FDIC's Crisis Mode Pressures Blackstone

The Blackstone Group L.P. (BX) gave up significant ground this week as investors weighed new potential regulations which could impact investment opportunities for the private equity firm. The stock was off 18.5% in the five trading sessions and the move was largely attributed to new FDIC crisis proposal which would place more restrictions on PE firms wishing to buy troubled banks. The current US administration appears hell bent on solving the financial crisis through instituting new piecemeal regulations. These regulations more often than not end up creating new problems as markets are not allowed to operate freely. Unintended consequences can ultimately become worse than the original issue which was intended to be solved through the regulations.

This week’s proposal comes from the FDIC which is dealing with a continual rash of bank failures. One of the FDIC’s major concerns is that private equity firms such as Blackstone my swoop in and buy out failing or troubled banking institutions on the cheap. While this type of transaction is welcome in today’s market (the FDIC continually needs to find institutions to take over these failed situations), the fear is that private equity firms will then turn around and spin off these banks before they are truly healthy - thus leading to repeat failures and continual uncertainty in the financial industry.

The typical business model for private equity firms is to purchase companies at attractive rates. The PE management will then make necessary changes to make the business more attractive to traditional investors. At some point several months or even years later, the PE firm will sell the particular business to outside investors and book a profit on the entire transaction. Most often, the PE firms will strip out much of the capital from the newly resurrected firm and spin it off with significant debt. The strategy works well in a healthy economy because the new company usually has adequate cash flow to cover the significant debt load. However, the fear is that as bank investments are spun off to new investors with significant debt loads, the failure rate could continue to be very high. This could have a very negative effect on the entire economy given the importance of the financial sector.

Currently, the required Tier 1 capital ratio is 4% meaning that for every $100 of risk weighted assets, the bank should have $4 worth of solid liquid capital to protect against losses. The new proposal would require private equity firms to put up 15% Tier 1 capital. This requirement would significantly cut the profitability of these types of transactions because the necessary investment is much higher. At the same time, the FDIC would require PE firms to hold a bank for 3 years as opposed to the current 18 month required holding period. So not only has the potential return of such a transaction been cut, but the minimum term has been increased. A PE firm could purchase a bank and turn around the operations within a year, but still be required to operate the bank for another 2 years before selling and recognizing a gain on their investment.

The regulations are designed with good intent. As mentioned, the FDIC doesn’t want to see these banks coming back around as failed institutions again. But at the same time, the FDIC needs the capital and stability of these PE firms in order to help support the banking system and protect consumers. According to a Forbes article “Beggars Can’t be Choosers” the FDIC is not in a very strong negotiating position considering it needs Private Equity more than PE firms need these particular bank deals.

So as Blackstone trades off sharply, it could represent a strong investment opportunity for those who believe in the private equity model. Despite the challenges in the banking industry, Blackstone has opportunities in many sectors across the gamut of industries. With equity prices very low, and many firms still struggling with liquidity concerns and debt burdens, Blackstone is operating in a “target rich environment.” The firm doesn’t necessarily need to be able to buy banks in order to succeed in its business model.

Blackstone has been successful in raising capital for several new and existing funds. This means that the company is well positioned to buy distressed situations and recognize strong profits in coming quarters and years. Keep in mind that the firm participates in the profitability of its clients so as this new capital is put to work in investment opportunities, Blackstone will often command 20% of profits while being at risk for a much smaller percentage of losses. It’s the perfect leverage game.

The FDIC proposal is concerning but shouldn’t represent a 18 or 20% decrease in the long-term profitability of the firm. On the other hand, as public outcry against an increasingly anti-free market administration gains ground, it is likely that some of the new proposals could be scuttled or negotiated to provide more business friendly terms. This could set off a sharp rally in stocks of companies like Blackstone with the opportunity to take advantage of the current situation. The ZachStocks Growth Model has strong realized and unrealized gains in BX and will likely continue to be involved in the situation throughout the next few quarters.

Disclosure: Author has a long position in the ZachStocks Growth Model

Comments

[Weston 448:]

Nicely done. I agree with all of the analysis other than the assumption that Bx's trading in the last week or so is soley attributable to the intrusive FDIC measures. The trading pattern is consistent with what has been occurring for some time now.
I do, however, believe that Bx is an attractive long-term buy now.

Jul 12 10:32 AM

[Squeaky:]

As a victim (employee) of a Blackstone spunoff company, I think the extra restrictions are a good step in regulating these parasites (private equity firms). Everyone wants a free lunch and it is this short term, "do a cosmetic fix and dump the problem on someone else" attitude that has degraded America and got us into this huge mess in the first place.

It is disappointing to see there are folks out there like you that still support this destructive and shortsighted behavior. Let's hope your genes arent passed down through the gene pool.

Jul 12 12:00 PM