Subordinated debt can be an attractive capital option for many banks. Will Brackett, managing director at Performance Trust Capital Partners, breaks down how bankers can think through their approach to using subordinated debt. He recommends that every financial institution take a hard look at its balance sheet and how it could perform under myriad interest rate scenarios. Those banks with strong track records, and little or no existing subordinated debt, are best positioned to fetch better than market pricing in an issuance.
Subordinated debt and preferred equity securities are making a comeback, with small community banks placing private offerings among high net worth investors and pooled investment vehicles alike with greater frequency and ease than in years past.
After years of worrying about whether community banks would survive the economic downturn, investors appear to be willing to tolerate the higher risks of subordinated debt, which falls behind senior debt but ahead of equity instruments in a bankruptcy. Major players like StoneCastle Financial and EJF Capital have established investment vehicles to acquire subordinated debt and other fixed-rate securities from community banks. These funds generally seek investments from $2 million to $15 million per institution, with rates from 6 percent to 8 percent and maturities of five, seven or 10 years.
For smaller community banks that have largely been frozen out of capital markets since the beginning of the Great Recession, the thaw presents a welcome opportunity because the benefits of such securities are significant for issuers. First, they do not dilute existing shareholders as occurs in any issuance of common stock. Second, for debt securities, interest payments are tax deductible, unlike dividends to holders of common or preferred shares. Finally, the proceeds of such securities, which may qualify as Tier 2 capital at the bank holding company level, are treated as Tier 1 capital when injected into a subsidiary bank if the company qualifies as a “small bank holding company.”
This shift in the market comes as more banks have the opportunity to use holding company debt to finance bank growth thanks to recent amendments to the Federal Reserve’s Small Bank Holding Company Policy Statement, which increase the policy’s consolidated assets threshold from $500 million to $1 billion and extend coverage to savings and loan holding companies.
As bankers consider whether these securities are the right way to boost their balance sheets, there are at least three major legal issues to consider before making an offering:
First, does the instrument qualify for capital treatment under Federal Reserve and Federal Deposit Insurance Corp. rules? For subordinated debt securities, there are a number of boxes that need to be checked to ensure an offering will qualify for Tier 2 capital treatment under Federal Reserve rules, such as subordination requirements, the elimination of common acceleration provisions, minimum maturity periods and the absence of other provisions designed to protect debtholders. Likewise, for preferred securities to qualify for favorable capital treatment, dividends must be noncumulative and redemption rights, if any, must be at the option of the issuer only. Federal Reserve regulations and policy statements generally require that redemption of these securities be conditioned upon receipt of prior Reserve Bank approvals.
Second, does the offering comply with federal and state securities laws? To qualify for an exemption under the securities laws, it is common to limit subdebt and preferred stock offerings to accredited investors only. However, even under those circumstances, it is important to provide full and fair disclosure to prospective investors to ensure that the offering is eligible for an exemption. As such, an offering memorandum should be prepared for the private offering that complies with applicable federal and state securities laws.
Finally, will the subdebt be sold to individuals or to a pooled investment vehicle? The aggregation of community banks’ subdebt into pools that will be sold to institutional buyers bears a striking resemblance to the pools of trust-preferred securities that proved so challenging to deal with during the last financial crisis. If your company’s subdebt will be issued to a pool, it is important to understand the legal mechanisms that will be available and with whom you will be dealing if there is an event that causes a payment to be missed.
Many community banks are seizing the moment, using such offerings to refinance debt, finance growth, redeem the Small Bank Lending Fund or trust-preferred securities, and pursue acquisitions in a way that is not dilutive to holders of common stock.
That said, subdebt or preferred stock may not be the best option available for all banks, particularly those with minimal holding company senior debt. For those that have not exhausted options to obtain bank stock loans, that market also has thawed and offers rates that are often 100 to 200 basis points less than coupons payable on subordinated debt or preferred equity.