Private Equity Funds Acquiring Financial Institutions: When Opposites Strive To Attract
By culture, regulators tend to prefer financial institutions to have a hard core of stable investors, whose pockets are sufficiently deep to sustain the needs of the financial institution.
By design, private equity funds acquire companies with the goal of eventually selling them. The sums invested are determined ex ante on the basis of stringent calculations of expected IRRs and more generally on the basis of a business case which sits firmly also on the exit strategies and their timing.
It is thus no surprise that acquisitions of financial institutions by PE funds generate a structural tension between these two opposing attitudes.
As such tension simmers under the surface, regulators must try to reduce frictions to a minimum, to preserve the role of PE funds without undermining the sound and prudent management of financial institutions.
Would you imagine a private equity fund confirming that it is willing to inject additional capital to sustain the development of the target’s activities or in case of its financial difficulties? And what about expecting a fund to show any such willingness without a predetermined cap to the potential exposure, a time horizon, and a precise definition of the events that may trigger such capital injection?
Quit difficult to imagine, I agree.
Alas, this is exactly what the regulations require, at least in theory.
Indeed, if one were to stick to the literal wording of the relevant guidelines by the EU ESAs, the application addressed, say, by Donald Duck PE Funds to the ECB, for the acquisition of Mickey Mouse Bank, would have to include a statement stating that “Donald Duck Funds is willing to support Mickey Mouse Bank with additional own funds if needed for the development of its activities or in case of financial difficulties”.
I’ll tackle in a second the possible legal effects triggered by any such statement, but for now let’s focus on its content.
Firstly, the statement does not address the issue of whether Donald Duck can support Mickey Mouse now, a separate question which is taken care of by other provisions of law. Rather, it addresses the issue of what happens if Mickey Mouse needs more capital in the future.
Secondly, there appears to be no cap to the potential exposure: Taken to its extreme, this may look dangerously close to a blank check to cover any losses borne by Mickey Mouse.
Thirdly, the statement does not allow the fund to assess whether pouring additional capital into Mickey Mouse makes commercial and business sense at the point in time when Mickey Mouse has run into troubles. This is possibly an even greater concern for the fund if one looks at the other reason which under the regulations might trigger a capital injection, that is, a “need” of capital for the “development of its activities”. Should Donald Duck sustain the bank’s “developments’ needs”, without being able to consider whether that is the right thing to do in the interest of the investors in the fund?
The regulatory requirements above might potentially set constraint to the ability of PE funds to decide whether to let go of the target itself or to stand by its side and invest additional capital. This is a fund’s nightmare.
True, the fund is expected to address that declaration not to the general public or the target, but only to the regulator in the context of the authorization process and I would hardly read that as giving rise to a legal, binding, obligation on the part of the fund. That is, I do not think the regulator may legally enforce the content of the statement and effectively force Donald Duck to inject capital.
Assume arguendo that this is true, as I believe it is (although if I were to assist outside creditors of Mickey Mouse in a bankruptcy litigation I would be tempted to somehow use that statement to try to drag Donald Duck into the litigation).
Still, this is not the kind of issue you may want to test in a court of law, no matter how intellectually stimulating — and how profitable for the lawyers involved — having such a discussion would be.
Most importantly, the statement may not be legally binding and enforceable and yet I do believe it would be rather myopic to consider it completely devoid of any legal effect.
As I have argued elsewhere, I think that the relationship between regulated entities and regulators may be fruitfully framed as a repeated game, one where cooperation may be the best strategy for the parties. Donald Duck Fund will most likely have multiple interactions with the regulator: The discussion as to whether Mickey Mouse Bank needs additional capital may occur at the same time as the fund is discussing the potential acquisition of another regulated entity or while it is seeking the consent of the regulator for a reorganization of the business of Mickey Mouse.
Indeed, I think the requirement at hand is a textbook example of a case where the regulations acknowledge that the regulators’ toolboxes will include also moral suasion powers, which in turn may derive their force also from the existence of a generally cooperative setting. In other words, regulators do not expect a legal commitment and yet, by requesting that declaration, they aim at preparing the stage for discussions with the fund, should the need arise.
Against the backdrop above, it becomes easier to grasp why in the real world the statement issued by funds may look quite different from what is formally required on the books and why this may still remain acceptable for regulators.
In the real world, one may find several “qualifiers” scattered throughout the statement, which, while watering down the actual content of the statement, do not prevent the fund from obtaining the authorization to acquire the bank.
Here is just one example from my experience. Any capital contribution may be contemplated — the statement may read — “if necessary”, a wording which immediately makes injections which are “only” appropriate or useful out of scope. In addition, the statement may clarify that any such “necessity” shall be “determined by the fund in consultation with the regulator”.
This is as close as one can get to an explicit acknowledgment of the significance of cooperation in the context of relationships between regulators and supervised entities, with funds and regulators striving to find a compromise which can serve the purposes of the regulations while acknowledging the complex realities of markets.
