or later be pressed to support new capital for failed banks, if faced with the prospect of nationalization.

The FDIC’s approach is similar to the one adopted by federal regulators in Blackstone’s failed acquisition of Alliance Data System. That deal broke up when the Office of the Comptroller of the Currency insisted that Blackstone backstop the credit card unit of ADS, which Blackstone was not contractually obligated to do. The banking regulators do not seem to have learned their lesson from that – private equity may walk away again.

Related Posts:

Revised FDIC Policy Clears Way for Experienced PE Firms

FDIC Adopts Strict Rules for Private Equity Investment in Failed Banks

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