After the reported successes of Pasadena’s OneWest Bank (which took over IndyMac Bank), and HomeStreet Inc.’s planned initial public offering, investors are again flocking to the banking industry with checkbooks in hand. Savvy investors and private equity firms have identified the banking industry as a gold rush with the potential for big profits and even bigger payouts for the investors. But realizing those goals may be harder than it looks.
To be sure, there is a lot of money to be made in the banking industry. Credit concerns — and the general difficulty of consistently valuing bank assets and loans — have depressed valuations of public and private community banks alike. Some investors view this as an opportunity to buy banks at a low cost and wait for the recovery to bring in huge returns.
The banking community is abuzz about all the enthusiasm in the investment community for bank equity, and rightly so. For the past few years, if a community bank found itself in troubled condition, investors would not invest, instead waiting for the bank to fail and then trying to buy the desirable assets from the FDIC at a significant discount. This was a low-risk strategy that had the additional benefit of allowing the buyer to take the bank assets without assuming any of the obligations of the bank holding company’s creditors and shareholders. But today, there are fewer banks being seized and fewer bargains being offered in FDIC sales.
The “New Bank” Investment
Adding to this sentiment is the anticipated momentum in the bank M&A market as the attractive returns obtained by early entrants have piqued the interest of more and more investors looking to enter the market. Potential investors have several options, with a popular one being the new bank investment. A team of experienced bankers — oftentimes backed by a private equity fund or funds — put together a pool of cash and purchase a small bank in an open-bank transaction. This gives them the platform to further grow by acquiring more banks and potentially becoming qualified to buy assets in FDIC-assisted purchases. An example is Grandpoint Bank, headquartered in Los Angeles, which has been on an acquisition spree after raising $335 million from investors. Another example is Opus Bank in Redondo Beach, Calif., led by Stephen Gordon, who raised $460 million in late 2010 for the same purpose. Other recent examples include a number of big name private equity funds, such as Oaktree Capital Management and Leonard Green & Partners LP, who have taken ownership positions in existing banks and provided funding for potential future acquisitions. Other market players are making smaller, strategic investments in existing banks in order to take non-controlling positions in a variety of banks across the country and diversify their risk.
The new bank phenomenon has energized bank investing, but also carries a fair amount of risk along with the potential rewards that are worth noting.
The banks with newly infused capital have a lot of funding and a mandate to acquire banks, but finding the right target is not as easy as it looks. First, there are not a lot of targets out there. This may seem counter-intuitive because there are still a significant number of smaller banks that need cash or an exit strategy. But despite the influx of investment cash in the industry as a whole, small banks in need of cash are not seen as an attractive investment as a stand-alone bank, so they are not receiving that cash directly.
In addition, even a small bank that is still healthy is seeing its cost of operations rise substantially as new government regulations increase their costs without a corresponding increase in profitability, especially as interest rates stay low. Many of the small community banks are being coined as “too small to succeed,” and few investors are interested in pouring money into a bank that may not ultimately survive.
So, these smaller banks are oftentimes left with the choice of continuing to struggle and ultimately face seizure by the FDIC, or merge with another smaller bank that has the same cash flow problems in the hopes of bulking up to afford the cost of the new regulations.
This situation should have small banks lining up to be acquired by a well-funded bank, but that has not been the case. Many banks have chosen to “wait it out” or try other alternatives, rather than turn their banks over to a new management team in a deal that will likely remove all existing management at the target bank and make the target’s existing stockholder equity largely valueless. As a result, the bank M&A market is left with far more buyers than sellers.
Even in markets with a fair number of potential merger candidates, profit and success are hardly inevitable for these new, well-funded banks. There are countless risks as the new banks identify and diligence potential target banks.
The first major hurdle is the FDIC disadvantage, meaning the bank M&A market was moribund in 2008 and 2009 because no one could compete with the deals being offered by the FDIC in assisted transactions. The private market for banking transactions shut down as investors found ways to participate in FDIC-assisted transactions because the profitability (and loss-share arrangements mitigating risk) were so much better. There was no appetite to invest in open-bank transactions. As the FDIC seizes fewer banks, and as the terms of loss-share arrangements have become less favorable for the purchasers, investors and private equity funds are starting to see the window of opportunity open.
In light of this new appetite for open-bank deals, the next hurdle is to identify, accurately evaluate and properly value the bank’s assets. This is complicated by the difficulty in assessing and valuing the bank assets. Valuing almost anything is generally more an art than a science, and real estate is an even more volatile valuation challenge. The real estate market has not settled and the market in California, and most of the Western United States, continues to be unpredictable. This means there is inherent risk in acquiring a bank’s balance sheet and trying to predict how the market will react during the next few years.
The next major hurdle is the debt and other complications at the holding company. Unlike an FDIC-assisted transaction, where the buyer only assumes part of the bank, most banks have a holding company, and any private investor in an open-bank transaction must factor in the cost of the holding company’s debt.
Stockholders of the holding company will also likely need to approve the acquisition, which in most cases will almost entirely de-value their equity positions. In many instances, holders of trust-preferred securities will refuse to be paid off at less than par, even if it means that the holding company has no other option but to allow the bank to be seized or for the holding company to enter into bankruptcy.
Beyond these challenges, we live in a constantly changing regulatory environment. Banks are faced with a constant barrage of shifting regulations and capital requirements. Investors could be negatively impacted if they acquire a bank that is more troubled than they originally thought. If the new bank is forced to further write down assets, that can negatively impact the overall health of the merged banks and potentially prevent it from acquiring other institutions and curtail the overall growth and profitability plan.
For these reasons, the M&A gold rush that so many are predicting may end up looking more like a few prospectors alone in the riverbed working 24/7 and hoping to strike it rich. However, if they start to find gold, then word will spread fast and we may see a flood of M&A start to hit the banking industry.
Ann Lawrence is a partner at law firm DLA Piper LLP in Los Angeles. Contact her at 213-330-7755 or ann.lawrence(at)dlapiper.com.
Copyright © September 2011 BankNews Media