June 13, 2000
Good morning Chairman Grams, Chairman Bennett and Members of the Subcommittees. I am Frederick M. Fritz, President of BancBoston Capital, the venture capital arm of FleetBoston Financial Corporation ("FleetBoston"). FleetBoston resulted from the combination of Fleet Financial Group and BankBoston Corporation in October 1999. We are a diversified financial holding company headquartered in Boston, Massachusetts, serving over 20 million customers nationally and internationally and with total assets of over $187 billion. I am pleased to have the opportunity today to speak on behalf of FleetBoston and The Financial Services Roundtable about the merchant banking rules released by the Federal Reserve Board ("Board") and the Department of Treasury ("Treasury").
FleetBoston has been in the private equity business for 41 years and currently does business through two groups, BancBoston Capital and Fleet Equity Partners. One of our companies, BancBoston Ventures Inc., is the proud holder of small business investment company license No. 1, issued in 1959. Since that time, BancBoston Capital has grown into a global leader in private equity, investing through offices in Boston, Palo Alto, London, Hong Kong, Buenos Aires, and São Paulo. BancBoston Capital provides a wide range of financing options, from early stage venture capital for emerging growth companies to later stage investments for more mature enterprises, particularly companies in consolidating industries, growth firms needing capital to expand and companies undergoing ownership transition.
BancBoston Capital's investment activity focuses on information technology, healthcare and communication companies and small to mid-market manufacturing and service sector companies. Today we have about $2.3 billion invested in over 250 companies and a similar number of private equity funds. Much of our investing is done through our SBIC, which has a portfolio of about $477 million. Representative companies we have supported include: In Focus Systems, Internet Capital Group, Allaire Corporation, Gomez Advisors, BumbleBee Tuna, Columbus McKinnon, Perkins Family Restaurants and Mortons of Chicago.
Fleet Equity Partners, our other venture group, has invested in over 50 enterprises since it was organized in 1982, and currently manages over $1 billion in equity capital. Fleet Equity Partners specializes in private equity investments in telecommunications, healthcare business services, manufacturing, information and consumer opportunities.
This joint hearing is critically important and timely for banking organizations and securities firms alike since the implementation of the merchant banking provisions of the Gramm-Leach-Bliley Act ("GLB Act") will impact both industries. FleetBoston strongly supported the enactment of the GLB Act, which represents a remarkable consensus among Congress, the Clinton Administration, the regulators and industry groups. Implementation of this landmark legislation can, and will result in a stronger and more efficient financial services market that will benefit our customers and the U.S. economy.
One of the primary reasons for our support of the GLB Act, and for becoming one of the first newly authorized financial holding companies (commonly referred to as FHCs), was to take advantage of the expanded authority to engage in merchant banking activities. It is clear that Congress intended to encourage merchant banking activities by FHCs because of the economic benefits that a vibrant capital industry provides to small and mid-size companies, including e-commerce and technology firms, that have been the engine of our economic boom.
FleetBoston shares the Roundtable's serious concern that the merchant banking rules will place undue burdens on FHCs that choose to exercise these new merchant banking powers and will prevent FHCs from competing effectively with securities firms that are not affiliated with banks. Moreover, we believe that the proposed capital charge and other restrictions contained in the merchant banking rules undermine the purpose and plain meaning of the GLB Act, in clear contravention of the carefully constructed congressional compromise that gave birth to the merchant banking provisions in the first place.
The Roundtable and FleetBoston have submitted comment letters to the Board and Treasury urging them to reconsider certain aspects of the merchant banking rules. As explained in these comment letters, copies of which are attached to my testimony, we are particularly concerned about five aspects of the merchant banking rules:
The Fifty Percent Capital Charge
FleetBoston and The Roundtable object most strenuously to the Board's proposal to impose a fifty percent capital charge on merchant banking investments and equity investments by bank holding companies under the Small Business Investment Act and other long-standing legal authorities. This charge results in an eight-fold increase in the capital required to be held against these activities. We strongly believe this charge violates the spirit of the GLB Act and is excessive and unnecessary. While we have many reasons for objecting to the proposed capital charge, which are fully articulated in the attached comment letters, I would like to focus this testimony on the issue of risk management.
The Roundtable believes, and FleetBoston strongly agrees, that the fifty-percent capital charge is excessive in light of the actual risk experience of bank holding companies that have participated in this business. There is no correlation between the Board's proposed capital charge and FleetBoston's experienced risk of loss.
It would be an overstatement to assert that individual private equity investments do not involve a fair degree of risk. Although we would like to believe we select only good investments, no venture capitalist is right on every investment. However, a well-managed portfolio of carefully selected private equity investments does not present an undue risk of loss, and certainly not one that requires a fifty percent capital charge. In the fifteen years I have been involved in BancBoston Capital, we have lost money on individual investments, but we have never had an unprofitable year as a company. In fact, we have exceeded our parent company's return on asset threshold each year, and during that period we have averaged seven times FleetBoston's target return on assets.
Moreover, we do not believe the riskiness of our portfolio will increase as a result of the new GLB Act powers. We do not expect our investment approach or the types of companies we invest in to change substantially under the new rules. In fact, FleetBoston believes that there will be a reduction of risk as we and other FHCs employ methods of protecting our investments authorized by the GLB Act and Board's regulations commonly used by other venture capitalists that were barred by prior law. For example, we would be allowed to have seats on the company's board of directors.
There are alternatives to monitoring and controlling the perceived risk in merchant banking which are far superior to the Board's proposed capital charge, which are set out in detail in the Roundtable's comment letter. The Roundtable and FleetBoston favor a supervisory approach that focuses on the adequacy of the procedures FHCs employ to control and monitor the perceived risks of merchant banking. The Board could evaluate the adequacy of such internal risk management procedures, including the capital allocated to merchant banking investments, as part of its current, comprehensive examination process. An additional capital charge could apply only to those institutions that either choose not to implement internal capital allocation systems or that have inadequate risk management procedures. This approach would be particularly effective because it could be tailored to reflect the experience, sophistication and track record of individual FHCs without unnecessarily disrupting the business of FHCs with established and successful operations.
To provide some perspective on why the Board uses this approach now, and why it can and should continue to do so in the post-GLB Act environment, I would like to briefly describe how we at FleetBoston analyze prospective investments and manage risk. We believe most well-run private equity institutions have similar procedures in place and that the existence of these procedures is the key to controlling risk in this business.
In my view, the key to successful private equity investing is selectivity. On average, we review over 3000 serious proposals each year. Of these, only about 10 percent make it past the review stage and are subjected to an in depth review and fuller due diligence. This second level review is performed by experienced and knowledgeable officers who have extensive industry experience in their area of concentration, and includes an exhaustive review of accounting, legal, environmental, managerial and operational aspects of the proposed investment opportunity. It also includes a thorough review of research relevant to the industry and competitive positioning of the prospect, as well as communications with customers, suppliers and other investors involved with the company. The results of this review are incorporated in detailed, written reports, which summarize the opportunities and risks and recommend a course of action. All proposals are then subject to a multi-tiered approval process. Only about 2 percent of all companies reviewed survive the process to make it to the investment stage.
Once a decision has been made to move forward with a particular company, we carefully negotiate the documentation to assure satisfactory business and structural terms and access to financial and other information on a timely basis, such as its performance against budget. This enables us to actively monitor the performance and momentum of portfolio companies, and if performance slips, to intervene as necessary to help put it back on track.
Careful portfolio management is also important to managing risk. Our portfolio is diversified to avoid undue concentrations by industry type, geography, stage of a company's development or the age of an investment. We regularly monitor and review our portfolio to avoid excessive concentrations in any of these areas. It is also important that the carrying values of investments on our books do not exceed their true value. We accomplish this through quarterly reviews of each investment in our portfolio. Any asset deemed to be less than satisfactory will require an updated action plan and a determination regarding whether a write down is appropriate.
As the Board has noted, keeping adequate capital in reserve against the perceived risk of loss is also important. However, in contrast to the across-the-board 50 percent requirement, it has been our experience that what constitutes adequate capital can vary depending upon a number of factors, including the composition of the portfolio, as well as general economic conditions.
For these reasons, as well as the reasons articulated by the Roundtable and others in the industry, we are convinced that the Board's current, comprehensive supervisory approach to the oversight of merchant banking and other private equity investments is more effective and preferable to its proposed 50 percent capital charge.
The Maximum Investment Cap
FleetBoston and The Roundtable also oppose the Board's proposed maximum investment cap on FHC merchant banking investments, which prohibits a FHC from making additional merchant banking investments if the aggregate value of all merchant banking investments exceeds the lower of $6 billion or 30 percent of the FHC's capital base.
We strongly believe the Board should abandon the maximum investment cap and address excessive concentrations in merchant banking through their normal supervisory process for three principal reasons. First, there is no legislative basis for the cap; in fact, we believe that the cap is contrary to the intent of Congress to encourage the full exercise of these powers. Second, the cap unfairly discriminates against FHCs. Third, the cap penalizes FHCs, such as ourselves, which have long-established private equity businesses. Organizations with robust, successful private equity businesses will exhaust the limit far more quickly than new players who may take years to develop a sufficient business volume to reach the limit. It does not make sense to penalize successful, established private equity players who have already demonstrated an ability to manage the risks associated with merchant banking.
Restrictions on Private Equity Funds
FleetBoston and The Roundtable also disagree with the Board's and Treasury's imposition of numerous restrictions on the ability of financial holding companies to invest in, and manage private equity funds. While the capital charge and maximum investment restrictions appear to be designed to discourage financial holding companies from expanding their investment businesses, the proposed rules on private equity funds make it difficult for FHCs to pursue the logical alternative of using their investment expertise to manage others' investments. We believe these restrictions are generally unnecessary and create yet another competitive disadvantage for FHCs vis-à-vis fund operators not affiliated with an FHC. In addition, these restrictions will substantially deter non-FHCs engaged in managing funds from becoming an FHC.
FleetBoston has suggested that the funds to which an FHC contributes 25 percent or less of the total contributed capital be exempted from the qualitative restrictions imposed by the proposed merchant banking rules. The market validation and dilution provided by having unaffiliated investors holding 75 percent of the equity of such funds will be sufficient to ensure that the fund will be engaged in bona fide investing activities and not used as a vehicle for controlling and operating commercial companies.
The Maximum Holding Period
FleetBoston and the Roundtable object to the maximum holding periods on merchant banking investments. The merchant banking rules provide that, in most cases, merchant banking investments may not be held beyond a 10-year period. Interests held by a FHC in a private equity fund could be held for the life of the fund, up to 15 years under certain circumstances.
The maximum holding period is contrary to the clear language of the GLB Act. The Act permits an FHC to hold merchant banking investments for a sufficient period of time to "enable the disposition thereof on a reasonable basis consistent with the financial viability" of the investment. This flexibility is important to any private equity investor.
While BancBoston Capital's portfolio goal is to have an average life of 3 to 4 years on our investments, because realizations are event driven and to a certain extent outside of our control, there are always exceptions. Out of our portfolio of 250 companies, we have 10 companies that we have held for 10 years or more, usually because of restructuring, recapitalization or restarts. These companies represent real value to our shareholders. For instance, this month we expect to get a check representing a $5.2 million gain from an investment in a consumer products company that has been sold. The original investment was booked in 1987. Had we been forced to sell the investment in 1997, pursuant to the Board's proposed holding limitation, we would have realized little or no gain.
It is precisely this need for flexibility that Congress recognized in the language of the GLB Act, and we believe this is the standard which the regulators should apply. FleetBoston and the Roundtable believe the Board has ample supervisory tools at its disposal to address whatever safety and soundness issues that arise, and to ensure that investments are not held in a manner that allows the impermissible mixing of banking and commerce.
Technical Compliance and Reporting Requirements
Finally, the merchant banking rules also contain numerous technical compliance and reporting requirements which impose undue burdens on FHCs making merchant banking investments and provide yet another disincentive for electing FHC status in order to engage in merchant banking activities. These requirements, described more fully in the Roundtable's and FleetBoston's comment letters, include: (1) onerous limitations on managing or operating portfolio companies; (2) burdensome reporting and recordkeeping requirements; and (3) overly broad cross-marketing restrictions.
Chairman Bennett and Chairman Grams, Members of the Subcommittees, the Roundtable and FleetBoston appreciate the opportunity to provide our comments on the proposed merchant banking rule, and why it could adversely affect FHCs, the financing of small and medium size business and our economy. I would be pleased to answer any questions you might have about my testimony.
Home | Menu | Links | Info | Chairman's Page