Private equity firms ravaged Simmons, could they do the same to banks?

A big cover story in Monday's New York Times looks at how Simmons Bedding Company, a 133-year-old firm, was driven into bankruptcy by private equity firms. The story is alarming in a number of ways, not least for implication that private equity can be a powerfully destructive force in the "real," productive economy.

Could these same firms use similar techniques to push troubled banks over the edge? Now that the FDIC has voted to allow private equity firms to buy troubled banks, we could be looking at another tsunami of bank failures several years in the future.

Let's first take a look at how private equity firms drove Simmons to bankruptcy while making $750 million in profits over the years. The current owner, Thomas H. Lee Partners netted about $77 million in profits collected as special dividends and fees for buying and running the company. Wall Street investment banks also made millions arranging for numerous takeovers of Simmons since its first sale in 1991 when the company had just $164 million in debt.
In ways that are reminiscent of the housing bubble, private investors firms kept selling Simmons for more and more money with each deal since 1991, taking what they could in profits and then finding another buyer to pay more for the company. As with housing speculators who got low-down or zero-down loans, the private equity firms put down little up front to pay for the company and loaded up the company with more and more debt. Today Simmons owes $1.3 billion thanks to the private equity deals.

Has the FDIC put in enough protection to avoid making the same mistakes with banks? The FDIC is desperate to find buyers for what could be another 150 failed banks or more. The insurance fund takes less of a loss if the FDIC finds a buyer rather than liquidating the bank's assets. So it now wants to turn to private equity firms and foreign banks to increase it's number of possible buyers.

In order to entice the private equity firms, FDIC approved new rules in August to reduce the amount of cash private-equity firms must maintain in banks they acquire. As we've seen in the Simmons example, private equity funds buy distressed companies, slash costs, take whatever cash they can out of the company and then resell the company a few years later. Do we really want people with that mindset buying up troubled banks?

Under the new rules, private equity firms must maintain the bank's capital reserves equal to 10 percent (prior to this change the private equity firms were required to maintain 15 percent reserves). Banks which buy banks are only required to maintain a five percent minimum requirement. Also, to protect against the type of flipping we've seen in company purchases by private equity firms, private investors must maintain a bank's minimum capital levels for three years. Will these rules truly protect these troubled banks from being used by the private equity firms as money makers until there is no more money to make -- placing banks back on the failure list just a few years later?

Lita Epstein has written more than 15 books, including Trading for Dummies and The Complete Idiot's Guide to Value Investing.

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