Why Investors Are Still Hungry for New Bank Equity


capital-10-12-18.pngThe U.S. economy is riding high. Bank stocks, while their valuations are down somewhat from their highs at the beginning of the year, are still enjoying a nice run. For most banks that want to raise new equity capital, the window is still open.

The banking industry is already well capitalized and bank profitability remains strong. According to the Federal Deposit Insurance Corp., the industry earned $60.2 billion in the second quarter of this year, a 25 percent gain over the same period last year, thanks in no small part to the Trump tax cut, which has also helped prop up bank stock valuations. The truth is, in the current environment, banks don’t need to raise new equity just to increase their capital base—they can do that through retained earnings. The industry is awash with capital and most banks don’t necessarily need even more of it.

“The industry overall is enjoying capital accretion,” says Bill Hickey, a principal and co-head of investment banking at Sandler O’Neill + Partners. “Capital ratios industry-wide have continued to increase as banks have earned money and obviously enjoyed the benefits of tax reform. … I think the need for equity capital has lessened slightly as a result of capital ratios continuing to increase.”

Over the last few years, banks have clearly taken advantage of the opportunity to repair their balance sheets, which were ravaged during the financial crisis. According to S&P Global Market Intelligence, there were 123 bank equity offerings in 2016, which raised nearly $6 billion in capital at a median offering price that was 125 percent of tangible book value (TBV) and 52.8 percent of the most recent quarter’s earnings per share (MRQ EPS). There were 146 equity offerings in 2017 that raised nearly $7.5 billion, with offering price medians of 66.3 percent of TBV and 16.6 percent of MRQ EPS. (The industry was much less profitable in 2016 than in 2017, which explains the wide disparity between the median values for the two years.) And through Sept. 26, 2018, there were just in 66 offerings—but they have raised $7.6 billion in equity capital, with a median offering price that was 175 percent of TBV and 13.3 percent of MRQ EPS.

As the median offering prices as a percentage of TBV have gone up over the last two and a half years, while also declining as a percentage of the most recent quarter’s earnings per share—which means that institutional investors are in effect paying more and getting less from a valuation perspective—you might think investor appetite for bank equity would begin to wane. But according to Hickey, you would be wrong.

“There is a lot of money out there looking to be deployed in financial services and banks,” he says. “So there are folks who need to deploy capital—pension funds, funds specifically focused on investing in financial institutions. They have cash positions they need to deploy into investments. So there is a great demand for equity, particularly bank equity at the current time.”

Hickey says most of this new equity was raised to fuel growth, either organic growth or acquisitions. But any bank considering doing so needs to provide investors with a detailed plan for how they intend to use it. “You have to be able to articulate a strategy for the use of the capital you intend to raise,” says Hickey. “That seems obvious, but it needs to be explained quite well to the investment community so they understand how the capital is going to be deployed and have a sense of what their return possibilities are.”

And if you’re going to tap the equity market to support your strategic growth plan, make sure you raise enough the first time around. “Arguably, a company [should] raise enough money that will allow it to fund their growth for at least 18 to 24 months,” Hickey explains. “Investors don’t like it when they’re investing today and then 12 months later the same company comes back looking for more capital. Investors would [prefer] to minimize the number of offerings so they’re not diluted in the out years.”

A Valuable Lesson from the Best Bank You’ve Never Heard of


strategy-8-24-18.pngThere are a lot of places you would expect to find one of the highest performing banks in the country, but a place that wouldn’t make most lists is Springfield, Missouri—the third-largest city in the 18th-largest state.

Yet, that’s where you’ll find Great Southern Bancorp, a $4.6 billion regional bank that has produced the fifth best total all-time shareholder return among every publicly traded bank based in the United States.

Since going public in 1989, just two years before hundreds of Missouri banks and thrifts failed in the savings and loan crisis, Great Southern has generated a total shareholder return, the ultimate arbiter of corporate performance, of nearly 15,000 percent.

What has been the secret to Great Southern’s success?

There are a number of them, but one is that the Turner family, which has run Great Southern since 1974, owns a substantial portion of the bank’s outstanding common stock. Between CEO Joe Turner, his father and sister, the family controls more than a quarter of the bank’s shares, according to its latest proxy report, which places most of their net worth in the bank.

The importance of having “skin in the game” can’t be overstated when it comes to corporate performance. This is especially true in banking, where a combination of leverage and the frequent, unforgiving vicissitudes of the credit cycle renders the typical bank, as one of the seminal books on banking written over the past decade is titled, “fragile by design.”

The trick is to implement structural elements that combat this. And one of the most effective is skin in the game—equity ownership among executives—which more closely aligns the interests of executives with those of shareholders.

“Having a big investment in the company…gives you credibility with institutional investors,” says Turner. “When we tell them we’re thinking long-term, they believe us. We never meet with an investor that our family doesn’t own at least twice as much stock in the bank as they do.”

An interesting allegory that speaks to this is the way the Romans and English governed bridge builders many years ago, as Nassim Taleb wrote in his book Antifragile:

For the Romans, engineers needed to spend some time under the bridge they built—something that should be required of financial engineers today. The English went further and had the families of the engineers spend time with them under the bridge after it was built.

To me, every opinion maker needs to have ‘skin in the game’ in the event of harm caused by reliance on his information or opinion. Further, anyone producing a forecast or making an economic analysis needs to have something to lose from it, given that others rely on those forecasts.

The most important thing having skin in the game has done for the executives at Great Southern is the long-term approach to their family business. “Our dad turned a valuable asset [stock in the bank] over to me and my sister [a fellow director at the bank] and my goal, when I’m finished, is to turn that over to my kids and have it be worth a lot more,” says Turner.

This becomes especially evident when the economy is hitting on all cylinders. “When institutional investors and analysts…are rewarding explosive growth, you need to have a longer-term view,” says Turner. “For instance, the explosive growth you can get from acquisitions is great in terms of the short-term boost to your stock price, but over the longer term that type of thing can reduce your shareholder return.”

Having skin in the game also addresses the asymmetry in risk appetite that otherwise exists between management and shareholders, where the potential reward to management in short-term incentives from taking excessive risk outweighs the potential long-term threat to a bank’s solvency, a principal concern of shareholders.

A long-term mindset promoted by skin in the game also causes like-minded, long-term investors to flock to your stock. This is a point Warren Buffett has made in the past by noting that companies tend to “get the investors they deserve.”

“That point is probably right,” says Turner. “We have a much larger proportion of retail investors than a lot of other companies do. I understand where institutional, especially fund, investors are coming from. It’s great for them to say they’re long-term shareholders, but they have investors in their funds that open their statements every quarter and want to see gains. So it’s harder for big money managers to be truly long-term investors.… It’s a different story with retail investors, who, in my opinion, tend to be longer term by nature.”

This cuts to the heart of what Turner identifies as the biggest challenge to running a successful bank.

“The hardest thing is balancing different constituencies,” says Turner. “We have a mission statement that is to build winning relationships with our customers, associates, shareholders, and communities. What we’re talking about is building relationships that are balanced in a way that allow each of those constituencies to win.”

The moral of the story is that, much like bridge builders in ancient Roman and English times, one of the most effective ways to construct an antifragile bank is by putting skin in the game.

Four Ways to Effectively Deploy Excess Capital


capital-7-23-18 (1).pngFavorable economic conditions for banks, which include a healthy business sector, a rising interest rate environment, and the impact of tax and regulatory reforms, have resulted in strong earnings for many community banks. While this confluence of positive market developments has led many growing banks to tap public and private markets for additional capital to fund growth opportunities, many other institutions are facing an opposing challenge.

These institutions, many of which are located in non-metropolitan markets, are experiencing record earnings yet do not have existing loan demand to effectively deploy the capital into higher yielding assets. As a result, these institutions must evaluate how best to deploy excess capital in the absence of organic growth opportunities in existing markets to avoid the impact on shareholder returns of reinvestment into the securities portfolio during a period that continues to be characterized by historically low interest rates.

Dividends. Returning excess capital to shareholders through enhanced dividend payouts increases the current income stream provided to shareholders and is often a well-received option. However, in evaluating the appropriate level of dividends, including whether to commence paying or increase dividends, banks should be aware of two potential issues. First, an increase in dividends is often difficult to reverse, as shareholders generally begin to plan for the income stream associated with the enhanced dividend payout. Second, the payment of dividends does not provide liquidity to those shareholders looking for an exit. Accordingly, dividends, while representing an efficient option for deploying excess capital, presents other considerations that should be evaluated in the context of a bank’s strategic planning.

Tender Offers and Other Stock Repurchases. Stock repurchases, whether through a tender offer, stock repurchase plan or other discretionary stock repurchase, enhance liquidity of investment for selling shareholders, while creating value for non-selling shareholders by increasing their stake in the bank. Following a stock repurchase, bank earnings are spread over a smaller shareholder base, which increases earnings per share and the value of each share. Stock purchases can be a highly effective use of excess capital, particularly where the bank believes its stock is undervalued. Because repurchases can be conducted through a number of vehicles, a bank may balance its desire to effectively deploy a targeted amount of excess capital against its need to maintain operational flexibility.

De Novo Expansion into Vibrant Markets. Banks can also reinvest excess capital through organic expansion into new markets through de novo branching and the acquisition of key deposit or loan officers. For example, a rural bank with a high concentration of stable, inexpensive deposits but weak loan demand could expand into a larger market where loan demand is strong but deposit pricing is elevated. By doing so, the bank can leverage excess capital and inexpensive deposits through quality loan growth and, optimize its net interest margin and earnings potential. With advances in technology, overhead costs associated with de novo entry into a new market have substantially decreased, although competition for deposit and loan officers is intense. Startup costs may be further diminished through a loan production office, rather than a branch in a new market.

Mergers and Acquisitions. Banks can deploy excess capital to jumpstart growth through merger and acquisition opportunities. In general, size and scale boost profitability metrics and enhance earnings growth, and mergers and acquisitions can be an efficient mechanism to generate size and scale. Any successful acquisition must be complementary from a strategic standpoint, as well as from a culture perspective. For example, a bank’s acquisition strategy could involve joining forces with, or eliminating, a competitor with a complementary business and corporate culture. Alternatively, it could be driven by corporate objectives to enhance earnings by expanding into a larger market with stronger demand for high-quality loans. On the other hand, an institution based in a metropolitan market may be inclined to target a lower growth market with a high concentration of lower cost, core deposits. In either case, the acquisitions are complementary to the institutions.

All banks with excess capital have strategic decisions to make to maximize shareholder value. In many cases, these decisions result in returning capital to shareholders, while others seek to leverage excess capital in support of future growth. The strategy for deploying excess capital should be a material component of a bank’s strategic planning process. There is no universal, or right, answer for all banks. Each bank must consider its options against its risk tolerance, long-term strategic goals and objectives, shorter term capital needs, management and board capacity.