Combining Banking with Private Equity Investing Adds Risk to Financial System
A new working paper from Harvard suggests investors may benefit if investment banks are forced to spin off their private equity operations as may occur under pending financial reform.
The paper attempts to address recent regulatory efforts to limit the ability of banks to undertake proprietary investing and trading activities.
Highlights from : “An Unfair Advantage”? Combining Banking with Private Equity Investing by Lily Fang, Victoria Ivashina, Josh Lerner
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.
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