The VC on the Corner
Banks -- and not just big banks -- have started to eye growth companies as targets for private-equity investments
When you think about everything a good bank could offer you, are you focused on a credit line? If you are, it may be time to refocus your priorities.
That's because a growing number of banks -- large and small -- are setting up venture arms to invest in private-equity deals with entrepreneurial companies. At a time when volatility in the stock market, reduced venture-capital investment, and a range of other economic concerns have put some constraints on capital raising, banks' increased involvement as investors is one trend that is moving in the right direction for business owners.
"There are so many banks doing these kinds of deals now that they've quickly become a standard source of financing to pursue," says Gordon Tunstall, a financing intermediary whose firm, Tunstall Consulting Inc., is based in Tampa. When Tunstall recently raised $20 million for a software company that needed the funds to convert to an application- service-provider model that would substantially broaden its customer base, several banks were among the equity investors. "I'd have to say that they're interested in the same kind of deals that any other professional private-equity investor would consider: companies with at least a 20% to 30% growth rate, good profit potential, and a clear exit strategy, which might mean an IPO or a sale to a strategic partner," Tunstall says.
Although the trend developed relatively quickly, it seemed for a while as though it might be confined to the nation's largest banks, with Chase, Bank of America, and First Union emerging as big players. "Throughout much of the late 1990s, large banks were successful in finding legal ways around the regulatory restrictions that had limited their abilities to underwrite securities and make equity investments," explains Jerome Walker, a partner and banking regulatory expert at Salans, Hertzfeld, Heilbronn, Christy & Viener, a law firm in New York City. "They were looking for ways to move beyond the small, community-based investments that the government had been encouraging them to make for decades."
The logic behind the appeal of equity was irresistible. "The return that a bank can earn on a good private-equity investment is a lot more than the spread between the interest it pays for deposits and the interest it earns on loans," comments Sarah Miller, general counsel for the American Bankers Association Securities Association, based in Washington, D.C. "This is why we're no longer just seeing the top-tier banks getting involved in what we call 'merchant banking' activities. Even the smaller banks are interested, and many have started getting their feet wet."
A friendlier regulatory environment has also helped clear the path. Although legal restrictions still exist -- largely to preserve the financial soundness of banks as they take on new risks -- many types of investment opportunities are now possible, among them joint ventures or investing in common-stock deals, leveraged buyouts, and mezzanine (or interim) financing.
"As of now, what we've seen is two common forces driving banks into these deals," reports Jay Hachigian, a partner in the Waltham, Mass., office of Gunderson, Dettmer, Stough, Villeneuve, Franklin & Hachigian, a law firm that represents venture-capital funds and emerging growth companies. "It might be that a bank already has a lending relationship with a company, so now this becomes a way of broadening that relationship to include an investment component. But we've also seen cases where banks decide that the way to start their dealings with a young company is through an equity investment. And their thinking may be, as this company grows and becomes more mature -- and therefore more able to sustain debt -- the bank will also become a lender."
What's the bottom-line impact of all this for the owners of entrepreneurial ventures? More financing sources mean, at least in theory, better prospects for raising growth capital. But with a developing trend like this one, you'll need to be creative in figuring out how to tap into the market.
Certainly, if you have a relationship with a lending institution, it's worth investigating whether that bank maintains a private-equity arm to invest in customers or other growth companies. But don't be surprised if it's tough to get an answer to that question. Tunstall laughs as he notes, "I regularly bring deals to First Union Capital Partners. But if I went to the local branch of First Union and asked someone there about private-equity financing opportunities, it's a pretty good bet that he or she wouldn't know what I was talking about."
If you have a relationship with a lending institution, it's worth investigating whether that bank maintains a private-equity arm to invest in growth companies.
Aggressive networking is, as always, a good idea. "The banks that have made private-equity investing a priority either have set up subsidiaries or acquired companies that know how to do it, so they're already out there following market trends and looking for good investment prospects," says Laurence Markowitz, a Salans partner who assists clients with private-equity placements and sometimes works with bank investors on equity deals. "If they haven't yet approached you, then you're best off working with some kind of middleman, whether it's an investment banker or your attorney or accountant, so long as they've got a proven record of dealing with banks as well as other sources of capital."
For any business owner who's been frustrated by the time-consuming loan-application process, there's some good news. When it comes to handling private-equity investments, banks are just as fast and efficient as any other players in the market are. That's because the decision makers in the banks' equity deals often gained their expertise working at traditional private-equity funds or investment banks.
If you're interested in pursuing this financing path, keep in mind a couple of caveats: Small-but-steady-growth companies need not apply. Also, if your growth model is very high risk, your prospects with bank investors may not be too strong, especially given the current state of the economy. Private-equity insiders say that the downturn in the Nasdaq market and, most especially, the dot-com collapse have raised caution levels and made banks likelier to nix deals that lack very clear exit strategies.
That's not too surprising. After all, willing and able as bank investors may be, they are simply not the same as other private-equity players. According to Miller of the ABA Securities Association, many banks have been spooked by proposed Federal Reserve Board regulations that would require them to set aside large amounts in reserve against such risky investments.
"Banks have problems with these rules, especially as they were initially proposed by the Fed, since they would have needed to set aside reserves worth 50% of each investment," says Miller. "That's very different from the requirements that they're used to dealing with, which allow them leeway about which loans they make small or large reserves against." One way that the nation's largest banks have tried to cope with such restrictions is by wooing outside investors to put up some of the funds the banks will invest. Chase Capital Partners has been particularly active in that regard.
The bottom line for business owners: look for new and expanded opportunities on the bank-equity front. And keep in mind a lesson that you've probably already learned in your search for a line of credit: bankers can be a hard sell, at least the first time you approach them. So build a good business plan, concentrate on achieving your growth objectives, and keep knocking on those doors.
Jill Andresky Fraser is Inc. 's finance editor.
It's hard enough to come up with a list of investors that are worth approaching in the private-equity market. It's even harder when a new trend is developing, as is the case today with banks.
Although there's no comprehensive, up-to-date source of information regarding which banks are doing what in investing in growth companies, the Internet is always a valuable tool when you're hunting for capital. One site that provides a wealth of leads about both debt and equity options is www.businessfinance.com. There you can explore local microloan programs and all kinds of government financing opportunities (including those connected with the Small Business Administration). The site also covers equity options (with investors divided into different categories, based on the type of private-equity money you're seeking).
After that, try doing an Internet search using such word combinations as "banks and merchant banking" and "commercial banks and venture capital." You won't generate a bank vault full of leads, but you may come up with some interesting prospects that you haven't learned about elsewhere.
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