In This Issue
By Gordon M. Bava and William T. Quicksilver
In December 2003, Jae Whan Yoo, Chief Executive Officer of Hanmi Financial Corporation, a $1.7 billion Los Angeles-based bank holding company, faced a dilemma. A major rival, Pacific Union Bank, a $1.0 billion Los Angeles-based bank, was on the market for sale. But, Mr. Yoo needed to secure commitments for at least $135 million of Tier 1 qualifying capital, or he was likely to lose to another competitor. With assistance from Castle Creek Financial LLC, Hanmi secured commitments in 10 days for $75 million of common stock and $60 million of trust-preferred securities from a relatively small number of institutional equity sources. The $312 million merger ($164.5 million in cash with the balance in Hanmi common stock) closed on April 30, 2004. Mr. Yoo likely would not have succeeded in acquiring Pacific Union Bank without the participation of the private equity market. Hanmi's success underscores the growing importance and potential of the private equity market for middle-market bank transactions.
The Private Equity Market
The financial press regularly reports the activities of private equity funds. While references are numerous, the category is ill-defined, referring to buyout, venture, hedge, and investment funds, as well as wealthy individuals and family funds. The typical private equity fund is an unregistered private investment partnership that invests and trades in different securities markets, instruments and opportunities. They are not subject to the same regulatory requirements as mutual funds, or, to date, any other regulation. Private equity funds sponsor acquisitions of public and private businesses and have made leveraged buyouts a commonplace feature of the acquisitions landscape. These funds also play a vital and widely recognized role in the venture capital area, providing capital, management, financial and operating expertise to early stage companies.
The private equity market's size is difficult to assess precisely. It is estimated that at least $88 billion of new private equity was raised globally in 2002, compared to $164 billion in 2001 and $250 billion in 2000. Buyout funds alone, had over $90 billion to invest at 2003's year end . These estimates do not include the billions of dollars available in hedge funds, which also invest in new capital issuances, such as convertible debt or equity securities.
Private Equity in the Banking Industry
Private equity has invested in the banking industry for many years. Private equity funds are regularly listed among institutional holders of publicly traded banking companies. Private equity funds have frequently purchased qualifying Tier 1 capital trust preferred securities for their attractive yields.
A myriad of legal restrictions and operational preferences of the private equity funds prevent private equity funds from acquiring controlling interests in U.S. banks. One major obstacle is the separation of banking and commerce long embedded in our banking laws. For example, Section 4 of the Bank Holding Company Act of 1956 generally restricts the activities of bank holding companies to managing or controlling banks. The typical private equity fund's activities – investing, owning and operating commercial companies – would disqualify it from becoming a bank holding company. Alternatively, a private equity fund could sell its non-financial investments in order to qualify as a bank holding company – an unwelcome prospect for most funds. Ironically, Pacific Union Bank would not have been sold except for the fact that its controlling shareholder, Korea Exchange Bank, Korea's sixth largest lender and a U.S.-registered bank holding company, sold a 51% controlling equity stake to Loan Star Fund IV, LP, a U.S. private equity fund. To avoid becoming subject to regulation as a U.S. bank holding company, Loan Star caused KEB to deposit its 62% ownership interest in Pacific Union Bank with a trustee charged with selling it as soon as possible.
In addition to ownership restrictions, private equity funds must commit to remain passive and not exercise a controlling influence over the management or policies of the banking company, a limitation that is antithetical to the typical hands-on approach of many funds.
A second barrier is the stringent bank regulatory capital requirements that makes impossible the conventional private equity buyout model – equity leveraged with debt to achieve the 25%-30% annual target returns typically required by investors in private equity funds. While banks have become increasingly creative in structuring their capitalization, the regulatory capital guidelines pose significant restrictions.
A third obstacle is the reluctance of most private equity fund managers to invest in a regulated industry that not only limits operating and financial flexibility, but also imposes important, uncontrollable partners – the bank regulators.
Kohlberg Kravis Roberts & Co.'s 1991 investment in Fleet/Norstar Financial Group, Inc. illustrates the ownership and operating restrictions private equity funds confront when they invest in banking companies. KKR structured its elaborate investment in Fleet to ensure that it remained at all times passive and noncontrolling. Further, KKR provided the banking regulators with commitments that expressly prohibited it from exercising a controlling influence over Fleet's management or policies. The Federal Reserve Bank of Boston monitored and enforced KKR's compliance with these commitments. Faced with these prospective severe restrictions, most private equity fund managers, not surprisingly, decide that there exist easier ways to generate investment return other than acquiring a controlling interest in a U.S. banking company.
Private Equity Support of Management-Led Buyouts
While restrictions attendant to acquiring controlling interests in U.S. banking companies are unattractive to many private equity funds, during the 1990s private equity funds played critical roles in facilitating the transfer of entire ownership interests in banking companies, without the necessity of obtaining time-consuming regulatory approvals.
The $220 million sale of East West Bank in 1998 exemplifies this acquisition model. During the first quarter of 1998, the two then owners of East West decided to sell and commenced discussions with a large foreign-based bank. However, the parties estimated that it would require 9 to 12 months to obtain the necessary regulatory approvals. Sensing that the owners desired a more expedited transaction, Dominic Ng, East West President, asked if he could attempt to raise the capital and match the foreign bank's price. With Friedman, Billings, Ramsey & Co., Inc.'s assistance, Mr. Ng obtained commitments from private equity sources within three weeks and the transaction closed a few weeks thereafter.
Earlier examples of private equity supported management-led buyouts include the 1997 $154 million acquisition of Local Financial Corporation, and the 1998 $140 million acquisition of UCBH, Inc. parent of United Commercial Bank, San Francisco, California. Each of these transactions involved the sale to private equity sources of common stock and debt securities financed the redemption of the existing ownership interest in the bank holding company.
These management-led, private equity finance transactions shared the following characteristics:
The investor typically confirms the structural components and representations concurrent with the purchase of the securities. With these structural components, no person acquires control of a banking company and no investor becomes a bank holding company. As a result, the parties avoid the time-consuming regulatory approval process. Advance notice to and consultation with the banking companies' primary regulators is strongly advised even though no formal approvals are required.
The Increasing Role of Private Equity in Current Bank Acquisitions
Prior to Hanmi Financial's effective use of the private equity market to raise cash needed for an acquisition, Franklin Bank Corp., Houston, Texas, demonstrated how private equity can create a strong institutional shareholder base for and potential liquidity in a company's stock. In April 2002, Lewis Ranieri and the former executive management team of Bank United Corp, formerly the largest publicly traded depository institution in Texas, formed Franklin to acquire Franklin Bank, S.S.B., a $62 million asset thrift for $11 million. Within six months, with the assistance of Friedman, Billings, Franklin privately placed $80 million in common stock at $10 per share and $20 million of trust preferred securities. From September 2002 to September 2003, Franklin's assets grew from $225 million to over $1.5 billion. Franklin completed its IPO at $14.50 per share with two acquisitions pending in December 2003.
At the time of this article, financing for at least two other acquisitions is being shopped in the private equity market. John Eggemeyer, a successful bank consolidator, operator and private equity principal, is raising $185 million to acquire Centennial Bank Holdings, Inc., a $700 million Colorado bank holding company. The $155 million purchase price represents approximately 2.63 times stockholders' equity. In a similar transaction, Stanley Bailey has formed a new company to acquire Gold Banc Corporation, Inc., a $4.3 billion financial holding company. The transaction is valued at $671.5 million, which represents 264.33% of Gold Banc's book value and 21.56% trailing 12 months' earnings. Keefe, Bruyette & Woods, Inc. is assisting in placing the $455 million in common equity required for the transaction. It has been reported that, as of the writing of this article, most of this amount is committed.
Unlike the management-led buyouts requiring little or no prior regulatory approval, these structures, involving mergers with financial institutions, require regulatory approvals.
Private Equity Fund Specifics
Private equity funds are willing to back qualified management teams with clear prospects for liquefying their investment within a three-to-five year time frame. Factors contributing to this receptivity include:
• attractive returns in recent deals, including East West, UCBH, Franklin and Hanmi
• an excess supply of capital with greater pressure to deploy it or return it
• less competition for bank deals compared to the more intense competition for deals with commercial enterprises
• banking company performance is more predictable in execution and exit strategy than commercial sector
According to Adam Desmond, principal of FIG Partners, LLC, an Atlanta based investment banking firm specializing in financial institutions, “deal terms are generally quite straight forward.” “Common stock is the security of choice,” stated Desmond. For public companies, the pricing is usually set at a 10%-15% discount from average trading prices over a recent period, typically 20 trading days. If no market exists for a security, a deep discount from projected trading prices based upon comparable company trading can be expected. The purchasers usually require registration rights to permit resales. Public companies can usually commit comfortably to a short deadline for registration, while private companies, such as the special purpose acquisition vehicles, will require a longer period. There is a direct correlation between the length and certainty of registration and the amount of the discount in pricing. There may be an increase in the cost of capital if the shares are not registered by an outside date.
To eliminate this risk factor, public banking companies may file a registration statement in advance of their selling efforts for a number of shares they plan to sell. This would result in selling registered, freely tradable shares rather than restricted shares, and may reduce the amount of the discount from market price required by the investors.
The large pool of private equity searching for attractive investment returns is emerging as an important source of growth capital for middle market bank transactions. These sources can be approached quickly and transactions closed in a relatively short time period—characteristics that can be crucial to closing a deal.
Gordon M. Bava
Mr. Bava's practice focuses on general corporate representation with substantial experience in mergers and acquisitions, underwritten securities offerings and representation of clients in a variety of industries.William T. Quicksilver
Mr. Quicksilver’s practice focuses on mergers and acquisitions, capital market activities, corporate governance, and strategic advisory services in the financial services industry and in a range of unregulated industries.
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H. Katerina Hertzog
Paul H. Irving
T.J. Mick Grasmick
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