Finding capital grows tough. Finding capital without strings grows impossible

 

By Steve Cocheo, executive editor, This e-mail address is being protected from spam bots, you need JavaScript enabled to view it

The capital story of American banking, right now, has several broad trends—among them the challenges of relying on private equity investments. But the individual banks out there looking for capital are on the firing line, so we’ll start this tale of challenges and promise with three stories. Each bank is a “work in progress.” A common element is time. For each of the three banks, the story began more than a year ago.

CHALLENGE IN
THE ROCKIES
If you wanted a “poster child” for the difficulties faced by community banks attempting to raise capital, you couldn’t do much better than Brighton, Colo.’s Valley Bank and Trust Co.

There’s a mixed bag of capital-related issues that hit community banks over the last few years, and  $228 million-assets Valley Bank has had to deal with many of them. In one painful example, the bank had to charge off  $2.5 million because of the government-forced wipeout of Fannie-Freddie preferred stock, plus some nonperforming loans, says Donna Petrocco, president and CEO. Then, in a June 2009 FDIC order, the bank agreed to bring its Tier 1 leverage capital ratio to at least 9%, and to bring its total risk-based capital ratio to at least 13%. The latter figure is higher than the 12% that bankers talk about as the new de facto requirement. Petrocco credits this to Valley being one of the next banks in line for an exam after a large Colorado failure.

Even before inking the formal order, Petrocco and her board had been seeking solutions. An investment banking firm was engaged to find additional investors, ultimately costing $100,000 in fees. Fifty different potential investors were found, but not one was interested, seeing the bank’s situation as too risky. Discouraged, leadership then tested the water for a sale, but what few offers came in bordered on insulting. Petrocco recalls one of 19 cents on the dollar. “We didn’t even respond to that terrible offer,” she says.

These setbacks were among the darkest hours for Petrocco, who comes from a banking family.

While this was going on, the bank pursued a parallel strategy, almost unthinkable in normal times: shrink. (At the high-water mark in June 2008, assets stood at $260 million.)

Three branches were closed, and one was nearly sold. Existing loans were not being replaced as they paid down, and some business was sent away (the local economy is slack, so that’s not so much an issue). Sometimes customers were encouraged to find another bank, and sometimes good borrowers found their rates being raised on renewal. They walked, as expected. In the end, the various efforts will have taken $30 million off the bank’s books.

“I’m probably in the only industry in the country where the government can tell me that I can’t grow my business,” says Petrocco.

Yet another hurdle was trust preferred stock. Once a boon for community banks, this capital source has gone away—first, when the crisis hit all structured securities, and, now, for all practical purposes, nailed into its coffin by the Dodd-Frank Act. The bank’s holding company had already floated two trust preferred issues. Under current conditions, the bank can’t upstream a cent to pay it off. One issue the holding company was able to defer, the other has been an ongoing expense.

Chopping and whittling continued. In 2009 there were no salary increases and incentive pay plans were killed. In 2010, increases were minimal. The bank’s attorney circulated a private-placement memorandum to attract fresh investment from “friends and family.” Community support was strong, but often couldn’t be turned into private investment, even where there was expressed interest, due to federal “qualified investor” rules that restrict unregistered offerings to those with higher income or assets.

Finally, the investment bank turned up a small group willing to put in $800,000—with conditions. That money sits in escrow, subject to this stipulation: The bank can have it when that money will put capital just over the 13% finish line.

In September, the bank missed its regulatory deadline. Neither FDIC nor the state would grant an extension. But Petrocco keeps working at it, and has come within a stone’s throw of the goal. (When interviewed, total risk-based capital came to 12.86%.) She has been working on a capital contingency plan. And the bank is also arranging to participate out $4 million in loans through its bankers bank.

When that deal is done, Petrocco’s calculations indicate the bank will be able to take the investor group’s $800,000.

“I think I’m within a few weeks of getting to my capital requirement,” the banker says.

LONG ROAD
BEGINS IN MICHIGAN
At $852.5 million-assets United Bancorp, Ann Arbor, Mich., President and CEO Robert Chapman is packing his bags. Not permanently. He’s got a period of investor road shows ahead of him.

At the end of 2009, regulators put the company under an MOU, wanting more Tier 1, though the bank had better-than-mandated ratios. United determined to go after more common stock. The deadline has come and gone.

“It’s taken us a while,” says Chapman. Given that United has decent capital, he underplays the passed deadline: “They give you a date to encourage you to get moving. They don’t put a gun to your head.” With 8% Tier 1 and 12% total risk-based ratios, he adds, “we’re not exactly undercapitalized.”

But no one does anything fast in the capital field these days, especially not when, in troubled Michigan, a company has had seven quarters of losses. All players say that due diligence goes deeper, wider, and runs longer than ever, whether by prospective investors or simply by investment bankers deciding if they want to take an engagement.

After a review, Sandler O’Neill & Partners, L.P., took on United for an offering of common shares, announced Oct. 5. Chapman explains that the company has a strong base in Ann Arbor, a university town with the lowest unemployment rate in the state; is working through its nonperformers; and has potential for the future. In time the game plan is to list on NASDAQ.

The offering of shares up to $25 million isn’t sold yet. You could say that United is at “the end of the beginning,” says Chapman. He plans to go the distance.

PRIVATE EQUITY TAKES
A TOEHOLD
On Oct. 28, $82.8 million-assets Saddle River Valley Bank, a savings institution based in northern New Jersey, announced a new majority owner, J.S. Flowers & Co., operating through a new entity, SRV Holdings. Flowers is a large private equity player, specializing in financial institutions.

The four-year-old savings institution squeaked into the black this year. Indeed, William Arnold, president and CEO, says “for a private equity group to make an investment, there has to be a value-added beyond the financial value of operations.” While the new capital will enable Saddle River Valley Bank to expand operations, there’s more. And that explains why both sides were willing to spend more than a year on the deal.

“Banking’s margins are thin,” right now, says Arnold, “and that’s typically not a private equity investment.” He explains that Saddle River not only is a healthy bank,  but represents a clean platform—a thrift holding company chartered by the Office of Thrift Supervision. In the wake of the Dodd-Frank Act the institution is a grandfathered base with a great deal of flexibility for future expansion for an investor like Flowers. A member of the bank’s board knew someone in the Flowers organization, and that started the negotiations.

Sums up Arnold: “I think we caught lightning in a bottle.”

That’s a flavor of what banks are up against. What follows are views from bankers, investment bankers, and others on the causes of the squeeze and the realities of dealing with private equity investors.

A scarce commodity
Kansas banker Earl McVicker has been many things, from community banker to ABA Chairman to community bank investor. He’s had experience in bank investing both through his bank’s holding company—$314 million-assets Central Financial Corp., Hutchinson, Kan.—and personally.

“To raise any capital at all, these days, you have to be considered pretty healthy,” says McVicker. “Passing the hat” still works, but local investors grow more cautious.

McVicker’s been involved in two capital raises this year, for his own portfolio. Both community banks “were raising capital to support growth,” he said. Both banks are Subchapter S corporations, so they went to their existing holders for more capital and found it. McVicker says that both are successful and well regarded by their regulators.

“But for those who need to raise capital because of performance issues and loan losses,” says McVicker, “it’s very difficult.”

“I really feel badly for the small banks,” says William Isaac, chairman of LECG Consulting, chairman of Fifth Third Bancorp, and author of Senseless Panic: How Washington Failed America. “They have been terribly mistreated in this latest crisis.” With passage of Dodd-Frank, Isaac says, it’s just grown worse. That the Act effectively killed trust preferred boggles his mind.

Many bankers find themselves in a game where capital, which once poured freely, has slowed to a trickle. Overall, in the words of Helen Sullivan, ABA senior vice-president, financial and capital markets, “investors are basically calling the shots.” The days of lining up to get into bank shares are gone.

Adds Michael Barry, managing director of Stifel Nicolaus, “The market is more difficult today. It doesn’t mean you can’t do a deal, but it means it will be more costly.” Barry says that if a bank is seeking funds for a recapitalization, as opposed to building for growth or acquisitions, “the investors will hold you hostage, no doubt about it.”

Trends to follow
There is some cause for hope. Valuations of bank stocks have fallen, but the deterioration of industry fundamentals appears to have slowed. That gives investors some confidence that there is now less downside risk, according to Tom Killian, principal, capital markets, at Sandler O’Neill.

Killian adds that there isn’t a single market for bank capital. The needs and tolerances of “opportunistic” and “precautionary” capital seekers aren’t the same as those requiring recapitalization. Sandler O’Neill analysis puts about 700 institutions, with $1.3 trillion in assets, into that third category.

In talks with bankers, investment bankers, bank attorneys, and others, we’ve found these broad trends:

• Common stock is mostly the name of the game, and while it’s not impossible for smaller banks to issue, it’s hard. Debt may be an option for Sub S banks, rather than risk bumping shareholder ceilings. Other community banks shut out of the equity market have convinced large borrowers or large depositors to purchase debt with a better rate than they’d earn on a CD.

• Private equity, despite some talk to the contrary, is available. But it’s incredibly picky, strives for a fine balance between actual and official control (for regulatory reasons), and has some patience but wants results. Also, if a bank courting it doesn’t have a compelling story or some jewel to offer, the effort is likely to be futile. These players are investors, not altruists.

• “Return on Effort” guides investment banking firms. They grow pickier as they look at candidates for capital assignments. The basic work is the same, and the payoff is better for bigger deals.

• Passing the hat around the boardroom and the existing investor base of smaller community banks still works—for now. Indeed, experts say this should be the first step, not an expedient. Sandler O’Neill’s Tom Killian sees many banks of $250 million and less in this category. “It’s hard to find much [market] interest there, because those institutions don’t have much franchise value, though there are investors out there who do like all size deals.”

• Regulators not only want more capital, but have become harder-nosed and less flexible about how banks get it—not just in their official pronouncements, but also in the field.

• Anti-government feeling runs high. In the wake of TARP, much bitterness remains among bankers, even those who didn’t take TARP. They are suspicious of any  “help” from Washington, such as the administration’s “Small Business Lending Fund.”

• With the coming sunset of OTS, a pickup has been seen in mutual conversions. During a capital session at ABA’s Annual Convention, a Pennsylvania savings banker in the audience put it in a nutshell: “If you are going to have to climb Mount Everest, you might as well start from base camp.” ABA’s Sullivan says record numbers of mutuals are moving towards conversion to stock form—at discounts to book value.

• Competition for capital will stiffen. With $80 billion in TARP obligations still to be retired by roughly 350 banks, “clearly there will be significant need for capital going forward,” says Barry of Stifel Nicolaus.

While Basel III (see p. 33) is important to community banks in several ways, that’s tomorrow’s challenge. So, how to handle today’s?

Know your story and tell it well
Talking to investment bankers, private equity players, and others, one lesson stands out: When it comes to numbers, these folks know your bank. Firms maintain lists, stratified by their sense of whether your bank is a “comer,” a “goer,” or a “goner.” You’d better get used to it.

But also realize that numbers pulled from FDIC and SNL Financial don’t tell your entire story.

“From afar, many community banks look alike, but quality, sooner or later, will rise to the top,” says Kirk Wycoff, partner at Patriot Financial Partners, L.P. Setting him and partner James Lynch apart from some other private equity players is that they have been, between them, CEOs of nine community banks.

Making your bank’s quality rise to the top means making a compelling case, and being able to back it up.

“There are a lot of deals being shopped around,” says Joshua Siegel, managing partner at StoneCastle Partners, LLC, which invests in small and mid-sized banks. “To be politically correct, a lot of them are not particularly attractive, and some of them are not at all attractive.”

What makes a bank attractive and a good story, for investors? Good management comes up as a “must.” Investors aren’t looking for a good bank in search of a leader, experts say. Asset quality, and asset management skills, are also critical. And then come robust markets with growth potential.

“You really have to match all three items,” says Siegel.

Numbers help, of course. Patriot’s recent deals, says Wycoff, share the common feature of “strong ‘pre pre’ earnings, meaning strong pre-tax and strong pre-provision.” In other words, clean fundamentals.

There’s also a strategic angle investors like that at first blush surprises. “It’s actually a back-to-the basics business focus on conservative credit standards and extensions of existing strengths,” says Matthew Moore, director at Protiviti. Investors are much more likely to buy strategic plans that call for in-market expansions and logical extensions of geographic footprints.

In terms of footprints, investors like banks with an established productive branch network, in spite of changing consumer usage of bank channels.

“The community bank is still a hub,” says Josh Siegel of StoneCastle. For him, this comes down to an important fact so obvious that people forget it about community banks: “When you ask their customers who their bank is, they give you a banker’s name.”

But investors also want to see robust remote channels.

“It’s now ‘table stakes’ to have a strong internet presence and strong mobile capability,” says Terry Moore, North American banking managing director for Accenture.

One last factor: Investors like to have company. Board and senior management participation in a new capital issue is critical.

Private equity plays for money
Before you even begin to consider tapping private equity, says Kirk Wycoff, ask yourself a critical question: “Would my bank’s board accept equity that wants to look under the covers?” If the answer is negative, don’t seek it.

Further, for many private equity players, a bank has to have more than $500 million in assets, and the firm will be looking for deep discounts on ownership, advises bank attorney and consultant Jeff Gerrish, of Gerrish McCreary Smith Consultants, LLC. In his opinion, such deals are the choice “when there is no other choice.”

Even if there’s willingness, there will be tradeoffs.

Smaller institutions should know that investors will assess a liquidity discount if a bank’s shares are thinly traded, warns Michael Barry of Stifel Nicolaus.

In banks under $100 million, the legal control issue, mentioned earlier, can lead to structures where multiple investors must buy in to avoid triggering control issues. Wycoff says such group deals can be difficult to accomplish in that size category, though not impossible.

But let’s say your bank makes it over every hurdle with a private equity firm or firms. Then things reset to 0, because the regulators become involved. Walt Moeling of Bryan Cave LLP has often helped bank clients and investors make their case to agencies, and he says private equity types and regulatory types have a built-in disconnect. Regulators, accustomed to barking orders to bankers like drill instructors, find the investors too independent. Investors, he says, don’t get the regulators at all.

Fundamentally, says Moeling, the investors go in feeling, “They can’t turn us down, because we want to put $50 million into a good bank.” Moeling chuckles, having been through it, and says, “They can, and they will.”

Shrinking the bank
Clearly, when regulators put a gun to your head, you’ll shrink your bank.

But there’s a great deal of sentiment against shrinkage as a strategy, and not just from bankers. “Shareholder value is about growth,” says Accenture’s Terry Moore. Furthermore, he says, the likely trend in banking will be, really has to be, spreading fixed costs such as compliance over more business, not less. “You really have to grow your way out of this,” says Moore of community banks.

“Shrinking is a band-aid,” adds StoneCastle’s Siegel, “and you’ll still be bleeding. Try, try, try again to find some capital.” • 

The electronic version of this article available at: http://www.nxtbook.com/nxtbooks/sb/ababj1110/index.php?startid=26

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