A recent study has called into question private equity investments by bank-affiliated PE firms. The study by INSEAD Professor Lily Fang with co-authors Victoria Ivashina and Josh Lerner of Harvard, called ‘An Unfair Advantage’? Combining Banking with Private Equity Investing, found that between 1983 and 2009, bank-affiliated groups accounted for more than a quarter of all PE investments.

It also found that the involvement of banks increases during peaks of PE cycles, with deals by bank-affiliated groups getting financing on ‘significantly better terms’ than other deals when the parent bank is part of the lending syndicate.

Yet, the bank-affiliated PE investments have slightly worse outcomes and deals during market peaks have ‘significantly higher rates of bankruptcy’.

So while there are clearly risks in combing bank and PE investing, are the bank-affiliated PE groups getting an unfair advantage?

“We argue in the paper that the concerns that regulators have, in terms of allowing banks into different risky opportunities and the concerns of risks associated with combining various activities (of banks and PE groups), do seem to be well justified”, Fang said in an interview with INSEAD Knowledge.

The study was completed as US lawmakers considered the so-called ‘Volcker rule’, named after Paul Volcker, the former chairman of the Federal Reserve who had championed it. The rule, part of the Dodd-Frank Act, seeks to curb the proprietary trading operations of US banks, in terms of speculating on the markets.

Fang says she and her co-authors were ‘quite lucky’ with the timing of the paper.

“We started this paper in early 2009. At the time, the ‘Volcker rule’ hadn’t been talked about and in fact the phrase -- ‘Volcker rule’ -- hadn’t been coined.”

She adds that the phrase became common currency a year later, just as the research team had prepared its initial draft.

“The study compares the financing and performance of private equity deals done by bank-affiliated private equity groups (such as Goldman Sachs Capital Partners) with those done by standalone private equity groups (such as KKR).”

“I, myself, was actually a bit surprised by how extensively banks were involved in private equity investments” as the researchers found that just 14 bank-affiliated PE groups accounted for more than a quarter of all PE deals between 1983 and 2009.

“That’s a significant amount. If we used our (data to assess) larger deals, they actually account for nearly 30 per cent of them.”

There was also a high concentration of activity, with Goldman Sachs alone accounting for more than a third of all the deals done by bank-affiliated PE groups.

Moreover, many of the bank-linked deals were done at the peaks of PE markets. One possible hypothesis is that this may have been due to the banks being more prepared to lend money based on the information they have about potential deals.

However, the authors believe another hypothesis may be more relevant: that the banks can take advantage of credit-expansion cycles and then pass this capital on to their subsidiaries.

“We do find that the banks seem to be able to take advantage of the cheap credit at the peak of the market and essentially that benefits the financing of the private equity deals done by their PE subsidiary.”

Asked whether the Volcker rule, which would cap the level of banks’ investment in PE groups, goes far enough, Fang replies: “We should look at the Volcker rule as trying to reduce the complexity of financial institutions. Complexity helps make banks ‘too big to fail’. And when certain institutions are enjoying taxpayer subsidies implicitly or explicitly, this is unfair. So the key question is whether any benefits of combining certain activities, such as banking and private equity investing, outweigh the costs in terms of risk-taking behaviour and its consequences”.

“If anything, our study shows that we have a very big knowledge gap in terms of these very complex investments and our study is really one of the first attempts to try to shed some light on the subject.”

Stuart Pallister is the editor of INSEAD Knowledge.