UK: Banking: Private Equity’s Final Frontier?

Heightened activities in cross-border banking mergers is now signalling a new phase in European retail banking. Recent transactions such as the purchase of Abbey by Santander and of HvB by Unicredito are creating pan-European retail banks, a trend in consolidation that could create new mega-banks to challenge the likes of Bank of America and Citibank. There is another new element evolving – shareholder activism – which has played a key role in the ongoing ABN Amro process.

Could we potentially see a new force entering the banking M&A arena? Having invested heavily in most other industries, will the private equity community now turn its attention to banks?

Private equity could potentially access significant value from a variety of different targets including: banks with under-managed assets; banks where there is an opportunity to reduce significantly cost:income ratios through centralisation/ synergies; or where the bank is significantly overcapitalised. In all cases however the funds will be conscious of having a clear exit route a few years down the line from either a listing or a trade sale. In this sector, private equity firms have already bought specific portfolios, e.g. residential portfolios or a minority interest in banks, e.g. the JC Flowers-led club investment in HSH Nordbank.

Two key dynamics in the bidding process will be the regulatory environment and whether the value that private equity can deliver would outweigh the synergy available to a trade player.

Most banks are overcapitalised when considered against the regulatory minima, current research indicates that there is €74bn of excess capital in the European banking system. The reasons include the following: management may be highly prudent, the rating agencies may demand levels of capital well above the regulatory minima in order to attain the higher credit grades, or the regulator may have set the bank a target capital level in excess of the minimum.

Initial indications are that the Basel II requirements would, in many cases, result in a lower capital requirement. Whilst it is considered unlikely that the regulator would permit a fund to release capital from a bank, it is conceivable that an increase in assets without increasing capital might be permitted.

Whilst the major banks currently in play are arguably much too large for a PE fund to swallow at present, shareholder activism is emerging as one means by which a fund could extract value, and funds might be able to afford smaller players or banks in emerging markets.

A key barrier to a private equity deal is the extent to which leverage might be permitted as part of transaction and, as yet, the precedents here are few.

Regulators may also require undertakings from the equity funds regarding further capital injections in the event of, for example, severe unexpected losses and a need for higher provisioning.

Most funds operate with capital structures that would make this prohibitive though we understand that there are no specific obligations on the regulator to require this.

Another factor that may deter equity funds is that regulators could require the funds’ investors to be made known to the regulators as there is a tradition for regulators to assess when the owners are "fit and proper".

With increased competition in the market, the risk appetite of funds is shifting and as such funds may be prepared to flex their established gearing structures if they can attain suitable returns without relying on it. If necessary, forming club deals in order to acquire the best assets could be an attractive option.

The stress-testing undertaken as part of a bank’s compliance with Basel II has typically improved the risk management and the visibility of the risk to the capital base. With a robust process in place it would be possible to gain sufficient comfort on further capital injections as part of a fund’s due diligence.

As for the need to convince the regulators of the change of ownership, any observations are speculative: regulators may possibly be less nervous of the acquisition of a wholesale bank (such as the Landesbanken in Germany), rather than high street retail banks as this would result in less direct risk to depositors. But they would also look at the overall impact on financial stability.

In summary, there are many practical issues to be addressed for a fund to buy a bank. However, as other industries become increasingly well invested by private equity, it is possible that financial services will become appealing, if investors conclude that the hurdles to investment serve to limit competition and keep entry prices reasonable. The real questions may be not if, but when private equity invests, and whether those first entering the market will achieve first mover advantage or find themselves on the edge.

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