Rising bank regulatory costs, a persistently low interest rate environment, and weak equity valuations may force increasing numbers of private equity (PE) firms with investments in U.S. banks to consider alternatives to traditional exit strategies in 2013, according to Fitch Ratings.

More than four years after the onset of the financial crisis, when many PE firms made initial investments in U.S. banks that were starved for capital, most investors are weighing exit options carefully as their typical investment periods of three to five years come to a close. The operating challenges faced by many smaller banks backed by private equity, including historically low net interest margins and higher regulatory compliance costs, have depressed expectations for organic returns. This has led many prospective acquirers and equity investors to mark down valuations, in many cases undermining exit economics for PE investors looking to sell stakes in leveraged banks.

As a result, we expect more PE investors to pursue alternative investment return strategies in 2013, including more reliance on share repurchases and special dividends in place of IPOs and M&A transactions. To a large extent, these changes reflect a new recognition of likely delays in the timing of exits, driving decisions to boost near-term returns via cash distributions while pushing ultimate exit dates further out.

Evidence of the shift in exit strategies began to emerge in 2012, when many high-profile investment firms moved away from IPOs and M&As to pursue other cash distribution policies or, in some cases, by extending their investment time horizon beyond three to five years.

Washington-based Sterling Bank, minority-owned by Warburg Pincus and Thomas H. Lee Partners, announced a special dividend that was paid out in late December. In addition, Webster Financial completed a $100 million share repurchase in December after the bank completed a partial IPO of its shares. After the IPO, Warburg retained a 14% ownership stake in Webster.

Absent a robust turnaround in U.S. bank fundamentals in 2013, Fitch expects more institutions with PE backing to evaluate alternative exit scenarios more carefully this year. A revival of the IPO market and a pick up in bank M&A could ease pressure on PE firms to consider exit alternatives, but many investors in banks will likely be forced to look away from traditional exit routes and push out return horizons as industry profitability remains under pressure.