Are You Ready For Private Equity?

Like many Southeastern lenders during the Great Recession, United Community Banks Inc., in Blairsville, Georgia, got caught with too many bad residential construction loans on its books. After nine consecutive quarters of losses, the $7.4-billion-asset company’s board was operating under a memorandum of understanding from regulators, with orders to bolster its balance sheet. It also had visions of clearing the books with a bulk sale of bad loans and perhaps even taking advantage of the turmoil to acquire some of its teetering rivals.

To move forward, United Community required capital. But its share price was so depressed-hovering just below $2, versus more than $33 four years ago-directors feared that pumping additional shares into the market via a secondary offering would dampen the already tepid appetite investors had for the stock. That could damage valuations further, they reckoned, and leave the company vulnerable to a takeover-or worse, failure.

So United Community’s board did what a growing number of capital-strapped community bank boards have concluded is their last, best hope to survive and remain independent: Swallow hard and jump into bed with private equity. In March, after much soul searching, directors agreed to exchange 22.5 percent of the company for a $380 million capital infusion.

The deal with New York-based Corsair Capital LLC, a big-money private-equity firm that flits around the globe recapitalizing distressed financial institutions, was painful in some ways for the board to accept. But the capital should ensure that United Community emerges from the crisis in strong enough financial shape to play the role of consolidator in its region and grow.

“We obviously felt anxiety about a lot of the components (of the deal). It’s terribly dilutive to our legacy shareholders,” says Jimmy Tallent, 55, United Community’s chief executive officer and a director. “But we decided this capital was the best way to fast-forward and start playing some offense.”

United Community is far from the only bank turning to private equity to help combat-and sometimes also to capitalize on-the effects of the financial crisis. From the beginning of 2007 through the first quarter of this year, PE firms invested more than $33 billion in 149 banks, according to Pitchbook Data, a Seattle firm that tracks PE investments across all industries. Today, more than 100 private equity firms-or companies backed by PE money-are actively kicking tires in the industry, estimates Jim Gallagher, managing director of financial sponsors coverage for Keefe Bruyette & Woods in New York. They range from the multi-industry giants of private equity, such as TPG Capital in Ft. Worth, Texas, Sequoia Capital in Menlo Park, California, and Greenwich, Connecticut-based General Atlantic, on the hunt for megadeals, to smaller firms, such as Hovde Private Equity Advisors LLC in Washington, D.C., and Philadelphia-based Patriot Financial Partners L.P., which write checks almost solely for community banks. In between are all sorts of other players that have been attracted by the scent of potentially big returns.

“Every time there’s a blip like this in the market, there’s an opportunity for private equity to provide capital-either to a healthy company that’s positioned to take advantage of the dislocation or to help fix the balance sheet of a company that’s experienced some illness,” says Richard Thornburgh, Corsair’s vice chairman.

“If, as an investor, you can buy in at tangible book value or below, and banks historically trade at 1.5-to-2.25 times book,” Thornburgh adds, “that’s an attractive environment.”

That the United Community deal occurred at all illustrates how rapidly PE’s role in the industry has evolved over the past four years. At first glance, the two are unlikely bedfellows. Banking is about dividends, slow-but-steady growth, long-term relationships and regulation. Private equity investors want to buy controlling stakes in companies on the cheap, engineer fast turnarounds and exit quickly at a profit. Regulation is not something most private equity investors relish.

“There’s an inherent mismatch in goals … and time horizons,” says Ken Thomas, a bank consultant in Miami. “I don’t think the PE model is appropriate for the commercial banking industry.”

A growing number of PE firms, as well as banks, clearly disagree. Money is a powerful incentive, and the industry’s credit-quality-driven need for capital, and historically low valuations, have led the two sides to overcome their misgivings and work together.

PE’s first major forays during the crisis came in 2008, when big PE-backed consortiums pumped $7 billion each into teetering giants Washington Mutual Inc. of Seattle and Cleveland-based National City Corp., both of which were battered by the mortgage crisis but appeared to have good recovery prospects.

The outcomes proved that PE is far from infallible. Within months, Nat City was forced to sell at a steep discount to PNC Financial Services Group in Pittsburgh, while WaMu turned into the biggest bank failure in U.S. history, resulting in a $1.35 billion loss for its lead investor, TPG Capital. JPMorgan Chase & Co. in New York acquired WaMu’s remains from the Federal Deposit Insurance Corp.

As banks began to stumble, attention shifted to failed-bank transactions, with PE firms hoping to leverage FDIC loss-share agreements to generate outsized profits. Perhaps the highest-profile PE-backed deal of the crisis occurred in May 2009, when a consortium of big-name PE firms led by John Kanas, former CEO of North Fork Bancorp, pumped $900 million into the failed BankUnited FSB of Coral Gables, Florida. The FDIC-assisted deal included loss-share guarantees on $10.7 billion of assets, and was coated with a $3 billion negative asset bid-cash paid by the agency to the ‘buyers’ to cover additional losses-that ensured the group would make money. The agency expects the deal to cost the Deposit Insurance Fund $5.7 billion, but Kanas’ investors-including the Washington, D.C.-based Carlyle Group, the Blackstone Group in New York and billionaire Wilbur Ross’ New York-based W.L. Ross & Co.-struck it rich when BankUnited raised $786 million in a January IPO that valued the company at $2.6 billion. The investors still own about 70 percent of BankUnited. “Frankly, I was a little uncertain about how it would work. I had never been partners with (private equity) before,” Kanas says. “But I’ve found them to be the perfect complementary partners.”

Big loss-share agreements have mostly disappeared amid greater competition for failed-bank assets, making direct PE-backed deals less common. Investments in larger banks also are waning, as bank balance sheets recover enough for managements to attract capital in more traditional ways.

In the first quarter, Cincinnati-based Fifth Third Bancorp, SunTrust Banks in Atlanta and KeyCorp in Cleveland all launched successful public offerings of common stock, and some larger acquirers also are feeling confident enough to shop for deals. Bank acquirers can almost always outbid PE players because they can leverage internal cost saves to get higher returns.

Today, most of the PE action lies on the smaller-bank recapitalization front. In some cases, the investments amount to survival capital; in others, they are earmarked for offensive purposes. Often, a combination of both dynamics is at play.

“There’s going to be a huge capital need in the community bank space over the next few years that can’t be filled by $100 million checks,” says Patriot Managing Partner J. Kirk Wycoff. “It needs to be done in chunks of $10 million or $20 million,” which often doesn’t appeal to large funds.

The arena’s most active investor in terms of deal volume, Patriot has invested about $200 million of its $300 million fund in 13 banks since the start of the crisis-most of them in the $1 billion to $3 billion-asset size range. Wycoff estimates his firm looks at about 25 banks per quarter, most of which face deeper loan troubles than he wants to take on.

The ones that make the cut often look like Heritage Commerce Corp., a $1.2-billion-asset commercial lender in San Jose, California, that got into some commercial real estate lending trouble. It used a Patriot-led $75 million capital injection to clean up nonperformers and position itself to “play some offense while their competitors are still handicapped,” Wycoff explains.

Patriot, which directly owns 9.89 percent of Heritage Commerce, holds similar ownership stakes in banks ranging in size from $2-billion-asset Guaranty Bancorp in Denver to Florida Business BancGroup, a $500-million-asset lender in Tampa-and is on the hunt for more.

“These are good banks in good markets that see an opportunity to merge with a competitor down the street or buy a (failed) bank,” Wycoff says. “If they don’t take the money now-even if it’s a little dilutive-they’ll miss that opportunity. So they come to us.”

Whether private equity’s elevated interest is good news for banks is open to debate. On the surface, it seems like a no-brainer: Banks need capital to bolster loss-battered balance sheets, meet stiffer regulatory capital requirements or pay off TARP funds. Some want to take advantage of expansion opportunities.

Regardless of its motivations, PE has been there when more traditional forms have been absent. “The industry needs capital anyway it can get it,” says Ralph “Chip” McDonald III, a securities law partner at Jones Day in Atlanta. “For many banks-especially those that lack an active public following-private equity is often the best, if not only, solution.”

Beyond the money, PE firms often bring a little something extra to the party: Merger-and-acquisition prowess, mortgage servicing efficiencies or simply the wisdom of experienced bankers who have been through previous tough cycles or hold other investments, and understand what it takes to succeed.

A chief reason United Community’s board chose to work with Corsair was because the investor has experience with distressed-asset sales. “We’re going to bulk sale performing and non-performing loans to get our metrics back to a respectable level, and they should be able to help,” Tallent says.

Last November, FirstAtlantic Bank, a $209-million-asset thrift in Jacksonville, Florida, accepted $11 million from Hovde. CEO Mitch Hunt, Jr., says Hovde-an offshoot of the Chicago-area investment bank-has offered timely insights as its supervision shifts from the Office of Thrift Supervision, which was phased out of existence by the Dodd-Frank Act, to the Comptroller of the Currency. “When we have questions about what the next exam might look like, they can tell us,” Hunt says. “They provide us with an industry perspective we didn’t have before.”

Heritage Commerce got two new board members with the Patriot-led investment: Wycoff and John Eggemeyer III, head of Castle Creek Capital, a Rancho Santa Fe, California-based private equity firm that has invested in banks for nearly two decades, and took a 4.89 percent stake in Heritage Commerce.

“It was a double-bonus,” says Jack Conner, Heritage Commerce’s non-executive chairman. “We raised the capital and we added a couple of board members who have a much broader perspective on the banking market than we have locally.

“There have been times when they’ve said, ‘Bank X tried that, and it didn’t work very well. Try this instead,’” Conner, 71, adds. “They’ve seen banks that are further down the road to recovery, and can offer really valuable advice.” Money plus sage counsel sounds like a winning formula. Even so, not everyone is sold. Some worry that the industry has too much capacity now; injecting PE money in banks that otherwise might go under could lead to an artificial glut of competitors and lower margins for the industry as a whole.

“Everyone (who gets PE money) says they are chasing commercial business, and everyone says they’re going to buy banks,” KBW’s Gallagher says. “I don’t know if there’s enough of either of those things out there” to justify the investments.

Most bankers that have taken private-equity money say they have heard plenty of howls from existing shareholders over pricing and dilution. They find themselves trying to explain how the capital is needed to strengthen the balance sheet and execute a new strategy that could someday make the bottom line sing.

FirstAtlantic’s capital raise, at a discount to the price original investors paid four years ago, raised some investors’ eyebrows. “The question was, ‘If I got in at $10, and they’re getting in at $7.75, am I not being diluted?’” Hunt recalls.

Hunt would note that the investment was valued at 101 percent of the company’s present tangible book value. “When you look at it, your $10 isn’t really worth $10 today,” he says. “We have to earn that back.”

At Heritage Commerce, which sold shares to the Patriot-led group for $3.75 each (they once sold for about $27), Conner’s response was more direct: “I know you’re diluted substantially by this, but how do you feel about going forward without more capital? Do you want to risk the whole bank and not suffer dilution?”

Financially, the trade-off for the money and guidance is that PE wants its returns. Most state plainly that they’re looking for annual returns of at least 20 percent at a time when earnings and revenue-growth are under severe pressure.

As those investments ripen, don’t be surprised, observers say, to see confrontations between PE firms and their investee bank boards. Some boards could be forced to slash expenses more than they want. Others could feel pressure to sell ahead of schedule, to meet an exit timetable.

“If you’re a PE firm that’s done a deal with a bank that doesn’t have a large market capitalization, how do you get out?” Thornburgh asks. “You need to make the market cap larger, and that usually means consolidation.”

The PE players acknowledge their profit and exit expectations are aggressive, but also say they are taking risks no one else is willing to take, and deserve to set some of the terms.

Those that haven’t traditionally focused on banks have brought on former commercial bank executives to manage their bank investments. Former Wachovia Corp. Chairman and CEO Ken Thompson, for instance, is a senior adviser at New York-based Aquiline Capital Partners LLC, which in 2010 invested $35 million for a 9.9 percent stake in $2.1-billion-asset BNC Bancorp of High Point, North Carolina. He now sits on BNC’s board.

Private equity also has adapted to regulations around control. Under Federal Reserve rules, PE investors that own more than 9.9 percent of a bank must sign passivity agreements that limit them to one board seat and prohibit efforts to “influence” how the company is run more than any other investor. They cannot own more than 24.9 percent of an institution without being classified as a bank or thrift holding company, with all the oversight and cross-industry ownership limits that implies.

“They have gone through a learning process, and given up some of the things they typically get from industrial companies,” McDonald says. Boards that consider going the private-equity route must step carefully, and be realistic about their own situations and the implications of the investment on both the business and existing shareholders.

The key, say those who have been there before, is to find the right partner-one that shares the board’s vision and goals for the institution, and can bring the expertise and insight needed to help execute the bank’s strategy.

In most cases, it’s a long journey-one that requires plenty of diligence on the front end, and the patience to endure regulatory scrutiny on the back. Boards can avoid some hangups by keeping primary regulators apprised of capital-raising plans and progress, and seeking their input where appropriate.

To protect themselves legally, smart boards hire outside legal and investment banking advisers. “You want to create a process that is coherent and workable, and you want to document what you’ve done in that process,” McDonald explains.

That process usually starts with an assessment of the bank’s broader strategic options: What are the bank’s present condition and future prospects? Would it be better off selling? Does it need to strengthen the balance sheet to confront credit-quality issues? Does it need a strategy shift?

Some banks might not need additional capital, in which case it would be silly to dilute shareholders. But even strong banks are concluding that now is the time to play offense-in terms of acquisitions and organic growth-and that often requires additional capital.

The public markets are the typical first starting point. But many banks don’t like their valuations right now, while others simply don’t have the oomph with public-market investors to get the job done. And that leads them to private equity.

FirstAtlantic was launched in the summer of 2007 as a play on the Florida mortgage market by a group of former executives from SouthTrust Corp., a $53-billion-asset company in Birmingham, Alabama, that was sold to Wachovia for $14.3 billion in 2004.

The real estate market began to crash almost immediately, which was bad news for a company bent on loan growth. But arriving late to the party helped keep the $209-million-asset bank’s asset quality and capital levels better than many peers.

At a 2009 strategic retreat, the board decided to tilt the business model more toward small-business lending. It also saw an opportunity to get bigger by acquiring some troubled rivals.

“We had excellent credit quality, excess capital and a management team that had experience running a much larger operation,” Hunt says. “We were in a perfect position to be a consolidator, but to maximize that opportunity, we needed more capital.”

The board considered a rights offering, but was scared off by the potential costs and hassles of adding more shareholders. Directors eventually concluded it was “more beneficial to remain a private company, and not be subjected to the expenses of (Securities and Exchange Commission) registration,” Hunt says.

Directors interviewed several PE firms, and encountered a variety of visions that didn’t fit the board’s plan.

Hovde had the money and liked what FirstAtlantic had in mind. It also had a longer exit timeline-seven years-than the other investors. To satisfy themselves further, Thomas Coley, a director and former SouthTrust vice chairman, met face-to-face with Eric Hovde, the parent company’s CEO.

“It was, ‘Strategically, are we headed in the same direction? Style-wise, would we be compatible with each other?” Hunt explains. “We had a good story to tell, and there was some comfort in the boardroom that we had an investor who didn’t want to change it.”

For all that, FirstAtlantic endured more scrutiny than it gave, which is par for the course. Before Patriot invested in Heritage Commerce, it sent a five-person team in to dissect every facet of the business. “We interviewed management, looked at the troubled loans, visited locations, did a tax analysis,” Wycoff explains, calling the process “exhaustive.”

It requires both work and humility for a board to get a deal done with private equity, but United Community’s Tallent says the effort was worth it. While “it would have been easier” to do a public offering, he says, getting the money from one source, at a predetermined price-and gaining some know-how in the process-made PE a better fit.

“We needed capital, and we needed investors who could understand what we were trying to do,” Tallent says, adding that most of the company’s investors are institutions to begin with. “In the end, I don’t know that private equity is much different from those guys.” |BD|

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