PE capital in PacWest deal 'the key that unlocked the door'

A seldom-used structure that included private equity backing helped put Banc of California Inc. in a position to merge with the much bigger PacWest Bancorp.

In the transaction, Banc of California is issuing about $1 billion of stock to PacWest shareholders, backed by $400 million of equity financing from Warburg Pincus LLC and Centerbridge Partners LP to "reposition the combined company's balance sheet," according to a news release. The capital provided by the private equity firms made it possible for the approximately $9 billion-asset-sized Banc of California to ink a deal with the roughly $38 billion-asset-sized PacWest, said Colarion Partners Managing Member Sam Haskell.

"That was the key that unlocked the door," said Haskell, whose firm is focused on financial sector investments and holds long positions in Banc of California and PacWest.

Attracting the capital meant getting investor support for a platform that included a bank at the center of the March storm after the collapse of Silicon Valley Bank and Signature Bank. PacWest fell out of favor in part because of its exposure to venture banking, leading to the company being heavily shorted and facing deposit outflows.

Like other banks, PacWest has also dealt with scrutiny over its unrealized losses, which increased across the industry as higher interest rates hurt the value of assets on balance sheets. Mounting underwater assets make a sale more difficult because companies involved in bank M&A follow the common deal accounting practice of marking the target's assets to market in an effort to reflect the seller's value in current market conditions.

To reduce the impairment, the deal was structured in a way to make the acquirer, Banc of California, the accounting target. While the reverse merger structure is not commonly used, this is not the first time the buyer became the accounting target in a bank deal.

In a deal announced in October 2021, Columbia Banking System Inc. and Umpqua Holdings Corporation used similar reverse merger accounting mechanics, where Columbia was the legal acquirer but Umpqua was the accounting acquirer. It allowed Umpqua to record Columbia's assets and liabilities by fair value, and the combined entity continued forward using Umpqua's balance sheet.

Making the deal investable

Making Banc of California the accounting target made the deal more attractive to the private equity investors, said Keith Noreika, executive vice president and chairman of the banking supervision and regulation group at consultancy Patomak Global Partners. If PacWest were the accounting target then the unrealized losses "would make the amount of capital that would have to be inserted into the bank a lot larger, and potentially make the deal unviable to invest in," Noreika said.

Turning to private equity was a logical step because without investor support, Banc of California's capital would not have been sufficient enough to ensure a healthy balance sheet at the combined entity and publicly issuing equity in the current environment is a challenge.

"You can't sell shares for the most part on the stock market. So properly private capital, through private equity, is one of the more readily available sources of funds," Noreika said.

For the investors, adding exposure to a bank that has a host of unrealized losses on its balance sheet is not risk-free, but it does come with some longer-term upside appeal. Investors can view interest rate marks as less of a concern than credit marks because the assets can look more favorable as they mature or if rates start to drop.

The combination of Banc of California and PacWest along with the PE investment should put the company on more sound footing. Executives expect the combined entity will have a capital base of over 10% pro forma common equity Tier 1 ratio. They plan to sell Banc of California's single-family and multifamily mortgages and its bond portfolio, all of which will have been fully marked as a result of the transaction, along with some of PacWest's available-for-sale securities, which are carried on its balance sheet at fair value although unrealized losses do not reduce regulatory capital.

The combination also offers strategic rationale, especially given the familiarity between the two companies. Banc of California CEO Jared Wolff — who is slated to lead the combined entity — worked at PacWest from 2002 to 2014 and held such roles as general counsel at PacWest Bancorp and president of bank unit Pacific Western Bank. The two banks have a similar branch footprint in the southern California market, and some view them as "cousin institutions," Janney Montgomery Scott analyst Timothy Coffey said in a July report.

Private equity solution

Still, the headwinds PacWest faced made any deal involving the bank more challenging. One person familiar with the deal said private equity's role in the transaction helped take "a problem child out of the system." Finding a solution for a regional bank is certainly a positive for a banking industry that was shaken by three of the largest failures in US banking history with the demise of Silicon Valley Bank, Signature Bank and First Republic Bank.

However, private equity firms are not always welcomed by regulators when it comes to buying banks. One concern is that private equity firms are driven to prioritize financial returns, which could conflict with the interest of depositors.

"I think a lot of private equity firms that made investments in banks in the wake of the global financial crisis had a challenging experience with regulators," said a private equity investor who focuses on financial services and fintech.

In the 2008 financial crisis, one notable private equity deal was the $13.9 billion acquisition of IndyMac Federal Bank FSB by a group of investors led by Steve Mnuchin in 2009. The Federal Deposit Insurance Corp. later called for new rules governing such deals, asking private buyers of failed banks to hold more capital than regulatory requirements and to hold onto their investments for at least three years.

The hesitancy has not gone away. During the failed bank sales process earlier this year, private equity bidders were not always allowed to access the data room used by bidders and sellers to exchange information prior to an auction. However, regulators can be "more relaxed" about private equities' involvement in the Banc of California deal because it makes a stressed institution in PacWest larger and more stable, said Eugene Ludwig, founder and CEO of Ludwig Advisors and former comptroller of the currency.

"If PacWest wasn't an institution that had been attacked by short sellers and otherwise abused by social media and market forces, I think there would have been more reticence to move forward," Ludwig said in an interview.