Commercial Banks and I-Banks: Not a Natural Fit

I believe that there are natural reasons for commercial banks to get out of private equity investing: Commercial bank on-balance sheet capital is quite different from that of I-banks, and the issue of conficts for I-banks is real.

First some perspective – I worked for a commercial bank in the US for 15 years, the last three years of which I was working in private equity within the bank.

Specific points:

– Commercial banks generally are not natural investors in private equity due to the timing of the recognition of profit and loss. Bank CFOs hate private equity because bank stock analysts are used to stable, slowly-growing earnings (driven from an overall reliance on net interest margins on loans, credit card balances and mortgages), and volatility in bank earnings often presages dramatic problems that need to be explained to stock analysts. Since private equity earnings are not smooth when looked at on a quarterly basis, many bank CFOs hate on-balance sheet PE businesses – unless they are Funds-of-Funds asset management businesses in which most of what hits the banks financial statements are the management fees they receive for managing other people’s money. For this reason, private equity has never been a core business of commercial banks, and over a twenty year horizon there have been several periods of financial stress where commercial banks have exited on-balance sheet private equity in order to devote key senior manager attention and scarce capital to core business problems that would make or break the bank – a position private equity has never been in. Investment bank’s earnings, on the other hand, are naturally more volatile than commercial banks (driven by trading or “one time” fee business like M&A advisory), and analysts following them are more understanding and more forgiving. A stronger argument can be made that the business is core to them – but I’m not sure I will. (See third bullet below.)

– Commercial bank regulations are slanted against PE – A problem I-banks don’t face: BASEL II, the regulations which revise capital adequacy requirements for banks (and which hit on balance sheet private equity harder this time around) are about to be finally implemented. Though it is certainly no surprise to banks as these regulations have been known about for a while, on the margin institutions having to review capital needs of their core businesses may be more inclined to sell off private equity assets that are non-core and redirect the capital freed up into core business lines. This problem is, of course, specific to commercial banks.

– Private Equity Universities. Another question entirely – should either commercial banks or I-banks be in private equity at all, or are they just Private Equity Universities, training grounds for private equity professionals? Again, if you look at things over the long run more private equity teams have spun out of their own accord than have ever been kicked out by a parent exiting the business. That’s because the only way that it makes sense for a bank of either flavor to sponsor a private equity fund is for it to take a significant amount of the economics, most often between 25% and 50% of the carry. Supposedly the team actually making the investments receives in exchange for this carry split deal flow and analytic services in addition to a fund commitment – though my experience from past due diligences is that this is very often not the case, and that the team does nearly all the heavy lifting itself. As a result, a team that builds up a solid track record often spins out (in part or in whole) and instantly improves its economic take by keeping 100% of the carry. And those that stay behind (like those who take 8 years instead of 4 to graduate from a university) are often not the best and the brightest. This doesn’t seem like the best business model I’ve ever heard of.

– Conflicts are a real problem for I-Banks: With so much profitability coming into I-banks from M&A activity driven by large buyout GPs, anything that jeopardizes that gravy train is dangerous. And competing head to head with these GPs could be dangerous. Is a passive co-investment strategy for I-Banks that only invests alongside sponsors any better? Only if this relatively passive “me too” strategy is one that institutional LPs are willing to pay for at full pricing – otherwise, there isn’t much to go around internally.