US private equity breaks into banks

[Sapphire Capital]

US private equity breaks into banks

source: Nicholas Pettifer, IFLR

Private equity houses will follow JC Flowers' lead after it found a way to bypass legislation to invest in distressed banks.

The Bank Holding Company Act states that investors of over 24.9% in a US bank must register as a bank holding company, which comes with its own restrictions. One is that bank holding companies cannot own more than 5% of any company outside of the financial services sector – an obvious problem for diversified private equity funds.

It has been reported that JC Flowers' chairman Christopher Flowers has set up an independent fund in his own name to get around the regulation. This is the first move from an industry that has been planning ways to invest in struggling banks for months.

"There was a time when the private equity community was lobbying for a change in the law, but this was unrealistic," said an M&A partner at a US firm. "So over the course of the year it has been talking quite aggressively to the Federal Reserve Board about new kinds of structures."

Although the structure of the JC Flowers fund is confidential, it seems the key is to set up a new entity that is a sacrificial bank holding company – its sole purpose is to invest in the chosen bank.

But the 25% rule applies to this holding company, and indeed any company that invests in it, too. So the ownership of the sacrificial company must be structured so that means no investor has an impermissible stake in it. In a simplified example, five investors in the sacrificial company could each hold 20% and thereby stop the 25% rule from applying to them as well.

This can be done by spreading the stakes in the sacrificial company across a club of private equity houses or across a number of limited partners from the same house. The former is easier to structure, but may prove less popular as the profits are diluted across many funds.

The latter requires more structuring:

"Under this option, the general partner of the private equity house still owns 100% of the voting power, so would have to register as a bank holding company. This isn't ideal as private equity houses like to use the same general partner for all its funds," said the partner.

"One solution is to create a brand-new special-purpose general partner who registers as another sacrificial bank holding company."

To add further complexity, there is another threshold that funds may want to consider. At 25% there is a legal presumption that the investor controls the bank and therefore must register as a bank holding company. At 10%, there is a rebuttable presumption:

"Different people have different risk profiles on the 10% rule, but the most popular approach is to go to the Federal Reserve Board and get them to bless it. Not because you need their approval, but because you don't want them to challenge you later on," said the partner.

Private equity funds may therefore want to consider complicating their structures further by catering for the 10% rule.

"When you get down to the weeds of solving this problem [with private equity investing in banks], solutions vary based upon the business objectives and the internal structure of the investor," said the partner. "Some are easier to solve than others."