Q&A

Flowers Weighs In
J. Christopher Flowers discusses the government's stimulus efforts, the bailout and how private investors can playa role in the recovery
By Julie Rogers

To really get the US econo­ my moving, I believe that a stimulus package of up to $2 trillion could be needed.

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MERGERS&ACQUlSmONS

.c. Flowers & Co. is the largest US private M&A: How is jCF & Co. targeting its investment in to­ day's markets? What rate ofreturn might investors hope to equity firm concentrating solely on the finan­ cial services sector, yet has ridden our the tur­ obtain in such turbulent markets? moil in the financial markets in relatively good shape. The firm stands ready for substantial Flowers: We consider potential private equity invest­ new investments in Asia, the US, and Europe, ments of $50 million upwards in the financial servic­ but according to the firm's founder, J. Christopher es sector including banking, insurance, asset manage­ Flowers, much still needs to be done for a financial re­ ment, brokerage, mortgages, and consumer finance. covery in the US that will boost financial markets We believe that target rates of return of 35% or high­ worldwide. er are achievable on new investments, especially in the Since its inception in 2001, JCF & Co. has raised US markets. JCF & Co.'s regional focus covers the US, close to $11 billion, with Fund III closing at $2.5 bil­ Western Europe, and Asia. Given current market op­ lion in September 2008. A parallel fund of $4 billion portunities, we are concentrating our efforts on the with sovereign wealth fund China Investment Corp. is US, which earlier appeared overpriced and less attrac­ also managed by JCF & Co. and invests alongside the tive due to the high premiums. Our overall preference is for developed economies and big private equity firm's deals. markets; however, strategic deals in A top financial adviser known to some as "Boy Wonder" at Goldman developing economies are considered. Sachs & Co., where at 31 he became M&A: How is the jCF & Co. portfolio the firm's youngest partner, Flowers has concentrated on the financial serv­ di1!ersified? Can risk be successfully di­ versified across regions in these finan­ ices sector for nearly 30 years. There is no question ofhis enthusiasm for his cial markets? work. Flowers concedes that it is easier Flowers: The currentJCF & Co. port­ in retrospect to provide advice, ac­ folio of banks (wholly owned or with controlling minority interests) counts knowledging that quick government actions in a troubled time have been eight as of early March 2009: one in the Netherlands, two in Germany, one necessary. There is clearly substantial work still needed, and he says it may J. Christopher Flowers in Japan, two in the US, one in Rus­ sia, and one in India. While there is no take until 2011 to achieve effective implementation under the Troubled Asset Relief Pro­ allocated percentage of investment by region, the firm gram. (The program is currently set to expire after Dec. seeks diversification across markets. It is important to note that with the increasingly higher correlation of 31, 2009, unless extended.) Flowers recently sat down with us to offer his insights markets that we have seen during this crisis, especial­ into current private equity investing, and his views on ly pronounced in the banking sector, benefits of re­ gional diversification are reduced. regulation, bailouts, economic stimulus, and more.

May 2009

Q&A

M&A: What is your approach to staffat your portfolio companies?
Flowers: Good people are the key to any success. Options are one im­
portant component of packages that we offer that both incentivize staff and align interests of stakeholders. Of course, in difficult mar­ kets srock options may not always be advantageous, yet overall we see equity participation as a good motivator.

M&A: The inconsistencies regarding how the government has gone about
rescuing certain firms have been a very hot topic. Any advice on how to proceed with government rescues?

Flowers: A consistent set of guidelines for government intervention
is needed, and you do not want to throw the baby out with the bath­ water. You do not want to wipe out equity holders all of the time even if they may take on that risk. The example of Washington Mutual, where new strategic in­ vestors quickly lost 100% of their equity, should not be continually repeated. That sort of investment scenario could quickly dry up des­ perately needed resources to restore financial markets. Government hopes for public-private partnerships for investment and bailout will also depend on the risk-sharing between government and the pri­ vate sector. These arrangements have yet to be established, leaving a large question mark as to what portion of finance will be mobilized from the private sector.

M&A: As a financial-services expert, what advice would you offer gov­ enzment and industry officials to address the financial crisis?
Flowers: In my view, there appears to be insufficient funds allocar­ ed for both the Troubled Asset Relief Program and the economic srimulus package. In addition, we need to take strong action and new measures addressing areas including regulatory reform for rhe financial services secror; government rescues and investments; Basel II international capital standards; US accounting standards; and, of course, the securities and company rating methodologies applied by rating agencies.

M&A: To expeditefinancial sector recovery, a "bad bank" or "aggregator
bank" isplanned as a government vehiclefor acquiring non-perfOrming assets. Will this resolve the bad debts?

M&A: There has been some talk o/the needfor a global, or "super-regu­
lator, "fOr financial services. What are your views on this option?

Flowers: Creating a "bad bank" can enable financial institutions ro Flowers: I do not see this as practically gaining traction or imple­
mentation at this time. I do strongly endorse, however, establish­ ment of a consolidated financial services sector supervisory and regulatory authority for the This is an intelligent approach, as we have seen with such authorities in England, Japan, and Ger­ many where JCF & Co. has operations. The insurance sector is es­ pecially problematic for us here in the US, given regulation by each state. continue with good assets intact as the bad assets are transferred off their books to the aggregaror bank. However, the critical issue here is at what price those assets will be purchased. Taxpayers will partic­ ipate in profits from the recovery of assets, which is a good thing. Bur offering too little for the purchase of those assets could result in no sale at all as some institutions cannot afford very large write­ downs. In such cases, other options will still be needed for bank res­ olution and sector recovery.

us.

M&A: To provide immediate support to troubledfinancial institutions in
the US, the Emergency Economic Stabilization Act 0/2008 was quick­ ly signed into law in October 2008. Will this work?

M&A: You mentioned Basel II capital standards. What needs to be done
in that area?

Flowers: The Act authorizes $700 billion for the Troubled Asset Re­
lief Program to help stabilize markets and institutions. In my view, the amount falls considerably short of the funds needed to get the job done. Even with additional amounts now marked in the budget for potential contingent expenditures under TARp, the total allocation falls short in my estimation.

Flowers: Further development of standards is required under the in­ ternational capital adequacy framework (Basel II). Of particular con­ cern are guidelines for risk-weighted assets in banks which result in a cyclical increase of risk-weights as loan losses are rising in a reces­ sion that further exacerbates the cycle by reducing available capital. This just doesn't work.

M&A: And the US Generally Accepted Accounting Principles? M&A: In addition to TARP, the economic stimulus package was heavily
debated in the Senate. With a final package amount close to $800 bil­ lion, is this enough to get the economy moving?

Flowers: Not sufficiently. To really get the economy moving, I be­ lieve that a stimulus package of up to $2 trillion could be needed. And that, of course, is assuming that all the stimulus components can in­ deed deliver the intended economic impacts as projected. And that is also a question.
May 2009

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Flowers: I strongly advocate changing the US GAAP to allow creation of general loss reserves in banks. This enables reserves to be built up in good times to cover unexpected losses in economic downturns. Currently lacking this option for risk management, US banks have had less of a cushion for protecting stakeholders. In contrast, we saw the Spanish banks, which are permitted to create general re­ serves, with significant reserves that helped them during this trou­ bled time. M>A
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