Raising Capital in a Difficult Environment

1-31-14-Hunton.pngIn this environment, bankers can be excused for a fixation on capital. The demise of trust preferred (“TRUPs”) pools means there is no longer “just in time capital.” Regulators have demanded higher capital levels for troubled institutions, and new rules under the global agreement known as Basel III are set to go into place for community banks in January of 2015. Accordingly, bankers need to plan for their capital needs.

The following are some options for raising capital.

Bank Stock Loan
Bank holding companies (BHCs) of more than $500 million in total assets will generally be required to maintain a leverage ratio of 5 percent, a Tier 1 capital to risk-weighted assets ratio of 6 percent and a total capital to risk-weighted assets ratio of 10 percent, all on a consolidated basis. Basel III increases the total risk based capital ratio, including a new conservation buffer, and will add a common equity risk-based ratio, starting Jan 1, 2015. Bank holding companies below $500 million in assets are subject to a leverage limitation (essentially, the company must have a ratio of 100 percent debt to holding company equity) and a requirement that a subsidiary bank remains well capitalized. Dodd-Frank phases in quantitative capital requirements for savings and loan holding companies regardless of whether they have $500 million in assets or not.

All BHCs can borrow funds and contribute such funds into their banks as capital. BHCs of less than $500 million in total assets need mainly to stay within the debt-to-equity limits. Obviously, interest on bank stock debt is tax deductible.

For larger BHCs (those subject to consolidated capital guidelines), the Federal Reserve generally provides that subordinated debentures with an average weighted maturity of at least five years count as Tier 2 capital. These debentures are also an option for any size BHC looking for an interest-only alternative. Subordinated debentures must be unsecured. There are also other technical requirements to count as Tier 2 capital.

Preferred Stock
Dividends paid by a BHC on preferred stock are not tax deductible. Preferred stock must be noncumulative to qualify as Tier 1 capital, in other words, it doesn’t pay the holder any unpaid dividends retroactively. Consequently, a BHC may be able to justify the higher cost as compared to debt if necessary to improve the BHC’s leverage or Tier 1 risk-based capital ratios. Cumulative preferred stock is Tier 2 capital.

Common Stock
Common stock is obviously the cheapest form of capital, but also the most dilutive, to shareholders.

Private Offering
There are a number of options for an offering of securities. The JOBS Act regulations allow broad marketability of offerings solely to accredited investors. A BHC can engage in a nonpublic offering for up to 35 accredited investors or an offering which is otherwise exempt from registration. For instance, the BHC can engage in an exempt offering under Rule 144A to qualified institutional buyers (QIBs), which allows subsequent resales of the securities when resold to QIBs. This can mitigate the embedded marketability discount on securities sold in private placements.

Public Offering
To the extent that the BHC is public and it anticipates making frequent offerings of its securities, it may decide to file a shelf registration under Rule 415. A shelf registration covers securities that are not necessarily sold in a single discrete offering immediately upon effectiveness, but rather a number of tranches sold over time or on a continuous basis. With a shelf registration in place, the BHC has increased flexibility to raise money without the need of further Securities and Exchange Commission (SEC) clearance. There is also a considerable saving in paperwork, as only a prospectus supplement need be filed with the SEC.

Rights Offering
A BHC may consider a rights offering to existing shareholders as a means to raise additional capital. The rights offering could either be registered with the SEC or, if an exemption from registration were available, as a private offering. In a rights offering, the BHC allows existing shareholders to purchase their pro rata share of the securities offered.

In a PIPE offering, which stands for private investment in public equity, a public company issues securities in a private placement to selected accredited investors, normally QIBs or other institutional accredited investors. As a part of the securities purchase, the issuer agrees to file a resale registration statement covering the resale of the securities within a period of time following the closing. This allows the holders of the securities to gain liquidity while allowing the issuer to receive the capital without the delay of an SEC registration process.

Our expectation is that the most likely source of funding for most is a retail offering either with or without an investment banker. Nonetheless, in light of the rebounding capital market, offerings in a 144A or in a public offering are increasingly available.