As the FDIC resolves recent bank failures by auctioning the banks’ assets, some in the private investment industry view the federal policies as creating an uneven playing field, preventing them from submitting competitive bids.
PE firms have raised this concern in part based on their experience participating in mitigating FDIC losses during past bank failures. Given the goal to maximize proceeds through auctions, the financial system would likely benefit from the additional competition PE firms would bring.
Should the FDIC offer enhanced transactional terms like loss-sharing agreements (LSAs) to a broader array of institutions, private equity investors might just structure winning bids. However, there are frequently overlooked drawbacks to LSAs, raising the question of whether PE firms should utilize such special terms if eligible.
When a Bank Fails, Somewhere, an Investor Smiles
To maintain financial system stability amid significant bank failures, the FDIC sometimes takes control of a failing bank and auctions its assets to a healthier institution. The acquirer is determined through a sealed bid process based on standard transaction terms. The FDIC structures the auctions to maximize the prices of auctioned assets and minimize losses to the Deposit Insurance Fund (DIF), a fund maintained to insure deposits and resolve failed banks.
An auction of a failed bank’s assets can be extremely lucrative for the successful bidder, making these events attractive investment opportunities. Accordingly, when investors saw the rapid withdrawal of $42 billion from accounts at SVB over a 10-hour period (equivalent to $1 million per second) in early March, many understood that an investment opportunity could be coming if the bank were to fail, as it ultimately did.
To see just how much a successful bidder stands to gain, look no further than the sale of SVB’s assets: The deal has preliminarily added $9.82 billion to First Citizens BancShares’ net income, and its share price was up 94% between March 10 and May 10.
PE Firms Feel Shut Out
Private equity firms, including Reverence Capital Partners, Sixth Street Partners and Apollo Global Management, each made bids to acquire Silicon Valley Bank’s assets. Like the other PE firms that submitted bids, they were unsuccessful.
On the other hand, First Citizens successfully took advantage of the special benefits the FDIC offered only to banks—utilizing a direct discount on the value of auctioned assets, an LSA, and favorable financing terms—to win.
Private equity firms walked away from the FDIC’s most recent auctions empty-handed, likely wondering how to compete against banks, which seem to have the upper hand. But their luck may change if the FDIC permits non-banks to enter into LSAs, as it did in the aftermath of the 2008 banking failures.
Between 2008 and 2014, 17 acquiring banks worked with private equity investment groups to purchase 60 failed banks. The FDIC sometimes allows multiple parties to submit bids jointly as “alliance members,” which increases competition by bringing smaller institutions into the fold. By joining an alliance, institutions that are otherwise unqualified to bid on an entire bank are able to do so.
In past auctions, the most successful bid structures submitted by PE groups in concert with banks:
- created new banks, which were used to acquire the auctioned assets; or
- provided substantial equity injections into existing banks that used the influx of capital to acquire the assets directly.
The 60 acquisitions mentioned above collectively cost the FDIC $21.3 billion, whereas the agency estimates that the cost of protecting the uninsured depositors at SVB and Signature Bank alone is $16 billion. The FDIC estimated that private equity’s involvement across these deals saved the government an estimated $3.3 billion. While the savings were small compared to the size of banks today, it demonstrates that PE firms can limit losses to the DIF if they’re allowed to bid competitively.
Given that the FDIC responded favorably to past bids submitted by PE firms that leveraged relationships with existing banks, firms that want to be competitive in future auctions should consider which banks could bring complementary expertise and existing regulatory approvals to the table. At least two PE firms may have taken this approach—albeit unsuccessfully—at the recent auction of First Republic Bank’s assets, where BlackRock apparently worked with Apollo to back PNC Financial Services Group’s bid.
LSAs Aren’t Perfect
While loss-sharing arrangements at the FDIC’s auctions have strong upsides, they may not be the perfect investment opportunities that bidders expect them to be. LSAs benefit acquirers by shifting some costs and risks to the FDIC, while allowing the FDIC to defer payments that would otherwise be immediately drawn from the DIF.
LSAs can be expensive to administer over their terms and can drive up the sale price of assets beyond their actual value by enticing bids from institutions that wouldn’t have participated without the assurances LSAs provide.
A working paper published by the FDIC’s Center for Financial Research (CFR) directly challenges the notion that a typical acquisition of a failed bank at auction creates shareholder value for the respective acquirer. Although the market consistently responds favorably to failed bank acquisition announcements, acquirers that utilize LSAs realize returns 19.8% lower than auction losers in the three years post-acquisition, the paper said.
So although the market has unequivocally responded favorably to First Citizens’ success at the auction, the success may be short-lived, according to the CFR.
PE Firms Will Need to Adapt
The recent series of bank failures may continue, and PE firms are likely taking note of the changes that they could make to refine their bids to better match what’s been successful in past periods of financial instability. Although FDIC research indicates that LSAs may suppress an acquirer’s returns in the years following an auction, the dramatic boost to First Citizens’ share price and net income will most likely keep PE firms motivated to continue submitting bids in pursuit of elusive profits that may come from the ashes of a failed bank.
Whether the FDIC will extend the same transaction tools to PE firms that it does to traditional banks, and whether these non-bank entities can deliver a winning bid with the tools they have, remains to be seen. In light of the success PE firms have seen in past auctions, they shouldn’t try to do it alone, but rather form an alliance with an established bank and bid together.
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