Private Equity Investments in Banking Institutions

The credit crisis that gripped U.S. and global markets and the subsequent recession have created fresh investment opportunities for private equity funds.  Traditionally, private equity funds were discouraged from investing in banking institutions by two primary factors: (1) high entity valuations dominated the banking industry, and (2) significant investments in banking institutions could trigger considerable regulatory burdens.  However, recently announced regulatory policy changes and significant declines in stock prices across the financial industry have combined to create a more attractive environment for private equity to invest in banking institutions.  Investments in failed banks will continue to be limited by strict Federal Deposit Insurance Corporation (“FDIC”) guidelines that are presently under review and may be relaxed to attract more private equity into failed bank transactions.

An Overview of Regulation of Investment in Banking Institutions

The Bank Holding Company Act imposes significant regulation and oversight by the Federal Reserve Board upon companies that control banks.  Companies that control banks are Bank Holding Companies and are subject to capital requirements, limitations on non-banking activities, restrictions on transactions with affiliate entities and other regulatory requirements.  For regulatory purposes, a company “controls” an entity if either (a) the company, directly or indirectly, owns or controls the power to vote 25 percent or more of any class of the entity’s voting stock; (b) the company has the ability to appoint a majority of the entity’s directors; or (c) the company has the ability to exercise a “controlling influence” over the management or policies of the entity.  Under the Bank Holding Company Act, the Federal Reserve retains significant discretion to determine what constitutes a “controlling influence” over a banking institution.

Recent Regulatory Policy Changes by the Federal Reserve Encourage Minority Investments by Private Equity Funds

In September 2008, the Federal Reserve relaxed many of its discretionary policy guidelines that it uses to determine what ownership thresholds, board representation levels and active conduct in a bank’s management constitute a “controlling interest.”  The new Federal Reserve policies encourage minority investment by private equity firms and principally include the following guidelines:

• A minority shareholder may own up to 33 percent of a bank’s or bank holding company’s total equity before the Federal Reserve presumes that the shareholder possesses a “controlling interest,” provided that the investor does not own or control the power to vote more than 15 percent of any class of voting securities.  The “25 percent ownership of any class of voting securities” threshold, as established by the Bank Holding Company Act, remains a bright-line test for control of a bank and bank holding company status.

• A minority shareholder may have at least one seat on the bank’s board of directors.  If the investor’s board representation is proportionate to its ownership interest in the bank, another shareholder is a bank holding company and a second board seat would not give the investor control of 25 percent or more of the board, the minority shareholder may have two seats on the bank’s board of directors.

• A minority shareholder may enter into business relationships or transactions with a bank or bank holding company on a case-by-case basis.  The Federal Reserve will focus on the size of the relationship or transaction, and whether the relationship is on market terms, is non-exclusive and may be terminated without penalty.

• A minority shareholder may communicate and consult with the board of the banking institution to influence the corporate policies of the bank or bank holding company in the same manner as any other shareholder.

• A minority shareholder may enter into a shareholders’ agreement that contains covenants prohibiting the issuance of senior securities or borrowings, consultation rights and information rights.  More extensive covenants (i.e. limitations on hiring practices, increases in compensation, additional capital raising or engaging in new business) may still be deemed to represent a controlling influence.

Structural Alternatives for Private Equity Investments in Banking Institutions

Several alternative transactions may permit a private equity fund to capitalize on the banking industry’s improved investment environment.  Assuming that no other investors are acting in concert, a private equity fund now may seek a minority investment position of up to 33 percent of a bank or bank holding company’s total equity.  If investors wish to act in concert to acquire up to 100 percent of the stock of a bank or bank holding company, these individuals may invest on a side-by-side basis with the private equity fund–so long as the investors do not vote in concert with the private equity fund and avoid exercising concerted control.  A private equity fund may always accept bank holding company status if it wishes to take a clearly controlling investment position in a bank, though the fund should avoid common control structures or economic linkages with any sister funds to prevent the Federal Reserve from considering the sister funds as bank holding companies.

A private equity fund syndicate comprised of WL Ross & Co, Carlyle Group and Blackstone Group LP recently completed a large equity investment in First Southern Bancorp ($450 million) under the Federal Reserve’s relaxed policy guidelines.  This investment indicates that regulatory authorities will work with private equity funds and their legal counsel on investment structures that are consistent with the funds’ investment intent.

The Office of Thrift Supervision (“OTS”) and its Relaxed Approach to Private Equity Investment in Savings and Loan Institutions

The OTS, as the primary regulator of federal saving associations (which includes both federal savings banks and federal savings and loans) has signaled that it will more liberally approve private equity investment in federal savings associations to maintain these instutions’ solvency.  For example, in January 2009, the OTS approved private equity firm MatlinPatterson Global Advisors’ $350 million investment in Flagstar Bancorp, the holding company of Flagstar Bank, a federally chartered stock savings bank.  Through its investment, MatlinPatterson purchased a 70 percent ownership of Flagstar Bancorp; however, the OTS did not require MatlinPatterson to register as a bank or a bank holding company.  Until the OTS modifies its approach as shown in the Flagstar Bancorp transaction, private equity funds may receive more favorable investment terms from the OTS than from the Federal Reserve.

FDIC Guidance on Investment in Failed Banks

Although the Federal Reserve’s relaxed policy guidelines encourage private equity investments in banks, and the OTS has taken a more lenient approach to private equity investments in banks, a recent release by the FDIC reveals that the FDIC intends to restrict private equity investment in failed banks.  Issued on July 2, 2009, the FDIC’s release proposes regulatory guidelines that would apply to private equity investments in failed depository institutions, including banks and bank holding companies, that are in receivership, conservatorship or similar proceedings.  If finalized as issued, the FDIC’s proposal would impose strict requirements on private equity investors in failed banks, is not likely to encourage future transactions and (if finalized and effective) would have governed and possibly hindered the large private equity investments in Washington Mutual ($5 billion) and BankUnited, FSB ($900 million) that occurred under the Federal Reserve’s relaxed policy guidelines.  For example, the FDIC would require private equity funds that invest in failed banks to:

• Provide detailed disclosures about the private equity fund, the fund’s investors and all entities in the fund’s ownership chain, including the size of the fund, its diversification, return profile, business plan and management;

• Meet raised bank capitalization requirements and be a “source of strength” for the bank;

• Prohibit all extensions of credit by the bank to the private equity fund, the fund’s affiliates, and any of the fund’s portfolio companies; and

• Agree to not sell or otherwise transfer the bank’s securities for three years following the private equity fund’s investment.

Private equity firms should approach investments in banking institutions aware of control issues and with the assistance of skilled and effective regulatory counsel.  Attorneys in Troutman Sanders’ Financial Institutions practice group and Private Equity and Venture Capital team have advised clients on control issues relating to minority investments in banking institutions and on structural issues relating to sophisticated private equity fund structures.  These attorneys are also tracking the FDIC’s proposal on investments in failed banks and will be well positioned to advise private clients on investment opportunities in both healthy and failed banks.  Please contact your Troutman Sanders representative for further information.