Many banks have left behind private equity and its volatile earnings but a core remain committed to in-house funds. However, Basel II’s proposed increase in the regulatory capital could deal a crippling blow to their investment ability. By Joanna Hickey.

Banks have been major private equity investors since the first leveraged buyouts in the early 1980s. Yet although banks still make substantial investments into external private equity funds – partially to maintain relationships with the independent firms for debt and advisory mandates – the number of banks with in-house funds has dwindled. Numerous banks have closed their direct investment in-house operations over the past few years, spinning them off through management buyouts (MBOs) or by secondary sales.

Such exits may be nothing new – many of today’s leading independent firms were bank spin-offs, such as CVC from Citigroup and Permira from Schroders. However, the pace of bank exits has increased since 2000. Some units have been sold off following mergers or for general strategic reasons – such as the MBO of Morgan Stanley’s unit in February, the 2003 MBO of HSBC’s Montagu Private Equity, the 2002 spin-off of PAI from BNP Paribas and Royal Bank of Scotland’s (RBS) 2000 sale of NatWest Equity Partners (now Bridgepoint).

But many exits have been a result of losses following the telecom boom or difficulty in managing private equity’s volatile earnings. Deutsche Bank sold its Morgan Grenfell portfolio and its late-stage direct investment unit through an MBO last year, while others, such as UBS and WestLB, are winding down.

Earnings volatility

JP Morgan’s experience highlights how volatile private equity earnings can be. Five years ago, 20% of JP Morgan’s profits came from private equity, but it recorded losses in 2001 and 2002 (although in 2003 its private equity profits bounced back, totalling $300m). “Private equity earnings are very volatile. Five years ago private equity contributed strongly to the bank’s profits. Unfortunately movements in the markets saw those profits decline and some losses incurred. But the last two years have seen a marked improvement in profitability, which we expect to continue,” says Jonathan Meggs, European head of JP Morgan Partners.

Conflicts of interest

Managing the long-term investment horizons and lumpy returns of private equity, which depend on value realised on exit rather than annual performance, is problematic for banks – annual accounting and quarterly reports require stable revenues. In addition, conflicts of interest abound. Independent firms can stop awarding debt and advisory mandates to banks that are bidding against them. Decision-making can be compromised – banks’ private equity units can feel pressured to award debt or M&A advisory mandates in-house, or, even worse, to buy an asset from a corporate client.

“Some banks have high-quality in-house operations. But the earnings volatility can be hard for publicly quoted companies and there are often conflicts of interest with the banks’ core products of debt and advisory services. As a result, the general trend is for banks to exit the industry,” says Will Schmidt, managing director at private equity independent, Advent International.

Despite the recent exodus, a core number of institutions have survived the downturn. The main European-based players comprise ABN AMRO Capital, Barclays Private Equity and, on a smaller scale, NIB, Fortis, Natexis, Bank of Scotland (BofS) and Royal Bank Equity Finance. The major US players, which are mostly active in the US and Europe, include CSFB Private Equity, Goldman Sachs Private Investment Area, JP Morgan Partners, Lehman Brothers (which is currently raising a new fund), Citigroup (which despite selling CVC Europe, still has a sizeable US operation) and Bank of America (BofA) Capital Partners.

Some banks are re-entering private equity. Although it has always kept a presence in France, Lazard is widening its strategy after a decade’s absence, recruiting Cinven’s Graham Keniston-Cooper in February and, rumours suggest, planning a £500m ($882m) pan-European fund. Following its co-investments in Debenhams and Scottish & Newcastle in late 2003, Merrill Lynch could increase its in-house operation, while it has been hinted that Danske Bank is looking to establish a direct investment fund.

Firms such as ABN AMRO, BofS, BofA, Fortis, NIB and Lloyds run captive funds, investing only the bank’s balance sheet. Others, such as JP Morgan, Barclays and Lehman, invest the bank’s balance sheet and manage third-party funds. Although Goldman also invests some of its own money, most of its funds come from outside capital (including employees). According to the European Venture Capital Association, banks raised E6.844bn ($8.095bn) in third-party private equity funds in 2002 and E9.189bn ($10.870bn) in 2001, compared with independent funds’ figures of E20.259bn ($23.966bn) in 2002 and E29.799bn ($35.253) in 2001.

Substantial players

They may not hit the headlines in the same way, but some banks’ operations exceed those of the largest independent firms. CSFB has $29bn in private equity funds under management (including real estate and mezzanine), JP Morgan has $14bn and Goldman has $17bn. By comparison, Permira has E11bn ($13bn), Blackstone has $13.5bn (including real estate and debt management) and Carlyle has $17.5bn (including venture capital, real estate and high-yield).

In the mid-cap arena, ABN has E2bn ($2.4bn) under management and Barclays has E2.5bn ($3bn), compared with independent Montagu’s E3bn ($3.5bn), HgCapital’s $1.4bn and Bridgepoint’s E4bn ($4.7bn).

But while the top banks rank among the world’s biggest players, private equity profits are minute relative to overall revenues. “Even for banks with major in-house funds, on average in-house funds represent under 5% of total profits,” says Chris Masterson, managing director of Montagu Private Equity.

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Staffing levels

Some banks’ also surpass the largest independents in staffing levels. JP Morgan has 130 private equity professionals across nine offices, CSFB has about 150 and Goldman about 100. This compares with about 70 at Permira, 50 at Blackstone and 150 at Carlyle. In the mid-cap arena, Barclays’ has 47 private equity professionals and ABN has 140, compared with Montagu’s 30 and Bridgepoint’s 50.

Although some banks reduced head-count during the downturn, others have been beefing up their teams. ABN cut its private equity staff from 180 in recent years, and in 2002, following telecom losses and the Chase merger, JP Morgan announced the planned reduction of the bank’s capital commitment to private equity from 20% to 10%, with the current figure at 14%. In contrast, Barclays has increased its team since 2000, CSFB is adding to its already sizeable operation and Lazard is likely to expand its fledgling European business.

In terms of equity investment per deal, Lloyds, Fortis and NIB are at the lower end of the market, with buyouts usually up to E100m ($118m) in enterprise value. Mid-market banks include ABN, which does buyouts from E20m-E500m ($24m-$594m) enterprise value, Barclays, from £20m-£250m ($35m-$440m), and at the higher end, JP Morgan, from $250m-$1bn.

These banks compete against mid-market independents such as Montagu, Electra, HgCapital, 3i and Bridgepoint. The big buyout arena, where enterprise values soar over E1bn ($1.19bn), is the domain of the investment banks and, at the lower end, JP Morgan.

Like the independents, banks’ level of activity varies greatly. Some do a few, very large deals, others, such as Barclays and ABN, complete lots of smaller deals, far outstripping the big-ticket banks and major independents in terms of deal-flow. As for target industry sector and geographic focus, banks tend to be more generalist than the independents, operating across most sectors and countries.

Partner or competition?

While banks’ strategies for target asset size, sector and region can vary widely, they fall into two distinct categories in terms of bidding strategy. Banks either run private equity operations to help service clients such as KKR and Permira, or they sole-lead deals, competing head-on with the independents.

Investment banks fall into the first group, viewing private equity as part of investment banking and integrating it to avoid the conflicts of interest that bidding against clients entails. In this “triple play” strategy, the bank aims to provide advisory, private equity and debt services.

“Independent firms can be unwilling to award advisory or financing mandates to a bank that is bidding against them in an auction. We operate on the philosophy our private equity activity is an investment bank driven activity that is beneficial to the Lehman franchise as a whole,” says Peter Combe, head of financial sponsors at Lehman Brothers.

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Opposing strategies

Rather than go into auctions against clients, Goldman, CSFB and Lehman participate with them as minority co-investors, boosting the independents’ bidding power. For example, in April CSFB supported KKR’s E2.25bn ($2.76bn) buyout of Dynamit Nobel with a minor equity stake. BofS also makes minor co-investments alongside its clients, where it is providing the debt.

The opposing strategy involves running private equity totally separately from the rest of the bank. This strategy – employed by ABN, Barclays, Lloyds, Bank of America and, as of last year, JP Morgan – sees the bank’s private equity team compete head-on with the independents.

“We are run very separately from the bank. As a semi-captive, we compete directly against the independent houses to lead deals, rather than just co-investing with them,” says Tom Lamb, MD at Barclays Private Equity.

It is true that the independent strategy has hurt some banks’ debt and advisory revenues and also caused conflicts in the past, but such issues can be resolved. “We are structured more like an independent limited partnership rather than a division of the bank,” says JP Morgan’s Mr Meggs. “The reporting line is to the chairman’s office, not through the bank, which enables us to control the flow of information and avoids any conflicts. When our lead strategy first became apparent, some firms were concerned our independence might be compromised. But we have shown that our Chinese wall policies work and decision making is totally separate from the bank. They are now happy to mandate our debt or advisory teams even if we are competing against them.”

Barclays’ Mr Lamb agrees: “As a captive there are potential conflicts of interest – on any deal, Barclays might be banking a competing bidder. But these potential conflicts are relatively straightforward to manage. We have a robust compliance function, with appropriate Chinese walls in place. We are managed separately at the operating level as well as being physically separate.”

Cloud looming

Only time will tell which strategy is more profitable. Similarly, many of the firms that have sold in-house operations and reduced external investing could re-enter, especially if their advisory and debt revenues plummet. Financial sponsors often veer towards mandating banks that invest in their own funds.

“For banks, in-house private equity is a cyclical activity. Banks may exit the market for some years if they have been losing money, but will re-enter in time, as they will any other type of business. I don’t think there has been an enduring, structural move away,” says Lehman Brother’s Mr Combe.

However, one cloud looms on the horizon, for banks and independents alike. Basel II, set to be introduced in 2007, could affect both banks’ ability to retain in-house operations and to invest in the asset class at all. “Under Basel II, private equity could take up far more of banks’ regulatory capital – under the worst scenario, it could be three times higher. This could have a very damaging effect on the amount of capital banks invest in independent external private equity funds,” says Ian Taylor, chief executive of ABN AMRO Capital.

As banks are one of the largest investors in external funds, given the potential damage to the industry, some feel that the current proposals may be softened. “We are still in discussion on Basel II and hope to make further progress,” says John Mackie, chief executive of the British Venture Capital Association.

Yet for now, the looming regulations are a cause for great concern. “Some banks could reduce their exposure to external funds or close down their in-house operations,” says Mr Taylor.

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