PE and the banking sector: a challenging marriage

Private equity firms have shown an increasing interest in the European banking sector in recent years, despite the challenges presented by a complex regulatory framework and critical conflicts of interest.

According to Unquote Data, 12 deals worth an aggregate value of €3.4bn were closed in the sector in the first 11 months of 2018 and 14 deals were inked in 2017 for a combined EV of €2.6bn. By way of comparison, the sector recorded only nine deals for a total of €358m in the whole of 2016 and seven worth €576m in 2015. In addition, several funds have been raised over the past couple of years with a focus on the sector, such as BlackFin Financial Services II, AnaCap Financial Partners III, Pollen Street Capital III and Corsair Financial Services V.

Janet Brooks, managing director at Monument Group, says: "We have seen a rise in the number of specialised funds dedicated to the financial sector, which is also linked to a more widespread trend towards specialisation of private equity firms in Europe, already visible in the healthcare and technology industries. In addition to these sector-focused players, an increasing amount of capital has also been raised by some of the largest pan-European funds, which have built up very experienced financial services teams within their own structures."

Several large buyouts were inked this year in the banking sector, including Bridgepoint's acquisition of a 60% stake in Estonian bank Luminor for around €1bn, Warburg Pincus's acquisition of Madrid-based Self Trade Bank, and the €1bn acquisition of Germany-based HSH NordBank by a consortium led by Cerberus Capital Management and JC Flowers.

"This is a rising trend that has emerged in recent years," says Filippo Annunziata, professor at Bocconi University and co-author of a Consob paper on the subject. "While it was inconceivable until a decade ago, it has now become increasingly frequent. Such transactions have raised new regulatory concerns because they involve two very different and complex regulations, the Alternative Investment Fund Managers Directive for closed-ended funds and the Capital Requirements Directive IV for the banking sector."

Secure and stable
In addition to the regulatory compliance challenges, private equity funds owning shares in the banking sector also presents risks surrounding the short-term investment horizons of private equity vehicles. Bank shareholders are expected to guarantee stable, long-term and healthy management, unrestrained by temporal limits and immune to potentially aggressive strategic moves.

"Private equity funds and banks are driven by a very different investment approach, which translates into diverse and often opposite asset and capital management strategies," says Annunziata. "While building its portfolio of companies, a private equity fund is already considering how to perform the best exit strategy to guarantee high returns to the fund's LPs. This logic can hardly be applied to the long-term investment perspective required by the capital structure of a bank."

This incongruity is particularly noticeable when the management of a bank requires the deployment of additional funds for growth capital and expansion operations. A private equity fund will typically be limited by the dimension and availability of its pool of assets and potential covenants.

Furthermore, the high levels of leverage often used by private equity funds in LBOs is an additional factor that can substantially affect the long-term stability of a bank, and presents cause for concern for regulators. This is particularly true should the sponsor use the vital resources of the bank to meet its debt obligations, deeply weakening the financial structure of the banking institution.

An increasing amount of capital has been raised by some of the largest pan-European funds, which have built up very experienced financial services teams within their own structures" - Janet Brooks, Monument Group

Despite these challenges, the entrance of a private equity firm in the shareholding of a bank can be beneficial and revitalise the capital structure of the company with valuable financing, while reducing the risk of a systemic default.

Says Monument's Brooks: "When single banking entities are owned by private equity firms and constitute only one standalone asset within a diversified portfolio, the fallout zone is much more contained, the possibility of knock-on situations is lower and there is less systemic risk."

Nevertheless, some risks might arise in the medium and long term, given that both sectors are highly leveraged and private equity firms have recently increased their focus on the management of private debt funds.

"Several private equity firms currently have more capital on their debt funds side than they manage on their equity funds side," says Brooks. "When they also become owners of large banking institutions, they end up having lending on both sides of their business, a dynamic that might develop into a challenging scenario, especially if interest rates start to rise."

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