A Missed Opportunity for Private Equity

It seems like the perfect fit. The U.S. banking industry, which desperately needs fresh capital, hooks up with private equity investors who are hungry for deals. But the reality has been quite different, and disappointing. While there have been some large transactions, private equity investors have played an insignificant role in the banking industry’s recapitalization. John M. Eggemeyer, managing principal at Castle Creek Capital-a Rancho Santa Fe, California private equity firm that has invested in community banks since 1992-explains why there have been so few deals, and what his firm looks for in investments.

BD: Has there been a missed opportunity for private equity firms to play an important role in recapitalizing the banking industry?

EGGEMEYER: I think that there was a lot of private equity money that wanted to find its way into the recapitalization of the banking industry. Many of those investors have become frustrated, and are now shifting their focus. Some of that money has gone back to original investors, while a number of other large investor groups are now looking at Europe and other economies outside of the U.S. This shift has been driven by their inability to find attractive opportunities here.

BD: Why has it been hard for PE firms to find deals, given the industry’s need for capital?

EGGEMEYER: There are several issues here. Clearly there is a regulatory concern about private equity investment in the banking industry. I think that this concern is based upon a traditional view of private equity, which is to say an equity investment that is compounded by the aggressive use of leverage followed by a rapid transformation of assets with the purpose of front loading returns. The concern is that in so doing the original company is dangerously weakened rather than strengthened. I think that is a fair concern about how large traditional private equity firms may initially look at a potential investment. Fortunately, that has not been the case to date with the large private equity investors in the community bank space.

BD: Based on your experience, how would you characterize the Federal Reserve’s views on private equity capital and investors?

EGGEMEYER: My perception is that the Federal Reserve is deathly afraid of private equity investors. I believe that the fear is that private equity investors will somehow find a way to circumvent their oversight and end up exerting significantly more control over a bank than current regulations permit.

BD: What does Castle Creek look for when it looks for banks to invest in?

EGGEMEYER: We look first and foremost for management. The biggest challenge in banking is finding management with the experience and knowledge that is consistent with the difficult environment that we have today. Secondly, we believe that banks are a product of their economies, whether those are local, regional or national, and as a consequence, we look very hard at the underlying economies of the banks that we are investing in.

BD: Are there certain types of situations that you try to avoid?

EGGEMEYER: Given the limited role that regulators will allow private equity to play in the management of a bank, it is critical to ensure that we as investors are in complete agreement with management and their board about the future plans for the organization before making an investment. We can seek to mentor management, we can try to influence management’s attitude about risk, but at the end of the day, we are but a single voice on a board of directors with limited ability to exercise our basic rights as shareholders.

BD: Someone whose opinion about private equity was formed 22 years ago when they read the best-selling book “Barbarians at the Gate” would probably have a pretty profound misconception of how it actually works today in banking.

EGGEMEYER: That is the stereotype that continues to dog private equity investors as they seek to invest in the banking industry. The fundamental difference between the hostile takeover of RJR Nabisco and private equity investing in banks has to do with regulatory constraints on ownership and the limitations on the governance of the business. In “Barbarians,” the investor group, led by Kohlberg Kravis Roberts & Co., owned 100 percent of a less regulated company and, as such, were able to do what they wanted with it. In the banking industry, there are strict limitations on the amount of voting stock that any individual investor can own without becoming a bank holding company, and there are significant restrictions on the actions that we are allowed to take post-investment based upon passivity commitments that we are required to sign with the Federal Reserve prior to investment. So “Barbarians at the Gate” is a poor model for people thinking about the role of private equity in the banking industry.