Combining Banking with Private Equity Investing

This post comes to us from Lily Fang, Assistant Professor of Finance at INSEAD, Victoria Ivashina, Assistant Professor of Finance at Harvard Business School, and Josh Lerner, Professor of Entrepreneurial Management and Finance at Harvard Business School.

In the paper, “An Unfair Advantage”? Combining Banking with Private Equity Investing, which was recently made publicly available on SSRN, we explore the phenomenon and economics of private equity investment by bank-affiliated groups. This paper is motivated by recent regulatory efforts to limit the ability of banks to undertake proprietary investing and trading activities. Despite the controversy and policy debate that the proposed Volcker rule has engendered, we know remarkably little about how banks have fared as investors. Does the combination of banking and private equity investing endow banks with superior information that allows them to identify good prospects and garner superior returns? Or does the combination bestow banks with an unfair ability to expand their balance sheets, capturing benefits within the bank at the expense of the overall market and ultimately the tax payers? We focus here on understanding the experience of bank-affiliated funds with private equity to shed light on these questions.

We take a comprehensive look at the role of banks in the private equity industry. Examining 7,902 transactions between 1978 and 2009, we find that 26% of all private equity investments involved bank-affiliated private equity groups. The evidence seems consistent with important advantages for the bank affiliates. Prior to the transaction, targets of bank-affiliated funds have significantly better operating performance than other targets. These deals were financed at significantly better terms than other deals when the parent bank of the affiliated private equity group is one of key lenders in the lending syndicate. We show that having a private equity subsidiary as an investor in a deal significantly increases the odds of the parent bank being chosen as a future lender, M&A advisor, or equity underwriter. However, “cross-selling” of bank businesses is an unlikely explanation for the better loan terms given that this superior financing primarily occurs during the peaks of the private equity market.

It is also unlikely that better financing terms for bank-related private equity groups are explained by access to better targets. Despite the fact that bank groups’ targets have superior performance before the investment, exit outcomes are mixed, with slightly poorer performance in bank-related investments. Importantly, the under-performance is particularly true for investments made in peak years. Larger deals, commercial-bank-led transactions, and investments involving both bank-affiliated investors and stand-alone private equity firms done at the peaks of the market face significantly higher odds of bankruptcy.

Overall, the cyclicality of bank-affiliated transactions, the time-varying pattern of the financing benefit enjoyed by affiliated deals, and the generally worse outcomes of these deals done at market peaks raise questions about the desirability of combining banking with private equity investing. Private equity is highly cyclical, with investments during peak period exhibiting problematic performance on a variety of measures. The involvement of bank-affiliated funds appears to exacerbate this cyclicality, and to introduce significant risks into the system. While there is some evidence that banks enjoy some information related synergies in that their target firms tend to have better ex ante characteristics, our overall findings seem to indicate that their involvement pose significant issues as well.

These results, however, cannot answer the broader questions about the desirability of the Volcker rule. There is a need for considerable further research. To cite one example, our analysis indicates that the increased negative outcomes of bank-affiliated transactions are concentrated at market peaks. What the lasting social consequences of these unsuccessful outcomes are remains unclear. Andrade and Kaplan (1998) argue that the lasting effects of financial distress for private equity transactions in the early 1990s was quite modest, a view also consistent with the more aggregated analyses of Bernstein, et al. (2010). Thus the negative impact may be muted overall.

The full paper is available for download here.

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One Comment

    Posted Tuesday, June 1, 2010 at 7:58 am | Permalink

    This is a very interesting paper, thanks for making it available, it shows how little we know about the true extent of the impact of mixing private banking funds with equity investing, and show that further regulation is required.