Supervisory Guidance on Equity Investment and Merchant Banking Activities

Clarification on the Responsibilities of the Board of Directors February 26, 2021: As described in SR

letter 21-4/ CA letter 21-3, “Inactive or Revised SR Letters Related to Federal Reserve Expectations for

Boards of Directors,” this SR letter was revised as of February 26, 2021 to better reflect the Federal

Reserve's guidance for boards of directors in SR letter 21-3 / CA letter 21-1, “Supervisory Guidance on

Board of Directors' Effectiveness,” and SR letter 16-11, “Supervisory Guidance for Assessing Risk

Management at Supervised Institutions with Total Consolidated Assets Less than $100 Billion.” No other

material changes were made to this letter.

Guidance on Equity Investment and Merchant Banking Activities of

Financial Holding Companies and Other Banking Organizations

Supervised by the Federal Reserve

FRB Guidance June 22, 2000

Revised February 26, 2021

Page 1 of 15

I. Introduction

Over the past several years, investing in the equity of non-financial companies [Footnote

1

- References to equity investments in this guidance are references to equity investments in non-financial companies unless otherwise noted. Non-financial companies include companies that engage in activities other than financial activities that a financial holding company may conduct pursuant to

section 4 of the Bank Holding Company Act, 12 U.S.C. 1843, as amended by the Gramm-Leach-Bliley Act, and the regulations and interpretations thereunder, including the regulations involving merchant banking adopted by the Board of Governors and the Treasury Department. End of Footnote 1.]

and

lending to private equity-financed companies, have emerged as increasingly important sources of

earnings and business relationships at a number of banking organizations. [See next page for Footnote

2]While equity

investments in non-financial companies can contribute substantially to earnings, such investment

activities, like many other fast growing business lines, can entail significant market, liquidity,

and other risks

inanced companies, have emerged as increasingly important sources of

earnings and business relationships at a number of banking organizations. [See next page for Footnote

2]While equity

investments in non-financial companies can contribute substantially to earnings, such investment

activities, like many other fast growing business lines, can entail significant market, liquidity,

and other risks. Equity investments can also give rise to increased volatility of both earnings and

capital. Accordingly, sound investment and risk management practices are critical in conducting

these activities.

This guidance discusses various sound practices related to the equity investment activities

of banking organizations that merit the attention of management, examiners, and other

supervisory staff. The guidance first describes the legal and regulatory authority under which

banking organizations may make equity investments. It then discusses basic safety and

soundness issues regarding the management of equity investments at banking organizations and

identifies sound management practices for conducting these activities. The guidance specifically

targets the equity investment activities of financial holding companies (FHCs), bank holding

companies (BHCs), state member banks, and their affiliates, regardless of the authority under

which investments are made.

Given the important role that market discipline plays in controlling risks, the guidance

also addresses the need for supervisors to encourage appropriate public disclosures of equity

investment activities by banking organizations and sets forth recommendations for the scope of

such disclosures

ate member banks, and their affiliates, regardless of the authority under

which investments are made.

Given the important role that market discipline plays in controlling risks, the guidance

also addresses the need for supervisors to encourage appropriate public disclosures of equity

investment activities by banking organizations and sets forth recommendations for the scope of

such disclosures. Finally, the guidance discusses various issues involving the provision of

traditional credit-based banking services to: 1) non-financial companies in which a banking

organization has an equity interest (i.e., portfolio companies); 2) portfolio company managers;

and, 3) general partners of equity investment ventures and funds that may have an association

with a portfolio company.

Page 2 of 15

[Footnote 2 - The term private equity technically refers to shared-risk investments outside of publicly quoted securities.

However, increasingly it has become an inclusive term of art that covers activities such as venture capital, leveraged

buy-outs, mezzanine financing and holdings of publicly quoted securities obtained through these activities. This

broader concept is employed for the purpose of this guidance. End of Footnote

2.]

Page 3 of 15

II.

Legal and Regulatory Authority

FHCs, BHCs, and depository institutions are able to make equity investments under

several statutory and regulatory authorities.

• Under sections 4(c)(6) and 4(c)(7) of the Bank Holding Company Act (BHC Act),

BHCs may invest in up to 5 percent of the outstanding voting shares of any one

company and up to 25 percent of the total equity of a company, with no aggregate

limits on the total dollar amount of equity investments held by the BHC.

• Banking organizations can make equity investments through Small Business

Investment Corporations (SBICs), which can be a subsidiary of a bank or BHC

t (BHC Act),

BHCs may invest in up to 5 percent of the outstanding voting shares of any one

company and up to 25 percent of the total equity of a company, with no aggregate

limits on the total dollar amount of equity investments held by the BHC.

• Banking organizations can make equity investments through Small Business

Investment Corporations (SBICs), which can be a subsidiary of a bank or BHC.

Investments made by SBIC subsidiaries are allowed up to a total of 50 percent of a

portfolio company's outstanding shares, but can only be made in companies defined

as small business, according to SBIC rules. A bank's aggregate investment in the

stock of SBICs is limited to 5 percent of the bank's capital and surplus. In the case of

BHCs, the aggregate investment is limited to 5 percent of the BHC's proportionate

interest in the capital and surplus of its subsidiary banks.

• Under Regulation K, which implements sections 25 and 25A of the Federal Reserve

Act and section 4(c)(13) of the BHC Act, banking organizations may, with Board

approval, make portfolio investments that in the aggregate do not exceed 25 percent

of the Tier 1 capital of the BHC. In addition, individual investments must be less

than 20 percent of a portfolio company's voting shares and not exceed 40 percent of

the portfolio company's total equity. [Footnote

3

- Also included in calculating a banking organization's investment are shares of the corporation held in trading or

dealing accounts or under any other authority. The 25 percent of Tier 1 capital limitation increases to 100 percent of

Tier 1 capital for certain non-BHC investors. See Regulation K for more detailed information. End of Footnote

3.]

• More recently, under the Gramm-Leach-Bliley (GLB) Act, FHCs may engage in a

broad range of merchant banking activities. [Footnote

4

- A BHC may qualify as an FHC if each of its depository institutions is well managed and well capitalized

ital limitation increases to 100 percent of

Tier 1 capital for certain non-BHC investors. See Regulation K for more detailed information. End of Footnote

3.]

• More recently, under the Gramm-Leach-Bliley (GLB) Act, FHCs may engage in a

broad range of merchant banking activities. [Footnote

4

- A BHC may qualify as an FHC if each of its depository institutions is well managed and well capitalized. The

Board must also find that each of the subsidiary insured depository institutions of the BHC has at least a satisfactory

Community Reinvestment Act rating when the company elects to be an FHC. End of Footnote

4.]

Permissible merchant banking activities

are broadly defined to include “investments in any amount of the shares, assets, or

ownership interests of any type of non-financial company.” Regulations governing

the conduct of merchant banking activities are issued jointly by the Board of

Governors and the U.S. Department of Treasury [Footnote

5

- An interim rule implementing the merchant banking authority of the GLB was adopted by the Board of Governors

and the Department of Treasury on March 17, 2000. This interim rule is subject to revision pending industry

comments that were due on May 22, 2000. End of Footnote

5.]

Page 4 of 15

Equity investments made under any of these authorities may be in publicly traded

securities or privately held equity interests. The investment may be made as a direct investment

in a specific portfolio company, or may be made indirectly through a pooled investment vehicle,

such as a private equity fund. In general, private equity funds are investment companies,

typically organized as limited partnerships, that pool capital from third party investors to invest

in shares, assets, and ownership interests in companies for resale or other disposition. [Footnote

6

- Private equity funds are defined in detail in the Board's rules and regulations on merchant banking adopted by the

Board of Governors and the Treasury Department

funds are investment companies,

typically organized as limited partnerships, that pool capital from third party investors to invest

in shares, assets, and ownership interests in companies for resale or other disposition. [Footnote

6

- Private equity funds are defined in detail in the Board's rules and regulations on merchant banking adopted by the

Board of Governors and the Treasury Department. End of Footnote

6.]

Private

equity fund investments may provide seed or early-stage investment funds to start-up companies,

or finance changes in ownership, middle-market business expansions, and mergers and

acquisitions.

This guidance is meant to apply to all equity investments in non-financial companies,

public or private, and regardless of the authority under which such investments are made.

Accordingly, this guidance applies to the equity investment activities of state member banks and

their affiliates and subsidiaries. It also applies to the investment management practices of FHCs

and BHCs, which should control aggregate risk exposures on a consolidated basis, while

recognizing legal distinctions and possible obstacles to cash movements among subsidiaries and

affiliates. Also, the basic principles set forth in this guidance should be incorporated into the

U.S. operations of foreign banking organizations, with appropriate adaptations to reflect the fact

that: (i) those operations are an integral part of a foreign bank which should be managing its

risks on a consolidated basis; and (ii) the foreign bank is subject to overall supervision by its

home authorities.

III. Sound Practices

High returns in both equity investments and in lending to private equity-financed

companies over the past few years have spurred an increased flow of funds into this segment of

the market

ons are an integral part of a foreign bank which should be managing its

risks on a consolidated basis; and (ii) the foreign bank is subject to overall supervision by its

home authorities.

III. Sound Practices

High returns in both equity investments and in lending to private equity-financed

companies over the past few years have spurred an increased flow of funds into this segment of

the market. Various types of institutional investors, including pension funds, endowments,

banking organizations, and other financial institutions, have allocated increasing portions of their

investment portfolios to equity investment-related activities, and competition in this market has

increased substantially. As has often been the case in other rapidly expanding and highly

profitable business lines, business and competitive pressures can lead to compromises in due

diligence, the use of overly optimistic assumptions, and breakdowns in internal controls.

Accordingly, sound investment and risk management practices are crucial to the success of

equity investment activities.

As with any financial activity, sound management practices for these activities involve:

• Active involvement by senior management;

• Appropriate policies, limits, procedures, and management information systems that

govern all elements of the investment decision-making and management process; and,

• Adequate internal controls.

Page 5 of 15

Management at banking organizations, examiners, and other supervisors should review

each of these areas to identify any deficiencies in the management of equity investment activities

that may pose potential risks to the financial condition of state member banks and other insured

depository institutions affiliated with FHCs and BHCs

ement process; and,

• Adequate internal controls.

Page 5 of 15

Management at banking organizations, examiners, and other supervisors should review

each of these areas to identify any deficiencies in the management of equity investment activities

that may pose potential risks to the financial condition of state member banks and other insured

depository institutions affiliated with FHCs and BHCs. Supervisory efforts in this area should be

targeted appropriately in accordance with Federal Reserve policies on risk-focused supervision

by taking into account both the findings of internal audit and other independent reviews, and the

materiality of these activities to the banking organization. Consistent with the Federal Reserve's

role as umbrella supervisor, reviews of the merchant banking activities of FHCs and the equity

investment activities of BHCs should focus on the potential exposure these activities may pose to

insured depository affiliates and should, where appropriate and available, utilize fully the

findings of primary bank supervisors and functional regulators of holding company affiliates. At

the same time, supervisory and examination staff should ensure that they continue to conduct

sufficient and targeted transaction testing across legal entity lines if necessary to fully assess the

adequacy of business line risk management. Transaction testing should be consistent with the

risk profile of the institution and the materiality of the activity to the institution's financial

condition.

As with all financial activities, institutions should ensure that they have sufficient capital

for conducting equity investment activities. Consistent with SR Letter 99-18 (July 1, 1999),

banking organizations conducting material equity investment activities are expected to have an

internal capital allocation system that meaningfully links the identification, monitoring, and

evaluation of the risks of the institution's equity investment activities to the determination of its

needs for economic capital

equity investment activities. Consistent with SR Letter 99-18 (July 1, 1999),

banking organizations conducting material equity investment activities are expected to have an

internal capital allocation system that meaningfully links the identification, monitoring, and

evaluation of the risks of the institution's equity investment activities to the determination of its

needs for economic capital. A review of these systems should be an important part of the

investment management process, as well as an integral element of on-going supervisory review

and monitoring of this business line.

The following discussion provides specific guidance regarding each of the three key

components of sound investment and risk management practices for equity investment activities.

The guidance draws from actual industry practices compiled from a variety of industry and

supervisory sources including insights gained during supervisory reviews of banking

organizations engaged in equity investment activities under SBIC and BHC authorities.

A. Role of Senior Management

Senior management should establish portfolio objectives, overall investment strategies,

and general investment policies that are consistent with the institution's financial condition, risk

profile, and risk tolerance. Portfolio objectives should address the types of investments, expected

business returns, desired holding periods, diversification parameters, and other elements of

sound investment management oversight. These objectives, strategies, policies, and procedures

should be documented and clearly communicated to all personnel involved in their

implementation. Senior management should actively monitor the performance and risk profile of

equity investment business lines in light of the established objectives, strategies, and policies.

eters, and other elements of

sound investment management oversight. These objectives, strategies, policies, and procedures

should be documented and clearly communicated to all personnel involved in their

implementation. Senior management should actively monitor the performance and risk profile of

equity investment business lines in light of the established objectives, strategies, and policies.

Page 6 of 15

Senior management should ensure that there are adequate policies, procedures, and

management information systems for managing equity investment activities on a day-to-day and

longer-term basis. Senior management should also ensure that there is an effective management

structure for conducting the institution's equity activities, including adequate systems for

measuring, monitoring, controlling, and reporting on the risks of equity investments. Senior

management should implement policies that specify lines of authority and responsibility for

both acquisitions and sales of investments, and ensure that an institution's equity investment

activities are conducted by competent staff whose technical knowledge and experience is

consistent with the scope of the institution's activities. Senior management should also adopt

limits on aggregate investment and exposure amounts, the types of investments (e.g., direct and

indirect, mezzanine financing, start-ups, seed financing, etc.) and appropriate diversification-

related aspects of equity investments such as industry, sector, and geographic concentrations.

B. Management of the Investment Process

Institutions engaging in equity investment activities should have a sound process for

executing all elements of investment management, including initial due diligence, periodic

reviews of holdings, investment valuation, and realization of returns

iversification-

related aspects of equity investments such as industry, sector, and geographic concentrations.

B. Management of the Investment Process

Institutions engaging in equity investment activities should have a sound process for

executing all elements of investment management, including initial due diligence, periodic

reviews of holdings, investment valuation, and realization of returns. This process requires

appropriate policies, procedures, and management information systems, the formality of which

should be commensurate with the scope, complexity, and nature of an institution's equity

investment activities. A sound investment process should be applied to all equity investment

activities, regardless of the legal entity in which investments are booked. As always, any

supervisory reviews of equity investment activities should be risk-focused, taking into account

the institution's stated tolerance for risk, the ability of senior management to govern these

activities effectively, the materiality of activities in light of the institution's risk profile, and the

capital position of the institution.

Policies and Limits -- Institutions engaging in equity investment activities require

effective policies that i) govern the types and amounts of investments that may be made, ii)

provide guidelines on appropriate holding periods for different types of investments, and, iii)

establish parameters for portfolio diversification. Investment strategies and permissible types of

investments should be clearly identified. Portfolio diversification policies should identify factors

pertinent to the risk profile of the investments being made, such as industry, sector, geographic,

and market factors. Policies establishing expected holding periods should specify the general

criteria for liquidation of investments and guidelines for the divestiture of an under-performing

investment

ments should be clearly identified. Portfolio diversification policies should identify factors

pertinent to the risk profile of the investments being made, such as industry, sector, geographic,

and market factors. Policies establishing expected holding periods should specify the general

criteria for liquidation of investments and guidelines for the divestiture of an under-performing

investment. Whereas decisions to liquidate under-performing investments are necessarily made

on a case-by-case basis considering all relevant factors, policies and procedures stipulating more

frequent review and analysis are generally used to address investments that are performing

poorly or have been in portfolio for a considerable length oftime.

Policies should identify the aggregate exposure that the institution is willing to accept by

type and nature of investment (e.g., direct/indirect, industry sectors). Adherence to such limits

should take into consideration unfunded, as well as funded, commitments.

Where hedging activities are conducted, there should be formal and clearly articulated

hedging policies and strategies that identify limits on hedged exposures and permissible hedging

instruments.

Page 7 of 15

Management and staff compensation play a critical role in providing incentives and

controlling risks within a private equity business line. Accordingly, clear policies should govern

compensation arrangements, including co-investment structures and sales of portfolio company

interests by employees of the banking organization.

Procedures -- As with investment policies, many institutions have different procedures

for assessing, approving, and reviewing investments based upon the size, nature, and risk profile

of an investment. Often procedures used for direct investments are different than those used for

indirect investments made through private equity funds. For example, different levels of due

diligence and senior management approvals may be required

icies, many institutions have different procedures

for assessing, approving, and reviewing investments based upon the size, nature, and risk profile

of an investment. Often procedures used for direct investments are different than those used for

indirect investments made through private equity funds. For example, different levels of due

diligence and senior management approvals may be required. Accordingly, in constructing

management infrastructures for conducting these activities management should ensure that

operating procedures and internal controls appropriately reflect the diversity of investments.

Supervisors should recognize this potential diversity of practice when conducting reviews of the

equity investment process. Focus should be placed on the appropriateness of the process

employed relative to the risk of the investments made and the materiality of this business line to

the overall soundness of the banking organization and the potential impact on affiliated

depository institutions.

Investment analysis and approvals - Well-founded analytical assessments of investment

opportunities and formal processes for approving investments are critical in conducting equity

investment activities. While analyses and approval processes may differ by individual

investments and across institutions, the methods and types of analyses conducted should be

appropriately structured to assess adequately the specific risk profile, industry dynamics,

management, and specific terms and conditions of the investment opportunity, as well as other

relevant factors. All elements of the analytical and approval processes from initial review

through formal investment decision should be documented and clearly understood by staff

conducting these activities

e

appropriately structured to assess adequately the specific risk profile, industry dynamics,

management, and specific terms and conditions of the investment opportunity, as well as other

relevant factors. All elements of the analytical and approval processes from initial review

through formal investment decision should be documented and clearly understood by staff

conducting these activities.

An institution's evaluation of potential investments in private equity funds, as well as

reviews of existing fund investments, should involve assessments of the adequacy of a fund's

structure, with due consideration given to: i) management fees; ii) carried interest [Footnote

7

- The carried interest is the share of a partnership's return received by general partners or investment advisers. End of Footnote

7.]

and its

computation on an aggregate portfolio basis; iii) the sufficiency of capital commitments by

general partners in providing management incentives; iv) contingent liabilities of the general

partner; v) distribution policies and wind-down provisions; and, vi) performance benchmarks and

return calculation methodologies.

Investment risk ratings - It is a sound practice to establish a system of internal risk ratings

for equity investments. This involves assigning each investment a rating based on factors such

as the nature of the company, strength of management, industry dynamics, financial condition,

operating results, expected exit strategies, market conditions, and other pertinent factors.

tion methodologies.

Investment risk ratings - It is a sound practice to establish a system of internal risk ratings

for equity investments. This involves assigning each investment a rating based on factors such

as the nature of the company, strength of management, industry dynamics, financial condition,

operating results, expected exit strategies, market conditions, and other pertinent factors.

Page 8 of 15

Different rating factors may be appropriate for indirect investments and direct investments. For

example, rating factors for investments in private equity funds could include an assessment of

the fund's diversification, management experience, liquidity, and actual and expected

performance. Rating systems should be used for assessments of both new investment

opportunities and existing portfolio investments.

Periodic Reviews - Senior management should ensure that there is periodic and timely

review of the institution's equity investments. Reviews should be conducted at both individual

investment and portfolio levels. Depending on the size, complexity, and risk profile of the

investment, reviews should, where appropriate, include factors such as:

• the history of the investment, including the total funds approved;

• commitment amounts, principal cash investment amounts, cost basis, carrying value,

major investment cash flows, and supporting information including valuation

rationales and methodologies;

• the current actual percentage of ownership in the portfolio company on both a diluted

and undiluted basis;

•

a summary of recent events and current outlook;

• recent financial performance of portfolio companies, including summary

compilations of performance and forecasts, historical financial results, current and

future plans, keyperformance metrics, and other relevant items;

• internal investment risk ratings and rating change triggers;

•

exit strategies, both primary and contingent, and expected internal rates of return

upon exit; and

•

other pertinent information for assessing the appropriat

nies, including summary

compilations of performance and forecasts, historical financial results, current and

future plans, keyperformance metrics, and other relevant items;

• internal investment risk ratings and rating change triggers;

•

exit strategies, both primary and contingent, and expected internal rates of return

upon exit; and

•

other pertinent information for assessing the appropriateness, performance, and

expected returns of investments.

Portfolio reviews should include an aggregation of individual investment risk and

performance ratings, analysis of appropriate industry, sector, geographic and other pertinent

concentrations, as well as total portfolio valuations. Portfolio reports containing the cost basis,

carrying values, estimated fair values, valuation discounts, and other factors summarizing the

status of individual investments are integral tools for conducting effective portfolio reviews.

Reports containing the results of all reviews should be available to supervisors for their

inspection.

Given the inherent uncertainties in equity investment activities, institutions should

include in their periodic reviews consideration of best case, worst case, and probable case

assessments of investment performance. Such reviews should evaluate changes in market

conditions and alternative assumptions used to value investments -- including expected and

Page 9 of 15

contingent exit strategies. Major assumptions used in valuing investments and forecasting

performance should be identified. Such assessments need not be confined to quantitative

analyses of potential losses, but may also include qualitative analyses.

As in the case of all investment management systems, the formality and sophistication of

investment reviews should be appropriate for the overall level of risk incurred by the banking

organization from this business line

nd forecasting

performance should be identified. Such assessments need not be confined to quantitative

analyses of potential losses, but may also include qualitative analyses.

As in the case of all investment management systems, the formality and sophistication of

investment reviews should be appropriate for the overall level of risk incurred by the banking

organization from this business line.

Valuation and Accounting - Valuation and accounting policies and procedures can

significantly impact the earnings of institutions engaged in equity investment activities. For

some equity investments, valuation can be more of an art than a science. Many equity

investments are made in privately held companies, for which independent price quotations are

either unavailable or not available in sufficient volume to provide meaningful liquidity or a

market valuation. Valuations of some equity investments may involve a high degree of

judgment on the part of management or the skillful use of peer comparisons. Similar

circumstances may exist for publicly traded securities that are thinly traded or subject to resale

and holding period restrictions or when the institution holds a significant block of a company's

shares. Accordingly, clearly articulated policies and procedures on the accounting and valuation

methodologies used for equity investments are of paramount importance.

There are several methods used in accounting for equity investments. Under generally

accepted accounting principles (GAAP), equity investments held by investment companies, held

by broker/dealers, or maintained in the trading account [Footnote

8

- The investments referred to in this letter would not normally be held in the trading account since they are not

intended to be traded actively. End of Footnote

8.]

are reported at fair value, with any

unrealized appreciation or depreciation included in earnings and flowing to Tier 1 capital. For

some holdings, fair value may reflect adjustments for liquidity and other factors

unt [Footnote

8

- The investments referred to in this letter would not normally be held in the trading account since they are not

intended to be traded actively. End of Footnote

8.]

are reported at fair value, with any

unrealized appreciation or depreciation included in earnings and flowing to Tier 1 capital. For

some holdings, fair value may reflect adjustments for liquidity and other factors.

Equity investments not held in investment companies, broker/dealers, or the trading

account that have a readily determinable fair value (quoted market price) are generally reported

as available for sale (AFS). They are marked-to-market with unrealized appreciation or

depreciation recognized in GAAP-defined “comprehensive income” but not earnings.

Appreciation or depreciation flows to equity, but for regulatory capital purposes only

depreciation is included in Tier 1 capital. [Footnote

9

- Under regulatory capital rules, Tier 2 capital may include up to 45 percent of the unrealized appreciation of AFS

equity investments with readily determinable fair values. End of Footnote

9.]

Equity investments without readily determinable fair

values generally are held at cost, subject to write-downs for impairments to the value of the asset.

As is the case with all assets, impairments of value should be promptly addressed.

Institutions should ensure that they have taken write-downs in a timely manner and in an

appropriate amount.

In determining fair value, the valuation methodology plays a critical role. Clearly

articulated methods for valuing investments are critical to the effective management of equity

investments. Formal valuation and accounting policies should be established for investments in

ly addressed.

Institutions should ensure that they have taken write-downs in a timely manner and in an

appropriate amount.

In determining fair value, the valuation methodology plays a critical role. Clearly

articulated methods for valuing investments are critical to the effective management of equity

investments. Formal valuation and accounting policies should be established for investments in

Page 10 of 15

public companies, direct private investments, indirect fund investments, and where appropriate,

other types of investments with special characteristics. In establishing valuation policies,

institutions should consider market conditions, taking account of lockout provisions, Securities

and Exchange Commission Rule 144 restrictions, liquidity features, dilutive effects of warrants

and options, and industry characteristics and dynamics.

For institutions acting as general partners of private equity funds, “clawback” or “look

back” provisions of partnership agreements can pose additional challenges in accounting for and

valuing the distributions received from the funds they manage. Clawback provisions are

promises made by general partners to repay limited partners at the end of the term of a fund if the

general partner has received more than its contractually defined compensation or “carried

interest” over the life of the fund. Clawback provisions can come into play in situations where

the liquidation and associated disposition of both limited partner and general partner returns on

good performing investments in the fund occurs before the liquidation of poorer performing

investments. Often, escrow accounts are established to hold a portion of the general partners'

carried interest during the life of the fund. Where applicable, institutions should appropriately

recognize the estimated impact of these provisions in accounting for and valuing general partner

activities, including the earnings therefrom.

Accounting and valuation of equity investments should be subject to regular periodic

review

unts are established to hold a portion of the general partners'

carried interest during the life of the fund. Where applicable, institutions should appropriately

recognize the estimated impact of these provisions in accounting for and valuing general partner

activities, including the earnings therefrom.

Accounting and valuation of equity investments should be subject to regular periodic

review. In all cases, valuation reviews should produce documented audit trails that are available

to supervisors and auditors. Such reviews should assess the consistency of the methodologies

used in estimating fair value.

Accounting and valuation treatments should be assessed in light of their potential for

abuse through the inappropriate management or manipulation of reported earnings on equity

investments. For example, high valuations may produce overstatements of earnings through

gains and losses on investments reported at “fair value.” On the other hand, inappropriately

understated valuations can provide vehicles for smoothing earnings by recognizing gains on

profitable investments when institutions' earnings are otherwise under stress. While reasonable

people may disagree on valuations given to illiquid private equity investments, institutions

should have rigorous valuation procedures that are applied consistently.

Given uncertainties in valuation methodologies and the relatively high volatility of the

equity market, equity investments that are reported at fair value can contribute to earnings

volatility at institutions where such activities play a major role. With the increasing contribution

of these activities to the earnings of some banking organizations, the potential impact of equity

investments on the composition, quality, and sustainability of overall earnings should be

appropriately recognized and assessed by both management and supervisors.

Exit strategies - Returns and reported earnings on equity investments are highly affected

by assumed and actual exit strategies

bution

of these activities to the earnings of some banking organizations, the potential impact of equity

investments on the composition, quality, and sustainability of overall earnings should be

appropriately recognized and assessed by both management and supervisors.

Exit strategies - Returns and reported earnings on equity investments are highly affected

by assumed and actual exit strategies. The principal means of exiting an equity investment in a

privately held company include initial public stock offerings, sales to other investors, and share

repurchases. An institution's assumptions regarding exit strategies can significantly affect the

valuation of the investment. The importance of reasonable and comprehensive primary and

contingent take-out strategies for equity investments should be emphasized. Senior management

should

Page 11 of 15

periodically review investment exit strategies with particular focus on larger or less liquid

investments.

Disposition of investments - Policies and procedures should be established to govern the

sale, exchange, transfer, or other disposition of the institution's investments. These policies and

procedures should state clearly the levels of approval required for the disposition of

investments, and, in the case of investments held under the merchant banking provisions of the

GLB Act, should take account of the time limits for holding merchant banking investments in

the rules and regulations specified by the Board of Governors and the Department of Treasury.

Capital - Given the potential volatility of returns on equity investments, the risks

associated with private equity investment and merchant banking business lines can exceed those

of many more traditional banking activities. Accordingly, and consistent with the general

guidelines identified in SR Letter 99-18 (July 1, 1999), banking organizations conducting

material equity investment activities should have internal methods for allocating economic

capital based on the risk inherent in these activities

equity investment and merchant banking business lines can exceed those

of many more traditional banking activities. Accordingly, and consistent with the general

guidelines identified in SR Letter 99-18 (July 1, 1999), banking organizations conducting

material equity investment activities should have internal methods for allocating economic

capital based on the risk inherent in these activities. Such methods should incorporate the

identification of all material risks and their potential impact on the safety and soundness of the

institution. The amount and percentage of capital that is dedicated to this business line should be

appropriate to the size, complexity, and financial condition of the banking organization.

Organizations substantially engaged in these activities should have strong capital positions

supporting their equity investments and should allocate economic capital to them well in excess

of the current regulatory minimums applied to lending activities. Accordingly, assessments of

capital adequacy should cover not only the institution's compliance with regulatory capital

requirements and the quality of regulatory capital, but should also include an institution's

methodologies for internally allocating economic capital to this business line.

C. Internal Controls

An adequate system of internal controls, with appropriate checks and balances and clear

audit trails, is critical to the effective conduct of equity investment activities. Appropriate

internal controls should address all of the elements of the investment management process, and

should focus on the appropriateness of existing policies and procedures, adherence to policies

and procedures, and the integrity and adequacy of investment valuations, risk identification,

regulatory compliance, and management reporting. Departures from policies and procedures

should be documented and reviewed by senior management. This documentation should be

available for examiner review

nd

should focus on the appropriateness of existing policies and procedures, adherence to policies

and procedures, and the integrity and adequacy of investment valuations, risk identification,

regulatory compliance, and management reporting. Departures from policies and procedures

should be documented and reviewed by senior management. This documentation should be

available for examiner review.

As with other financial activities, assessments of compliance with both written and

implied policies and procedures should be independent of line decision-making functions to the

fullest extent possible. Large complex banking institutions with material equity investment

activities should have periodic independent reviews of their investment process and valuation

methodologies by internal auditors or independent outside parties. In smaller, less complex

institutions where limited resources may preclude independent review, alternative checks and

balances should be established. Such checks and balances may include random internal audits,

reviews by senior management independent of the function, or the use of outside third parties.

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Documentation -- Documentation of key elements of the investment process, including

initial due diligence, approval reviews, valuations, and dispositions, is an integral part of any

private equity investment internal control system. Accordingly, institutions should appropriately

document their policies, procedures, and investment activities and should make this

documentation accessible to supervisors.

Institutions should be aware that the statutory and regulatory authority under which some

equity investment activities are conducted may impose specific documentation and record­

keeping requirements

internal control system. Accordingly, institutions should appropriately

document their policies, procedures, and investment activities and should make this

documentation accessible to supervisors.

Institutions should be aware that the statutory and regulatory authority under which some

equity investment activities are conducted may impose specific documentation and record­

keeping requirements. For example, merchant banking regulations may have special books and

records requirements such as:

• records of transactions between an FHC and companies held under merchant banking

authority, specifically documenting transactions that are not on market terms;

• incentive arrangements in connection with controlling or advising a fund, including

the carrying value and market value of the arrangement and amounts that may be

payable based on future asset performance; and

•

documentation of the legal separation between the holding company and the portfolio

company.

Legal Compliance -- Compliance with all federal laws and regulations applicable to the

institution's investment activities should also be a focus of an institution's system of internal

controls. Regulatory compliance requirements, in particular, should be incorporated into internal

controls so managers outside of the compliance or legal functions understand the parameters of

permissible investment activities.

It is important to recognize that the conduct of private equity and merchant banking

activities are subject to different laws and regulations, depending upon the authority under which

the activities are conducted. For example, regulations on merchant banking investments may

call for holding period limits and restrict involvement with portfolio companies by defining

prohibitions on routinely managing or operating a company in which it has made a merchant

banking investment

ing

activities are subject to different laws and regulations, depending upon the authority under which

the activities are conducted. For example, regulations on merchant banking investments may

call for holding period limits and restrict involvement with portfolio companies by defining

prohibitions on routinely managing or operating a company in which it has made a merchant

banking investment. Accordingly, management should have a system in place, consistent with

applicable laws and regulations, to ensure that impermissible control is not exercised over these

activities. This practice is also important to protect the institution from lender liability claims.

Likewise, certain cross-marketing restrictions may apply to depository institutions held

by FHCs and portfolio companies controlled under statutory merchant banking authority.

Management should ensure that these limits are observed. Also, the limitations in sections 23A

and 23B of the Federal Reserve Act on transactions between a depository institution and its

affiliates are presumed by the GLB Act to apply to certain transactions between a depository

institution and any portfolio company in which an affiliate of the institution owns at least a 15

percent equity interest. This ownership threshold is lower than the ordinary definition of an

affiliate, which is typically 25 percent.

Page 13 of 15

Moreover, to ensure compliance with federal securities laws, institutions should establish

policies, procedures, and other controls addressing insider trading. A “restricted list” of

securities for which the institution has inside information is just one example of a widely used

mechanism for controlling the risk of insider trading. In addition, control procedures should be

in place to ensure that appropriate reports are filed with functional regulators.

Compensation -- Often, key employees in the private equity investment units of banking

organizations may co-invest in the direct or fund investments made by the unit

ide information is just one example of a widely used

mechanism for controlling the risk of insider trading. In addition, control procedures should be

in place to ensure that appropriate reports are filed with functional regulators.

Compensation -- Often, key employees in the private equity investment units of banking

organizations may co-invest in the direct or fund investments made by the unit. The return on

this co-investment, which the FHC may underwrite, may constitute a significant portion of the

compensation of these employees. These co-investment arrangements can be an important

incentive mechanism and risk control technique and can help to attract and retain qualified

management. However, “cherry picking,” or selecting only certain investments for employee

participation while excluding others, should be discouraged.

In many cases, the employees' co-investment may be funded through loans from

affiliates of the banking organization, which, in turn, hold a lien against the employees' interests.

The administration of the compensation plan should be appropriately governed pursuant to

formal agreements, policies, and procedures. Among other matters, policies and procedures

should address the terms and conditions of employee loans and sales of participants' interests

prior to the release of the lien.

IV. Disclosure of Equity Investment Activities

Given the important role that market discipline plays in controlling risk, institutions

should ensure that they adequately disclose information necessary for the markets to assess their

risk profiles and performance in this business line. Indeed, it is in the interest of the institution

itself, as well as its creditors and shareholders, to disclose publicly information about earnings

and risk profiles. Institutions are encouraged to disclose in public filings information on the type

and nature of investments, portfolio concentrations, returns, and their contributions to reported

earnings and capital

mance in this business line. Indeed, it is in the interest of the institution

itself, as well as its creditors and shareholders, to disclose publicly information about earnings

and risk profiles. Institutions are encouraged to disclose in public filings information on the type

and nature of investments, portfolio concentrations, returns, and their contributions to reported

earnings and capital. Supervisors should fully utilize such disclosures, as well as periodic

regulatory reports filed by publicly held banking organizations, as part of the information that

they review routinely.

The following topics are relevant for public disclosure, though disclosures regarding each

of these topics may not be appropriate, relevant, or sufficient in every case:

• The size of the portfolio;

•

The types and nature of investments (e.g., direct/indirect, domestic/international,

public/private, equity/debt with conversion rights);

•

Initial cost, carrying value, and fair value of investments, and where applicable,

comparisons to publicly quoted share values of portfolio companies;

•

The accounting techniques and valuation methodologies, including key assumptions

and practices affecting valuation and changes in those practices;

Page 14 of 15

• The realized gains (losses) arising from sales and unrealized gains (losses); and

• Insights regarding the potential performance of equity investments under alternative

market conditions.

V

oted share values of portfolio companies;

•

The accounting techniques and valuation methodologies, including key assumptions

and practices affecting valuation and changes in those practices;

Page 14 of 15

• The realized gains (losses) arising from sales and unrealized gains (losses); and

• Insights regarding the potential performance of equity investments under alternative

market conditions.

V. Institutions Lending To or Engaging In Other Transactions with Portfolio Companies

Additional risk management issues may arise when a banking institution or an affiliate

lends to or has other business relationships with: i) a company in which the banking institution or

an affiliate has invested (i.e., a portfolio company); ii) the general partner or manager of a private

equity fund that has also invested in a portfolio company; or iii) a private equity-financed

company in which the banking institution does not hold a direct or indirect ownership interest

but is an investment or portfolio company of a general partner or fund manager with which the

banking organization has other investments. Given their potentially higher than normal risk

attributes, institutions should devote special attention to ensuring that the terms and conditions of

such lending relationships are at arms-length and are consistent with the lending policies and

procedures of the institution. Similar issues may arise in the context of derivatives transactions

with or guaranteed by portfolio companies and general partners.

Lending and other business transactions between an insured depository institution and a

portfolio company that meets the definition of an affiliate must be negotiated on an arms-length

basis, in accordance with section 23B of the Federal Reserve Act. The holding company should

have systems and policies in place to monitor transactions between the holding company, or a

non-depository institution subsidiary of the holding company, and a portfolio company

epository institution and a

portfolio company that meets the definition of an affiliate must be negotiated on an arms-length

basis, in accordance with section 23B of the Federal Reserve Act. The holding company should

have systems and policies in place to monitor transactions between the holding company, or a

non-depository institution subsidiary of the holding company, and a portfolio company. (These

transactions are not typically governed by section 23B of the Federal Reserve Act.) A holding

company should assure that the risks of these transactions, including exposures of the holding

company on a consolidated basis to a single portfolio company, are reasonably limited and that

all transactions are on reasonable terms, with special attention paid to transactions that are not on

market terms.

Where a banking organization lends to a private equity-financed company in which it has

no equity interest but where the borrowing company is a portfolio investment of private equity

fund managers or general partners with which the institution may have other private-equity

related relationships, care must be taken to ensure that the extension of credit is conducted on

reasonable terms. In some cases, supervisors have found that lenders may wrongly assume that

the general partners or another third party implicitly guarantees or stands behind such credits.

Reliance on implicit guarantees or comfort letters should not substitute for reliance on a sound

borrower that is expected to service its debt with its own resources. As with any type of credit

extension, absent a written contractual guarantee, the credit quality of a private equity fund

manager, general partner, or other third party should not be used to upgrade the internal credit

risk rating of the borrower company or prevent the classification or special mention of a loan

e on a sound

borrower that is expected to service its debt with its own resources. As with any type of credit

extension, absent a written contractual guarantee, the credit quality of a private equity fund

manager, general partner, or other third party should not be used to upgrade the internal credit

risk rating of the borrower company or prevent the classification or special mention of a loan.

Any tendency to relax this requirement when the general partners or sponsors of private equity-

financed companies have significant business dealings with the banking organization should be

strictly avoided.

Page 15 of 15

When an institution lends to a portfolio company in which it has a direct or indirect

interest, implications arise under Sections 23A and 23B of the Federal Reserve Act, which

govern credit-related transactions and asset purchases between a depository institution and its

affiliates. Section 23A applies to transactions between a depository institution and any company

where the institution's holding company or shareholders own at least 25 percent of the

company's voting shares. The GLB Act extends this coverage by establishing a presumption

that a portfolio company is an affiliate of a depository institution if the FHC uses the merchant

banking authority of the GLB Act to own or control more than 15 percent of the equity of the

company. Institutions should obtain the assistance of counsel in determining whether such

issues exist or would exist if loans were extended to a portfolio company, general partner or

manager. Supervisors should ensure that the institution has conducted a proper review of these

issues to avoid violations of law or regulations.

In addition to limiting and monitoring exposure to portfolio companies that arises from

traditional banking transactions, BHCs should also adopt policies and practices that limit the

legal liability of the BHC and its affiliates to the financial obligations and liabilities of portfolio

companies

nstitution has conducted a proper review of these

issues to avoid violations of law or regulations.

In addition to limiting and monitoring exposure to portfolio companies that arises from

traditional banking transactions, BHCs should also adopt policies and practices that limit the

legal liability of the BHC and its affiliates to the financial obligations and liabilities of portfolio

companies. These policies and practices include, for example, the use of limited liability

corporations or special purpose vehicles to hold certain types of investments, the insertion of

corporations that insulate liability between the BHC and a partnership controlled by the BHC,

and contractual limits on liability. BHCs that extend credit to companies in which the BHC has

made an equity investment should also be aware of the potential for equitable subordination of

the lending arrangements.