Private equity investment in U.S. banks may pick up

NEW YORK (Reuters) - With U.S. banks struggling to raise new capital and a cutback in lending threatening to deepen the economic downturn, chances are increasing that regulators will relax rules that have deterred private equity from investing in banks and thrifts.

A major break from the past is not likely, but buyout firms expect regulators to bring more clarity to existing rules and feel they may be able to push the envelope on the current system. That could lead to more private equity stakes in banks and thrifts, and even prompt takeovers, said a lawyer who has spoken with regulators on the matter.

The U.S. Federal Reserve could clarify rules governing minority investments of less than 25 percent as early as next month, said the lawyer, who did not want to be identified because of the sensitive nature of discussions with regulators. The Fed declined to comment.

Private equity firms have been eyeing troubled banks and thrifts as investment opportunities as the credit crisis has taken a toll on share prices.

Randal Quarles, managing director at Carlyle Group CYL.UL, one of the world's largest buyout firms with $83 billion under management, forecasts that many of the investments will be minority stakes -- which can be accomplished without dramatic changes in the Fed's rules.

Quarles, previously undersecretary of the U.S. Treasury, said there could be an uptick in investment activity before the end of the year.

"It is going to be hard to raise (capital) in the public markets, particularly for depository institutions," he said. "I think that's going to drive a lot of private equity deals."

Buyout shops are also optimistic that regulators, on a base-by-case basis, will be more open than they were even six months ago to deals involving a change of control, said the lawyer, who represents private equity firms.

Among various regulators, the Office of Thrift Supervision, which oversees thrifts, is considered more liberal on the issue than the Fed, and so a thrift takeover may come before a bank deal, the lawyer said.

BALANCING ACT

The Fed has long tried to keep banking largely distinct from other commercial activities by maintaining a tight leash on banks and requiring extensive disclosure of their activities.

This stems from laws that suppose that banks are crucial to the economy and that allowing banking and unrelated commercial businesses to mix might lead to misuse of federal credit and guarantees that are meant to keep the banking system healthy.

These rules apply to investments in banks that have federally insured deposits such as Wachovia Corp WB.N or National City Corp NCC.N, but not to investment banks such as Goldman Sachs Group Inc (GS.N) or Lehman Brothers Holdings Inc

LEH.N.

Private equity firms typically do not want to become bank holding companies because of insistence on this separation, fearing that doing so would hinder their ability to invest in unrelated industries like retail or manufacturing.

They can still take smaller stakes that are below certain ownership levels, but the firms fear they will then have too little power to sway a bank's strategy.

Buyout shops have largely stayed away from U.S. banks and thrifts, other than a few deals, such as TPG Capital LP TPG.UL taking a stake in Washington Mutual Inc (WM.N) and Corsair Capital LLC leading a cash infusion for National City.

But they have been arguing their case for more flexibility.

In June, Quarles said in a Wall Street Journal opinion piece that the limitations on capital investment are far stricter than necessary, and that private equity was "ready and willing to step forward in large amounts."

That argument is not lost on regulators, who recognize that buyout shops may be one of the few remaining sources of fresh capital for banks and thrifts in the current market turmoil. But it is not an easy decision.

"It is a difficult balancing act between trying to address the immediate needs of the market versus the historic precedent they (the Federal Reserve) have established," said Gregory Lyons, chair of law firm Goodwin Procter's financial services group.

Carlyle's Quarles said there were three potential solutions on the regulation front: More flexibility on the thresholds themselves; more flexibility on so-called "separateness commitments"; and more flexibility in allowing several investors to take stakes at the same time without being ruled to be acting in concert.

If a group of investors were ruled to be acting in concert, they could be forced to submit to stringent regulations. Changing separateness commitments could allow a buyout shop to set up a parallel investment vehicle that could become a bank holding company without affecting the firm's other business activities.

Already, some funds that have been raised of late include a provision that would allow private equity firms to draw money into a completely separate vehicle set up just for bank and thrift investments, the lawyer said.

But even if persuading regulators is a bit easier now, it will still be a big task to get a full takeover of a bank done.

"It's still a few months before a lot of this sorts itself out, but the money is clearly there," the lawyer said.

(Additional reporting by Tim Ahmann in Washington)