Small Banks Can’t Beat Private Equity. But Now, They Can Invest in It.

The booming private equity industry is poised to benefit from relaxed regulation, according to Pepper Hamilton.

A First Community Bank of the Heartland Inc. bank branch in Wickliffe, Kentucky (Houston Cofield/Bloomberg)

A First Community Bank of the Heartland Inc. bank branch in Wickliffe, Kentucky

(Houston Cofield/Bloomberg)

The private equity industry may soon get a boost from community banks, according to law firm Pepper Hamilton.

The easing of Volcker Rule restrictions last month makes it possible for community banks to use depositors’ money to invest in private equity and hedge funds, according to Deborah Enea, a partner in Pepper Hamilton’s financial services practice. The final rule, adopted July 9, allows banks with $10 billion of assets or less to immediately begin investing with such alternative fund managers, she said Friday in a phone interview.

The Volcker Rule, a provision of the Dodd-Frank Act put in place after the 2008 financial crisis, was designed to rein in risk-taking on Wall Street. Relaxing these constraints for smaller banks could give them access to yield from direct lending funds, which similarly target the middle market and are often created by private equity firms, according to Enea.

“The private equity market is just booming,” said Enea, whose clients include mid-market buyout firms and community banks. “The private equity market has just eaten up market share from traditional banks.”

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Direct lending funds typically finance the acquisition of companies by private equity firms or organic expansions. The funds can offer more attractive rates to borrowers, making it harder for community banks to compete as lenders, Enea said.

While smaller banks tend to be conservative investors by nature, she believes it’s possible they’ll take advantage of the new opportunity to invest in private capital funds because they want bigger returns. They might view private equity as way to get “a piece of the action,” she said.

Mid-market private equity firms, meanwhile, will probably desire partnerships with community banks to help fuel their buyout and direct lending strategies, according to Enea.

“It’s something they’ll be interested in,” she said.