Fed Weighs Plans to Spur Bank Investment by LBO Firms

By Jonathan Keehner and Jason Kelly

July 24 (Bloomberg) -- The Federal Reserve, looking to spur investment in lenders hit by credit-market losses, is weighing three measures to ease rules for private-equity funds that buy bank stakes, people with knowledge of the deliberations said.

One proposal would permit buyout firms to use ``silo'' funds walled off from their other investments to buy the stakes without subjecting the rest of their holdings to more federal oversight, said the people, who declined to be named because the talks aren't public. Under another scenario, the Fed would let private equity firms exercise more control of banks they invest in. A third plan would encourage firms to team up on bank deals.

Buyout firms are ``hesitant to invest in banks because of the various levels of regulation that would apply to them,'' said Thomas Vartanian, a partner at Fried Frank Harris Shriver & Jacobson LLP in Washington who advises buyout funds and lenders. ``The banks need capital, and private equity has it. Necessity is often the mother of invention.''

Treasury Secretary Henry Paulson has called on banks and brokerages to raise cash as their losses from the collapse of the mortgage market and the ensuing credit-contraction climb to more than $466 billion. Blackstone Group LP and Carlyle Group, the world's two biggest private-equity firms, discussed the topic when they met with Paulson this month, say people briefed on the talks.

Representatives for Paulson, the Fed, Carlyle and Blackstone declined to comment.

Bonderman, Paulson

Washington Mutual Inc., the biggest U.S. savings and loan, this week reported a $3.3 billion second-quarter loss, while Wachovia Corp. booked an $8.9 billion loss and slashed its dividend. Citigroup Inc., the biggest U.S. bank by assets, said it lost $2.5 billion; profits shrank at smaller rivals JPMorgan Chase & Co., Bank of America Corp. and Wells Fargo & Co.

A few private equity firms ventured into bank investments this year. David Bonderman's TPG Inc. led a group that injected $7 billion into Washington Mutual in April. National City Corp., Ohio's biggest bank, agreed the same month to sell a $7 billion stake to investors led by Corsair Capital LLC. Hedge fund manager John Paulson plans to start a fund this year to invest in banks and brokerages, people with knowledge of the matter said yesterday.

While lenders including Citigroup and UBS AG have raised capital from sovereign wealth funds controlled by overseas governments, buyout firms, which typically seek controlling stakes, remain leery of subjecting themselves to U.S. bank rules, Vartanian said. ``The regulations weren't written with an inherent bias against private equity firms, but that's how it has turned out.''

`Controlling Influence'

The Fed subjects private equity firms to more oversight when they exceed a 9.9 percent voting stake in a bank. If they buy more, they may be deemed to have a ``controlling influence'' and be classified as a bank holding company, which triggers restrictions on non-banking activities and the amount of debt they can take on. To avoid that classification, investors may agree to be passive, which can mean limits on board representation.

The Fed is considering liberalizing the control guidelines, the people with knowledge of the deliberations said. That may allow buyout funds to amass up to 24.9 percent of a bank while also taking a more active role and getting board seats.

Buyout funds typically rely on debt funding to make acquisitions and invest in multiple companies, often in a variety of industries. The firms typically hold numerous stakes in a single fund.

Clubs, Orphans

Under the proposed silo structure, the buyout firm would ``orphan'' the bank investment by limiting its ties to other investments or funds, the people said. This could be done by eliminating any lending or cross-investment among the funds and preventing asset transfers between them, they said.

Another proposed plan would make it easier for a group of private equity firms to invest together in a so-called club deal without triggering bank-holding rules. The firms would collectively buy stakes in a bank and the Fed would agree to treat each firm's investment independently instead of aggregating their holdings to calculate control.

The Service Employees International Union, a Washington- based labor group that led a protest this month calling for higher taxes on buyout firms, said the Fed shouldn't encourage them to invest in the banking industry.

``It would be absurd to ease regulations and make it easier for private equity to buy banks,'' said SEIU official Stephen Lerner. ``Their business model of running up huge amounts of debt jeopardizes the consumer.''

`On the Sidelines'

Douglas Lowenstein, president of the Private Equity Council, a Washington trade group whose members include Carlyle and Blackstone, said buyout firms are in a position to help struggling lenders that are short on options.

``We're not out of the woods in terms of the health of financial institutions,'' Lowenstein said. ``Sources of capital right now are very thin. Private equity has a substantial amount of money sitting on the sidelines.''

To contact the reporter on this story: Jonathan Keehner in New York jkeehner@bloomberg.net.