Chrysler Meets its New Daddy. Is Your Bank Next?

Question: What do Chrysler, RJR Nabisco, Clear Channel Communications, Harrah’s Entertainment and Hertz all have in common?
Answer: These companies represent some of the largest private equity deals that have transpired in the United States.

Private equity is a hot topic these days. One can hardly open the Journal without coming across headlines screaming of a new, mega-deal involving some PE firm taking a company private so that it can sell or take that same company public again in three years. And the deals are getting mongo BIG. In the decade between 1990 and 2000 there were only 10 private equity deals requiring more than $500 million in fund equity. Since 2000, there have been an astounding 47! In the first quarter of 2007 there were over $100 billion of leveraged buyout transactions in the United States, and the frenetic pace of deals shows no sign of abating, even though industry pundits say the overheated market is due for a necessary icing. Barclays Capital estimates that buyout shops have about $160 billion to spend in the United States alone, which translates into about $750 billion of deals this year.

PE firms have been around for decades, known by various monikers such as merchant capital and leveraged-buyout (LBO) firms. Traditional PE targets have included companies in manufacturing, retail, technology, transportation and communications. Despite the recent flurry of PE activity, Gonzo readers have been able to sleep at night because they haven’t seen a lot of headlines in the Journal announcing the buyout of U.S. banks by PE firms. It has happened – Goldbanc of Kansas was acquired by Silver Acquisition Corp. in 2004 – but the event is a rarity.

Even though private equity has avoided banks, they are starting to nose a lot closer to the banking “space” by acquiring the technology companies that service them. Over the past several months we’ve seen a spate of headline deals: Kohlberg Kravis Roberts purchase of First Data Corp. for $29 billion; Carlyle Group and Providence Equity Partners acquiring Open Solutions for $1.4 billion; and Warburg Pincus announcing a $625 million investment for a 25% stake in Metavante, to name a few.

What has held back the PE firms from setting their sights on the companies that employ our faithful Gonzo readers? A few things in my estimation:

1. The bank regulatory environment is burdensome, complex and adds an incremental layer of expense not found in most other industries. PE firms are notoriously private, and providing all of that detailed financial information to government regulators has never been appealing. On the flip side, regulators are likely to be leery of letting a buyout firm make a leveraged purchase of a bank.
2. Banks are highly leveraged. Many PE firms focus on leveraged buyouts, consummating deals with debt to equity ratios of 70% and higher. Banks, by their nature, are already highly leveraged vehicles, making them less attractive to PE firms.
3. It’s a matter of comfort. PE firms are familiar with cash flow analysis, balance sheet management and selling a widget at a certain margin. The world of interest rate risk, credit risk and variable loan pricing is, for the most part, foreign to PE firms. Closely tied to this “comfort” concept is the complexity of bank ownership and the distinct possibility that in the event of a bank failure, depositors would likely go after the fund itself to be made whole.

The million, or should I say billion, dollar question is, “Will these factors continue to keep PE firms from doing a deal in the banking space?” If I were a bettin’ man, I’d have to say no. In no particular order, here are some of the factors I believe may start to keep some of our bank execs up at night wondering whether their institution may become the target of these voracious deal makers.

• Regulators, Schmegulators. Sure, the bank regulatory environment is a real pain in the you know what, but if Cerebrus Capital (Chrysler’s potential new owner) is ready to take on the UAW, I can’t imagine some of the big egos at the PE firms being too afraid of a regulator in a short-sleeved dress shirt and clip on tie from the OCC. The recent acquisition of Sallie Mae, which maneuvers in a heavily regulated industry (with the recent student lending scandals, some might argue not heavily enough) by two PE firms and two banks shows that the sharks are circling. Moreover, Sallie Mae was highly leveraged, with debt at 25 times equity and a low equity-to-assets ratio. The “leverage” factor may not be as daunting as we’d have all thunk.
• What are we going to do with all this money? Industry analysts estimate that since January 1, 2002, PE firms worldwide (the vast majority of which are in the U.S.) have raised over $800 billion of total private equity capital. In my humble opinion, there’s just too much money to be put to work to keep an entire, very profitable industry like banking “off the table” for private equity. Even risk averse China, whose insatiable appetite for U.S. treasuries may be getting sated, is realizing it needs to put its enormous reserves to work. Its first move – a $3 billion stake in Blackstone, the second largest PE firm in the United States with nearly $90 billion under management. Can you see “First National Bank of Guangzhou” in downtown Topeka?
• Being “public” just ain’t what it used to be. Warren Hellman, the San Francisco financier of Hellman & Friedman, one of the very first PE firms, in a recent interview made an interesting observation. “In the old days you looked at a private company and asked what discount we could get it at relative to a public company. A fundamental change now is how much of a premium is paid to the public market price. Now almost everything you look at is public-to-private transactions. Thank you, Mr. Sarbanes and Mr. Oxley, for doing us [PE firms] a tremendous favor.”

  In an ironic twist of fate, the stringent SOX regulations handed down by Congress meant to protect us little folk may be the very catalyst for banks to seek out PE firms to go “private” and avoid all of the cost, headaches and complexity of SOX compliance.

• Let’s go, go, grow. In this attention deficit/Fast Times at Ridgemont High business world we live in, we’ve got to grow and we need to do it fast. Organic growth is nice, but your typical stock analyst isn’t as enthralled as he used to be watching you move your products per customer from 3.14 to 3.24 over the course of 12 months. PE firms have successfully executed “roll ups” in numerous other industries, so why not banking? Iowa, a state with 3 million residents (2.25 million of which are over 18 and would most likely use a bank), has, according to the FDIC Web site, 398 banking institutions, the largest of which is under $2 billion in assets. These sorts of numbers cry out for consolidation. Does Iowa really need one bank for every 5,653 residents?

  You may agree that Iowa doesn’t need that many banks, but argue that the super regionals like BofA, Chase, Citi and others are already executing a “roll up” model, so why should the PE firms get in on the action? Two reasons – these big guys are too slow and too easily distracted. There are 8,672 banking institutions in the United States. The sheer size of a BofA or Citi dictates that the bank acquisitions they target have to be huge to make any difference in their numbers – probably about 50 banks in the U.S. worth looking at. That leaves 8,622 institutions that PE firms can target. Moreover, the super regionals get easily distracted with non-bank acquisitions, like brokerage, investment banking, insurance and wealth management firms. That means ripe pickin’s for a PE firm that wants to roll up 20 or 30 banks in Iowa.

• So how do we pay for this consolidation? In a leveraged industry, how will a PE firm execute its rollup model? One idea that comes to mind plays upon the thing PE firms do best right now – getting rid of all those pesky public shareholders by taking a company private. What do banks pay public shareholders? You got it – dividends – and very generous ones at that. In the first quarter of 2007 three banks (First Citizens Banc Corp., New York Community Bancorp, and First Commonwealth) actually paid out dividends in excess of their earnings with dividend payout ratios ranging from 113% to 121%. Many public banks are in that 50% dividend payout ratio range.

  KeyCorp is often cited as one of those banks with scale that would be potentially attractive to PE firms. If KeyCorp were taken private tomorrow by a PE firm, the firm would immediately stop the half a billion dollars KeyCorp paid out last year in dividends. Combine that with the other half billion of earnings and you’re talking about some serious money that could fund an acquisition or two.

With banks throughout the country being squeezed by an inverted yield curve, desperately searching for low cost deposits, one could reasonably argue that this might be an ideal time for a PE firm to have a run at a bank. I won’t be so bold as to predict that a bank buying spree will start tomorrow, but if this private equity bubble doesn’t burst in the next 12 months, don’t be surprised if you do see that headline in the Journal announcing that the bank two towns over was acquired along with five others in your state. That will definitely keep you up at night wondering who your new daddy might be.
-sas

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