Buyouts and banks

Not a few buyout executives guffawed at Treasury Secretary Henry Paulson's suggestion on Nov. 12 that private equity act in concert with the federal government to prop up the nation's faltering commercial banks. He might just as well have invited them to go play in rush-hour traffic.

With or without the prospect of government involvement, "firms are afraid and nervous about investing in the banking sector now," says a partner at a leading private equity house. "Many have learned the hard way how complex and risky these investments are."

Indeed, the ugly truth is the vast majority of recent financial bailouts of banks and related businesses that buyout firms have attempted on their own have performed miserably, some disastrously. Months ago, before the subprime mortgage disturbance metastasized into the worst global financial crisis in decades, private equity was viewed by many as an ideal cure for ailing institutional balance sheets. Starting last December with Warburg Pincus' deal to inject $500 million in MBIA Inc., a bond insurer perilously exposed to mortgage derivatives, some of America's leading private equity houses led equity infusions totaling $21 billion or more in an array of U.S. banks and financial services providers and invested an additional $5 billion or more in troubled banks overseas.

When they were announced in April, the two biggest of these deals -- a $7 billion slug of equity in Seattle's Washington Mutual Inc., the nation's largest thrift, invested by a consortium organized by David Bonderman's TPG Capital, and a similarly sized investment two weeks later in a Cleveland regional bank, National City Corp., led by Corsair Capital LLC -- stood as models of the central role private equity aspired to play in cleaning up the mortgage mess and healing the financial sector's wounds.

But come autumn, as uncertainty mounted over the true extent of the sector's ills, Lehman Brothers Holdings Inc. imploded and fear ran riot. Depression-era-style deposit runs prompted the government to seize Washington Mutual and force National City into the arms of a healthier rival.

The mayhem has cut a swath through private equity, utterly obliterating TPG's huge investment in WaMu, squeezing Corsair out of what it thought would be a long-term investment in Nat City and ravaging values of most of the industry's remaining investments in the sector.

In the devastation's wake, the private equity industry has taken a collective deep breath. It has been forced to take stock of its losses and to regroup and to rethink the role buyout firms ought to play in the deleveraging and restructuring of the banking and financial services sector. How assertively should sponsors pump cash into needy institutions? Is the safest move the wisest -- namely, to swear off investing in the sector entirely for now?

There are no easy answers. And a handful of buyout industry executives and participants surveyed for this story turned up a range of views on the matter, from those saying they'll steer clear of the blighted sector to others who contend that the blight is sure to beget opportunity. No matter where they stood, all noted the sobering effect of the litany of losses.

"People are quite chastened following some of these balance-sheet-oriented deals," says one private equity player. "You saw some smart money going into the sector, and a few of the deals have been real disasters. That tends to give you pause."

Similarly, some institutional investors in buyout funds, like HarbourVest Partners LLC managing director John G. Morris, embrace the better-safe-than-sorry mindset: "We're elated that our buyout managers don't have a damn-the-torpedoes attitude, because many could find themselves sunk the way TPG did in WaMu," Morris says. "They're waiting for valuations to adjust and some sign we've reached a bottom."

Meanwhile, there are other, bolder buyout sponsors who, even though they've taken a breather, probably won't be idle for long. They yearn to capitalize on the financial industry's woes and on havoc in the broader markets.

Prices of assets have dropped so steeply they're hard to resist. Notwithstanding WaMu-style blowups and the slew of investments under water, some see considerable upside now in everything from private investments in public entities -- the PIPE investment TPG made in WaMu and Corsair made in Nat City -- to buying loans and junk bonds of LBO'd companies at fire-sale prices to snapping up subprime mortgage portfolios at pennies on the dollar.

For judicious investors sufficiently attuned to the risks, opportunities abound, argues Carlyle Group's Randy Quarles. "The sector isn't toxic -- just a certain portion of the assets are. You have to approach it with caution and understand the right way to invest in it," says Quarles, a former undersecretary of the Treasury in the Bush administration who co-heads Carlyle's financial services investment team.  Continued...