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Capital for Community Banks: Time to Get Real

By: Eliot Stark and Tad Gage

The reality for a sub-$1 billion asset community bank hoping to raise capital in a stand-alone deal is a rather harsh one. Everything said about the billions of investment dollars looking for a home in the devalued banking sector is true, but the capital comes with caveats: investors want size and scale, sufficient shareholder liquidity for a realistic exit strategy, a clean balance sheet and a clear growth opportunity.

In a slow-growth economy, investors have continuing concerns about eroding asset quality. High-quality small business loan demand remains weak and many banks find it difficult to balance legacy portfolio issues with the addition of quality new credits with better margins.

Undoubtedly, many community banks have proved during the past two years they are well-managed and competitive with larger institutions in the markets they serve. However, a realistic possibility for attracting growth and operating capital is scaling up through mergers or acquisitions. Most investors, particularly institutional investors, are interested in financing acquisitive growth strategies and not in providing capital to simply improve a weak balance sheet and hope for the best as the economy improves over time.

Although small bank loan portfolios are easier to analyze and value, many community banks appear under-reserved when institutional investors take a close look at loan portfolios. Typically, their issues are related to currently performing loans and not with loans that are already non-performing. Equity investors are tougher on loan quality and rising loan-to-value ratios than regulators.

Strategic Mergers Facilitate Capital Opportunities

However, through mergers that can scale up assets and build strength to meet these challenges, community banks now have an incredible opportunity.

Customers often do business with community banks for specific reasons, and successful community bank mergers have demonstrated the ability to retain a high percentage of these customers through a continuing commitment to the benefits of the community bank model, even at a somewhat larger size.

Additionally, consolidation typically creates operating efficiencies, larger lending limits, a lower relative exposure to regulatory and accounting-related expenses, and the ability to market new products and services to a larger customer base.

There are roughly 8,200 chartered banks operating today, and we believe this number will be closer to 4,000 within five years. Regulatory and operating costs, higher capital requirements, and a lack of significant sources of new loan and deposit business for the foreseeable future is putting pressure on smaller community banks.

Of the 8,200 banks currently operating, more than 6,000 have less than $300 million in assets. Another 1,400 have assets between $300 million and $1 billion. With investors favoring scale and liquidity of their investments and the capital squeeze on smaller institutions, it is not hard to figure out where the bulk of industry consolidation will occur.

For smaller banks, the best and perhaps only option for a capital raise is tapping into a current stakeholder base: those who are already invested and support the bank. There may be opportunities to tap into a limited portion of a customer base, as well. However, many “friends and family” investors may already be invested at maximum levels. Other options, such as junior debt like trust preferreds, have disappeared because there are no buyers, while existing junior debt is nearly impossible to restructure.

Even stakeholders who feel “maxed out” may be convinced to participate in a consolidation that provides significant potential upside. A capital raise associated with a merger or acquisition is certainly more attractive to third-party investors, particularly when it involves healthy banks joining forces to create a larger entity with economies of scale, increased marketing muscle and the capacity to grow without jeopardizing all-important capital ratios. Many, if not most, markets have enough community banks to offer numerous inorganic growth options, whether full mergers of institutions or major branch, asset and customer acquisitions.

Tough But Necessary Conversations

Standing at this capital crossroads is not an easy place to be. A blunt assessment of a bank’s prospects for growing and attracting capital requires boards of directors and senior management to examine the prospects as would an investor. For instance, in many community bank mergers of equals, customer-facing employees tend to be retained. Attrition of back-office personnel is inevitable. And while consolidation always involves the expense of integrating systems and operations, the positive financial benefits are quantifiable.

Internal discussions about the fate of boards and management in a consolidation can be uncomfortable. A merged entity doesn’t need two boards and there will be management redundancy issues. It usually does not make sense for consolidated banks to continue operating as separate entities. At some point, operations must be unified under one banner.

An outside consulting perspective can ease this internal conversation and facilitate an analysis of optimal merger partners and opportunities to finance the transaction. In an economy where most community banks are priced at or below tangible book value, smaller banks that do not consider the “to merge or not to merge” question are essentially sitting ducks waiting to be scooped up at below-market valuations.

Consider the alternative of avoiding the consolidation discussion: tread water and wait for a regional or mega-bank to enter the picture, dictate the terms of an agreement and sale price, cherry-pick customers and open the door to the departure of customers who don’t want to do business with a large institution.

The Upside of Internal Analysis

Whether or not an outside capital infusion is an immediately realistic possibility, banks have everything to gain by making their operations and balance sheets as clean and transparent as possible:

Two healthy banks with different strengths can consolidate to create a more powerful equation than a simple one-plus-one-equals-two scenario. As an example, a great lender with weak deposits joining forces with a weak lender featuring sticky, low-cost core deposits can solve a lot of problems. A bank domiciled out of state may have a significant operation that no longer fits its business model or with a true market focus or customer expertise elsewhere, which can provide attractive opportunities. And there are generally fewer management and board issues in such an acquisition.

Finally, avoid the mistake many smaller community banks make — being visible and accessible to customers but functioning on the corporate side as a well-kept secret. Communicating a bank’s strength, capabilities, management, vision, asset-management ability and growth opportunities in outreach and websites increases a bank’s visibility and transparency with potential investors and also potential merger or acquisition partners.

The community bank operating and service model remains an exceptionally viable and vibrant one, but the $200 million community bank of today may well need to be the $2 billion-asset community bank of tomorrow. While consolidation is not the easiest internal conversation to have, the prospects for a small community bank raising capital make it imperative.

Eliot Stark is managing director, Headwaters MB, and Tad Gage is executive vice president, Capital Insight Partners.

Copyright © January 2011 BankNews Media