Understanding Your Bank’s Capital Alternatives


capital-10-18-17.pngIt is crucial for executive management to engage their boards in practical conversations surrounding the raising of capital. Important questions include what form of capital is best from a strategic perspective, how much dilution to earnings per share (EPS) is acceptable and how soon can the dilution be earned back. To answer these questions, management must first have a solid understanding of each type of capital.

Common Equity
Common equity tends to receive the most favorable treatment from a regulatory perspective and is fully included in Tier 1 capital. This, however, comes at a cost beyond the 5 to 7 percent fee paid to your investment banker. A common equity raise increases the number of shares outstanding. This translates to dilution of earnings per share and existing ownership until the new capital is leveraged, or put to work.

When a bank undergoes a common equity raise, it also gives up ownership and voting rights. If the bank is unable to raise common equity at or above current tangible book value per share (TBVS), or is concerned with existing ownership dilution, it should seriously consider an alternative source of capital. Banks must have clearly defined parameters in place for raising capital, particularly its impact on TBVS and EPS.

When evaluating a common offering, two key considerations are: (1) whether to conduct a private offering or undergo an IPO, and (2) whether to raise capital internally or externally. Having a strategic plan in place is critical to ensure that the bank can execute on deploying capital and earning back the initial shareholder dilution.

IPO or No?
Not everyone needs to conduct an initial public offering (IPO), but for larger institutions or institutions seeking liquidity, it is an excellent option. An IPO provides liquidity for stockholders, generates capital to accelerate growth, and depending on trading volume establishes currency that can be utilized in acquisitions. Once an institution undergoes an IPO it has also created access to capital markets for follow-on offerings to continue to raise capital as needed. While IPOs provide a faster vehicle to raise capital, they also require more time from key management, detracting from their role in day-to-day operations.

Subchapter-S corporations must consider ramifications of increasing their shareholder base before triggering a requirement to convert to a stock corporation. Once an S-corporation exceeds 100 stockholders, it must convert to a C-corporation, which has immediate tax implications and changes in reporting requirements.

Private Placements
For smaller banks or institutions that are closely held, private placements may be preferable to an IPO. Although the timeframe for a private placement may be longer, less time is required from management. Private placements are limited to existing stockholders, accredited investors and qualified institutional buyers. While private placements are generally smaller and less dilutive to EPS, it can also may be difficult to raise larger amounts of capital using this vehicle. The bank will be able to remain private with less pressure to immediately leverage capital, allowing greater autonomy in strategic decisions.

Alternative Sources of Capital
Noncumulative perpetual preferred stock can be counted towards Tier 1 capital and can be used to increase tangible equity. Banks with a clean risk profile may be willing to operate with lower levels of tangible common equity and focus on bolstering tangible equity. Preferred stock is generally less expensive to raise, although there is a post-tax dividend that can range from 5 to 9 percent.

For banks with a holding company, another form of capital—debt—can be down-streamed in its entirety to common equity at the bank level. Debt is the least expensive form of capital, costing approximately 3 percent to raise with no dividends and tax-exempt interest expense.

Regardless of the approach used to raise capital, be realistic in how much you can effectively leverage. Excess capital may be viewed favorably from a regulatory perspective but can become a value detractor if not effectively deployed. This is particularly true for banks entertaining the possibility of a sale. Over-capitalized targets are likely to be priced on a leveraged capital approach, meaning that tangible common equity in excess of a certain percentage of average assets will be priced at 100 percent TBVS and only the leveraged portion of capital will receive a premium.

When raising capital in any form, proactively communicate with regulators and stockholders remembering that neither party likes surprises. Work with your financial advisor to run pro forma analyses on multiple scenarios and establish parameters for EPS and ownership dilution to maximize the impact of your capital raise.

A Second Life for an American Bank


bank-rebirth-8-18-16.pngThere were 437 bank failures in the United States between 2009 and 2012, according to the Federal Deposit Insurance Corp., most of them victims of the financial crisis and the sharpest economic downturn since the Great Depression. CalWest Bancorp was not one of them, despite experiencing some financial difficulties of its own during the crisis years, and today it faces a bright future with a successful recapitalization and reconstituted board.

As much as anything, the story of CalWest, a $136.6 million asset bank holding company based in Rancho Santa Margarita, California, is a strong vote of confidence for the potential of community banking. It is often said that small banks, especially those under $500 million and even $1 billion in assets, won’t be able to survive in a consolidating and increasingly competitive industry. The story of CalWest is about a group of professional investors who put $14 million into the bank and joined the board without compensation because they believe in the long-term future of their small community bank and are ready to roll up their sleeves and get to work.

Formed in 1999, CalWest has four branches in Southern California’s Orange County that uses three different names: South County Bank in Rancho Santa Margarita, where it has two branches, Surf City Bank in Huntington Beach and Inland Valley Bank in Redlands. President and Chief Executive Officer Glenn Gray says CalWest provides “white glove service” to a small and midsized businesses. “These are companies with probably $30 million or less in annual revenue, mostly family owned,” says Gray. “We focus on C&I lending, although we do commercial real estate [lending] as well.”

CalWest’s biggest problems during the recession were primarily bad commercial real estate loans and loans guaranteed by the Small Business Administration. The bank tried “quite a few different attempts” to either recapitalize or sell itself without success, according to Gray, although it did take approximately $5 million in Troubled Asset Relief Program (TARP) funds from the federal government in 2009. Attracted by the challenge of reviving a flagging franchise, Gray signed on as CEO in 2012, leaving a different Orange County community bank where he had been the CEO for six years. “I made the move primarily because of the opportunity to come into something that clearly needed to be fixed,” he explains. “I had a pretty good idea that it could be fixed. I like doing turnaround situations.” Gray was also drawn in by the chance to invest personally in the bank’s recovery.

The bank had entered into a consent agreement with its primary regulator, the Office of the Comptroller of the Currency, in January 2011, that among other things required it to raise its regulatory capital ratios. Gray spent the next couple of years cleaning up the loan portfolio and shrinking the bank’s balance sheet to improve its capital ratios, but wasn’t ready to raise new capital until 2015 when it retained Atlanta-based FIG Partners to manage a recapitalization of the bank. The effort ended up raising $14 million in fresh capital in December of last year from a group of private investors, although it actually had commitments for $30 million, according to Gray. The funds will be used to strengthen the company’s regulatory capital ratios, support its growth plans and retire the TARP funding. The consent order with the OCC was terminated in May.

One of those investors is Ken Karmin, chairman and CEO of Ortho Mattress Inc., a bedding retailer located in La Marada, California, and a principal in High Street Holdings, a Los Angeles-based private equity firm. Karmin had first met Gray shortly after he took over at CalWest in 2012 and they talked about Gray’s plans for the bank. “It was just too early in the process for new capital to come in,” Karmin recalls. “He had work to do to get the bank in a position to be recapitalized. But I was impressed from the moment we met. I knew he was the real deal; a very capable CEO…in control of the situation and every facet from BSA [Bank Secrecy Act] to credit quality, the investment side, lending, the relationship with the regulators. It was an amazing opportunity for investors like me to put money behind someone like Glenn, who can really do it all.”

Karmin came in as a lead investor and today serves as CalWest’s board chair. (All but two members of the previous CalWest boardGray and Fadi Cheikha—voluntarily resigned when the decision was made to raise capital by bringing in new investors.) Other investors, who also received a board seat, were William Black, the managing partner at Consector Capital, a New York-based hedge fund; Jonathan Glaser, managing member at Los Angeles-based hedge fund JMG Capital Management; Clifford Lord, Jr., managing partner at PRG Investment and Management, a real estate investment company in Santa Monica, California; Richard Mandel, founder and president of Ramsfield Hospitality Finance, a New York-based hotel real estate investment firm; and Jeremy Zhu, a managing director at Wedbush Asset Management in Los Angeles.

Although Gray and Cheikha did stay on as directors, the current board is really a new animal. The rest, with the exception of Zhu, were people that Karmin already knew. The new CalWest board also has an awful lot of intellectual and experiential horsepower for a small community bank. “A board for a bank of this size, we have the luxury of intellectual talent basically at our finger tips,” says Karmin. The composite knowledge base of the CalWest board includes extensive experience in C&I lending, BSA, investing, commercial real estate and the capital markets. “We have the talent to make intelligent, thoughtful decisions and support management,” Karmin says.

When asked what kind of culture he would like to create on his board, Karmin mentioned a couple of things. First, he says the current directors are “willing to serve and do the work and the heavy lifting.” And from an investment perspective, they are taking the long view. Karmin says they will not receive any fees or compensation for their board service “until the bank is right where we want it, operating at the highest possible level.” Nor will the directors be taking personal loans from the bank. “If you want to borrow from our bank, this is the wrong board for you,” he says. “We’re not going to do any Reg O loans.”

More importantly, perhaps, Karmin wants a board that is very focused on performance. “We want a culture of first quintile performance,” he says. “That means that we expect our financial performance on the most important metrics to be in the first quintile of banks of our size in our geographic area.”

Given the strong private equity and investor background of all of the new directors, it’s logical to assume they will be looking for an exit strategy at some point. Karmin suggests that day, when it finally arrives, will be well off into the future. For one thing, Karmin and Gray are jazzed about the potential of the Southern California market. With about 9 percent of the country’s population, “We expect that it’s going to be one of the most important growth areas in the United States,” Gray says. “Whether the [national] economy grows 2 percent or 1 percent, it’s not going to matter to us. We’re going to be a first quintile performer under all those scenarios.”

“We have instructed Glenn to run the bank for the long haul,” Karmin says. “We were making this investment for a lot of different reasons, but that we expected to be investors and to be on the CalWest board for a long time. We have real plans to grow the bank in a controlled strategic fashion. [The directors want to] use our contacts to make new contacts, use our contacts to make new loans, use our contacts to gather new deposits. We are the kind of a board that can really help on all those metrics.”

Gray says this is the fourth bank board that he has participated on and the CalWest board is very different from all the others. “It’s a board that is very involved,” he says. “They ask good questions. They ask tough questions. If you wanted to be a CEO of a bank [that has] the old country club atmosphere, this would not be the place to be.”

Identify Your Customers Based On Need, Not Revenue


segmentation-3-28-16.pngFor banks that don’t specialize in a particular market, it can be difficult to truly know every customer’s changing wants and needs. And while there’s significant customer research available on retail consumers and large corporate clients, there’s less help available when it comes to understanding mid-market corporate customers.

Despite the lack of information readily available, mid-market companies are a fast-growing segment of customers that banks can’t afford to ignore. In fact, a recent Citizens Commercial Banking survey found that a quarter of mid-market companies, defined as having $500 million to $2 billion in annual revenues, are actively engaged in raising capital, while another 40 percent are looking for opportunities to do so. Additionally, more than half of the mid-market companies in the US alone indicated they are actively seeking M&A deals in 2016.

In an effort to capture and better understand commercial customers, banks have historically tried to segment companies based on the value of their annual sales or revenue range (e.g. less than $5 million, $5 million to $20 million, etc.). However, these revenue estimates are extremely unreliable, because typically, mid-market companies aren’t public companies. They have no obligation to report revenue and are not subject to strict audit guidelines. This means that the main metric banks are using to understand their mid-market customers is self-reported, without any independent validation.

But more important than yielding unreliable data, revenue segmentation really doesn’t give banks much insight into a customer’s needs, aside from their credit need or credit worthiness. This is a severely flawed approach to understanding customers because there are so many non-credit products that banks can profit from.

Take payments, for instance. With payments, the needs of a $5 million construction company have little in common with the needs of a $5 million healthcare services company. While technically in the same revenue segment, the two companies have vastly different payment transaction numbers, payment processes and workflow, payables vs. receivables, and enterprise resource planning and accounting systems.

Simply put, revenue is a misguided way for banks to segment their corporate customers, particularly when it comes to the mid-market. Except in rare cases when revenue estimates are actually reliable and indicative of customers’ needs, the knowledge gleaned from a single revenue figure is minimal, and it doesn’t help banks better understand and serve their customers.

The good news is, there are other ways for banks to effectively target customers and strengthen customer relationships. One approach is to use transactional data as a means to develop detailed portraits of customers and their needs. By identifying and segmenting customers by need (rather than revenue), banks can establish stronger relationships and drive new fee income by offering solutions to address those needs. For example, banks could learn a lot about a customer by looking at their outgoing payments. How many payments are they making each month? What methods are they using to make these payments—paper checks, ACH, credit cards, debit cards?

Understanding the volume and value of payments for specific businesses can be extremely valuable for determining how to market and sell existing products more effectively. It can also expose areas where a bank might be failing its customers and losing good grace with otherwise loyal organizations. For example, seeing that a large group of customers is making payments through third-party solutions is an obvious sign that it’s time for a bank to develop a new or better payments solution of its own.

Banks are sitting on literally millions of customer records that can offer invaluable insights into customers’ wants and needs, however this data is often unused or under-leveraged. It’s an unfortunate reality, but one that can be easily addressed.

In today’s golden age of big data and analytics, banks need to leverage far more than just revenue figures to better understand their customers. By failing to fully understand customers, banks won’t be able to serve customers well, and they’ll run the risk of losing customers to hungrier and more innovative competitors as a result. Luckily, the treasure trove of existing transactional data can provide banks with infinite ways to better segment customers, and the breadth of that data will allow them to serve their customers more precisely and comprehensively.

Identify Your Customers Based On Need, Not Revenue


segmentation-3-28-16.png

For banks that don’t specialize in a particular market, it can be difficult to truly know every customer’s changing wants and needs. And while there’s significant customer research available on retail consumers and large corporate clients, there’s less help available when it comes to understanding mid-market corporate customers.

Despite the lack of information readily available, mid-market companies are a fast-growing segment of customers that banks can’t afford to ignore. In fact, a recent Citizens Commercial Banking survey found that a quarter of mid-market companies, defined as having $500 million to $2 billion in annual revenues, are actively engaged in raising capital, while another 40 percent are looking for opportunities to do so. Additionally, more than half of the mid-market companies in the US alone indicated they are actively seeking M&A deals in 2016.

In an effort to capture and better understand commercial customers, banks have historically tried to segment companies based on the value of their annual sales or revenue range (e.g. less than $5 million, $5 million to $20 million, etc.). However, these revenue estimates are extremely unreliable, because typically, mid-market companies aren’t public companies. They have no obligation to report revenue and are not subject to strict audit guidelines. This means that the main metric banks are using to understand their mid-market customers is self-reported, without any independent validation.

But more important than yielding unreliable data, revenue segmentation really doesn’t give banks much insight into a customer’s needs, aside from their credit need or credit worthiness. This is a severely flawed approach to understanding customers because there are so many non-credit products that banks can profit from.

Take payments, for instance. With payments, the needs of a $5 million construction company have little in common with the needs of a $5 million healthcare services company. While technically in the same revenue segment, the two companies have vastly different payment transaction numbers, payment processes and workflow, payables vs. receivables, and enterprise resource planning and accounting systems.

Simply put, revenue is a misguided way for banks to segment their corporate customers, particularly when it comes to the mid-market. Except in rare cases when revenue estimates are actually reliable and indicative of customers’ needs, the knowledge gleaned from a single revenue figure is minimal, and it doesn’t help banks better understand and serve their customers.

The good news is, there are other ways for banks to effectively target customers and strengthen customer relationships. One approach is to use transactional data as a means to develop detailed portraits of customers and their needs. By identifying and segmenting customers by need (rather than revenue), banks can establish stronger relationships and drive new fee income by offering solutions to address those needs. For example, banks could learn a lot about a customer by looking at their outgoing payments. How many payments are they making each month? What methods are they using to make these payments—paper checks, ACH, credit cards, debit cards?

Understanding the volume and value of payments for specific businesses can be extremely valuable for determining how to market and sell existing products more effectively. It can also expose areas where a bank might be failing its customers and losing good grace with otherwise loyal organizations. For example, seeing that a large group of customers is making payments through third-party solutions is an obvious sign that it’s time for a bank to develop a new or better payments solution of its own.

Banks are sitting on literally millions of customer records that can offer invaluable insights into customers’ wants and needs, however this data is often unused or under-leveraged. It’s an unfortunate reality, but one that can be easily addressed.

In today’s golden age of big data and analytics, banks need to leverage far more than just revenue figures to better understand their customers. By failing to fully understand customers, banks won’t be able to serve customers well, and they’ll run the risk of losing customers to hungrier and more innovative competitors as a result. Luckily, the treasure trove of existing transactional data can provide banks with infinite ways to better segment customers, and the breadth of that data will allow them to serve their customers more precisely and comprehensively.

Issues & Ideas for M&A Related Capital Raising




During Bank Director’s 2015 Acquire or Be Acquired conference in January, this session explored alternatives for raising capital required to close a specific M&A transaction. The discussion included the pros and cons of both public and private transactions with specific examples of offerings that worked well and those that faltered. The presentation also focused on the evolving role of private equity as a source of acquisition related capital.

Presentation slides

Video length: 54 minutes

About the speakers

Todd Baker – Managing Director & Head of Americas Corporate Development at MUFG Americas Holdings / MUFG Union Bank NA
Todd Baker is managing director and head of Americas corporate development at MUFG Americas Holdings / MUFG Union Bank NA. He has had a lead role in scores of bank and financial services M&A transactions over the past 30+ years. Some of his more recent transactions in the community bank sphere include the 2012 acquisition of Pacific Capital Bancorp by MUFG Union Bank, the 2009 acquisition of The South Financial Group by TD Bank and the 2006 acquisition of Commercial Capital Bancorp by Washington Mutual.

Frank Cicero – Global Head of Financial Institutions, Managing Director Investment Banking at Jefferies LLC
Frank Cicero is the global head of financial institutions, managing director investment banking at Jefferies LLC. He specializes in M&A and capital markets transactions for depository institutions. Previously, Mr. Cicero was the head of investment banking coverage for banks at Lehman Brothers and Barclays Capital.

John Eggemeyer – Founding & Managing Principal at Castle Creek Capital LLC
John Eggemeyer is a founding and managing principal at Castle Creek® Capital LLC which has been a lead investor in community banking since 1990. The firm is currently one of the most active investors in community banking with approximately $700 million in assets under management. Prior to founding Castle Creek®, Mr. Eggemeyer spent nearly 20 years as a senior executive with some of the largest banking organizations in the U.S. with responsibilities across a broad spectrum of banking activities.

Can a Capital Raise Jeopardize Your Tax Assets?


Crowe_1-30-13.pngThe short answer to the question of whether a capital raise can jeopardize your tax assets is yes. In the wake of the worst financial crisis in decades, many financial institutions are still looking for capital to satisfy regulatory demands and improve their balance sheets. But this new capital might come with a price – namely, loss of deferred tax assets due to Internal Revenue Code Section 382.

Section 382 in a Nutshell

In simple terms, Section 382 prevents corporations from trafficking in unused tax losses and credits. Take, for example, a hypothetical money-losing corporation that has been struggling for several years and has accumulated tax losses of $20 million, which at a 40 percent tax rate represent an $8 million tax benefit, or deferred tax asset. The money-losing corporation is nearly insolvent, with bleak prospects of generating future profit and, absent these tax benefits, almost zero value to a prospective buyer. Enter a hypothetical profitable corporation, which might be willing to pay $4 million for the stock of the money-losing corporation in order to use the $20 million of tax losses to offset its future taxable income and reap the $8 million benefit.

Not so fast, according to Section 382. While the $20 million in tax losses technically are available to the profitable corporation, Section 382 limits how much of those losses can be used in any one year to an amount equal to the value of the money-losing corporation immediately before the deal—let’s say that is $50,000—multiplied by a specific rate published monthly by the IRS, which currently stands at less than 3 percent. Based on these facts, the annual limit is only $1,500 ($50,000 x 3 percent). Because unused tax losses expire in 20 years (earlier in some states), at best $30,000 of the losses could be used ($1,500 annual limit x 20 years), providing a tax benefit of roughly $12,000 at a 40 percent rate. That is hardly worth a $4 million price tag.

In the previous example, we assumed a 100 percent turnover in ownership of the money-losing corporation. However, Section 382 applies any time there is a greater than 50 percentage point increase by major shareholders in their ownership of a money-losing corporation’s stock during, typically, a three-year period. Therefore, even a corporation raising capital from new or existing shareholders can run afoul of Section 382 and trigger substantial limitations on the use of its existing unused tax losses and credits, and even on the use of what is known as built-in losses.

Section 382 and Built-In Losses

Let’s take another simple example. A hypothetical bank raises capital via the issuance of new common stock and triggers a Section 382 ownership change. At the time of the ownership change, the bank has no unused tax losses or tax credits, but it has total assets with a fair market value of $200 million and a tax basis of $225 million. The tax basis in excess of fair market value, or $25 million, is a built-in loss. If the bank sells any of these assets during a five-year window (beginning from the date of the ownership change) and generates a loss from the sale, Section 382 may limit the deductibility of that loss. In addition, Section 382 also could limit the deduction of loan charge-offs claimed within a one-year period following the ownership change.

Planning for Section 382

What can be done to avoid the onerous results of a Section 382 ownership change? Planning is the key. Here are some ideas that might help avoid an ownership change altogether or mitigate its consequences:

  • Raise capital from both new and existing shareholders.
  • Execute a tax benefits preservation plan to guard against future stock acquisitions that might trigger an ownership change.
  • Issue stock for cash, versus converting existing debt to stock, due to specific Section 382 provisions on the deemed allocation of cash-issued shares to existing shareholders.
  • Dispose of certain assets in advance of an ownership change, or accelerate recognition of taxable income to potentially reduce losses subject to the Section 382 limitation.

If any of this seems confusing, that’s because it is. Section 382 is complex, but it must be considered in any capital-raising scenario where a corporation has unused tax losses, unused tax credits, or built-in losses. While it might not always be possible to structure a capital raise to avoid the limitations of Section 382, a methodical, well-thought-out strategy could preserve some or all of your tax assets.