Mirror, Mirror On The Wall, How Will Private Equity Profit From It All?

The PEU Report speculates on some of the ways The Carlyle Group, Bain Capital, KKR, and Merrill Lynch Private Equity may profit from the Paulson Plan, here.

Hedge Fund Industry Behind Congressman Rangel's Troubles

After 38 years in the U.S. House of Representatives, suddenly Congressman Charlie Rangel wakes up to almost a hit piece a week in New York City newspapers.

In July, the New York Times reported on Rangel's four rent controlled apartments. In August, the New York Post first reported on Rangel's "beachfront villa in a sun-drenched Dominican Republic resort." Yesterday, NyPo followed up with another attack on his failure to report income from the villa. Then there was the report of Rangel using his official congressional stationary to solicit money from constituents for a Columbia University Center to encourage minority participation in government.  

This stuff the papers are focusing on is all in a days work for a ranking congressman. It is generally, impossible to get newspapers to feature stories about it. But, as  the second scandal broke, we wrote, "Somebody is out to get...Ways and Means Committee chairman, Congressman Charlie Rangel....Reports like this don't come out by accident. Somebody that is very powerful is after Rangel."

The Ways and Means committe chair has always been a hot seat.

Rep. Wilbur Mills (1957-1974) was removed via a set-up affair with a stripper, Fannie Fox; Rep. Dan Rostenkowski (1981-1994) was forced out in a concocted House Post Office scandal, and President William McKinley, who was assassinated in 1901, had previously been Chair of the Ways and Means Committee.

Now it's Rangel's turn. Who is powerful enough and has the money to sponsor and fund the takedown this time?

Wall Street friends tell us that it is the hedge fund and private equity industries.

The hedge fund and private equity industries have targeted Rangel because of his legislation in the House that would have taxed the earnings of hedge fund and PE managers at a 35% income tax rate, instead of the current capital gains rate they pay of 15%. Rangel's legislation for a tax increase on the fund managers passed the House 233-189, but it was blocked in the Senate.

Now it's pay back time for Rangel, who also has been makng noise about reinstituting the draft.

One Wall Street insider said to me, "This is almost as much fun as taking out Eliot Spitzer."

Randal Quarles Is Polishing His Presentation of Why Carlyle Group Should Takeover Banking

Oligarch of the future, Randal Quarles, spoke to FT recently and appears to have polished his presentation as to why private equity operator Carlyle Group should be allowed to plow into the banking sector with privileges allowed none other.

FT reports:

"Private equity really is almost tailor-made to solve the difficulties currently faced by financial institutions in a way that will cause less friction down the road," says Randal Quarles, managing director of the Carlyle Group's new financial services team.

"A number of investments by private equity will tend not to be majority investments, which make can them even more politically palatable," says Mr. Quarles, who is a former US Treasury undersecretary for domestic finance.

Quarles is clearly more sensitive to the political aspects of PE investing aggressively in the banking sector. This is the first time to my knowledge that he has publicly discussed the non-majority nature of investments PE plans to make in the banking sector and the political palatablity of such.

Mr Quarles says private equity is an ideal solution for politicians concerned at the cost of bailing out banks...

Any private equity group with more than 25 per cent is considered a "bank holding company" and required to make "source of strength" commitments to provide more capital if required.

Mr Quarles argues that these regulations should be relaxed to encourage capital to flow where it is needed. In any case, he says private equity is likely to find ways to invest consistent with the rules, such as by investing via separate vehicles.

The above is about limiting downside risk. If PE puts in chips to buy a stake in bank, they want to be protected against being required to ante up a second time.

Ben Bernanke, chairman of the Fed, last month promised to clarify bank holding company regulations. "Private equity is a very good source of capital. There are the issues relating to effective control . . . what constitutes control. We are looking at that and we will make a clear statement about that."

Mr Quarles says: "Private equity has become popular to demagogue unfairly but I don't believe that politicians are succumbing to that temptation."

"Private equity is really about standing between the taxpayer and these losses for a finite period, then returning the stake to the public markets once the problems are addressed."

"Private equty is about sttanding between the taxpayer and these losses for a finite period, then returning the stakes to the public markets once the problems are addressed." Hmm.

This nobility of Quarles to protect taxpayers means only one thing, Quarles sees the banking crisis as overblown . While fear runneth in the streets, Quarles is going to aggressively buy into the sector, add capital where needed, whip the banks into shape and then blow the shares out the door into the public's hand, again. What a play!!

As we have stated in the past, we have no qualms with any operator willing to step in and buy into the banking sector, however, we suspect that along with stepping up to the plate, PE will have government created special privileges that will ease its operation in the field. That said, PE, Carlyle and Quarles are going to make a fortune on the banking sector.

Watch wherever they put their money and if the stocks are still publicly trading and at a price close to the insider price they negotiate for themselves, then it is certainly an investment to take a look at. These guys know what they are doing. Why not go along for the ride if you can?

The Players Have Settled On A Loophole

Bank stocks have been crushed and Private Equity is ready to step in and scoop up the pieces. And, it appears they have settled on a loophole du jour to do it.

First, we hear from HEC Private Equity/Venture Capital Club:

Considering that the private sector is always better at coming up with solutions to business problems than the public sector (i.e. government), there’s been ever increasing discussion that private equity should take a larger role in helping turn around the banks. The catch being pesky U.S. regulations. But as everyone should know, if there’s a law or rule then there is a way around it and private equity firms are beginning to find ways to bypass stipulations on bank ownership.

One method is to simply create a separate, unique fund without ties to a firm’s other funds which is what J. Chistopher Flowers of JC Flowers is doing. He’s created a fund under his own name that is not directly connected to his firm’s funds. This would
allow him to take controlling interest of a financial institution (at least greater than 24.9% in the U.S.) while permitting JC Flowers & Co. to own other businesses, which they wouldn’t be allowed to due if they controlled more than that percentile threshold in a bank. Nicely done.

And, FT is covering the story:

Executives of large private equity firms believe they have found ways of overcoming US rules that make it difficult for their funds to buy large stakes in banks. This would position them to bolster the faltering sector without changes in regulations.

Private equity firms have trouble buying banks because federal rules bar investors holding more than 24.9 per cent of a bank from owning other kinds of companies. This was intended to prevent conglomerates taking control of banks and using them to fund themselves.

Funds have also been skittish about bank investments because of fears that financial regulators could compel them to provide additional capital to such institutions in bad times.

However, with banks trading at historically low valuations, private equity firms have been scouring the sector for bargains, while their lawyers work on structures that would make such purchases palatable from a regulatory standpoint.

At the head of the pack isJC Flowers, a renowned investor in struggling financial institutions. The solution of its chairman, Christopher Flowers, has been to launch a fund under his own name - with no ties to his other funds - that would enable him to buy a controlling stake in a bank.Carlyle, the private equity group, could also consider establishing funds in the names of individuals, lawyers familiar with the matter say. Meanwhile, Carlyle has taken a 17.8 per cent stake - including 9.9 per cent of the voting stock - in Boston Private Financial Holdings, which has a subsidiary that is a private bank in addition to an asset management arm.

The Carlyle stake is of interest because the Federal Reserve does not usually sign off on private equity purchases of more than a 14.9 per cent stake in a bank. Carlyle has also been able to name a director at Boston.

Tony James, president of rival buyout house Blackstone, referred to the Fed rules as a problem in an earnings conference call on Wednesday. However, he hinted that Blackstone might try to back an experienced bank management team in raising a fund to buy bank stakes.

Will we be hearing of the formation of a Randal Quarles/Oliver Sarkozy Fund soon?

Whichever way Quarles decides to buy into the banking sector, keep an eye on the deals he makes. He is a SAP--Sharp, Aggressive and government Protected. If you can buy into a deal on the open market, at a price close to the insider price he cuts for himself, it is the best way I can think of to bottom fish the banking sector. BTW: The Boston Private Financial Holdings/Carlyle deal was his deal.

What Private Equity Can Do for Banking

In addition to the huge potential upside PE can experience from the leverage of buying into bank stocks in anticipation of an eventual turnaround in the real estate sector, there is also the fact that PE can bring its efficiency skills to banking.

Leo D'Acierno and Hugh MacArthur of Bain & Co. explain:

The subprime woes that have hit bank balance sheets with massive write-downs are helping to forge some unusual partnerships.

Private equity investors, with their well-honed talents for spotting opportunities to create value in troubled businesses, are buying big stakes in bank holding companies. In early April, groups led by TPG Capital and Corsair Capital Partners bought stakes in Washington Mutual Inc. and National City Corp., respectively. According to an analysis by Goldman, Sachs & Co., the 20 most stressed commercial banks need to raise between $25 billion and $35 billion in new capital. With the Federal Reserve Board's recent announcement that it would consider loosening regulations to make it easier for private equity firms to invest in banks, much of it will likely come from PE investors.

While welcoming the fresh equity infusion, bankers will be challenged to adapt to the hands-on management style of activist private equity shareholders. At a time when banks are under pressure to fundamentally rethink their businesses, learning to apply the winning formula of the top private equity firms may be just the tonic they need. According to Bain & Co. data, the top 25% of U.S. private equity funds raised between 1969 and 2007 have earned internal rates of return of 34%, on average.

Banks and their PE partners have their work cut out for them. Many banks have been too willing to stay in low-margin businesses that do not even earn back their true risk-adjusted cost of capital. This pervasive disease of "hidden underperformance" can be cured by embracing three time-tested private equity lessons.

Define full potential. No company can succeed when it divides its resources among too many initiatives. What sets PE leaders apart is their commitment to scrutinizing how money is actually made in each business in their portfolio. Only after taking stock of competitive trends, customers and demand to determine what the full potential of a business is do they commit to the few key initiatives.

Some institutions have already started taking a private equity lens to their business. For example, First Horizon National, the financial services holding company, recently turned to the capital markets to raise more than $600 million to replenish its balance sheet. It is using the capital to close peripheral branches in Atlanta and Washington and sell off its big mortgage lending unit to MetLife Co. The company will refocus on retail and commercial banking in its home state of Tennessee, where it is the dominant player.


Develop the blueprint. Once they've pruned their list to a handful of key initiatives, PE owners link them to specific activities and anticipated results that are spelled out in a detailed "blueprint" for action. Unlike traditional strategic plans, which focus on "what we want to be," blueprints spell out "how we are going to deliver."...

Accelerate performance. Because they typically hold their investments over three to five years, private equity owners create a sense of urgency about delivering results. They mold the organization to the action blueprint by setting up rigorous program management tools to drive implementation of the key initiatives. They track progress toward their goals by focusing on a few key metrics.

Outside the U.S., PE funds have applied this lesson to achieve remarkable turnarounds. In South Korea, for example, Newbridge Capital (now a unit of TPG) transformed Korea First Bank from a bankrupt commercial lender into a top retail bank, earning a nearly fourfold return on its equity investment in the process. Newbridge launched a bottom-up plan to revitalize the branch network. They consolidated corporate business into a handful of large-scale branches, stripped remaining office of low-value functions, and refocused the network on customer sales by retraining frontline employees and introducing performance-based compensation. The program resulted in $50 million of bottom-line improvements in the first year

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