Ann Iveson's Blog - Archive (January 2011) - London Business School

Ann Iveson's Blog - Archive (January 2011)

PRIVATE EQUITY CAPTIVES – ANOTHER REASON WHY THE VOLCKER RULE MAKES SENSE

19 January 2011 by Ann Iveson

I’m hoping you’ve had a chance to dip into the latest issue of Private Equity Findings. It’s all interesting but perhaps this issue’s “Beyond the Abstract” entitled The End of the Captive is worthy of an extra mention here.

Why?

Academics are often criticised for having their heads either in the sand or stratosphere not on what’s happening right now. Not in this case though! The research paper “Unstable Equity? Combining Banking with Private Equity” by L Fang, V Ivashina and J Lerner is spot on given the resurgent wave of criticism levelled at banking models, bankers and their worth.

I should say upfront that these are my opinions, not those of the Coller Institute. However as an Institute focused on Private Equity such criticism provides an interesting distraction. Indeed many in PE would side with those that argue bankers, on average, are richly paid in relation to what they earn for their investors. But that’s not my point here.

Although focused on captives, what this paper is really examining and accumulating evidence on is the much broader and evocative question - the extent to which banking activities are cyclical and whether specific types of activity promote cyclicality within the financial system? This in essence is what the Volcker rule is all about and its sceptics should look at the authors’ findings at least as it relates to bank affiliated private equity businesses.

The findings are based on a sample of 7,902 unique US private equity transactions between 1978 and 2009.
The 14 captives identified during the period 1983 – 2009 were involved in over 25% of all the deals done. Significant as this is, the real issue is that their involvement was pro-cyclical, peaking at over 45% of dollar volume at the height of the market (2006).
Overall the amount invested equalled 9.4% of the parents’ total equity (not just Tier 1 !) during this period although it peaked at 23% at the top of the cycle (2005-2006).
It is the concentration of exposure amongst the affiliated group that should at least raise a regulator’s eyebrow if not their blood pressure – the top 5 account for 80% of the total dollar value transacted by this entire group and the leading captive – Goldman Sachs Capital Partners alone accounts for 36%! In the non-affiliated group KKR accounts for 15% of the dollar volume and the top 5 transacted 50%.

So what drove the banks to get involved and to such a great extent? Go beyond the immediate knee jerk Gordon Gecko response and think about this strategically. The whole economic study of comparative and competitive advantage in terms of how it might apply to banks and specialised GPs is all really very interesting. However the paper looks at two initial factors; superior knowledge and access to capital, especially debt.

The former if prevalent would be demonstrated by the affiliated deals selecting financially stronger ex ante targets. This they do find but when the parent bank is a lender in the syndicate the targets are weaker.

Who is driving this? – the leveraged loan group, knowing that they can record the fees today, syndicate or securitise most of their residual exposure and book the loan at cost with no mark to market, brings in the prized equity of the captive in order to earn a league table lending position or is the captive in the driving seat? No longer able to find the growth equity transactions it changes focus, wanting exposure to the larger deals to improve their future potential deal flow and so persuades the leveraged loan group. Or is it simply evidence of opportunistic behaviour deployed by banks during boom times. Those appearing in front of the Treasury Select Committee have and will no doubt continue to deny such a stance!

So with no comparative advantage on sourcing better deals, what about access to capital? Here is the edge, bank affiliated deals enjoy much better terms when the parent is in the lending syndicate with the greatest advantage concentrated during the boom years.

The amount of the loan is increased by US$ 557 million – almost double the average loan size,
the maturity is extended by 4.3 years - two thirds increase above the average 6 years and
the spread is reduced 33 basis points – a 10% reduction to the average spread.

But what about the returns? Can average to weaker targets be transformed by significantly cheaper capital? Overall, bank affiliated deals are only slightly worse. However whilst it is accepted that transactions done at market peaks are more prone to distress, this outcome is more pronounced for transactions done by mixed groups - a bank affiliated together with a non-affiliated group.

Whether pushed or pulled apart by regulatory or management pressure is it any wonder then that the incidence of banks shedding their captives has increased. The promise of cross selling revenues from exit IPOs and future lending cannot make up for the increased cost of capital let alone the new regulatory stance.

The evidence provided in this paper does indicate that banks’ private equity in house groups added to the overall cyclicality within private equity and that one of the key factors was the parent bank’s involvement as provider of debt capital. The positive impact of cheaper and longer term financing has not allowed their affiliates to generate superior returns but has created additional and detrimental repercussions as part of the credit expansion.

If this is the case relating to private equity activities one may ask what other businesses have banks created, that a crisis and regulatory shift is required to force a management rethink.

Whether a comparative advantage for banks operating within private equity existed is unclear – they certainly have not been able to exploit it. Indeed the corollary is that non-banks have an advantage; perhaps created by the shift in talent, a more aligned remuneration structure, better information and until now, lighter regulation. However comparative advantage is not static and regulators should be vigilant to ensure that such advantages, comparative or absolute, are not being driven by regulatory and fiscal differences.

Which brings me back to the bankers and one last question - does the absolute advantage conferred by being too big to fail warrant the bonus payments currently under consideration?

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About me

Ann Iveson

BSc (Econ, LSE), MSc Sloan Fellow (London Business School); ACA

Senior Advisor

Ann was Executive Director at the Coller Institute of Private Equity for the past two years (2008-2009) playing a key role in defining and implementing many of the strategic initiatives and projects. She has extensive banking experience within the fields of credit, fixed income sales, derivatives and capital markets. She headed credit at CSFB and European Corporate Origination at BNP Paribas. She qualified as a Chartered Accountant with PriceWaterhouse Coopers and holds a BSc (Econ) from LSE and is a London Business School Sloan Fellow. Ann is a member of the Advisory Board.

London Business School Coller Institute of Private Equity