June 13, 2000
Chairmen Grams and Bennett, Ranking Members Dodd and Bryan, Members of the Subcommittees, thank you for the opportunity to appear here today to discuss the regulation of merchant banking activities under the financial services legislation.
The enactment of financial modernization legislation was intended to stimulate greater competition and innovation in the financial services industry. The Administration and Treasury strongly supported the enactment of financial modernization legislation and worked hard to produce a balanced bill that serves the interests of consumers, companies, and the economy. As part of that legislation, banks are allowed to engage in merchant banking activities, both as intermediaries and as investors, to enable them to better compete with other institutions that are active in these markets. At the same time, however, Congress intended to limit the mixing of banking and commerce and to ensure that merchant banking activities are conducted in a safe and sound manner.
The new merchant banking authority provided under the financial modernization legislation significantly expands the ability of bank affiliates to invest in the private equity market. We and the Federal Reserve Board are in the midst of a rule-writing process implementing the merchant banking provisions of the financial modernization legislation. As part of this process, we are consulting broadly to ensure that those rules fully carry out Congress's intent to grant financial holding companies this important new authority and to preserve the safety and soundness of our financial system, the strongest and most vibrant in the world.
I would like to discuss four areas in my remarks today:
The most important thing to understand about investments in the private equity market, or as it is often called, merchant banking, is that these investments are generally higher risk, longer term, illiquid investments. To help you better understand this market, let me begin by describing the history and size of the private equity market, the nature of the investments and the risks they pose, and the vehicle through which most of these investments take place, the private equity partnership.
History and Size of Private Equity Investing
Private equity investing has been a feature of the capital markets for centuries. Private equity investments generally are understood to include transactions undertaken by professional investors in unregistered shares of private or public companies. The organized private equity market represented over $400 billion in assets under management as of year-end 1999. Until the 1950s, private equity investing was largely the domain of wealthy individuals. Families like the Whitneys and Rockefellers made significant venture capital investments in the post-war period. Institutions started to become involved in this type of investing in the 1960s and 70s, through direct investments, limited partnerships, and Small Business Investment Companies ("SBICs").
After a series of tax and pension law changes in the late 1970s, limited partnerships became the predominant vehicle for collective investment in private equities, leading to dramatic growth in this market. Although information on this market is limited, the available data indicate that the organized private equity market has grown from under $5 billion of private assets under management in 1980 to over $400 billion in 1999, a more than 80-fold increase over twenty years. This growth has paralleled a long period of strong growth in the public equity market. During this time, the public equity market has grown from approximately $1.5 trillion in 1980 to over $17 trillion in 1999, an approximately 12-fold increase.
During the period from 1980 to 1999, the composition of the private equity market shifted significantly. In 1980, approximately two-thirds of private equity investments were in the form of venture capital, that is, investments in start-up or early stage companies. By 1999, venture capital investments had fallen to one-third of the private equity market. From 1980 to 1999, non-venture capital investments grew almost 150-fold and now constitute two-thirds of the private equity market. While leveraged buy-outs represent the bulk of non-venture capital investments, such investments also include privately held, middle-market companies and companies in financial distress.
Nature of the Investments
Private equity generally is the most expensive form of finance available. Equity investing, by its nature, represents the highest-risk part of the capital structure, because it has the lowest priority of claim on the cash flow of a company. Private equity investing adds further risk elements. First, these investments are illiquid, as they cannot be readily bought or sold the way registered shares of a publicly held company can be. Second, the investments generally are made in higher risk companies, such as start-ups, leveraged buy-outs, or similar investments. Third, the investments are typically held for the intermediate to longer term in the expectation of higher returns for higher risk.
Private equity investors demand high rates of return to compensate for the risks associated with these investments. For venture capital investments, there are significant risks that a product or strategic plan of a start-up company may prove unworkable. For a leveraged buy-out of an existing firm, there are significant risks associated with the high levels of debt a company takes on in connection with such a buy-out.
Private equity investments generally are longer-term investments. They are generally held from three to seven years, and may be held longer. These investments tend to be illiquid, in part because the securities generally are not registered or the companies are not public. The ownership stakes held by private equity investors also tend to be quite large, further contributing to the illiquidity of the investments. Investors often will have controlling or majority stakes in companies.
Private equity investments are made with a goal of eventual resale. An investor's exit strategy may consist of selling a stake in a company through a merger or acquisition or taking the company public. The ability of investors to successfully exit an investment and realize any appreciation in value depends in large part on how receptive markets are to such a sale. Thus, one of the most important opportunities and risks of private equity investing relates to the performance of the equity and merger markets.
We are currently in the midst of the longest economic expansion in our history. In addition, the U.S. capital markets have had a long period of strong performance. Experience over the last decade, therefore, can provide only partial guidance as to the riskiness of private equity investments in the future. We should be careful not to let today's confidence lead to complacency as to the general risks associated with these investments in the future.
Private Equity Partnerships
Let me briefly describe the vehicle by which most of these investments take place. The best estimates are that approximately 80 percent of private equity is invested through limited partnerships. These partnerships generally have a professional asset manager acting as the general partner. The general partners most frequently are independent private firms that are not affiliated with either commercial or investment banking organizations. The investors are generally public or private pension plans, endowments, foundations, corporations, and wealthy individuals.
For many of these investors, the funds placed with private equity partnerships represent a portion of their funds that they dedicate to higher risk assets. Other high risk investments sometimes include investments in real estate or hedge funds. Indeed, the partnerships that invest in the private equity market are set up in much the same way as hedge funds. An important difference between private equity partnerships and hedge funds, however, is that private equity partnerships generally do not use leverage within the partnership. The portfolio companies themselves, however, often do have leverage.
Role of Financial Institutions in the Private Equity Market
Let me now turn to the role of financial institutions in the private equity market. While private equity investment takes place largely outside of financial services firms, commercial and investment banks play a number of roles in this market, as agents, intermediaries, and investors.
As agents or underwriters, financial services firms provide services to investors, companies, and asset managers. In particular, they raise funds for portfolio companies and partnerships and advise on mergers and acquisitions. They also act as intermediaries, managing private equity partnerships and investments for others. Investment banks, in particular, are active in each of these areas. In these roles, financial services firms generally are more insulated from risk than they are when acting as investors.
Commercial and investment banks also are investors in the private equity market. Investment in private equity by commercial and investment banks has grown during the last ten years. While precise figures are not available, the best estimates are that these investments currently represent roughly 20 percent of the organized private equity market. Investment banks have invested in private equities since the 1970s, generally as a complement to their management of private equity partnerships. Some of the earliest venture capital partnerships, such as the Sprout Group, were formed by investment banks.
Prior to enactment of the financial modernization legislation, commercial banks and their affiliates had limited authority to invest in equities through Edge Act corporations, under the Bank Holding Company Act, and through SBICs. These investments accounted for just under ten percent of the total investments in the private equity market. This activity has been concentrated in a few large banks, with the top ten commercial banks accounting for an estimated 90 percent of the total private equity investments held by commercial banking organizations.
Currently about $5.3 billion, or approximately 14 percent, of the private equity investments held by commercial banks are invested through SBICs. While this is only a small portion of commercial bank investment in private equity overall, commercial banks represent 60 percent of the total private investment in SBICs.
In removing many of the restrictions of the Glass-Steagall Act to allow broader affiliations of financial services firms, last year's financial modernization legislation sought to provide increased competition and innovation in financial services. The legislation permits financial services firms to participate more broadly in merchant banking activities. This will enable commercial and investment banks to affiliate while allowing investment banks to retain their private equity investments. We fully support this "two-way street" approach. In addition, the legislation allows financial services firms to take advantage of the complementary nature of private equity investing with many of their existing activities.
Nonetheless, the legislation does not allow for unrestricted merchant banking activities. When the President laid out his four key principles for achieving an acceptable financial modernization bill, one was to ensure that the legislation did not permit inappropriate mixing of banking and commerce. We had learned important lessons from the experience of other countries, and we did not want to repeat their experience in our country. In particular, we had seen the risk of permitting combinations of companies that allocate capital with those that compete for capital. After much debate, Congress concluded that we should be cautious about allowing banking and commerce to mix through the affiliation of financial and commercial organizations.
The United States has the most efficient capital markets in the world. The allocation of capital and risk in our markets is not burdened by corporate affiliations or relationships between financial and commercial enterprises. Other countries, both in Europe and in Asia, allow their banks to have direct, long-standing, ownership interests in commercial firms. None of these countries, however, has capital markets as efficient and as well-developed as ours. None has a capital market that contributes so successfully to its economy as ours does.
Congress followed two key principles in authorizing financial holding companies to engage in newly authorized merchant banking activities - first, to maintain an appropriate separation between banking and commerce, and second, to ensure that merchant banking activities are conducted in a safe and sound manner. To achieve these objectives, the Act permits financial services companies to engage in the newly authorized activities only if the following conditions are met:
Finally, Congress provided joint rule-writing authority to the Treasury and the Federal Reserve Board to ensure that merchant banking activities would be conducted in a safe and sound manner and would preserve an appropriate separation between banking and commerce. As Chairman Gramm stated, "[t]he conferees . . . have specifically authorized the Federal Reserve and the Treasury Department to jointly issue rules on merchant banking activities. If the regulators determine that any such rulemaking making may be necessary and desirable going forward, the conferees encourage them to act expeditiously." Commenting on the rulemaking authority in separate statements during floor debate on the conference report, Conference Chairman Leach and Senator Sarbanes each stated that "under the [rulemaking] authority, the Federal Reserve and the Treasury may define relevant terms and impose such limitations as they deem appropriate to ensure that this new [merchant banking] authority does not . . . undermine the safety and soundness of depository institutions or the Act's general prohibitions on the mixing of banking and commerce."
We are currently in the midst of the rule-making process. Two rules have been published for comment. The first is an interim rule and request for comments published jointly by Treasury and the Federal Reserve implementing the merchant banking provisions of the legislation. The interim rule addresses issues such as permissible investments, risk management, holding periods and other issues. The second is a proposed rule published for comment by the Federal Reserve that would establish capital requirements at the bank holding company level for equity investments.
The comment period on each of the requests for comment recently closed. We are currently reviewing and analyzing the comments received. We plan to discuss the issues raised by commenters both with the Federal Reserve and with the other bank regulatory agencies. It is therefore premature to make any predictions as to how we will resolve any of the issues addressed in the comments.
In developing these rules, Treasury and the Federal Reserve not only relied on institutional knowledge of the financial markets, but also conducted research and broad surveys of market participants. Interviews with some of the larger financial firms engaged in merchant banking highlighted current industry practices, including holding periods, involvement in the management of portfolio companies, and monitoring and risk management systems.
The firms we interviewed clearly recognized that private equity investments often are riskier, less liquid and more volatile than other types of investments. These investments also often involve investment in leveraged companies. Consequently, these investments require greater capital support and careful monitoring and risk management. This was consistent with what I had seen in my 18 years on Wall Street. The interim rule is meant to be consistent with industry practices in making, monitoring and managing the risks associated with merchant banking investments.
The interim rule includes six main provisions:
In addition to the rule that Treasury and the Federal Reserve have jointly issued on the new merchant banking activities, the Federal Reserve has proposed, with our participation and support, a rule governing the regulatory capital treatment of equity investments in non-financial firms.
The Board's capital proposal would place a 50 percent capital requirement at the holding company level for such investments throughout a bank holding company. The capital requirement, as proposed, would apply not only to newly authorized merchant banking investments, but also to certain specified investments made under previously existing investment authorities, including equity investments made by banking organizations through SBICs and Edge Act corporations. I would like to note here that these capital requirements would not apply to investments through SBICs made by organizations that are not affiliated with a depository institution.
Given the risks of merchant banking investments, no one would suggest that it is appropriate for an institution to borrow $24 of debt, add one dollar of equity, and invest $25 in a private equity investment. This, however, is what is permitted by existing regulatory capital rules. The 50 percent regulatory capital requirement proposed by the Federal Reserve would allow financial holding companies to modestly leverage one dollar of equity with one dollar of borrowing to invest two dollars in private equity investments. The proposed requirement is half of the customary 100 percent equity capital that is raised by private equity partnerships managed by non-financial services institutions. The 50 percent requirement also is within the range of economic capital often held by financial services firms to support private equity investment.
We and the Federal Reserve have received significant comments with respect to the proposed capital requirements. Commenters have raised concerns as to the appropriate level of the capital requirement and the scope of its application with respect to investments under pre-existing authority. While Governor Meyer will discuss these issues further, I know that both the Federal Reserve and the Treasury will be considering all these comments carefully prior to publication of final rules.
At the present time, we continue to review the comments received on the rules and will carefully consider the important issues raised by the commenters. As we move forward, Treasury and the Federal Reserve will work closely to ensure that the new merchant banking authority is used in a way that preserves the safety and soundness of our financial institutions and the strength of our capital markets.
Thank you. I will be happy to answer your questions.
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