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John R. Engen

Tapping a rich vein: how investors are using retirement money to buy stock in bank start-ups...six tips for superior due diligence.

Tapping a Rich Vein: Boosting Capital with IRAs

The banking market in Chico, California, about 100 miles north of Sacramento, has been hit hard by consolidation. Outside buyers, including PremierWest Bancorp and Umpqua Holdings—two Oregon institutions making a move on northern California—have completed deals here recently, reducing the number of locally owned banks. Mark Francis, a former executive with Tehama Bank, an Umpqua acquiree, saw opportunity in the decline, and last year set out with some partners to raise between $12 million and $14 million to capitalize startup Golden Valley Bank, now a year-old, $15 million institution where he’s the CEO.

Like a lot of other bankers seeking to raise capital nowadays, Francis quickly discovered what he calls “the dirty little secret your broker doesn’t tell you about,” namely that individuals can invest their personal retirement assets—IRAs, 401(k) rollovers, Keoghs, and more—in pretty much anything they want, including startup banks. Francis turned potential investors on to the notion, and largely as a result of retirement funds, which contributed about 25% of the total, the issuance was way oversubscribed, at $22 million. “People had more to invest, because they could pull money from their IRAs,” Francis says.

Welcome to what’s quietly emerged as one of the hottest trends in the bank capital-raising world. Investors have been able to use retirement money to buy stock in bank startups for more than 30 years, and it’s not at all an uncommon use of that money. Dan Hudson, CEO of NuBank, a San Luis Obispo, California consulting firm, says he’s helped launch 140 banks “and we’ve never done one without using retirement money.”

But the practice is gaining more attention of late—perhaps because there’s so much retirement money available. At the end of 2005, Americans held some $14.5 trillion in retirement assets, according to the Investment Company Institute. It’s a big, relatively patient—and growing—pool of money, and just the type of funding that organizers of a community bank would love to tap into.

While no one is keeping specific track of exactly how much retirement money has been invested in banks, the evidence suggests that at least several hundred million dollars have flowed into bank balance sheets since the beginning of the decade. Most of that tally has gone to startups such as Golden Valley. But increasingly it’s also considered a viable option for existing banks in need of a secondary round of capital.

Jim Wagner, CEO of Trust Administration Services Corp., a Carlsbad, California firm that specializes in self-directed retirement plans for individuals, says his company has helped about 75 private-bank startups tap into investors’ retirement accounts.Those banks typically get about 20% to 30% of their overall capital from investors’ retirement accounts. Hudson says the average amount invested is about $22,000 per individual.

Managers of self-directed investment plans, including Trust Administration, a division of Los Angeles-based First Regional Bancorp, and The Entrust Group of Reno, Nevada, don’t find investors for organizers. Rather, they serve as the facilitator/custodian for investors the bank has already lined up, who want to pump some of their retirement assets into a financial institution but run into resistance from incumbent brokers.

The process is pretty much a winwin for all sides, says Peter Weinstock, a Dallas-based head of the financial institutions practice for law firm Hunton & Williams, who has worked on dozens of such deals. For investors, banks are viewed as a safe play—no bank has failed in more than two years, according to the Federal Deposit Insurance Corp.—and typically provide good returns. “To own stock in a bank that will appreciate over time, and then be able to sell it for a nice price, and not have to pay taxes on it, is extremely attractive,” he says.

For banks, the appeal is no less compelling. Firms like Trust Administration make their money by serving as custodians to investor accounts, charging nominal management fees.The bank pays nothing. Since the money in retirement accounts typically has a longer-term investment horizon, folks are less likely to agitate for quick returns or a sale. More than that, retirement funds are home to big chunks of local money.

Capital Bank of New Jersey, based in Vineland, opened its doors this April with about $20 million in capital—one quarter of it retirement money.The minimum investment was $25,000, and “a lot of people don’t have that kind of scratch just lying around. But they do have it in their retirement accounts,” says CEO David Hanrahan.“We had a lot of folks jumping at the opportunity to invest their IRAs this way.”

The approach won’t work for everybody.Weinstock says the tax implications can make raising funds from retirement accounts inefficient, and “unlawful” for a subchapter S company. “To the extent that a bank wants to go subchapter S, that could be a big hurdle,” he says.Weinstock worked with one bank in Dallas that intended to go sub-S. “They wound up not being able to raise all the money they needed from individuals and trusts, so they changed their organization to a C corporation so they could take plan money.”

Wagner says many prospective bank boards are initially leery about steering local investors toward a relatively unknown strategy. To overcome such misgivings, he says, one or two board members usually “will run through the process themselves first to see what it’s like, before they cut us loose on their investors.”That’s what Hanrahan did. “What helped me sell it to people was that I was able to say that my $100,000 investment was retirement money,” he explains. “I was the guinea pig, so to speak. It wasn’t a hard process.”

Even so, insiders also should watch their steps,Weinstock says. In some cases, board or management investments “could potentially be prohibited under ERISA and invalidate the IRA,” he says. “Each case has to be analyzed individually to understand the implications.”

For investors, the biggest stumbling block might be resistance from the brokerages that administer their retirement accounts. Hanrahan says about half of his investors’ incumbent brokers were willing to shift the money to his bank’s stock. The other half cited compliance concerns. “The bottom line is, most brokers don’t stand to make anything off the transaction, so they’ll look for excuses not to do it,” he says.

Despite the challenges, investors are happy with the results of this strategy—and so are the banks.“We didn’t want outside speculators as investors.We wanted local shareholders who would also be customers,” Golden Valley’s Francis explains. “Tapping retirement assets allowed us to achieve that.” —John R. Engen

Six Tips for Superior Due Diligence

Experts say the key to effective due diligence is to look beyond the numbers and focus on the people and other forces that drive value.The thought leaders at Crowe Chizek and Co. LLC, a nationwide public accounting and consulting firm, have developed six tips for successful acquisitions.They include:

Account for human capital—Mergers and acquisitions fail most often because companies overlook the importance of managing human capital. To ensure the buyer retains the management talent needed, the buyer must communicate future roles early and often with both companies’ employees during the due diligence process.

Kick the tires—A seller’s financial statements provide buyers with information about its assets, liabilities, and operations, but reveal little about its quality. A tour of the seller’s facilities can give the buyer a feel for its condition and help the buyer determine whether significant capital investments will be required.

Look carefully at IT systems—Information is the lifeblood of most organizations and integrating two companies’ information technology systems can be costly.The buyer’s due diligence team should determine whether the seller’s IT system is compatible with the buyer’s system. Do not forget the cost of integrating systems when projecting capital expenditures and obtaining financing.

Defuse financial time bombs—Detailed due diligence can reveal hidden costs that may not be apparent from an initial review of financial statements and other documents. Some sellers may attempt to enhance their company’s perceived value by reducing spending on certain functions such as research and development, advertising, or maintenance. Downward trends in spending on advertising and other essential business activities can be a red flag. Buyers can uncover deferred compensation practices by analyzing historical salary patterns, obtaining local comparable pay rates and interviewing the seller’s employees.

Uncover liabilities—Hidden liabilities can quickly erase the value of an otherwise promising transaction. Buyers should thoroughly analyze and evaluate potential exposure to environmental risks, employee legal claims and other liabilities and, if necessary, adjust the purchase price accordingly. Interview employees to assess potential liability for wrongful termination, discrimination, sexual harassment, or other employment-related claims.

Analyze supply and demand—A company’s future growth depends on its relationships with customers and suppliers, but all too often these relationships are neglected in the due diligence process. Determine why customers do business with the seller. Buyers also should conduct a thorough review of the seller’s supply chain.

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