In this tutorial, you’ll learn about the key differences between private equity investing in financial services and traditional companies, and you’ll see how a bank “buyout” or growth equity deal might work using a simplified example for MidFirst Bank.
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Bank Growth Equity And Buyout Deals: Key Differences
Table of Contents:
1:12 Key Differences Between Traditional LBOs and Bank Buyouts
7:09 Overview of Simplified Bank Buyout Model
12:29 IRR, Multiples, and Returns Attribution
15:28 Evaluating the Deal
16:33 Recap and Summary
There’s very little private equity activity in the commercial banking sector due to regulations and deal math.
If a PE firm acquires over a certain percentage of a bank, it may be classified as a “bank holding company,” and it will have to comply with regulatory capital and other requirements – which no PE firm wants.
Also, most banks are already highly leveraged and cannot use much additional Debt to support a deal; Debt works differently for a bank, and most banks do not aim to “de-lever” over time. If a bank’s Equity is written down and replaced with insufficient new Investor Equity, it might also run into a regulatory capital shortfall.
As a result, PE firms almost always have to use a significant amount of Equity, if not 100% Equity, to invest in banks. They often make minority-stake investments, invest in something other than Common Equity, and do club deals with multiple other PE firms to get around these problems.
So, “bank buyouts” are more like growth equity deals or debt investments than traditional leveraged buyouts.
The main returns sources are Tangible Book Value growth, P / TBV multiple expansion, and Dividends; “Debt Paydown and Cash Generation,” a key returns source in a traditional LBO, does not exist in the same way.
TBV growth depends on the bank’s ability to source Deposits and Loans and grow its Net Income over time while issuing modest Dividends.
P / TBV multiple expansion depends on the bank’s ability to boost its ROTCE or ROE, boost its Net Income to Common growth, and reduce its Cost of Equity.
Of those, it’s most viable for the PE firm to implement strategies to boost the bank’s Returns-based metrics such as ROTCE or ROE. It might plan to cut the bank’s costs, target higher-yielding Assets, aim for higher Asset growth, or secure lower-cost funding sources.
A “Bank Buyout” Model in Steps
Start by making Transaction and Operating Assumptions, such as the Purchase P / TBV Multiple, Fees, Exit Multiple, and Loan and Deposit Growth.
Then, set up the Sources & Uses and PPA schedules. You still write down a bank’s Common Equity, Goodwill, and Other Intangibles, and replace them with new items in a control deal.
In a growth equity deal, you would skip this part and just assume extra Cash and Equity from the minority investment.
Next, adjust the Balance Sheet – items such as Cash, Gross Loans, the Allowance for Loan Losses, Goodwill/Intangibles, Deferred Taxes, and Equity will change. In a growth equity deal, only Cash and Equity change immediately after.
Project the Balance Sheet and use Federal Funds Sold and Purchased as the balancers, and then use the Balance Sheet figures to project the bank’s Income Statement and Cash Flow Statement.
Finally, project the bank’s Regulatory Capital. Focus on CET 1, which is close to Tangible Common Equity, and “back into” the Dividends the bank can issue based on its Targeted vs. Actual CET 1. Risk-Weighted Assets can be a percentage of Interest-Earning Assets.
Calculate the MoM Multiple and IRR at the end based on the Equity Purchase Price, Exit Equity Proceeds, and Dividends, and create a summary and sensitivities for the entire model.
This deal doesn’t seem great because we need 20% Exit P / TBV multiple expansion, from 2.5x to 3.0x, to get a 20% IRR, but the bank’s ROA and ROTCE fall over this 5-year period. It doesn’t seem plausible for the bank’s P / TBV to *increase* when its financial performance declines.
But to evaluate it more fully, we’d have to look at different scenarios and sensitivities.